Markets update - Credit - Long hope - Short faith, Hungary and Bank Recapitalization

“A good solution applied with vigor now is better than a perfect
solution applied ten minutes later.”
General George S. Patton

Call it a bear squeeze or a short squeeze, the action today in the credit space is clearly pointing to short covering with some players capitulating and forced to cover their short positions in both Corporate Single names CDS as well as in some credit indices.
Regardless of how you call it, given the short bias of the street, some got hurt pretty bad probably today, not helping their profit and loss trading account in the process.

So yes, another long post, looking slightly at the periphery with Hungarian mortgages and approaching the hot subject of Bank recapitalization and the somewhat apparent issue of raising equity.

Here is the market overview for Itraxx Credit indices in the European space - Source Bloomberg:

Itraxx Crossover CDS index 5 year of 50 High Yield names tighter by 23 bps on the day to around 746 bps.
Itraxx Main Europe CDS index 5 year (Investment Grade) tighter by 5.5 bps to around 173 bps.
Itraxx Financial Senior CDS index 5 year closed the day tighter by 8 bps to around 233 bps and the Itraxx Financial Subordinate Index declined 16 bps to around 468 bps.
Itraxx Main Europe 5 year CDS index (Investment Grade) versus Itraxx Crossover 5 year CDS index (High Yield):

Slightly better between both indices from the widest point.

Letting off the gas in the credit space, European Gas companies an example of the tightening move in the single name CDS space:

Source CMA

The Liquidity picture - Source Bloomberg:

Some improvement. Keep in mind the drop in the level of deposits at the ECB is due to the start of the new reserve period as of yesterday (September reserve period was shorter at 28 days). Also we learned today that the ECB had lent 1.4 billion USD to 6 European banks for three months at a fixed rate of 1.09%. One bank was also allotted 500 million dollars in its weekly operation, reason being and we know from our previous credit conversations as reminded by Bloomberg: "European banks need dollars to fund their own lending in the U.S. as well as to clients elsewhere doing business in the world’s leading reserve currency."

So all in all, we have, Itraxx Financial Senior 5 year index falling, Eurostoxx rising with German Bund 10 year bond yield above 2%, Volatility falling in the process - Source Bloomberg:

As you can see Eurostoxx and German Bund yield moving in lockstep, as there is a reduction in the flight to quality mode.

Germany Sovereign 5 year CDS level and German 10 year bond yield, from divergence to convergence - Source Bloomberg:

In the Emerging Markets Bond Yield space we also have a significant tightening wove. We discussed previously the sell-off in Emerging debt in the post "Markets update - Credit - Anterograde and Retrograde amnesia" - JP Morgan EMBI Global Diversified - Source Bloomberg:
The J.P.Morgan Emerging Markets Bond Index Global ("EMBI Global") tracks total returns for traded external debt instruments in the emerging markets:

And in relation to the SOVX Western Europe 5 year CDS index versus the SOVx CEEMA (Central Europe and Middle-East and Africa) we have complete convergence currently as both trade roughly at the same levels - Source Bloomberg:

But what I have been following more closely in the Sovereign CDS space for the last couple of months is the relationship between France Sovereign 5 year CDS and Austria 5 year Sovereign CDS:

Why did it catch my attention? Because I am expecting Austria's sovereign CDS to trade wider than France at some point, given the exposure of Austria's banking sector to Eastern Europe and in particular Hungary where a new law has been passed allowing foreign currency mortgages borrowers in Hungary to repay their loans at a fixed exchange rate with large discounts to current FX market rates, which will trigger losses to Austrian Banks.
According to an article from CreditSights from the 11th of October relating to Erste bank in particular and Hungary in general:
"With subsidiaries of foreign banks accounting to 80% of the banking system, the bulk of the losses will be suffered by western European banks. These include Erste Bank, Raiffeisen Bank International, Intesa, Unicredit, Bayerische Landesbank and KBC."
Under the new legislation borrowers can repay their mortgage in a single instalment at a HUF/CHF rate of 180 or a HUF/EUR rate of 250. Current FX rates are around 239 for HUF/CHF and HUF/EUR is around 297, a 25% and 16% discount according to CreditSights.

And the losses are significant, according to Boris Groendahl in Bloomberg on the 10th of October:
"Erste Group Bank AG, eastern Europe’s second-biggest lender, fell the most in more than two years in Vienna trading after saying that it expects to post a full-year loss of 800 million euros ($1.1 billion) this year.
Erste wrote down the value of its Hungarian and Romanian units by a combined 939 million euros, the Vienna-based bank said in a statement today. Erste won’t pay a dividend for 2011 and shelved for at least a year a plan to repay 1.2 billion euros of aid from the Austria government."
Ouch...

And Boris Groendahl in Bloomberg adding:
"Erste is writing off its remaining 312 million euros of goodwill in Hungary and made additional bad-debt provisions of 450 million euros. The lender will also inject 600 million euros of fresh capital into its business, Hungary’s fourth-biggest bank."

And about the mortgage relating problems in Hungary this is what CreditSights had to say in their report in relation to the size of the problem and the deleveraging needed:
"For several years now, the widespread practice in Hungary of mortgage borrowers taking out loans in foreign currencies, predominantly the Swiss franc, has seemed like an accident waiting to happen."
And we know it did...

CreditSights size up the problem:
"With foreign currency mortgages accounting for roughly 75% of total mortgage loans in Hungary on a system-wide basis (of which 80% are in Swiss francs), this will result in some losses for the banks."

And CreditSights to add:
"Based on the latest disclosure by Erste Bank, it appears that the proportion of mortgage lending in foreign currency is even higher for foreign banks than the 75% system average, reaching about 100% in the cases of Erste Bank and Raiffeisen International."
The two largest Austrian banks and CreditSights estimates the impact could be significant as the 10% to 30% of mortgage borrowers could take advantage of the new legislation covering mortgages issued before 2009.
CreditSights estimates under three scenarios (10%, 20% and 30%) pre-tax losses, as a percentage of the banks consolidated, annualised 1H11 pre-tax profit ranging from 6.6% for Erste Bank (10% scenario) to 19.7% (30% scenario) and 2% to 6% for Raiffeisen International.

And CreditSights to conclude:
"Although the specific damage from the FX mortgage legislation looks containable, the legislation casts wider doubt on contract enforceability in the system in the context of a difficult economy, which is likely to lead to other impairments."
So, when the economic situation change, the government can indeed, change the rules...

But another interesting item from the CreditSights article was relating to the CDS exposure for Erste:
"180 million euros P&L reclassification of CDS protection written by the bank, to account for it in the derivatives category, instead of classifying the CDS as financial guarantees. This followed a clarification from the IASB (International Accounting Standards Board), that, in order to use the guarantee classification and avoid marking contracts to market, a protection seller would have to suffer a loss on an underlying reference instrument. The CDS book largely relates to Western European sovereigns and amounts to between 2 billion euros and 2.5 billion euros. Some of this in periphery countries, but total sovereign exposure (including derivatives) to Greece, Portugal, Spain, Ireland and Italy is down to 0.6 billion at 3Q11, from 1.9 billion at FY10, within which the Greece/Portugal component has been reduced to just 10 million euros. Management pointed out that the CDS book was built up prior to the euro zone sovereign crisis as a risk diversification trade to compensate for Erste Bank's concentration in Central and Eastern Europe. The recognition of formerly unrealised losses accumulated from prior years in Available-for-Sale reserves in shareholders' equity leads to simultaneous adjustments of 310 million euros to regulatory capital, or 460 million euros to shareholders' equity in the balance sheet."
So to compensate for Eastern Europe exposure, Erste bank sold CDS protection on Western Europe countries prior to the European sovereign crisis. No comment.

And that leads me to the intense discussions on the subject of banks recapitalization in Europe as the EBA (European Banking Association) is discussing plans for banks to maintain a 9% Core Tier 1 Capital benchmark.
According to Bloomberg article from Ben Moshinsky and Aaron Kirchfeld:
"Nine percent of core capital based on EBA definitions may be roughly equivalent to the 7 percent of reserves that lenders will be obliged to hold from 2019 under measures agreed last year by the Basel Committee on Banking Supervision."
As a reminder, in July, the EBA stress test required Core Tier 1 threshold was put at 5%, 1% lower than the 2010 level of the EBA stress test at 6%.

So where the money is going to come from?

In relation to discussions surrounding Capital Regulation, contrary to many beliefs, Bank Equity is not expensive. It is a myth.
A study realised by Stanford University by Anat R. Admati is a must read and available here:
"Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Expensive"

Anat R. Admati is a professor of finance and economics at Stanford University and the co-author of “Fallacies, Irrelevant Facts and Myths in the Discussion of Capital Regulation: Why Bank Equity Is Not Expensive.”

and a summary of the presentation made to the Bank of England by the co-author is available here, a must read:
http://www.bankofengland.co.uk/publications/events/ccbs_workshop2011/presentation_admati.pdf

"Historical Facts About Bank Capital
• In 1840, equity funded over 50% of bank assets in US.
• Over the subsequent century equity ratios declined
consistently to single digits.
• There is evidence that steps to enhance “safety net”
contributed to this. In the US
– National Banking Act, 1863
– Creation of the Fed, 1914
– Creation of FDIC, 1933.
• Similar trends in UK, Germany. More trading business.
• Bank equity did not have limited liability everywhere
in the US until 1940s!"

Banks have fought bitterly against increasing equity buffers which is the cheapest and easiest way to recapitalize banks.

Why? because allowing high payouts to shareholders, namely bank employees in many cases, allows financial institutions to raise their leverage.

The author of the study Anat R. Admati voiced her opinion on the 25th of February in the following Bloomberg article:

"Fed Runs Scared With Boost to Bank Dividends: Anat R. Admati"

"In 1994, the Financial Accounting Standards Board wanted executive stock options to be expensed to reflect their actual cost. Industry opponents threatened that doing so would prevent entrepreneurial firms from obtaining financing, impede growth and reduce U.S. competitiveness.

Massive lobbying forced the board to back off. A decade later, after WorldCom Inc., Enron Corp. and other corporate scandals, the political atmosphere was different, and the FASB finally changed the rules. Since 2006, all companies must treat executive options as an expense. And the doom and gloom we were promised? There is no evidence that expensing options had any negative economic consequences."

and Anat Admati to comment:
"Like homeowners who took a mortgage with little down payments, when banks are highly leveraged, their equity can be easily wiped out by small declines in asset values. If 95 percent of a bank’s assets are funded with debt, even a 3 percent decline in the asset value raises concerns about solvency and can lead to disruption, the need to “deleverage” by liquidating inefficiently, and possible contagion through the interconnected system. As we have seen, this can have severe consequences for the economy."

Source - Anat Admati - http://www.bankofengland.co.uk/publications/events/ccbs_workshop2011/presentation_admati.pdf

"While equity is used extensively to fund productive business, bankers hate to use it. With more equity, banks have to “own” not only the upside but also more of the downside of the risks they take. They have to provide a cushion at their own expense to reduce the risk of default, rather than rely on insurers and eventually taxpayers to protect them and their creditors if things don’t work out.

Fixation with return on equity also contributes to bankers’ love of leverage because higher leverage mechanically increases ROE, whether or not true value is generated. This is because higher leverage increases the risk of equity, and thus its required return. Focus on ROE is also a reason bankers find hybrid securities, such as debt that converts to equity under some conditions, more attractive than equity."

Source - Anat Admati - http://www.bankofengland.co.uk/publications/events/ccbs_workshop2011/presentation_admati.pdf

“More equity… would restrict [banks’] ability to provide
loans to the rest of the economy. This reduces growth and
has negative effects for all.” Josef Ackermann, CEO of
Deutsche Bank (Nov. 20, 2009).
Wrong...

Anat Admati concluded her Bloomberg column by adding:
"The muddled debate on capital regulation has left us with only minor tweaks to flawed regulations, even after banks’ catastrophic failure in the crisis and the lasting consequences for the economy. The proposed solutions that regulators in the U.S. are focused on, such as resolution mechanisms, bail-ins, contingent capital and living wills, are based on false hopes. They can’t be relied on to prevent a crisis. Increasing equity funding is simpler and better than these pie-in-the-sky ideas."

And why do banks need more regulations and larger equity capital buffer?

The answer is given to us by Simon Jonhson, who served as chief economist at the International Monetary Fund in 2007 and 2008, and is now a Massachusetts Institute of Technology professor and a senior fellow at the Peterson Institute for International Economics in the following Bloomberg article - "Low Bank Capital Is Next Fiscal Crisis":
"Why was the financial crisis so devastating to the real economy? The answer is that, in large part, financial firms had become so highly leveraged, meaning they had very little real equity relative to their assets. This was a great way to boost profits during the economic boom, but when the markets turned, high leverage meant either that firms failed or had to be bailed out. Many financial firms in trouble at the same time means systemic crisis and a deep recession. In effect, a financial system with dangerously low capital levels creates a nontransparent contingent liability for the U.S. budget through the fall in GDP and loss of tax revenue."

Source - Anat Admati - http://www.bankofengland.co.uk/publications/events/ccbs_workshop2011/presentation_admati.pdf

For more on the subject:
"Procyclical bank risk-taking and the lender of last resort" - Mark Mink © voxEU.org

"Providing banks with liquidity support thus effectively allows them to use maturity transformation as a means to lower their borrowing costs, without worrying too much about the higher illiquidity risk.

Through reducing banks’ borrowing costs, the prospect of receiving liquidity support also stimulates forms of bank risk-taking other than maturity transformation. First, it provides banks with an incentive to increase their leverage, i.e. to use more debt and less equity to finance their activities. Doing so, however, comes at the risk of a small decline in asset value being sufficient to wipe out banks’ equity buffers and cause them to become insolvent."

"A leader is a dealer in hope."
Napoleon Bonaparte

So yes, markets are indeed long "false" hopes and most likely, short faith, or short leaders, or both.

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!

Markets update - Credit - Misery loves company

"Only the educated are free."
Epictetus

Misery loves company, and this quarter, there has been plenty, in nearly all asset classes.

We know from the last few credit posts, that the ongoing European debt crisis, led to liquidity concerns. As solvency issues became more acute, credit spreads started widening significantly and with liquidity deteriorating, we have had a shut down in effect of the unsecured term funding market for banks in the process. Poor economic data with US revised GDP figures, US and European downgrades, following the debt ceiling debate and the European game of kicking the can down the road, finally leading to equities taking the plunge, redemptions/liquidations in commodities, Emerging Markets, catching up as well, with various currencies impacted in the process and of course credit wasn't really spared either.
It is going to be another long post. Many important points to go through.

We will start with credit with a recap of what happened in the third quarter and what to expect next.
Societe Generale and its latest Credit Weekly published on the 30th of September sum it up nicely:
"New quarter, same problems: There’s no drawing a line in the sand as we enter Q4 after a disastrous third quarter for credit. The ratification by the German parliament of the EFSF helps at the margin, but it was what the market needed…. in July. We’ve moved on, and the politicians remain well behind the curve. With a leveraged/further expanded facility looking unlikely at the moment, we suspect the market will continue as is. That means low turnover, poor liquidity and pockets of supply where issuer curves get repriced aggressively. The iBoxx at B+316bp with 118bp of widening in the quarter still leaves us unable to answer what the next big three digit spread move will be. There might be some temptation to add, but we would stay sidelined until we get some clarity. The price action at the
end of the week serves to highlight how jittery and depressed the
market remains. It could be a long run into year-end."

So you can expect more of the same unfortunately given current dislocation in the credit space, where any new issue which is able to come to the market, leads to a vicious repricing of the secondary market:

The lowest level of issuance in September since 2001 in Investment Grade credit (BBB- minimum).

We also know from previous post that apart from covered bonds backed by pools of prime loans, the market of new issues for bank remains a concern.
But, this week, on Thursday, Deutsche bank came to the market with a 2 year Senior Floating Rate Note (FRN) having to pay significantly up to reopen the senior market. For instance, Deutsche Bank issued a similar two year FRN in February at 3month Euribor + 40 bps. This issue was trading at around Euribor +70 bps in the secondary market, yet they came to the market this time around paying Euribor +100 bps. But, on Friday, ABN Amro Bank tested the market for a similar 2 year Senior FRN, having a very close rating profile to Deutsche Bank (ABN Amro Bank - Aa3 / A / A+ / A High all stable outlook), this time around pricing thoughts were Euribor + 130 bps. 30 bps more. What a difference a day makes these days...

In terms of issuance, corporate credit markets have had their worst quarter in Europe since the demise of Lehman.
According to Ben Martin from Bloomberg on the 30th of September:
"The Markit iTraxx Crossover Index of credit-default swaps linked to 50 companies with mostly high-yield credit ratings climbed more than 400 basis points since July 1, the biggest rise since the fourth-quarter of 2008 when it surged 456 basis points, according to data compiled by Bloomberg. Relative yields on investment-grade company bonds have increased the most on record, Bank of America Merrill Lynch data show. Yield spreads on investment-grade bonds have surged 140 basis points since the start of the quarter to 309 yesterday, the EMU Corporate index of 1,763 securities shows."

And from the same article, Jim Reid, head of fundamental strategy at Deutsche Bank AG in London commented:
"The stats speak for themselves. You’ve got a situation where if the European authorities drop the ball it could be worse than 2008."

And my good credit friend to comment on Friday:
"The European Credit Market did not really perform and is very weak again today following both the European inflation figures at 3% and the understanding that the overall (IG Main Europe is trading at 198 bps, higher than 3 days ago).

So the outlook is still not positive, and it will not be as long as credit investors are ready to pay that much to remain short and/or insured against the risk of default. The actual cost is about 8 % for junk rated companies and 5% for subordinated debt (LT2 … not Tiers 1 for which there is no CDS and the only hedge is equity)."

And in relation to issuance, here is what Societe Generale had to say in their report:
"The French are close to being funded – any more will lead to saturation of the market (nine issues this month alone), German corporates are unlikely to print at these levels and don’t need the cash, while Italian and Spanish corporates are unable to access the capital markets and the slack is unlikely to be taken up elsewhere. The Deutsche Bank deal is the only one from the banking sector since the beginning of July and is unlikely to open the market for others in any big way – if at all. Covered bond issuance came in at just under €5.5bn, but again this is the lowest total for September since at least 2005. The high yield market is effectively closed after Heidelberg’s 9.5% deal on Wednesday essentially made the barrier for other issuers insurmountable."

We know:
"The recent significant increase in credit spreads for many financials has been driven by the markets concerned about the ability of the weaker players to access credit at reasonable rates."
The race for funding/capital is on, and even in the corporate high yield space. Survival of the fittest...and defaults we could have as it looks highly likely by know we might enter another period of recession.

Mind the gap...

The Itraxx CDS indices picture on Friday - source Bloomberg:

Itraxx Crossover 5 year index (High Yield), wider by 47 bps to around 842 bps
Itraxx Europe Main 5 year index (Investment Grade), wider by 12 bps to around 202 bps.
Itraxx Financial Senior 5 year index wider by 19 bps to around 280 bps
Itraxx Financial Subordinate 5 year index wider by 34 bps to 535 bps.
SOVx 5 year index western Europe (15 European countries, sovereign CDS risk) versus SOVx CEEMA (Central Eastern Europe, Middle-East and Africa) - source Bloomberg:

SOVx CEEMA trading now wider than SOVx Western Europe, as contagion has spread to other regions with the ongoing European crisis.

The liquidity picture - source Bloomberg:

Not really improving, ECB overnight facility deposits on the increase. The reserve period started on the 14th of September and is shorter this time, 28 days until next reserve period.
Flight to quality mode on Friday following the inflation figures in Europe coming at 3% (2.5% expected), German 10 year Government bond versus Germany 5 year CDS - source Bloomberg:

More delays and inactions by European politicians could therefore have significant consequences in the credit space.

Everyone is hoping the EFSF is the silver bullet for the European debt issues plaguing Europe. I do not believe it is and agree completely with my good credit friend, which is a good follow up on the post "Much ado about nothing" where we discussed EFSF being a CPDO redux:

"While everybody is waiting for “The Solution” and rumors are the investors’ daily bread, volatility remains high. I have been asked a lot of questions about the EFSF and its capacity to be used to sort out the current crisis… To be honest I do not know how the EFSF will help recapitalizing the banking system. But I can tell you that the EFSF is structured in a way that there is no pre-funding, that there is not implicit guaranteed by the full faith and credit of the guarantors, and that the structure will be subordinated to the new coming structure called ESM. This means that the cost of funding of the bonds issued by the EFSF will continue rising each time a European State will be downgraded. EFSF bonds are already trading 1% above German government bonds. In addition, any rumor about increasing the EFSF size is based on a totally misunderstanding of the consequences of such a bold act. With a lending capacity of 440 billion and a commitment of 780 billion of guarantees, the structure has already a leverage of 165 %...doing more would be inconsiderate and would imperil the ratings of France and potentially Germany! Keep in mind that any downgrade will impact the rating of the structure and its funding costs, which will weight on its ability to help the countries in need. In addition, any bond issued by the structure has a defined number of guarantors and this number is decreasing as more States cannot commit anymore: as an example, the first bond issued to help Ireland had Portugal among its guarantors …. And Portugal cannot guarantee new issues anymore! So the ability of the EFSF to raise money is impaired each time a country is downgraded, putting pressure on the countries which still have a strong rating.

Any solution will have to go through the ECB as there is no other viable possibility."

For more on why the EFSF is not the Holy Grail, I recommend reading the following opinion from M&G Mike Riddell:
M&G's Riddell: Ten reasons why the EFSF is not the Holy Grail

While all eyes are still focused on the ongoing European crisis, we discussed contagion to Emerging Markets  in our post - "Markets update - the EM Contagion" and it could be a significant event - source CMA, Sovereign CDS 5 year Wideners on Friday:

Asian sovereigns 5 year CDS widening, the picture on Thursday - source CMA:

And Japan affected as well - source CMA:


SOVx Asia 5 year CDS as of close 28th of September - source Bloomberg:

With the slowdown in Asia, we know China has been withdrawing subsidies program such as the one HAIER Electronics Group Co, one of the world's leading white goods home appliance manufacturers benefited from, leading to a significant sell-off of its shares:

Looks like there are some additional collateral damages, due to China withdrawing its subsidies/stimulus program. This time it is number two in the home appliance sector, namely Gome Eletrical Appliances Holding, which fell 22% on Friday, the most in almost three years. This time around following a Credit Suisse note on transparency and funding concerns according to Bloomberg.

GOME going?

In relation to the Emerging Markets contagion story we have been discussing recently, the currencies movements we have seen so far have been fairly important. In fact Asian currencies have had their biggest monthly loss in more than a decade:
South Korean won, worst month since February 2009 and Taiwan dollar dropped the most since 1997 according to Bloomberg:
"The Bloomberg-JPMorgan Asia Dollar Index slid 3.9 percent this month to 114.98, the biggest drop since December 1997."

Sinking Won and plunging Real leading to inflation concerns - Source Bloomberg:

Bloomberg chart indicates:
"THE CHART OF THE DAY shows the so-called breakeven rate on South Korea’s inflation-protected security due March 2017 rose 16 basis points this month to 2.93 percent yesterday, the most since February, as the won weakened 9.1 percent. In Brazil, the two-year breakeven rate jumped 40 basis points to 6.21 percent as the real slid 12.9 percent. The gauges measure the gaps between inflation-linked and conventional bond yields and indicate expectations for average annual inflation until the debt matures."

And we know Central banks in Emerging Markets have been busy trying to sustain the stability of their currencies: Russia, Argentina, India, Brazil, South Korea, selling dollars and for some starting to deplete their dollar reserves in the process.

But before we go through some of the reasons behind these currencies movements tied to commodities selling off, it is time for a coffee break:

Source Bloomberg

The reason behind the Real currency's weakness is the start of the great unwind of the "Double-Decker" funds, and I am not talking about the variety of Double-Decker one can find visiting London.

Investors Take Risky Ride on Double Deckers - John Jannarone -WSJ

"Compared with Americans, the Japanese are veterans of ultralow interest rates. Japan began monetary easing two decades ago, only rarely raising rates much above zero since. In response, even regular Japanese investors have gone great distances to find countries with better growth prospects and higher interest rates.

The latest answer from Japan's financial laboratory: "double-decker" funds that bundle high-return assets with high-yield currencies. Double deckers were insignificant at the end of 2008, but now manage ¥9.65 trillion ($126 billion), according to Morningstar. The first layer of the strategy is to invest in assets such as stocks or bonds that often carry big coupons or dividends. Those returns are turbocharged with foreign-exchange derivatives, which make an equal-sized bet on one or more currencies.

The result is potential yields that are too attractive to resist. Take double-decker funds stacked with bets on the Brazilian real, the most popular currency category. One such fund, Mitsubishi UFJ Bond Currency Select Brazilian Real, has a dividend yield of 21% and has generated a 17% annualized return over the last two years, Morningstar says."

And John Jannarone to comment in his article:
"To fight inflation, Brazil continues to raise interest rates, putting the economy under strain. If that or, say, a correction in commodity prices triggered a downturn, the central bank could respond with interest-rate cuts, leading to a depreciation of the real. Any underlying double-decker assets with exposure to Brazil also could suffer."

And suffered it has, with commodities selling off after the bubble popped (Copper, source Bloomberg, 22nd of September 2011):

JP Morgan commented on the "Double Deckers":
"Interesting to note we have an analyst monitoring this situation…He reckons BRL overlay funds amount for $ 44bn of Japanese retail money and that, while these investors have net sold BRL overlay funds for the 7th consecutive biz day, total net sales only amount to $ 4bio this year.

Should we see a Lehman-type financial crisis and further JPY appreciation (20% more vs BRL) he reckons up to $ 31bn of this Japanese retail money could be unwound."
Ouch!

And John Jannarone to conclude his article:
"The lesson in Japan and elsewhere: Sustained low interest rates force investors into risks they may not fully appreciate. And with markets already volatile, investors should beware sudden unexpected moves that leave them out of pocket."

And we know the following from an article published in Bloomberg on the 30th of September:
"Japanese investors, who hold $102 billion worth of Brazilian assets, are pulling the most money out of the Latin American country’s currency market since April, deepening a slide in the real that’s fueling bond losses.
Pensioners and other individual investors took 52.7 billion yen ($689 million) out of so-called currency overlay funds that speculate on the real this month through yesterday, according to data compiled by JPMorgan Chase & Co."

So yes, you have a big rush towards the exit from Japanese retail investors.
Its forced liquidations/redemptions time - source Bank of America Merrill Lynch:
"EPFR Mutual Fund data for week ending September 28th
-US HY puts together 4 straight weeks of inflows, +$424mm of inflows
-Non US HY outflows remain remorseless with $1.5bn of outflows, $-13bn for qtr.
-Loan outflows (10 straight weeks) continue to wipe out YTD inflows: -$176mm
-EM Debt see largest outflow ever, 17% of YTD inflows with $3.2bn outflows
-High Grade inflows rip to a record $6.8bn:Big EM to DM with in Fixed income
-Munis deliver inflows in every week in September with $552mm of inflows
-All Fixed Income saw inflows of $10.5bn
-Commodities see outflows of $915mm, large outflow from precious metals
-Equities officially deliver $70bn of outflows for qtr after -$4.8bn this week
*Despite S&P flat since last week, data flow would suggest many investors are clearly in risk off mode, with a high bias to increase credit quality of portfolio ($8bn into HG). EM equity outflow streak reaches longest streak since 2002."

So, the differential in FX between DM (Developed countries) and EM (Emerging Markets) is leading to big outflows and the Japanese "Double Deckers" getting whacked in the process.

And on a final note, in addition to ECRI pointing towards another recession, I give you Bloomberg's April Oil price jump as an additional indicator:

Source Bloomberg:
"THE CHART OF THE DAY shows that 10 of the last 11 U.S. recessions were preceded by jumps in oil prices, at least four of which were associated with Middle East conflicts and embargoes by the Organization of Petroleum Exporting Countries: the OPEC oil embargo of 1973-74, the Iranian revolution of 1978-79, the beginning of the Iran-Iraq War in 1980, and the first Persian Gulf War in 1990."

"Leadership is the art of getting someone else to do something you want done because he wants to do it."
Dwight D. Eisenhower

Stay tuned!