Macro and Credit - The Zimmermann Telegram

"No matter what political reasons are given for war, the underlying reason is always economic." - A. J. P. Taylor, British historian

Looking at the evolution of the trade war rhetoric in conjunction with cold war 2.0 heating up following the events in London as of late, as well as the weakness in risky asset prices and issues surrounding FANG stocks darling Facebook, when it came to selecting our title analogy we reacquainted ourselves with the "Zimmerman Telegram". The Zimmermann Telegram was a secret diplomatic communication issued from the German Foreign Office in January 1917 that proposed a military alliance between Germany and Mexico in the prior event of the United States entering World War I against Germany. Mexico would recover Texas, Arizona, and New Mexico. The proposal was intercepted and decoded by British intelligence. Revelation of the contents enraged American public opinion, especially after the German Foreign Secretary Arthur Zimmermann publicly admitted the telegram was genuine on March 3rd 1917, and helped generate support for the United States declaration of war on Germany in April 1917. The decryption was described as the most significant intelligence triumph for Britain during World War I, and one of the earliest occasions on which a piece of signals intelligence influenced world events. One could indeed make a parallel and wonder if the latest disclosure on privacy issues relating to Facebook will not mark a turning point for the strong winners (FANG stocks) of the rally seen in recent years in equities.

In this week's conversation, we would like to look at the US dollar funding pressure which has been highlighted by many pundits particularly given that the Libor-OIS spread, has more than doubled since the end of January to 55 basis points, a level unseen since 2009 reflecting an increasing scarcity of dollar funding it seems with large implications as per the below Bloomberg charts as well as US corporate leverage:

- source Bloomberg

Synopsis:

• Macro and Credit - Libor and leverage, my dear Watson...
• Final charts - Dispersion matters 

• Macro and Credit - Libor and leverage, my dear Watson...

No doubt the returns on everything beta including the Russell 2000 since Trump's election in the US has been stellar but, we are seeing it seems a change in the narrative since early 2018 with the continuous hiking pattern of the Fed, making markets more prone to heightened volatility and questioning the continuation of the "goldilocks environment" which had prevailed so far in credit markets. One most sensitive candidate we think for a "short" bias when the markets will eventually turn in the footsteps of the Fed's hiking course that will in the end "break something" is the Russell 2000 small cap index we think. Given that more than 40 percent of debt issued by Russell 2000 companies is floating, they are therefore susceptible to the rise in the benchmark rate namely our old friend Libor. While the CFOs of some of these firms have made good use of derivatives to effectively swap from floating-rate into fixed obligations, these companies are still more interest-rate sensitive than their larger counterparts that have embarked on a bond-issuance frenzy in recent years particularly so with a significant amount of leverage. At the end of 2017 around 34% of the Russell 2000 was made up of loss-making companies with an average LT debt to Capital of around 35% versus 29% in 2007. In our book higher leverage and rising Libor even if some smart CFOs have swapped some exposure from floating to fixed doesn't look too promising when the market will finally turn to a bearish stance (we are not quite there yet).

On the pressing subject of Libor and OIS rates, we read with interest UBS Global Macro Strategy note from the 2nd of March entitled "USD Funding Pressures: Myth and Reality:

"Here's what's happening

Some investors are worried about the rising gap between LIBOR and OIS rates (Figure 1) as being indicative of a nascent funding problem.

At the root of this widening is an increase in T-bill rates; as Fed funds and T-bill yields rise, so does the cost of unsecured LIBOR funding. The gap between T-bills and LIBOR rates, the Ted spread, has not changed much. Bill rates have been rising particularly sharply since early February, as Congress agreed on further fiscal spending (we estimate net bill issuance in '18 at $475bn vs $200bn in '17). Supply is in play here, not credit issues. The gap between LIBOR and Fed funds rate is hardly out of line with previous hiking cycles (Figure 2).

Will this widening between LIBOR and OIS persist?

If we're right about T-bills being the real driver of this move, then LIBOR-OIS should not widen much more. The spread between T-bills and OIS is now positive (Figure 3), and this has typically been a limit in the widening.

Note that when funding stresses have risen in the past because of credit reasons, the T-bill to OIS spread has gone the other way. What we're witnessing today is higher rates, not a clogging of financial plumbing. 

Distinguish between the price of funding and access to funding

It is undeniable that higher US rates will have an impact on the 'price' of funding, perhaps globally, and that this will have consequences. But 'access' to funding is a completely different story. We see few signs of this having been compromised thus far. 

Neither credit nor currency markets suggest funding is becoming a problem

As we have argued, the underbelly of the risk trade – the weakest rating buckets in the US HY – are actually outperforming on a beta-adjusted basis. Spreads are remarkably stable in the context of higher front end rates and equity volatility (Figure 4).

Issuance and demand for paper have not been a problem. In currency markets, basis swaps (Figure 5) (difference between local currency and $ funding), risk reversals (the price of a $ call vs a $ put), and volatility are showing no signs of stress.

So, is there nothing to see here? Does the cost of funding not matter at all?

It does. But instead of LIBOR–OIS widening, which is likely a red herring, we need to focus on the right channels to assess changes in market trends. First, watch the hit from yields to floating rate HY credit. We estimate floating rate loans at $2.2tn, of which $1.1tn of loans ($690bn of leveraged loans, $459bn of bank C&I loans) have been extended to issuers rated below BB-. Our recent analysis shows leveraged loan issuers fundamentally will remain resilient to the next 75-100bp increase in Fed Funds rates, but further rises could elevate funding vulnerabilities. Second, watch US growth surprises relative to those in the rest of the world. Widening front end rate differentials will become more meaningful for currency trends if mirrored in growth differentials. We would pay particular attention to China, where data has been mixed to weak. The EM currency complex, thus far calm, may begin to weaken if growth here softens in backdrop of higher US rates (Figure 6).

Third, and most importantly, we would watch term premium in the US. Markets have been worried about the impact of higher rates, but thus far US rates volatility itself hasn’t risen meaningfully, and shouldn't do so unless term premium rises sharply (Figure 7). We have argued against a big shift here.

Where does this leave us?

We are positioned defensively on US HY credit, and are looking for modest trade weighted weakness in EM currencies (Figure 8).

However, we think back-end rates are likely more range-bound here and, based on the facts today, are not inclined to take a negative view on US stocks. We would be watching the three channels above to reassess our view." - source UBS

Obviously when it comes to the LIBOR-OIS widening more, UBS hasn't got it entirely right given, it Libor has been rising for 31 days in row so far. Is it a case of "reflexivity"? We wonder. One thing for certain, we have noticed since the beginning of the year a weaker tone in fund flows, particularly in US High Yield, which, we think could be indicative of the start of the end of the "Goldilocks environment" in credit markets which had still been prevailing in 2017 in the beta part of the market, with the CCC rating bucket posting some strong returns (Russell 2000 as well...).

While recently we have touched on the "hidden" leverage in the US consumer in our conversation "Intermezzo", if Libor is indeed a growing concern for some credit market and sell-side pundits then obviously one need to take into account "leverage". As per the explosion of the yield pig's short vol straw house in February akin to the equity tranche in the capital structure of our complex markets, identifying the leveraged players is essential as the credit cycle shows clear signs of fatigue and the start of tightening thanks to the hiking path of the Fed (and QT). On that particular question about leverage we read with interest UBS Global Credit Strategy note from the 19th of March entitled "Is US corporate leverage higher than reported?" and below is the summary before we go into their detailed note:

"Key questions

The state of US corporate balance sheets and the outlook is one of the key debates for fixed income investors. The consensus is, while we are in the later stages of the US credit cycle, a recession is not on the horizon. We agree. But we believe identifying those pockets within credit markets where credit and leverage growth has been excessive is crucial to capturing a potential inflection point in the credit cycle early and to calibrating the extent of the fallout.

Where are US corporate credit market excesses? A focus on loans

Our view is there are three corporate credit market imbalances in this cycle. First, the rise in lower-rated, longer dated investment grade debt1; second, a 100% increase in the number of triple C rated issuers to over 1,400, many of which have floating-rate liabilities; and third, excessive debt growth in the technology, electronics and pharmaceutical sectors. Our focus here is on US leveraged loans (LL), where $1.1tn in lower rated, spec grade loans is more vulnerable to our house view for 7 Fed hikes and a material flatting in the US yield curve through '19.

Leverage is high. After normalizing for addbacks, it is even higher.

US leveraged loan gross issuance hit $500bn in 2017, with 60% used for M&A, LBOs or recapitalizations. Total leverage on new deals is 5x, and near 5x since 2014, while 1st lien leverage is 3.9x, the highest in two decades. But are these figures understated? EBITDA add-backs are rampant and material, averaging 20-21% for M&A related deals in 2017 and 26% for large sponsor deals YTD (largest in the tech, metals and food sectors). The jury is still out on add-back realization rates, but a conservative view would push average total/ 1st lien leverage to 6.2x and 5x, respectively, on M&A deals.

What are the early warning signals and current prognosis?

Corporate leverage is therefore a structural risk. But are we at an inflection point in the credit cycle? Leveraged loans (1.35%) have outperformed high yield bonds (-0.52%) YTD even as LL default rates have risen moderately to 2.2% (from 1.4% in Q3 '17). First, we have created a proprietary non-bank LL liquidity indicator to assess if lenders are beginning to ration loan supply. This metric led spread widening in '15 and '07, but currently the indicator is at -2%, indicative of slight easing and a stable backdrop. Second, the key demand source for LL is collateralized debt obligations (CLOs), and portfolio concentrations are highest in technology (13-15%), healthcare (11-12%) and cable/media (8-9%). Our recent flows analysis suggests rising USD hedging costs and duration concerns are driving more foreign investors into loans. And while total returns in the above sectors are lagging the LL index, they remain in positive territory.

How to position credit portfolios?

Overall bank and non-bank lending standards are not showing signs of tightening credit, our credit-based recession gauge is at a modest 13% through Q3 '18 and broad US credit valuations are moderately overvalued. With the house view calling for materially higher short rates but a modest rise in long end yields and USD depreciation, we favour EM over DM corporate credit and US leveraged loans over US high yield. Our HY spread target remains 380bp vs 341bp current. We maintain the view that corporate credit markets can absorb the next several rate hikes, but spread tightening is over and investors should be more cautious as the hiking cycle matures. And we remain structurally underweight healthcare and tech across credit portfolios for 2018." - source UBS

We do agree with the above, namely that we would favor EM over DM in corporate credit. The recent outperformance of local-currency emerging-markets credit has been impressive, with the debt returning 2.4% so far this year while U.S. IG credit has lost 2.5%. If indeed the weaker tone in the US dollar continues its course, then again having exposure to Emerging Markets Local Currency debt is still an enticing proposal, even in the light of recent outperformance of the asset class. Regardless of some Zimmermann Telegram and Cold War 2.0 narrative, Russian debt continues to be appealing we think, and much more appealing than dangerously overpriced European Government bonds which in fact, like the German bund as of late, are barely trading in similar fashion to what happened with Japanese Government Bonds market (which in effect has ceased to trade). Getting Japanese? We really think so: Private investors hold only 10% of German government bonds. It’s impressive that this market functions at all.

- source IMF and ECB

But moving back to our US leverage story, UBS looks into details about the state of the US corporate leverage:

"Is US corporate leverage higher than reported?

The health of corporate balance sheets, particularly speculative grade and private firms, was one of the key thematic debates during our client visits in London. We break down the genesis of the questions into three sub-themes: first, within the US corporate credit markets where are the excesses? Second, how concerned are you about levels of leverage, and to what extent are earnings add-backs hiding risks? And third, what early warning signals are you monitoring and what is the current outlook?

Where are corporate credit market excesses?

We have previously outlined three corporate credit market imbalances that bear close tracking, with the latter two in focus in this piece3. First, in high grade the rise in lower-rated, longer dated issuance with the ratio of BBB/BB 10yr+ debt rising from 4.8x to 13.3x. Second, in speculative grade a doubling in the number of triple C rated issuers to over 1,400 (US corporate debt: revisiting financial stability concerns). A majority of these issuers have funding in the US leveraged loan market, issuing secured loans to boost issue level ratings; B-rated loans outstanding have risen from $195bn to $467bn since 2012 (Figure 1).

And third, above average debt growth in the technology, electronics and pharmaceutical sectors; for US leveraged loans specifically this thesis is evident in the growth of the broad manufacturing and sectors which have grown from $117 to $295bn and $256 to $448bn, respectively, since 2012 (Figure 2).

By sub-industry growth, manufacturing has been primarily electronics ($124bn from $52bn). In services, business services ($98bn from $77bn) and lodging/ leisure ($87bn vs. $52bn) have led the increase.

More recently, we have discussed lower rated firms as structurally more vulnerable to rising interest rates with near-peak leverage and relatively low interest coverage (Lesson Learned: The Underbelly of US Tightening). And we argued that $1.1trn of lower rated, spec grade loans were the fulcrum – i.e., more vulnerable to our house interest rate outlook characterized by aggressive Fed rate hikes (7 through '19) but significant yield curve flattening (with 5yr Treasuries projected to remain below 3% through '19). Our analysis suggested these issuers would be resilient to 3-4 Fed rate hikes, but 4 more would lower coverage ratios near pre-crisis ('06) levels (A deeper dive into US credit markets more vulnerable to aggressive Fed hikes).

How concerning are leverage levels, and are earnings add-backs hiding risks

US leveraged loan gross issuance hit a record of approximately $500bn in 2017, with about 60% of use of proceeds for leveraged buyouts (LBOs), M&A/acquisition or recapitalizations (Figure 3).

While the theme of LBOs is less prevalent this cycle vs the prior, M&A has been a more persistent theme – primarily between private/sponsor firms. The market has been a sellers/borrowers market in recent months, in part driven by duration concerns which are fueling inflows into floating rate products (The Technical Pulse: Where will yield-hungry investors next leave their global footprint?), the perceived safety of secured debt and financial deregulation (with bank adherence to the 2013 Leveraged Lending Guidance fading). While median total leverage metrics have declined from peak levels of 5x to 4.5x post-crisis, they are still above the 4.25-4.5x pre-crisis. In addition, the negative tail remains fatter as the proportion of issuers with leverage above 6x is 29% (vs a post-crisis high of 35%, and 19% pre-crisis).

To reiterate, these figures represent the median leverage for public leveraged loan issuers outstanding (i.e., leverage on the stock of public issuer loans). But 65% of the lev loans are actually from private firms. While we do not have median leverage data on the stock of private issuer loans outstanding, credit metrics are available on all new deals – public and private (i.e., the flow). This data shows average total leverage for all deals at 5x, with private leverage running at 5.2x (c1x higher than on new public deals). Total leverage on new private deals has been running above 5x on average since early 2014; in the last cycle, average leverage above 5x was seen from Mar '07 to Mar '08 (Figure 4).

Across the capital  structure, however, leverage through the 1st lien for all new deals is at 3.9x, and has been running higher than prior peaks since 2013 – one key reason why lev loan investors have heightened recovery rate concerns in this cycle (Figure 5).

But what if leverage (and coverage) figures are wrong? The issue of earnings adjustments (or engineering) has consistently reared its ugly head in our client discussions for several years, and it is certainly not confined to US leveraged loans – but the rhetoric from leveraged finance/distressed credit investors has grown stronger. Market participants suggest nearly every acquisition-related deal now has its share of EBITDA add-backs, and a number of long term investors have suggested this cycle is unlike any others they have witnessed. Figure 6 depicts our best estimate of the average EBITDA add-back (expressed as a turn of total leverage) for M&A deals over time.

We would posit that the phenomenon of EBITDA add-backs is partly an unintended consequence of macroprudential regulation. The 2013 Leveraged Lending Guidelines (not enforced until late 20147) capped pro forma leverage at 6x (and required 50% debt amortization within 5-7 years8), incentivizing issuers to manage pro forma EBITDA such that leverage would remain below the 6x threshold. Rising add-backs are likely also a byproduct of low interest rates and QE, which have pushed up asset valuations and M&A deal multiples and contributed to reach-for-yield behaviour and material easing in lending standards.

Aggregate data on the magnitude of EBITDA add-backs is not easily sourced. For this we have leveraged the work of Covenant Review, and more specifically data from their CR Trendlines Topical Reports. Their work suggests that EBITDA addbacks for M&A - related deals across sponsor/ non-sponsor deals in 2017 were approximately 20-21% of Pro Forma Adjusted EBITDA. In 2017, the tendency seemed to be greater add-backs appeared first among large sponsor deals, and then spread across mid-sized and non-sponsored loans. And in 2018 this seems to be taking shape again, as EBITDA add-backs for M&A-related deals for large sponsors are averaging 26% of Pro Forma Adjusted EBITDA – suggesting another "high water mark" for EBITDA add-backs is attempting to take shape now (as addbacks for mid-sized sponsored/ non-sponsored loans remain at 20 – 21%).

Finally, in terms of sector outliers, the magnitude of EBITDA add-backs is more aggressive in electronics, software, metals/mining and food/food services (ranging from 24 – 29%). Are the add-backs being realized? The verdict is still out. First, it is difficult to monitor the aggregate credit fundamentals for the stock of private loans post-deal. Second, the credit agreement and covenants typically allow borrowers 24 months or more to realize a majority of the add-backs, in part a function of the significant easing in lending standards post-crisis (consistent with the shift from covenant to covenant-lite loans, 75% in '17 vs. 29% in '07; Figure 7).

For illustrative purposes, if one assumes a liberal view that all add-backs are realized then leverage levels are unchanged; however, if one takes a conservative view and excludes add-backs, total and 1st lien new deal leverage would increase to 5.0x and 6.2x, respectively, on average from 3.9x and 4.9x, respectively (Figure 8).

What early warning signals are you monitoring and what is the prognosis?

At this point, we don't see an inflection in the credit cycle. First, leveraged loans (1.35%) have outperformed high yield bonds (-0.52%) year-to-date amid higher rate and equity volatility, and LL spreads remain firm at 368bp (4yr discounted spread) even as LL default rates tick up moderately to 2.2% from a low of 1.4% in August (Figure 9).

Second, we have also created a proprietary non-bank LL liquidity indicator, following the methodology of our non-bank liquidity indicator (Credit Cycle Turning? Non-bank Liquidity Hits Multi-Year Lows), which calibrates changes in net loan issuance for low quality credits to determine if lenders are starting to ration their existing liquidity to higher quality borrowers. Historically, this proxy proved to be a warning signal in Q3 2007 and Q4 2014 when net tightening in lending standards reached +5 to 10% while spreads were still relatively tight (Figure 10).

Currently the indicator is at -2%, indicative of net easing and a constructive backdrop in the LL primary market.

Third, in terms of market structure and sector risks, the key demand source in terms of flow and stock of LL is collateralized debt obligations (CLOs, Figure 11).

And CLO portfolio exposures can be quite diverse, suggesting investors should pay attention to concentration risks. In this respect, we are focused on the outlook for technology (13-15% average exposure in CLOs), mainly software given robust debt growth, M&A activity and EBITDA add-backs and, secondarily, the healthcare (11-12%) and cable/media (8-9%) industries10. YTD total returns in these sectors are lagging the overall index modestly (electronics 0.90%, healthcare 1.12%, cable television 0.86%), but remain positive overall. 

Lastly and more broadly, bank and non-bank lending standards are not showing signs of tightening credit, our proprietary credit-based recession gauge is a modest 13% through Q3 '18, and broader US credit valuations look 0.8 standard deviations rich (vs. 2 standard deviations back in Q2 '07; Where are we in the credit cycle?)." - source UBS

One thing for certain is that the M&A wave we foresaw for 2018 has been staggering and as a late cycle red flag it is as clear as you can get with global deal making this year crossing the $1tn mark on Tuesday, the fastest it has ever reached that level, as a wave of consolidation spreads across the US and activity in the UK, China, Germany and Japan accelerates. You don't need no Zimmermann Telegram to tell you this but it certainly feels like late 2007 all over again and even early 2008 one could posit given we are seeing the return of Mega M&A deals as indicated by Wells Fargo in their Credit Spotlight note from the 15th of March entitled "Mega Deals Strike Back":

"Animal spirits continue to swirl in corporate boardrooms as evidenced by the recently announced Cigna/Express Scripts and Comcast/Sky proposed acquisitions. Industry consolidation is clearly en vogue across a range of sectors, and with debt markets willing to finance mega debt cap-structures, it seems unlikely to stop anytime soon. As a result, despite a healthy economic backdrop, credit investors need to tread cautiously as they navigate an upsurge of idiosyncratic risk, and for index oriented investors, what you don’t own could be just as important as what you do when it comes to performance.

We expect a record amount of M&A in 2018. This should result in another year of record bond issuance in the IG market.

M&A Update – Continue to Expect a Record Year

Mega Cap M&A continues to be a key driver of U.S. credit markets, both as a driver of leverage and a driver of bond issuance. We continue to expect M&A in 2018 to move to a new all-time high and lead to increased bond issuance in the IG market. There has been more than $387 billion of M&A announced so far in 2018, on pace to be the largest first quarter of M&A announcements on record. In fact, M&A is currently on pace to reach $1.8 trillion, breaking the previous record of $1.7 trillion from 2015.

We expect M&A to be the main driver of increased bond issuance in 2018 as we expect M&A-related funding to rise from $175 billion to $250 billion, accounting for substantially all of our increase in net supply for the year. We expect the Consumer Non-Cyclical sector to be the primary driver as M&A heats up in each of the Health Care, Pharmaceutical, Food & Beverage and Consumer Products subsectors. The rising M&A and issuance need are the key drivers of our Underweight recommendation on the sector.

The mega deals have really been the driver of increased M&A over the past few years. In each of 2016 and 2018 over 20% of the total M&A volume has come from deals over $40 billion. In addition, with the exception of 2017 over 40% of the M&A volume has come from deals in excess of $10 billion.

The increase in the propensity of these larger deals also has increased the funding need in the IG bond market and has led to a significant increase in the size of the average capital structure within the market. These large cap structures are now nearly on par with the mega banks in terms of index weightings." - source Wells Fargo.

The return of large M&A mega deals is clearly as stated a late cycle behavior we think akin to what we saw in 2007. If indeed the credit amplifier is still going to 11 in true spinal tap fashion, then again a flattening US yield curve and the rise in the front end, will make Investment Grade credit less and less alluring we think from a pure allocation perspective in the current environment. No doubt overall the liquidity picture is changing and you should take notice and start to be more defensive in regards to "cyclicals" at least, even if the FOMC shows greater "optimism" on the economic cycle.


In November in both our conversations "Stress concentration" and "The Roots of Coincidence" we argued that we were starting to see cracks in the credit narrative thanks to rising dispersion at the issuer level as well as growing negative basis credit index wise. We added that rising dispersion meant better alpha generation from pure active credit players, particularly in the light of rising M&A activity in 2018 and the need to reach for your LBO screener to avoid potential sucker punches in the form of sudden credit spreads blowing out in your face. As we pointed out in our previous conversations, dispersion is indicative of the lateness in the credit cycle and the beta game, and it means, as we posited that active managers should outperform in 2018. In our final point below, we would like to look again at dispersion given rising dispersion in our book amounts to credit deterioration.

• Final charts - Dispersion matters 

Normally, higher dispersion should drive eventually spreads wider. Since 2013, balance sheet leverage has been widening, therefore on top of Libor woes building up, investors should be wise in tracking leverage ratios in 2018. One of our final charts comes from Barclays note from the 16th of March 2018 entitled "Lessons in Leverage" and displays the history of the US High Yield Index spread versus the dispersion of net leverage at the single name level (ex-financials):

"Figure 5 overlays the history of the US High Yield Index spread versus the dispersion of net leverage at the single name level (ex-financials), with dispersion measured as the difference in turns of net leverage between the 80th and 20th percentiles of high yield credits at any point in time. While there are many drivers of spreads, we could expect at least a reasonable relationship between the dispersion of leverage and the overall market spread - namely , high and increasing dispersion likely coincides with periods of credit deterioration derived from macro challenges, and vice versa. Note that the dispersion of leverage remains reasonably far above the 2014 lows (given the drivers and observations noted above), while the high yield market spread is less dislocated. That may suggest that any credit improvement that might occur in 2018 (particularly for lower-quality segments) has already largely been factored in and that a further tightening of credit risk premia would have to be sourced from other drivers besides fundamentals" - source Barclays

This trend of rising dispersion can also be seen in the synthetic derivatives part in the US credit market namely in the CDX HY index where dispersion is also on the rise as indicated by CITI in their Global Credit Strategy Focus note from the 15th of March entitled "What is happening with CDX IG volatility?":

"There are several reasons why CDX HY may not be a good tail risk hedge at the moment. First, the default environment is expected to remain benign going forward. In addition to the decline in HY defaults over the past year, Moody’s is expecting the HY default rate to fall even further over the next year. Second, two other metrics of HY cash portfolios also provide reasons for optimism.
The maturity distribution for the Bloomberg Barclays cash HY index indicates that less than 5% of the entire portfolio by notional will mature over the next 2 years, out of which less than 1% is expected to mature in the next year. In other words, even if rates were to rise, the total amount of HY debt coming up for refinancing is quite small. there is a fairly limited overlap between CDX HY constituents and the Bloomberg Barclays cash HY index. We find only 35% of the total notional in the cash index corresponds to the names in the CDX HY index (see Figure 4 (left)). Given that a significant component of tail risk in HY is a pick-up in defaults, using CDX HY as a hedge against cash HY portfolios would leave a large portion of the average cash HY portfolio exposed.
All of these reasons have contributed to investors currently staying away from using CDX HY payers as a tail risk hedge. Instead, what we are observing at the moment in HY hedging is investor activity targeted at individual names, which has also caused dispersion to rise in the CDX HY portfolio (see Figure 4 (right)).

In contrast to CDX HY which is more sensitive to (idiosyncratic) default risk, CDX IG is more sensitive to macro risks. One of the major tail risks on investors’ radar is rising inflation. As investors digest the effects of the newly instituted tariffs on aluminum and steel, the rising risk from potential trade war scenarios and the overall wealth effects from tax cuts, we are seeing inflation tick higher, as evidenced by the rise in 5y inflation breakevens.

Our analysis of data during a past rising rate environment (1963-1981) has shown that higher inflation can potentially drive credit spreads wider (see Figure 5 right), and here) for a more detailed discussion. Such dynamics would make CDX IG spreads an appropriate choice for inflation-driven tail risk for credit investors.

At the current time, markets are pricing in roughly 3 (25bp) rate hikes over the next year, which is also the base case projection from Citi economists (see here). However, a 4th rate hike has not been completely ruled out, and if it were to materialize, we could see another sell-off in credit spreads, especially concentrated in IG since IG credit is more sensitive to duration risk." - source CITI

Rising credit dispersion, rising inflation and a potential trade war means that no matter how you look at your Zimmermann Telegram from the credit markets, the Goldilocks narrative which has been prevailing for so long look to us increasingly at risk in 2018.

"Like most of those who study history, he (Napoleon III) learned from the mistakes of the past how to make new ones." -  A. J. P. Taylor, British historian

Stay tuned ! 

Markets update - Credit - A Tale of Two Central Banks

"It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us, we were all going direct to Heaven, we were all going direct the other way – in short, the period was so far like the present period, that some of its noisiest authorities insisted on its being received, for good or for evil, in the superlative degree of comparison only."
A Tale of Two Cities (1859), historical novel by Charles Dickens, opening paragraph of the novel.

“The European Central Bank has a different task from that of the US Fed or the Bank of England”
Chancellor Angela Merkel.

This week analogy with Charles Dickens' masterpiece, relates to the different stance currently being taken in Europe in relation to what the ECB's role should be in the ongoing Europe sovereign debt crisis. Given recent macroeconomic set of data, for both the US and Europe, indeed we can say we have a Tale of Two Central banks.
European PMI pointing towards recession:

But I wander again...

Last week, no sooner we had posted a credit update relating to the deterioration of liquidity in the financial system on the 30th of November, that we encountered the mighty coordinated intervention of 5 central banks to unfreeze somewhat a financial system, which is in dire need of dollar support. Well, we already knew from one of our very first credit discussion that liquidity issues always trigger a financial crisis: "It's the liquidity stupid...and why it matters again..." which was in August. We discussed at the time:
"Why liquidity matters again? Because bank funding is a key source for bank earnings, ability to lend, therefore a drag on the economic recovery if it doesn't happen smoothly."

We also noted the following:

"Lack of funding means that bank will have no choice but to shrink their loan books. If it happens, you will have another credit crunch in weaker European economies, meaning a huge drag on their economic recovery and therefore major challenges for our already struggling politicians."

But before we engage in another long credit conversation, revisiting the recent central bank intervention and discussing as well yet another tender, this time around by Lloyds in the UK and the implications, it is time for a quick credit overview.

The Credit Indices Itraxx overview - Source Bloomberg:

The Itraxx SOVx Western Europe index (15 European Western Europe Sovereign CDS) fell towards 328 bps, following the relief rally triggered by the joint intervention of the central banks.
The Itraxx Financial Senior 5 year index (CDS linked to senior bonds of 25 European banks and insurers) dropped as well below 300 bps to around 285 bps (weekly drop of 72 bps).

My good credit friend commented on the recent price action:

"While the equity market wants to believe in Santa Claus, the credit market does not. I know that credit market participants are often perceived as “negative”. No one seems to remember how positive they have been from 2004 until 2007. Nevertheless, the point is that credit market is the key to the future as the equity market will not perform over time if credit growth does not resume."

The current European bond picture, an impressive relief rally - source Bloomberg:

A significant tightening move as well between the spread of German 10 year government bonds and French 10 year government - source Bloomberg:

German 10 year government yield falling in lockstep with German 5 year sovereign CDS, following the intervention of the central banks - source Bloomberg:

Even our CPDO/EFSF benefited from the fall in European bond yields and fell in conjunction with French OAT 10 year government yields - source Bloomberg:

The somewhat "improved" liquidity picture in four charts. ECB Overnight Facility, Euro 3 months Libor OIS spread, Itraxx Financial Senior 5 year index, Euro-USD basis swaps level - source Bloomberg:

In relation to the acute liquidity issues we have been following, The Economist in their latest publication commented about the intervention of the central banks to ensure a flow of dollars into the system:
"While America has largely escaped spillover from Europe's banking squeeze so far, the shortage of dollars in Europe remains a problem. To relieve that pressure, the Fed lends dollars to the European Central Bank via a "swap" line, which the ECB then lends to its banks, for up to three months. Demand, so far, has been low, because of the stigma for any bank that uses the system, and the cost: 100 basis points more than a benchmark overnight rate.
On November 30th the Fed, ECB and other central banks sought to rectify this by lowering the spread to 50 basis points. Stock markets soared but the euphoria may not last: illiquidity is a symptom of Europe's crisis, not the cause. As long as sovereigns are at risk of insolvency, their banks are, too. If the euro collapses, the resulting chaos will not spare America's economy, despite the health of its banks".

We have discussed at length the issues relating to the oncoming wall of issuance for 2012 for both banks and sovereigns and the issue of circularity, leading to high correlation between both Sovereign credit risk and European banks credit risk.

My good credit friend commented:
"Pro-cyclical austerity budgets will affect a wide range of sectors, and when added to the European banks deleveraging, will have far reaching consequences all over the Globe. Non-financial corporations will not be immune from the slowdown and we should see credit metrics deteriorate further.
The market may breathe better, but health is far from being back. Psychology is key for a recovery, but how will investors react when they will realize that the road to recovery may take years. While US equities are priced for perfection, the risk is for more disappointment."

It brings us back to our "Tale of Two Central Banks" and the European political situation. Germany favors legally binding rules with a possibility to settle cases of fiscal mis-behaving before the European Court of Justice, at the same time President Sarkozy in his latest speech, is ready to crater to German demands of surrendering economic and fiscal sovereignty in exchange for more ECB involvement in helping out on the ongoing European debt crisis. Mario Draghi has also reacted positively to the ongoing French and German conversations: Europe needs a "fundamental restatement of [its] fiscal rules, together with the mutual commitments that euro area governments have made", before the ECB steps in.

We are all awaiting to see the outcome of the paramount meeting of the 9th of December. The most recent interesting proposal in relation to resolving the ongoing European debt crisis has been made by German Finance minister Wolfgang Schauble and the possibility of setting up "redemption funds", in effect pooling sovereign debts exceeding 60% of national GDPs, which would be supported by specific tax provisions and would remain in place for 20 years until all excess debt is finally reimbursed. This proposal was first made by the German Council of Economic Experts.

Credit Agricole Cheuvreux Nicolas Doisy, in his latest Microscope issue published on the 2nd of December entitled - Quantitative Easing euroZone (QE-Z): surviving Near-Death Experience had to say the following in relation to the ECB much needed support:

"Only the ECB has pockets deep enough to ring fence Eurozone sovereigns from market attacks, since Germany is still firmly opposing (i) Eurobonds now and (ii) making the ECB a lender of last resort. Thus, one of the few options for the Eurozone to survive its near-death experience is a QE-Z, i.e. a larger use of the Eurosystem's balance sheet.
Given the risk of governments free-riding such help, Germany is sensibly pushing for a strong safeguard in the form of very strict fiscal discipline through a rapid and limited change to the Treaty. This would limit such a QE-Z to legacy debts on top of the safeguards introduced on 21 July, whereby the EFSF is to conduct government bond purchases at the ECB's initiative and carry the risk.
This would give the ECB full control over its nonconventional
policy within its current mandate, i.e. provide liquidity at longer maturities (2-3 years)and fine-tune it with government bond purchases. This would also maintain sufficient leverage for an efficient use of the carrot & stick approach retained so far to force fiscal and structural reforms. A political accord on tight fiscal discipline at the European Council of 9 December should suffice."

There was as well an interesting rumor about the ECB channeling funds via the IMF which is worth commenting as related by Bloomberg James Neuger on the 2nd of December - Euro Central Banks Seen Providing Up to $270 Billion Through IMF:
"A European proposal to channel central bank loans through the International Monetary Fund may deliver as much as 200 billion euros ($270 billion) to fight the debt crisis, two people familiar with the negotiations said.
At a Nov. 29 meeting attended by European Central Bank President Mario Draghi, euro-area finance ministers gave the go-ahead for work on the plan, said the people, who declined to be named because the talks are at an early stage."

Credit Agricole Cheuvreux Nicolas Doisy commented on the above in his latest article previously mentioned:
"At the same time, informative (and very likely organised) "leaks" let it be known that something involving the ECB to a larger extent was being considered. One such leak was made public by Reuters which quoted un-named Eurozone officials about a "do-able idea": the ECB would lend to the IMF, "to provide the fund with sufficient resources for bailing out even the biggest euro zone sovereigns". Although neither endorsed nor denied by anyone, this "leak" was surely meant to acknowledge the receipt of the markets' demand for larger ECB involvement.
Indeed, it could not be about the IMF, since it would be strange to see the fund put in the very political position of a Eurozone Treasury just when the role of the EFSF was being discussed. The message was rather about securing the ECB’s independence."

We would have to agree with the above analysis. Like any good cognitive behavioral therapist, we tend to watch the process of how and why the message is delivered, rather than focus solely on the content of the message.

Truth is the German's fearful position relating to the ECB is consequent to the rise in ELA (Emergency Liquidity Assistance) in peripheral countries.

And, as Nicolas Doisy interestingly points out:

"The Eurozone's national central banks could go "rogue" and threaten to disorderly run their own quantitative easing."

He also added:

"One major risk arising from a free use of ELA by NCBs (National Central Banks) is a string of disorderly national quantitative easing on the back of free-riding by national governments. Ireland is a living illustration of such a strategy: up until October 2010, the Irish central bank has used ELA generously to keep its banks afloat. It has thus accumulated large amounts of bad assets in return for the commensurate amounts of cash to banks."

As we indicated in August in our post "It's the liquidity stupid...and why it matters again..."

"Conclusion for the banks in the peripheral countries:
The ECB is currently the ONLY SOURCE of wholesale funding for these smaller banks and have therefore prevented aggressive deleveraging to happen and liquidations."

In terms of liquidity issues, there is always what you see, and what you don't see and as Credit-Agricole Cheuvreux Nicolas Doisy puts it nicely in his latest report:

"Indeed, NCBs hold a wild card, as they can provide large Emergency Liquidity Assistance (ELA) at their own initiative and without the ECB's prior consent to their domestic banks. As the name indicates, such ELA is meant to be provided to illiquid but solvent credit institutions shut out of capital markets by exceptional events. Strangely, the NCBs' only legal obligation is to keep the ECB informed."

The Irish stealth QE...ELA as percentage of GDP.

"A year ago, Ireland's ELA operations were revealed suddenly and forcefully by the ECB due to the risk of continued monetary financing of the government. Indeed, the central bank of Ireland was sparing banks the need to restructure by providing them with cheap liquidity. It was thus also indirectly subsidising the Irish government by relieving it from the need to put expensive equity in its banks.
A two-third majority at the ECB's Governing Council would be needed to put an end to such (potentially very large) ELA operations by other NCBs in the future. With much more than one country concerned, such a game of chicken could well turn quickly into a nightmare. Indeed, such a vote would be politically very delicate to hold (the majority threshold is high) and thus likely to trigger panic in the market.
Hence, with contagion spreading to the Eurozone core, a very sensible fear on Germany's side is that monetary financing of fiscal deficit turns widespread. This would jeopardise two pillars of the European Monetary Union: (i) fiscal discipline would be even more relaxed because of the very monetary financing allowed by ELA and (ii) high (if not rising) inflation would eventually ensue from this feedback loop."
source Credit-Agricole Cheuvreux - Quantitative Easing euroZone (QE-Z): surviving Near-Death Experience.

This is the reason Germany is asking for stricter fiscal discipline. A sustainable fiscal federation in the long term is needed of course, backed by a European Central Treasury. In relation to our "Tale of Two Central Banks", you cannot ask the ECB to suddenly morph into a Fed. This process will undoubtedly take time and a due process, but a larger involvement of the ECB is so far conditional to stricter fiscal discipline. Truth is both Germany and France are trying to make amend for their mistake in violating the European Stability Pact in 2003, a subject we discussed in January 2011 in our post "The moral hazard mistake of 2003 - The violation of the European Stability Pact":

"The ECB had to step in and follow a tighter monetary policy.
Between 2003 and 2004 it allowed real interest rates in the Eurozone to fall to zero. The ECB also abandoned the so-called monetary pillar of its strategy -- "a prudent cross-check that looked at the rate at which money supply was growing". For several years, money growth exceeded the ECB's target rate of growth of 4.5 per cent a year. This equated to overreliance on credit in the Eurozone. It made the Eurozone government fiscal balances over dependent on tax revenues from activities that were based on borrowing, namely housing and construction: hence the housing bust in Spain, Ireland, etc."

On another credit note, and in direct relation to our previous warning to subordinate bondholders from our last post, Lloyds, this time around, announced a bond tender on LT2 (subordinate debt), John Glover and Gavin Finch in Bloomberg article - Lloyds Offers to Exchange Up to $7.7 Billion of Junior Notes - 1st of December 2011 indicated:

"Lloyds Banking Group Plc, 41 percent owned by the British taxpayer, offered to exchange as much as $7.7 billion of capital notes for new bonds to boost capital.
Lloyds asked investors in the Tier 2 securities to swap their holdings at a discount to face value of as much as 30 percent, it said in a statement. The transaction will contribute about 20 percent of the bank’s funding needs for next year, according to London-based spokeswoman Nicole Sharp.
“In light of ongoing market volatility and regulatory uncertainty, the group is undertaking an exchange offer on its Tier 2 capital securities which are eligible for call in 2012,” Sharp said in an e-mail. “The exchange offer also provides the group with an opportunity to improve the quality of the group’s capital base.” Regulators are pushing banks to boost their capital, or ability to absorb losses, before taxpayers have to step in. Bank of England Governor Mervyn King urged lenders today to step up efforts to bolster their defenses against the euro area’s debt turmoil, which now looks like a “systemic crisis.” By exchanging Tier 2 notes, banks are getting rid of securities that, under new rules, will start to lose their value as capital notes from 2013. Lenders also get a boost to their capital against losses by swapping the debt at a discount."

Lloyds launched an exchange on all (11 LT2 and 2 UT2) securities with call date in 2012 ("with the exception of those already being treated on an economic basis") into a new LT2 2021 "callable" in 2016 but without step up, coupon range 5yr MS+850-1000bp (depending of currencies) and added "It is the intention of the Group that all decisions to exercise calls on any Existing Notes (the securities targeted in this exchange offer) that remain outstanding after 31 January 2012, will be made with reference to the prevailing regulatory, economic, and market conditions at the time."

Meaning that future calls will be on "economic basis" for the new security. We could summarise the above as follows:
"Dear LT2 subordinated bondholders tender your bonds or the 2012 call gets it, but it doesn't mean the 2016 call won't get it either..."
Oh dear...
Lloyds Isin - XS0195810717 - source Bloomberg, closing cash price before tender 72.2, exchanged price 77.25. A 22.75% "haircut"...

And my good credit friend to opine:
"A nice “slow death” for subordinated bondholders…"

For more on this particular bond tender, FT Alphaville Joseph Cotterill goes into the detail in his post - "Debt swaps: we can do this the easy way or…"

In our previous post we voiced our concern on subordinated bank debt:
"Given the wall of refinancing for banks in 2012 we detailed previously, we would therefore disagree with the current credit market assumption that LT2 haircut will not happen again."
It still looks our concerns are clearly justified.

On a final note I leave you with Bloomberg Chart of the Day showing "Derivative traders are hedging for the risk that European policy makers fail to end the sovereign- debt crisis that a coordinated central-bank move this week to cheapen dollar funding didn’t resolve."

"The CHART OF THE DAY shows that the one-year U.S. interest-rate swap spread rose yesterday following a plunge the prior day after the Federal Reserve and five other central banks cut by half percentage-point the rate on emergency dollar swap lines. The chart also shows that options traders’ projection of the pace of future swap-rate swings is more than 27 percent above the year’s low.
Swap spreads are based on expectations for the dollar London interbank offered rate, or Libor, and are used as a gauge of investor perceptions of banking-sector credit risk. The swap’s floating rate is indexed to three month Libor, which fell yesterday for the first time since July 25."

"Our liquidity is fine. As a matter of fact, it's better than fine. It's strong."
Kenneth Lay - CEO and chairman of Enron from 1985 until his resignation on January 23, 2002.

Stay tuned!

Markets update - Credit - The Eye of the Storm.

"The fishermen know that the sea is dangerous and the storm terrible, but they have never found these dangers sufficient reason for remaining ashore."
Vincent Van Gogh

As we move towards the nth European summit of the last chance on the 9th of December and with liquidity becoming scarce by the day, in today's post we will review ongoing liquidity issues, as well as some recent market developments and some previous calls.

On the recent price action, my good credit friend commented:
"As equity traders still enjoy a kind of Bull Run based on very thin air, credit traders keep on focusing on facts that could alter the metrics for the months to come, or, on events that could change the credit momentum. Even though European politicians have finally understood what needs to be done to place their economies on a strong footing, they are facing many hurdles, as political agendas collide with the needed structural reforms. So, it will take a lot of time, and time is a luxury that market participants cannot afford. Why? Because the overall system and our society does value “time” as something that humanity as a whole is short of. Consequently, we are experiencing a major social shift in term of savings behaviour and capital allocation. This is what I call a global re-pricing of all assets, which bears a lot of risks if it occurs disorderly."

But first, as always, it is time for a credit market overview before our long conversation.

The worsening liquidity picture in four charts. ECB Overnight Facility, Euro 3 months Libor OIS spread, Itraxx Financial Senior 5 year index, Euro-USD basis swaps level - source Bloomberg:

The current European bond picture with contagion to core Europe - source Bloomberg:

German 10 year government yield rising in lockstep with German 5 year sovereign CDS, following the failed auction casting doubt on the safe haven status of German bonds which had prevailed so far this year - source Bloomberg:

The Credit Indices Itraxx overview - Source Bloomberg:

While we have somewhat receded since our last post, in relation to CDS credit indices levels, volatility remains elevated, and liquidity is becoming an issue, given bid-offer spread for Itraxx Financial Subordinate 5 year CDS is 10 bps whereas it is is only 5 bps on the Itraxx Crossover 5 year CDS index (European High Yield gauge).
A market maker commented:

"Another fairly thin session as we approach Dec 9. Environment continues to be tough to trade -- just take a look at some of the intraday index moves. It becomes increasingly more difficult if you're a single name bank cds trader and trying to "hedge" your book. You are guaranteed to lose money on almost every occasion as you cross bid/offer."

Intraday movement remains indeed very elevated in the Credit Indices space:
Itraxx Financial Senior 5 year index closed around 340 bps (today's range was 330-355).
Itraxx Financial Subordinate 5 year index closed around 588 bps (today's range 569-626...).

Itraxx Financial Senior 5 year CDS versus Itraxx Subordinate 5 year CDS - source Bloomberg:

The same market maker commented on the above:

"Snr vs Sub relationship in Index is also not moving. You would have expected the spread to decompress in the widening but it did not even blink. The only real explanation for this, is because nobody feels like buying Sub protection at these levels; which is fair if you don't think LT2 will get haircut and believe CDS will go to zero one day (post Basel III)."

In relation to LT2, as a reminder from our September credit conversation "Credit - Crash Test for Dummies":

"Typically, in subordinated CDS single names, the bond reference is a Lower Tier 2 bond (LT2), and not Tier 1 (T1) bonds or Upper Tier 2 bonds (UT2), as coupon payments can be deferred in these structures. For Tier 1 bonds and UT2, missing a coupon does not constitute a credit event, therefore they cannot be used as a reference for a single name financial subordinate CDS, so no CDS on these bonds."

In our September post we discussed:

"If a financial entity is able to buy back its LT2 debt below par, it generates earnings 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)."

We would have to disagree with the market maker in the sense that we could go wider still on the Itraxx Subordinate 5 year CDS index, given the market doesn't fathom the possibility of getting haircuts on LT2 subordinate bonds. It has happened and will happen again for weaker financial institutions in the peripheral countries.

Tracy Alloway in FT Alphaville on the 22nd of October described what happened in Ireland, for Anglo Irish Bank subordinate bondholders in her post - "Anglo Irish’s burden-sharing template":

"The bank is offering holders of some of its outstanding sub-debt to swap their notes for new Irish government guaranteed bonds that will be due in 2011 with a coupon of three-month Euribor plus 3.75 per cent. Holders of the €1.57bn worth of three Lower Tier 2 (LT2) bonds will receive just 20 cents on the euro. Investors in about €377m of perpetual junior debt will get even less — 5 cents on the euro."

And Tracy also reminded us what happened in 2009 in the UK in relation to the Bradford and Bingley precedent:

"In 2009, the nationalised British bank enforced burden-sharing on both LT2 debt and perpetuals — offering 45 pence for every pound of LT2, and 25 pence on perpetuals. That was a premium of about 10 to 12 points at the time.

Bradford and Bingley burden-sharing, however, also came with a ‘special resolution regime.’ The UK government went ahead and changed the terms of outstanding Bradford & Bingley subordinated bonds — allowing the bank to defer coupon and principal payments."

And Tracy concluded at the time:
"The future is here, and it bites for bondholders."

We already know the score given the flurry of bond tenders which we had seen coming fast and furious following Spanish bank Santander's bond tender. Given the wall of refinancing for banks in 2012 we detailed previously, we would therefore disagree with the current credit market assumption that LT2 haircut will not happen again and Itraxx Financial Subordinate CDS index could go wider still. This time is different? Probably not, given the European Banking Association's willingness to ensure European banks reach 9% Core Tier 1 capital ratio by 2012.

"Something has gotta give" - subordinated bondholders or shareholders, or both, we argued recently.

It seems Moody's Investors Services is confirming our September assumption given it is considering lowering debt ratings for banks in 15 European nations to reflect the potential removal of government support. This will likely help banks quietly retire their LT2 bonds at even more discounted levels, shoring up in the process somewhat their Core Tier 1 capital. According to Jacob Greber and Chitra Somayaji in their Bloomberg article - Moody’s Considers Bank Debt Downgrade in 15 European Nations published on the 29th of November:
"All subordinated, junior-subordinated and Tier 3 debt ratings of 87 banks in countries where the subordinated debt incorporates an assumption of government support were placed on review for downgrade, the ratings company said in a statement today. The subordinated debt may be cut on average by two levels, with the rest lowered by one grade, it said.
Lenders in Spain, Italy, Austria and France have the most ratings to be reviewed as governments in Europe face limited financial flexibility and consider reducing support to creditors, the rating company said. Moody’s has said that a “rapid escalation” of Europe’s sovereign debt crisis threatens the entire region."

The difficulties for banks to issue term funding debt have been a recurring theme in our conversations. The two journalists from Bloomberg also added:

"Banks will cut bond sales by 60 percent in Europe next year as the sovereign debt crisis drives up issuance costs, Societe Generale predicts. Lenders will sell 50 billion euros ($67 billion) of senior notes, down from a euro-era low of 121 billion euros so far this year, according to the French bank.
The extra yield that investors demand to hold European bank bonds is the highest since May 5, 2009, widening to 424 basis points on Nov. 25 from 336 on Oct. 31, Bank of America Merrill Lynch’s EUR Corporates Banking index shows."

In the great European bank deleveraging process, not even German bank Commerzbank is immune according to Bloomberg journalists Nicholas Comfort and Aaron Kirchfeld - Debt Crisis Puts Commerzbank Back to Drawing Board Fighting Aid:

"Commerzbank AG Chief Executive Officer Martin Blessing spent the last three years trying to free Germany’s second-largest lender from the shackles of government aid needed to survive the 2008 credit crunch. Europe’s debt crisis may put him right back where he started.
Blessing, 48, this year pulled off a capital increase of 11 billion euro($14.6 billion), among the biggest ever in Germany.
The stock sale, a conversion of shares held by the government and excess capital enabled the Frankfurt-based lender to repay 14.3 billion euros of government aid in June. Blessing has pledged not to accept state funds again, even as Commerzbank comes under pressure to boost capital to meet tougher requirements.
European leaders are demanding banks bolster their capacity to withstand losses after financial firms agreed to accept losses on Greek sovereign debt. Commerzbank, told by the European Banking Authority last month that it may need 2.94 billion euros in fresh capital, may have to raise as much as 5 billion euros in a worst-case scenario, people familiar with the situation said last week. “If the bank’s capital requirements rise significantly, it would be very hard for Commerzbank to reach them with the traditional measures they have to hand,” said Michael Seufert, an analyst with Norddeutsche Landesbank Girozentrale in Hanover. “Taking state aid again would be the very last option they’d try as it would be seen as a signal of weakness.”

So subordinate bondholders beware as the article added:
"Commerzbank is exploring options including buying back hybrid bonds and placing sovereign holdings in an external entity, or bad bank, one of the people said. The goal remains to avoid taking state aid. The bank already announced plans to scale back risk-weighted assets and new loans, and to sell non-strategic businesses.
The bank may have to seek assistance from Germany’s Soffin bank-rescue fund, which the government plans to reactivate, if the EBA significantly raises its capital requirements, one person said last week.
Commerzbank’s consideration of putting sovereign debt into a bad bank was reported by the Financial Times on Nov. 25, while the Financial Times Deutschland said yesterday the bank is weighing buying back as much as 1 billion euros of hybrid bonds in exchange for new shares."

In our conversation "Goodwill Hunting Redux", we were expecting this eventuality of debt to equity to materialise:
"First bond tenders, then we will probably see debt to equity swaps for weaker peripheral banks with no access to term funding, leading to significant losses for subordinate bondholders as well as dilution for shareholders in the process."

As for mortgage insurer PMI we mentioned in our post "Credit Terminal Velocity", in August, where we discussed the future for the mortgage insurance business, it is indeed goodbye PMI.
By Mary Childs and Sapna Maheshwari, November 29 (Bloomberg):
"Bondholders are unlikely to recover as much as PMI Group Inc., the guarantor of U.S. home loans that filed for bankruptcy protection last week, indicated in its Chapter 11 petition, debt-market trading shows.
PMI, which pays lenders when homeowners default and foreclosures fail to recoup all of the mortgage debt, reported $225 million of assets and $736 million of debt as of Aug. 4 in its Nov. 23 filing. That means senior bondholders would get about 30 cents on the dollar. Credit-default swaps on Walnut Creek, California-based PMI signal a recovery expectation of 20 cents on the dollar for its senior bonds, according to data provider CMA. The company’s $250 million of 6 percent senior unsecured notes due in September 2016 traded at 22.75 cents on the dollar on Nov. 23
The insurer’s assets may have deteriorated since August, according to analysts at debt researcher CreditSights Inc. They said in a Nov. 27 note that the assets in the filing were higher than they are now and the company likely would be liquidated."

The Bloomberg team interviewed a fixed-income strategist on the subject:
"“The fundamental question behind whether a company can restructure or must liquidate in bankruptcy is whether that company has a viable business model,” Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott LLC in Philadelphia, said in an e-mail. “Whether PMI is able to restructure or ends up in liquidation is essentially a referendum on the mortgage insurance industry as a whole.” Mortgage insurance may not be a sustainable business because home prices have proven to move in sync, making it difficult for providers to diversify, he said.
If mortgage insurance pricing rebounds, PMI’s liquidation would reduce competition and allow for better conditions for those who remain such as Radian Group Inc. and Genworth Financial Inc., LeBas said."

Survival of the fittest...PMI 5 year CDS in upfront price, indicating the recovery for Senior bonds will be in the region of 26 cents to the dollar, definitely less than the assumed 40% recovery rate in the senior CDS - source Bloomberg:

On a final note I leave you with Bloomberg Chart of the day, showing that "Investors are shifting haven demand out of core Europe and in to foreign markets as the region’s debt crisis reaches its most fiscally sound nations, according to UBS AG."

"The CHART OF THE DAY shows the 120-day correlation coefficient between French and German 10-year yields and the euro-dollar has fallen from highs earlier this month. The correlation between U.S. Treasuries and the currency pair continues to increase as the common currency is sold to buy debt outside the euro zone. The measure for 10-year U.K. gilts also remains stronger than Germany and France."

"The only safe ship in a storm is leadership."
Faye Wattleton

Stay tuned!