A proposal for the ongoing European debt crisis involving debt compression.

How do you make four triangles with 6 matches? Most people instinctively think in 2 dimensions when the solution involves changing your thought process and switching to 3 dimensions.

The European sovereign debt crisis is of two levels:
-Current outstanding debt which is unsustainable given weaker growth for some peripheral countries, which will be impacted even more by austerity measures.
-Long term dynamics of debt levels and solvency issues.

The contagion we have seen to Italy and to some extent Spain recently, is directly linked to the amount, at least for Italy, to the considerable size of the existing Italian outstanding government debt stock.

The objective of debt compression is to simplify the outstanding exposures, reducing therefore credit risk, which is currently plaguing the European Financial system.
While I see it as alleviating funding issues in the near term for both sovereign countries and to their respective domestic financial institutions, it has to be part of a bigger plan involving Euro bonds.
The long term solution is a proper central treasury for Europe as proposed by some, including George Soros.

As a reminder:
European debt map:

European countries cross border exposure:

The process of European debt compression would consist in certain number of market participants voluntarily giving information to a 'compression institution' about their sovereign exposures.

About trade compression already existing and provided by vendors in the Credit Default Swaps space:
"Trade compression is the reduction of the notional amount of trades outstanding in the market, with particular focus towards the credit default swap market. Methodologies include index netting, tear-ups, and trade composting. The specific details of these methodologies are beyond the scope of this definition. However, in general, the process involves aggregating a large number of trades with similar factors such as risk or cash flow into fewer trades with less capital exposure.

Trade compression is a fairly new strategy with few applicable platforms prior to the credit default market crash. Since then the strategy has gained momentum with several competitors vying for the market leader position. Two of these companies, Markit and Creditex, seem to have taken the lead as they were selected by the International Swaps and Derivatives Association (ISDA) to create a platform to support trade compression. In August 2008, the joint effort was able to reduce the notional amount of compressible trades involving 14 dealers by approximately 56%.

Overall, trade compression is a promising strategy that is still in its infancy and with technology and regulation that are still in development."

In December 2010, I mentioned debt compression as a part of the solution for the current stock of debt and the interconnections between countries and financial institutions in the post "Europe - The end of the Halcyon day"

In May 2011, Anthony J. Evans, Associate Proffessor of Economics at ESCP Europe realised a study entitled - "The great EU debt write off". The study is available on - "The great EU debt write off". Thanks for ZeroHedge for pointing out this very interesting study.

It is the continuation of what I suggested back in December 2010, ESCP this time is doing a very interesting simulation on the exercise of debt cancellation.
In December 2010 I wrote:
"A way of reducing the burden of debt for peripheral countries, would be to create a European Compensation house and to do some debt compression. They would need to allow creditors to swap the debt of peripheral countries into more solid Euro-bonds issued at the ECB level, provided their is a haircut on the existing peripheral debt. Unfortunately the game of kicking the can down the road is still well alive with French and German politicians. At some point restructuring of the debt for some peripheral countries will have to happen."

The main findings of their simulation is as follows:

"• The EU countries in the study can reduce their total debt by 64% through cross cancellation of interlinked debt;
• Six countries – Ireland, Italy, Spain, Britain, France and Germany – can write off more than 50% of their outstanding debt;
• Three countries - Ireland, Italy, and Germany – can reduce their obligations such that they owe more than €1bn to only 2 other countries.

In addition the simulation revealed that:
• Around 50% of Portugal’s debt is owed to Spain;
• Ireland and Italy can write off all of their debt to other PIIGS countries, and Ireland can
reduce its debt from almost 130% of GDP to under 20% of GDP6;
• Greece can reduce their debt by 20%, with 60% owed to France and 30% to Germany;
• Britain has the highest absolute amount of debt before and after the write off (owed mostly to
Spain and Germany) but can reduce their debt to GDP ratio by 34 percentage points ;
• France can virtually eliminate its debt (by 99.76%) – reducing it to just 0.06% of GDP"

and the results are summarised in the table below:

Source ESCP May 2011 study.

The solution for European sovereign debt issues starts with debt compression as well as the implementation of Euro Bonds via a European central treasury.

Markets update - Credit - After all tomorrow is another day.

"After all tomorrow is another day", is the last line of the American Civil War novel Gone With The Wind.

Like Scarlett in Gone With the Wind, credit markets, though deeply grieved also seems to hold up, so far, under the strain. And if Gone With the Wind has a theme it is survival:

"If Gone With the Wind has a theme it is that of survival. What makes some people come through catastrophes and others, apparently just as able, strong, and brave, go under? It happens in every upheaval. Some people survive; others don't. What qualities are in those who fight their way through triumphantly that are lacking in those that go under? I only know that survivors used to call that quality 'gumption.' So I wrote about people who had gumption and people who didn't."
Margaret Mitchell, 1936

Here is the market picture for Itraxx 5 year credit indices today following the "shock and awe"(a military doctrine based on the use of overwhelming power) coordinated central banks intervention to ease dollar funding issues for European banks (we already knew about these concerns from previous posts):
Itraxx Crossover 5 year CDS index (High Yield), tighter:

Market closed at around 714 bps, 27 bps tighter.

Itraxx Financial Senior 5 year CDS index:

Cooling off as well.

Itraxx Financial Subordinate 5 year CDS index:

The liquidity picture:

The massive fall in deposits at the ECB is due to the start of a new reserve period on the 14th of September until the 11th of October.
The three-month cross-currency basis swap fell to 80.25 bps from a high of 112.6 bps on the 12th of September, thanks to central banks intervention.

So, who has what Margaret Mitchell calls "gumption" in Europe in the peripheral space?

Portugal 5 year Sovereign CDS versus Ireland 5 year Sovereign CDS:

Ireland clearly is decoupling from Portugal.

Spain 5 year Sovereign CDS versus Italy 5 year Sovereign CDS:

Spain decoupling as well. Spain sold today 3.95 billion euros of bonds maturing in 2019 and 2020 at an average yield of 5.156% compared to 5.2% in February and 5.196% on the secondary market before the auction took place.

The liquidity issues we discussed a month ago in "Macro and Markets update - It's the liquidity stupid...and why it matters again...", is not only a European problem anymore. It is as well a Russian problem:
Bloomberg - Maria Levitov and Denis Maternovsky:
"Russia is struggling to contain a cash squeeze at the nation’s banks after cutting lending rates for the first time in 15 months.
Government bond yields surged to their highest level since February, with the rate on ruble notes due in March 2014 climbing 19 basis points to 7 percent yesterday, as Bank Rossii sought to boost the amount of cash available to lenders by lowering the rate charged on repurchase loans by 25 basis points and lifting the rate earned on deposits by the same amount yesterday. The three-month MosPrime interbank rate hit an almost 19-month high.
Russia is following Brazil and Turkey in cutting borrowing costs as a way of shielding the nation’s economy from a global slowdown as the U.S. falters and the European debt crisis continues. While the refinancing rate was left on hold at 8.25 percent yesterday, the changes to the repurchase and deposit rates should “contain volatility of money market” rates, Bank Rossii said in a statement."

And why liquidity always matter, also from the same Bloomberg article:
“Economic growth must be fueled with liquidity,” Vladimir Osakovsky, chief economist for Russia at Bank of America Merrill Lynch, said by phone from Moscow yesterday. “If this doesn’t happen, growth in money market rates could stifle investment and therefore growth.”

Credit Suisse published today a review of European Banks under the title - European Banks - The lost decade.

Given ongoing liquidity constraints we discussed plaguing European banks in general, and dollar funding in particular, at this point, as the story unfolds/evolves, it is important to try to find out who has "gumption" and who hasn't in the European banking space.

In this lengthy report, Credit Suisse analysts tell us:
"Whilst many observers may see these two events as separate, we see them as part of the same process which ultimately, we believe, may force banks to deleverage and restructure in a much more significant way. Further, as a result of the current crisis, given European banks have only reduced about half of their original sub prime exposures according to our estimates, we could again see losses related to these assets come through the P&L.
Overall, based on our analysis we see that whilst overall losses associated with credit market assets are c.€184bn so far, European banks effectively ‘raised and retained’ a much higher amount to reach a tangible equity position of €811bn last reported. We note that the additional capital has also been part of higher capital requirements mandated under Basel III and is an important indication that European banks are in a better position in terms of capital going into the sovereign crisis. It has also however, been a drag on profitability.
We compare these losses with the potential losses from the current sovereign crisis. On our estimates, assuming an accelerated sovereign shock scenario, we could see a further €213bn of losses i.e. higher than the losses experienced thus far with credit market assets.
This includes:
(i) further losses on sub prime assets (€52bn); (ii) sovereign losses of €125bn and (iii) one year of higher funding costs of €37bn. If we were to include risk weighting for sovereign exposure of €22bn then the total would be €235bn."

 And Credit Suisse to add:
"Estimating the capital shortfall for the sector
Going into this crisis, given higher regulatory capital demands and funding markets requiring larger capital cushions, our base case suggests the sector will still have a €165bn capital deficit at year end 2012E. In the core scenario that we present we estimate the sector would have a total recapitalisation requirement of c.€400bn (Figure 3) compared to the current market cap of €541bn."

Clearly Europe needs a European TARP. Could that be the message that Treasury Secretary Timothy Geithner will convey to European finance ministers in Poland?

We know from my post "Macro and Markets update - It's the liquidity stupid...and why it matters again..." that the lack of disclosure of the LCR (Liquidity Coverage Ratio), which unfortunately is not published by the majority of banks is an issue as Credit Suisse put it in their report: "A more significant market dislocation in terms of bank failure e.g., Lehman in the sub prime crisis,would make a liquidity coverage ratio (LCR) analysis more relevant, as it highlights the vulnerability of funding on a 30-day basis."

Unfortunately as we previously discussed, lessons have not been learn from the 2008 onslaught and the lack of disclosure and transparency for the majority of European banks does not really allow for a proper "gumption" assesment process under very adverse liquidity conditions. But a good point Credit Suisse points out in their report is as follows:
"European banks have effectively ‘raised’ a much higher amount—of €835bn—since 2007 i.e. five times the losses incurred. We note that the additional capital is also part of higher capital requirements mandated under Basel III but it is an important indicator that highlights that European banks are in an improving position in terms of capital going into the sovereign ‘sub-prime’ crisis. This is why tangible equity for the European banks has almost doubled from the level at the start of 2007."

Sweden is also bracing for impact should it happen:
Source Bloomberg - Johan Carlstrom - 14th of September:
“There will be facilities in place to support banks that may have problems,” Reinfeldt said in an interview today in Stockholm.

Sweden has a good first hand experience of financial crisis:
"Sweden, which suffered through a banking crisis in the early 1990s and then again in 2008 and 2009, chose to inject capital into struggling banks only in return for equity to avoid raising deficits and burdening taxpayers. The government in 2008 set up a financial stability fund by charging banks an annual fee and enacted various crisis-management measures including a bank guarantee program to help support lending.
The fund will grow to 2.5 percent of gross domestic product by 2023 and stood at 35 billion kronor ($5.2 billion) at the end of 2010, including shares in Nordea Bank AB, according to the Swedish National Debt Office.

On another note, Bloomberg Chart of the day shows that the currency ugly contest is well alive and kicking between the Euro and the Dollar:

And finally, to end up on a less somber note this what I think Ben Bernanke could have said after today's coordinated intervention: I know what you're thinking. "Did the FED fire six shots or only five?" Well, to tell you the truth, in all this excitement I kind of lost track myself. But being this is the FED, the most powerful central bank in the world, and would blow your head clean off, you've got to ask yourself one question: Does the ECB feel lucky? Well, do they, punk?

Stay tuned!

Markets update - Credit - Crash Test for Dummies

I had previously extended an invite for next post title, given one of the reader had already used my previous analogy relating to the "Chandrasekhar limit", but I have not received a suggestion yet. I felt the urge of posting an update after another eventful session today.

All credit indices went through the roof, once again:
Itraxx Crossover 5 year index (European High Yield - 40 companies in the index):

Risk of contagion is truly on, and Greece is drifting wider still, with two years notes yielding more than 60%.
For Greece, we already know the score with the central government's budget gap hitting 22% in the first eight months. The Greek goverment is now expecting the economy to contract by more than 5% in 2011, more than the 3.8% forecast by the European commission.

Here is the picture for Greece today:
Greek Yield one 1 year government bond - 117% yield:

Greek 2 year bonds yielding 63.4%:

Greek 10 year bonds, 21.87% yield:

Greece's fate is signed, sealed and delivered.

What caught my attention today was Italy's auction on T-bills with yields hitting a new three year record at above 4.153% from 2.959% a month ago. Contagion is still on.

And liquidity indicators were still worsening today,

But the deterioration seems to be accelerating still as the Euro-USD Basis swap 3 months indicator is telling us:

Banks have now 181 billions euros of deposits parked at the ECB, up from 152 billions when I wrote "Markets update - Credit - Crossing An Event Horizon" on the 5th of September:

So yes, flight to quality it is, and flight to quality we have. Correlation between 10 year Swedish government bonds and 10 year German government bonds is 1:

And financials, both in the equity space and in the credit space, took the brunt of the sell-off / widening today:
Itraxx Financial Senior 5 year index flying through 300 bps:

Itraxx Financial Subordinated 5 year index, widening faster:

This movement in credit indices was summarised by a dealer today as following. We had capitulation in the Financial Subordinate space and in relation to Financial Senior, the widening was strong but not sustained by flows. Size for hybrid Tier 1 trades was around 1 million euros, with significant downwards movement, 10 points down. In relation to High Yield volumes, they are very light. Whereas CDS so far had been leading the widening move, in last couple of days, cash has been underperforming CDS today.

In relation to bank capital structure, it is important at this juncture to go through the architecture, from the most senior to least subordinated bank debt.
Covered bonds backed by prime pool of loans are deemed senior to Senior debt.
Below senior debt, you have subordinated debt:
Lower tier 2 (LT2), Upper tier 2 (UT2), Tier 1 debt and finally equity (preferred shares).


And we know by now that European and UK banks face more funding pressures than US banks:


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 deffered 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.

A typical LT2 Structure is as follows:
10 years, non-callable for 5 years (10-NC5)
-Final maturity is hard, meaning no get out clauses.
-No coupon deferral. A coupon deferral would constitute a credit event and therefore trigger a credit event and the relating CDS.
-Ratings: 1 notch below senior debt (Moody's / S&P).
-More standardised structure than Tier 1 or UT2. Given regulatory capital treatment decreases as it moves towards maturity (as it gets closer to 5 years to maturity) so many deals structured have had callable features, meaning the issuer can decide to call the bond.

Why am I going through these details relating to Bank Capital structure? Simply because mister Market "sometimes" has a short memory span. On the 17th of December 2008, Deutsche Bank decided to skip the call option on a 1 billion euro LT2 bond. Not so good for their reputational risk at the time.

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.

The big issue today is that we know from previous credit posts that they cannot at the moment issue term debt given current market dislocation and the only bonds which, so far have been issued, have been the most senior ones, namely covered bonds backed by pools of prime loans but by only for top issuers.

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).

But, it is clear that not all banks have the same liquidity/funding costs, particularly today. So the game is going, once again to be as follows, remember: "The recent significant increase in credit spreads for many financials have been driven by the markets concerned about the ability of the weaker players to access credit at reasonable rates." (Macro and Markets update - It's the liquidity stupid...and why it matters again... ), banks with access to cheaper senior term funding than the cost of their outstanding LT2, for them, an early call could make sense, compared to the cost of issuing senior debt. For the others, I am not so sure...

Survival of the fittest.

And is this fully priced in the subordinate space? I don't think so, given borrowers are expected generally to repay subordinated bondholders at the first opportunity and the bonds are valued on that basis.

So, dear credit friends, I am afraid to say that, skipping calls, are going to happen, and will trigger losses because end of the day, why would you call a bond, if it costs you more to issue a new one?

This time is different? Nope. It is still deleveraging.

And my good credit friend agrees on the above, I am not alone:
"Do not forget that in 2008, when funding became an issue (and it is becoming an issue right now) Deutsche Bank decided not to call a LT2 bond at its call date, and all participants suddenly woke up to the reality that subordinated bonds could not be called.

Needless to say that it could and …… should happen again."

And given UK banks have just been given the ICB slap, recommending on ring-fencing retail banking and increasing loss absorbency, meaning lower ratings (downgrades), lower profitability and higher funding costs, this might bring some solace to their French counterparts (Moody's fear of downgrades), which recently have been at the receiving end of the cricket/baseball bat, you can expect additional widening unfortunately.


Until next time, I give you Bloomberg Chart of the Day, pointing towards additional pressure on the Euro:

Stay tuned!