Markets update - Credit - The LTRO Alkaloid

"The expense of a war could be paid in time; but the expense of opium, when once the habit is formed, will only increase with time."
Townsend Harris- first United States Consul General to Japan.

Homer conveys the effects of Opium in The Odyssey. In one episode, Telemachus is depressed after failing to find his father Odysseus. But then Helen (ECB)...

"...had a happy thought. Into the bowl in which their wine was mixed, she slipped a drug that had the power of robbing grief and anger of their sting and banishing all painful memories. No one who swallowed this dissolved in their wine could shed a single tear that day, even for the death of his mother or father, or if they put his brother or his own son to the sword and he were there to see it done...".

In a recent conversation we discussed the LTRO impact on liquidity flushed towards the market. While our Greek Calends are still taking center stage (no tears shedding for Greece given the "euphoric" effect of the LTRO alkaloid), we thought comparing the European LTRO to the most famous historical alkaloid, would be appropriate given the significant rally experienced in risky assets through January. True to our addictive writing habits, we divagate again, using literary and historical references.

In this credit conversation, after a quick credit overview, we will again revisit the LTRO alkaloid impact, given the rally is not based on fundamentals, an interesting bond tender courtesy of Greek Bank EFG Hellas, as well as a follow up on Hungary and Egypt in relation to our first post of the year "Hungarian Dances".

The Credit Indices Itraxx overview - Source Bloomberg:

Are the LTRO alkaloid effects waning? Or is it because the markets are getting tired by the Greek Calends? The SOVx Western Europe Index (15 Sovereign CDS) 5 year index has seen its first weekly increase in five weeks, moving back towards the 330 bps level, indicating a rise in risk aversion. But overall, credit indices have been wider across the board, with Itraxx Crossover 5 year index (50 European High Yield names, High Yield credit risk indicator) wider by 32 bps (first weekly increase since December 16) and Itraxx Financial Subordinate 5 year index wider by around 23 bps on the day.
So there goes the Greek spanner in the works as argued by CreditSights from our previous conversation "Lather, rinse, repeat":

"Greece, and the obvious unsustainability of its existing debt position, has been somewhat of a sideshow to the main act of Italy and Spain for some time now. But negotiations over the restructuring still have the capacity to throw a spanner in the works."

Spain 5 year Sovereign CDS versus Italy's 5 year sovereign CDS level - source Bloomberg.

Italy's Sovereign 5 year CDS rose by 24 bps to around 394 bps while Spain widened by 20 bps to around 368 bps.

The current European bond picture with Italy and Spain 10 year government yields converging - source Bloomberg:

The liquidity picture, as per our 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 new reserve period in relation to the level of deposits at the ECB will start on the 15th of February and will only last 22 days this time around for deposits earning 0.25%.

The relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge):

Risk-off?

"Flight to quality" picture, with tighter Germany 10 year Government bond and falling 5 year CDS spread for Germany - Source Bloomberg:

The LTRO Alkaloid is in effect capping the widening potential for German 10 years yield. As indicated by Lukanyo Mnyanda and Emma Charlton in their Bloomberg article - ECB Cash Fails to Wean Investors Off German Debt: Euro Credit:
"Investors are sticking with German government debt amid concern that unlimited three-year cash from the European Central Bank won’t end the region’s debt crisis.
The yield on 10-year bunds, perceived to be the among the region’s least risky government debt, has averaged 1.90 percent since Dec. 8, when the ECB announced the three-year loan plan, compared with 3.34 percent over the past five years. Bund yields have held close to their record low of 1.64 percent even as the Stoxx Europe 600 Index has rallied 26 percent from last year’s low and 7.5 percent this year."

So yes, we have to concede, German yields are unlikely to rise, given the ongoing demand for precautionary assets (German bunds, UK Gilts, US Treasuries) in relation to the ongoing European issues. It is all about capital preservation rather than a hunt for yield.

In fact, it ties up nicely with 10 year Sweden government bonds versus 10 year German bund risk-off indicator, moving back in sync - source Bloomberg:

It has been a recurring theme of ours that there is a clear distinction between the FED and the ECB ("A Tale of Two Central Banks"), namely that one has been financing stock (mortgages), while the other, has been financing flows (deficits). We would like to go further, and explain why the LTRO cannot be viewed as QE. Nomura in their recent Rates Insights - How long can we rally - published on the 9th explain the following:
"The LTRO is a repo transaction so there is no initial transfer of risk to the ECB from the transaction with the ECB's risk stemming from a bank default scenario. But the haircut structure is in place to ensure that this does not lead to a transfer of private sector credit risk. In our opinion through the first operation banks are using the ECB LTRO as replacement funding for 2012 refinancing obligations, which is liability replacement rather than asset replacement. The reduction of a form of asset substitution is more at play in the slowing of deleveraging i.e. a substitution of assets for cash."

Whereas the FED dealt with the stock (mortgages), the ECB via the alkaloid LTRO is dealing with the flows, facilitating bank funding and somewhat slowing the deleveraging process but in no way altering the credit profile of the financial institutions benefiting from it! While it is clearly reducing the risk of banks insolvency in the near term, it is not alleviating the risk of a credit crunch, as indicated in the latest ECB's latest lending survey which we discussed in our last conversation.

Nomura also made the following valid comment in relation to why the LTRO is not QE, although perceived as such:
"ECB LTRO is not QE in the traditional sense – there is no risk transfer to the central bank.
Liquidity has seeped into certain parts of the system at a lower rate, which has helped to drive certain asset levels, notably the front end of peripheral curves, but as we have said previously this is more about the perception that the ECB has exacted a more pure form of QE affecting the asset side of balance sheets. The traditional asset allocation shift from QE is stifled in that under LTRO risk is not transferred to the national central banks, which does not immediately change the credit profile of banks. As a result the immediate use of QE cash to purchase instruments further out the credit is somewhat limited."

What the ECB has done is not akin to QE version 1 as enacted by the FED in 2008 given, as indicated by Nomura that:

"Liquefying of bank balance sheets through repo does not constitute a change in their construct. The US efforts of 2008 included forced recap alongside additional collateral provision through multiple programme, which helped banks help themselves. The current ECB action is simply a funding replacement mechanism rather than a mechanism for the facilitation of market based funding."

We have to concur with both Nomura (Nomura being in agreement with Moody's take), in relation to the LTRO Alkaloid namely that it is a credit negative event, not positive:
"In this time of pleasant thoughts with regards to rating agencies we have the unusual honour in that Moody's have joined us in our view that the LTRO is credit negative for banks, which makes the carry trade using this funding source credit negative.
What is needed are new funds, in other words real money stepping in alongside bank buying. Real money have been buying in small sizes, but not the volume required to take down the debt issuance profile without bank/LTRO help. This is because the fundamental issues that drove investors from these markets haven't changed.
With many foreign investors, including those from within the euro area, seemingly away from the bid Italy and Spain are effectively becoming domestic bond markets. The domestic bid size seems reasonable, but it remains to be tested on a longer term basis."

Lather, rinse, repeat:
"We agree with our friends at Rcube, namely that the focus should be going forward, on European economic data and rising unemployment levels."

Therefore, looking at the recent LTRO Alkaloid induced rally, Nomura to add:

"Rallies eventually need to be fundamentally based, can the fundamentals keep pace?"

We do not think so:

"The euro area probably will contract this year by 0.5 percent with recessions in crisis-hit Greece and Portugal, compared with a 2.3 percent expansion in the U.S., according to Bloomberg surveys of economists."

FED versus ECB, stocks versus flows as we reminded ourselves last week:
"We do not know when European deficits will end, until a clear reduction of the deficits is seen, therefore the ECB liabilities of the ECB will have to depreciate. It is therefore not a surprise to see the ECB's current reluctance in getting a haircut on their Greek holdings in relation to the ongoing negotiations revolving around the Greek PSI."

"The law of unintended consequences" is taking its toll.

Nomura also commented in their note in relation to fundamentals:
"The fundamentals may be worsening. The damage has been done through procyclical responses.
Political uncertainty, austerity, and regulations (Basel 2.5 and 3, EBA instruction to banks to raise core tier 1 capital to 9%) have driven down growth expectations significantly. Although the negative Spanish Q4 GDP number of -0.3% was somewhat expected the negative implication of Belgium.s -0.2% Q4 GDP, clearly more semi-core, is a negative bellwether for the periphery.
With the continued response to deficit slippages being a further cut in expenditure, the negative fiscal multiplier effect keeps increasing. When the private sector is increasing balance sheet there is some offset, but at the moment with house prices tapering or decreasing rapidly, as the largest component on the private balance sheet, this puts major pressure to deleverage on other aspects such as credit cards and hence consumer spending. This is backed up by the ECB lending survey.
Fiscal slippages could lead to further downgrade risk by agencies. This, the LTRO can do nothing about it."

So the LTRO, we think, could amount to "Money for Nothing".

Moving back to the Greek Calends and bond tenders, courtesy of EFG Hellas Ltd, a member of Group Eurobank EFG, another subordinated bond tender hit the market on the 9th, targeting 3 Tier 1 notes with an aggregate face amount outstanding of €415mn and 1 Lower Tier 2 note with a nominal outstanding amount of €467mn, with similar purposes to previous ones, with a proposed price of 40 cents to the euro:
"The purpose of the Offers is to generate Core Tier One capital for the Offeror and to strengthen the quality of its capital base. If completed, the Offers would generate a gain for the Group and thereby increase Core Tier One capital. The Offers also provide investors with an opportunity to monetise their investments at the relevant Purchase Price."

An opportunity to get out while you can...While the exercise is indeed helping in raising much needed capital, it doesn't alleviate in no way the reliance on emergency funding through ELA and the deterioration of their domestic earnings prospects and deposit flights and rising Non-Performing loans (for more, please refer to our post "Liquidity? The IV Greek Credit Therapy" - August 2011).

My good credit friend had to say the following in relation to the latest Greek austerity plan:

"Now that the political game in changing in Greece, the other political leaders will have a tough time to justify their decision for more austerity. With very high unemployment rate, the country is on its knees. In opening a new front within the domestic political Greek landscape, the LAOS party is putting the other political leaders in a very difficult position : if they support the bailout, they are about to commit a political suicide or at least to face a big defeat in the coming elections (even worst if they decide to postpone the elections). If they decide to play hardball with the creditors (Troika), they endanger the bailout.
I suspect the LAOS MPs will not vote for the bailout, which will put them in a “win-win” position. While supporting Papademos action, the populist party will let “things fall apart”, criticizing openly the decisions of the other leaders and waiting for the right time to provoke elections and win a big part of the seats in the Parliament."

As Napoleon rightly said, "A leader is a dealer in hope". Time has come to become once again a good behavioral therapist and focus on the process rather than the content in relation to the Greek situation.

Moving on to our "Hungarian dances" update, the Hungarian FSA has given new details of the repayment levels of the FX currency mortgages plaguing Hungarian households. The losses on conversions are marginally higher, meaning Erste Bank and OTP will have to increase their provisions levels according to Credit Suisse - Hungarian FX Mortgage scheme - 7th of February 2012:
"HFSA has said that loans with a book value of HUF 1073.7bn were repaid using HUF 776bn, suggesting a loss to date of HUF 297bn for the sector as a whole. This is 19% of the total FX mortgage stock and translates to a 27% loss on the repayment, we calculate. This loss is marginally higher than the loss assumed by the banks – due to the weaker FX rates seen over the later part of 2011, we believe. These repayments were related to 141,976 mortgage contracts. There are a further 19,052 contracts which have been registered for repayment but have not yet been repaid. We expect that some but not all of these contracts will be repaid."

"Mind the Gap...", in November we referred to Geoffrey T. Smith from the Wall Street Journal - "Austria Has a Déjà Vu Moment":
"As a result, the biggest threat to Austrian banks is still what it was in 2009—wholesale capital flight from emerging Europe."

It still is the biggest threat,  as indicated by Exane BNP Paribas in relation to deposits moving elsewhere in their February note relating to Hungary:

There is an existing Bank levy (0.53% of banks 2009 assets to bring EUR580m per year to the State) in Hungary.

Hungary will need a bailout by the IMF, while European banks exposed to Hungary will face additional losses:

Given FX Currency Mortgages are taking a heavy toll on the country's already strained refinancing needs as indicated by Exane BNP Paribas:

According to Exane BNP Paribas:
"In the absence of an IMF/EU agreement Hungary is likely to avoid default in Q1 2012 and little time after. An external financial aid (IMF and EU) agreed within H1 2012 should average EUR25–30bn in order to cover Hungary’s financing needs over the next two years."

Exane BNP Paribas adding in relation to a potential bail out:
"A EUR25bn of second bail-out would increase the total Hungarian debt from
EUR79bn (i.e. ~84% of GDP) to EUR104bn (i.e. ~111% of GDP)."

On a final note, please find Bloomberg Chart of the Day, showing that Hungary is most at risk when borrowing costs rise:

"Hungary is the most vulnerable of the European Union’s Eastern states to a sudden jump in borrowing costs, underscoring the need for a bailout accord and government action to restore investor confidence.
The CHART OF THE DAY compares countries’ projected average interest rate on state debt in 2012 with the so-called critical interest rate, the level that Erste Bank AG estimates would push the share of debt-servicing costs above an unsustainable 10 percent of tax revenue. Hungary has the smallest buffer in Eastern Europe and is closest to that threshold after Greece, Portugal, Ireland and Italy, which already breach the limit."

So upcoming bailout for Hungary, followed closely by Egypt, recently downgraded to single B, with Egypt’s FX reserves lower by more than half since the start of 2011 to 16.4 billion USD in January, and import cover now at 3.3 months and still falling. The IMF plan involves removing gasoline subsidies (114 billion pounds expected budget costs in 2012 compared with 100 billion pounds in 2011) which could potentially trigger more unrest in Egypt if it removes its fuel "Alkaloid" but that's another story...

"Nobody will laugh long who deals much with opium: its pleasures even are of a grave and solemn complexion."
Thomas de Quincey - Confessions of an English Opium-Eater (1821).

Stay tuned!

Markets update - Credit - Lather, rinse, repeat

Greek Calends - "To defer anything to the Greek Calends is to defer it sine die. There were no calends in the Greek months. The Romans used to pay rents, taxes, bills, etc., on the calends, and to defer paying them to the “Greek Calends” was virtually to repudiate them. (See NEVER.)" - E. Cobham Brewer 1810–1897. Dictionary of Phrase and Fable. 1898.

In our previous conversation, we reviewed the significant tightening move in credit courtesy of liquidity flushed towards the markets thanks to the ECB's LTRO and FED's FOMC decision. Given market are addicted on liquidity and depending on it, the rally has been of epic proportion. Indeed the year of Dragon has started on a very positive tone. In our conversation "The European Overdiagnosis", we argued that the Year of the Dragon should be rebranded the Year of the Central Bank given the market movement reminiscent of the 2009 rally in risky assets. So far in 2012, we have flying PIIGS with very significant tightening moves in Government peripheral yields, and Greek calends in relation to the ever ongoing discussions surrounding the Greek PSI. But, as per our usual style, we ramble again.

It is time for our credit conversation, we will look at the Greek sideshow and its "unintended consequences", some more pain for subordinated bondholders with additional Italian bond tenders making the headlines, and in extension to our previous conversation "The European Overdiagnosis", Spanish decision to enforce 50 billion euros of charges on banks given the rising growth of Non-Performing loans on banks balance sheet as we discussed in "Money for Nothing".

The Credit Indices Itraxx overview - Source Bloomberg:

Given the ongoing PSI is taking center stage again, it isn't really a surprise to see some widening today in the Credit indices albeit in quiet and thin market.

The relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge):

As commented by one of our macro friends, after a month and half of impressive decorrelation between credit and equities volatility, spreads have finally reconnected towards the absolute level of equities and equities volatility. The 1 year implied volatility dropped by 15% in one month whereas Itraxx Crossover 5 year index (High Yield risk gauge) by more than 30%. On these levels, one should expect relative value trade to unwind given credit doesn't appear extremely cheap versus other asset classes.

As a follow up on previous post, it is interesting to note that Itraxx Financial senior 5 year index (representing 25 European banks and insurance companies), still indicate the strength of the support brought by the LTRO on their spreads compared to the SOVx 5 year Sovereign CDS index (15 countries).

In our last conversation "Money for Nothing", our friends at Rcube Global Macro Research argued the following:
"With European equity markets having rallied almost 25% since last September’s lows (mostly on expectations that the LTRO liquidity injections would ease the credit crunch), we fear that the surprise factor has just changed sides again. Now that numbers north of €1Tn are circulating for the 29/02 LTRO announcement, positive catalysts are drying up. We believe that sensitivity to European economic data has increased a notch."

We commented at the time:
"We agree with our friends at Rcube, namely that the focus should be going forward, on European economic data and rising unemployment levels."

The latest study of the correlation between the Bloomberg Industries EU Bank index and the European PMI manufacturing survey points to some interesting decoupling between EU banks and the PMI survey as indicated by Bloomberg - EU Banks More Macro Sensitive as Liquidity Concerns Abate:

"The correlation between the Bloomberg Industries EU bank index and the European PMI manufacturing survey decoupled significantly from late 2009 to early 2011, having been very strong heading into and through the banking crisis. As the ECB pours liquidity into the market, the PMI indicator is becoming more useful as the correlation returns." - source Bloomberg.

In fact it isn't the only data decoupling recently given the growing divergence between US and European PMI indexes - source Bloomberg:

US PMI versus Europe PMI from 2008 onwards.

We will not venture again in the distinction between the FED and the ECB, namely that one has been financing stock (mortgages), while the other, has been financing flows (deficits), which partially justify our negative stance on Europe, but, as reminder from our post "The law of unintended consequences":
"We do not know when European deficits will end, until a clear reduction of the deficits is seen, therefore the ECB liabilities of the ECB will have to depreciate. It is therefore not a surprise to see the ECB's current reluctance in getting a haircut on their Greek holdings in relation to the ongoing negotiations revolving around the Greek PSI."

Moving back to Greek calends, namely the never ending PSI story, CreditSights in their January Credit Review had some interesting points:
"Greece, and the obvious unsustainability of its existing debt position, has been somewhat of a sideshow to the main act of Italy and Spain for some time now. But negotiations over the restructuring still have the capacity to throw a spanner in the works."

CreditSights, in relation to the Collective Action Clause which Germany proposed to introduce into all Eurozone Government bonds, which could lead to a supermajority of bondholders (66%) to impose the same terms on all holders made the following interesting point:
"Greece, and the obvious unsustainability of its existing debt position, has been somewhat of a sideshow to the main act of Italy and Spain for some time now. But negotiations over the restructuring still have the capacity to throw a spanner in the works. For example, introducing a CAC into Greek law won't, by itself trigger the CDS. But if the CACs are used to impose a restructuring on all bondholders, it is difficult to see how that won't trigger any CDS written before the clause was introduced into Greek law (see Sovereign CDS: Collective Action Complications). We believe the primary reason for avoiding triggering the CDS has been to avoid the known unknown of how it will affect other Eurozone governments rather than worries about the cost of payouts to European banks. One concern is that triggering the CDS may encourage leveraged speculation against Spain or Italy. In other words, if sovereign CDS are demonstrated to be an effective hedge against bond default, then there should be a link between the bond spreads and CDS spreads. If speculators are able to drive CDS spreads wider by selling protection on relatively light volumes, then the bond yields may also be pushed up to potentially unsustainable levels.
Secondly, if Greece can't negotiate a restructuring with bondholders, then it will be faced with the choice of either defaulting or repaying the €14.4 billion in bonds (all domestic-law bonds) that come due in March(the debt that matures before March is all bills). A disorderly default has plenty of scope to undermine investors' confidence in Eurozone governments and repaying any holdouts from the bond restructuring in full will make future negotiations much harder and is sure to prompt the kind of political rhetoric that has previously proved so destabilising."

A case study in the making...

While Greece is taking center stage again, it is interesting to see Spain 5 year Sovereign CDS moving closer to Italy's 5 year sovereign CDS level - source Bloomberg.

While Italian banks have risen thanks to an opportune change of bond buy back rules, Spanish banks have been asked to face the music and will bear 50 billion euros of charges, as Spain is forcing banks to take more losses on the 175 billion euros of real estate assets. On the 1st of February according to Bloomberg:

"The Italian central bank’s new regulations meet European buyback rules on hybrid securities. Banks won’t have to simultaneously issue new instruments to replace those being repurchased and don’t need the approval of Italy’s stock market regulator, the Bank of Italy said on its website.
The Bank of Italy will authorize banks to buy back securities that qualify as regulatory capital as long as their financial position isn’t put at risk, it said."

So go ahead, buy back, the ECB's got your back. And, true to form, this is exactly what has happened following the tweak in the rule book, given, Banco Popolare Società Cooperativa (BPIM) is doing a bond tender for Tier 1 bonds and LT2 bonds, while Intesa, as well, announced today tender offers for 3 Series of Subordinated Tier 1 Notes with a face amount outstanding of EUR 3.75bn:

"The invitation on the Subordinated Notes has the objective to strengthen and optimise the regulatory capital composition of Intesa Sanpaolo and the Group, while at the same time offering Holders the possibility to realise their investment in the Subordinated Notes at a price higher than the prevailing market price immediately prior to anouncement."

Buying the 9.50% Perp. Subordinated Notes (XS0545782020) €1,000,000,000 at 70% of par on the 19th of January, given the bond tender is offered at 90%, would have landed a 20 points gain on the bond, a rapid 28% gain for the brave punter and a 10 points loss for the subordinated buy and hold bondholder.

We touched the subject of rising Non-Performing loans in Europe and in Spain in particular recently. By accelerating the realisation of losses, the new Economy Minister Luis de Guindos is trying to overhaul Spain's crippled financial sector and dealing with its "zombie" banks as indicated by Charles Penty and Emma Ross-Thomas in their Bloomberg article - Spain Coaxes Banks to Merge as Extra Time Given to Purge Losses:
"The government will make banks increase the ratio of provisions set aside for urban and rural land to 80 percent from 31 percent, de Guindos said. For unfinished developments, the provisioning level will rise to 65 percent from 27 percent and to 35 percent for other so-called “troubled” assets including finished developments and houses."

The new 50 billion euros charge according to Bloomberg: "compares with 66 billion euros of provisions taken by banks between 2008 and June 2011 to cover specific loan risks, according to the ministry."

So carrot for Italian banks, and just stick for Spanish banks.

It appears to us that given the ongoing surge in Non-performing loans, if the European recession deepens and unemployment rises, non-financial corporates will suffer as well:

Source - SocGen Sees 4 New Worrying Signs In Italy - Business Insider.

Given the ongoing deleveraging, in the light of the recent Sovereign CDS convergence between Italy and Spain, we might be viewed as contrarian but given the ongoing deleveraging process and the sectorial composition of debt as a percentage of GDP, Spain appears to us as being in a less favorable position particularly given its housing hangover:

On a final note and in relation to the ongoing Greek PSI case study and given Portugal's recent widening in both bonds and CDS, please find below Bloomberg Chart of the day indicating the value of English law when it comes to sovereign debt:

"Portugal’s bonds show how investors concerned about losses being imposed on them are willing to pay up for the extra protection given by English law.
The CHART OF THE DAY shows the prices of Portugal’s $100 million of floating-rate notes and 7.8 billion euros ($10.2 billion) of 3.6 percent bonds, both due in 2014. While the dollar notes are governed by English law and have covenants restricting the issuer’s ability to act against lenders’interests, the euro-denominated securities are issued under local law and lack those protections.
Portugal’s bondholders are concerned the nation will follow the example of Greece, which is negotiating a debt exchange to cut the value of its notes by more than half. The Greek government said it may pass a law to insert so-called collective action clauses into the terms of its domestic-law bonds to force holdouts to accept a writedown."

When the game changes, change the rules...

Stay tuned!

"You can't expect to solve a problem with the same thinking that created it". - Albert Einstein

Markets update - Credit - Money for Nothing

"Now, what I want is, Facts. Teach these boys and girls nothing but Facts. Facts alone are wanted in life. Plant nothing else, and root out everything else. You can only form the minds of reasoning animals upon Facts: nothing else will ever be of any service to them. This is the principle on which I bring up my own children, and this is the principle on which I bring up these children. Stick to Facts, sir!"
Charles Dickens - Hard Times - 1854

What a month in credit! The significant tightening move we have seen in credit as well as the rise in risky assets can certainly be attributed to the LTRO factor as well as the FED stepping with the FOMC decision of maintaining rates low for an extended period of time. Given markets are addicted to liquidity, the rally has been significant and could be even more significant as we await the next round of LTRO funding by the ECB.

So why our title "Money for Nothing" you might wonder? Could it simply be us referencing to one of Dire Straits most successful singles? Or just simply because the temptation of "Money for Nothing" courtesy of the ECB in their next round of LTRO operation might be an offer which might be too good to decline even for banks that doesn't even need the money? Even Nordea Bank recently said it would consider participating in the next LTRO simply as the money "looks cheap", according to CreditSights.

So, in this week special credit conversation, grab a cup of tea because in our long conversation we will go through, LTRO impact, worsening credit conditions leading to rise in Non-Performing Loans in banks balance sheet, and why the Baltic Dry Index matter for Nordic banks, more bond tenders, and Spanish Non Performing Loans and more.

First a quick credit overview.

The Credit Indices Itraxx overview - Source Bloomberg:

The SOVx Western Europe (basket of 15 European sovereign borrowers), was marginally tighter at 322 compared to Wednesday.

But comparatively to Itraxx Financial Senior representing the spreads for European banks and insurance companies, clearly indicates the impact of the unconditional support the ECB has provided to banks relative to Sovereign countries given the spread between both indexes is at a high point of 115 bps - Source Bloomberg:

The current European bond picture with Italy and Spain 10 year government yields falling still; and France receding below 3% yield for 10 years government bonds - source Bloomberg:

In relation to Spain and Italy, there is an interesting convergence between Sovereign 5 year CDS levels  between both countries - Source Bloomberg:

Ireland 5 year sovereign CDS versus Portugal 5 year sovereign CDS spread, while the absolute spread has been falling as well as government bonds, Portugal is still pretty much in the danger zone as indicated by its current 5 year CDS spread - source Bloomberg:

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

From our previous conversations we have discussed liquidity at lengths and its impact credit spreads and markets.

What is interesting to note as indicated by Bloomberg is the following:

"At the end of 2011, the Italian banking system drew over 200 billion euros of gross liquidity from the ECB, just shy of 25% of its total gross lending. This reliance has grown in step with the rising sovereign auction costs in Italy, and investors are likely to want granularity on individual bank usage in forthcoming full-year results."

Bringing us to our main conversation, namely individual bank usage of "Money for Nothing", courtesy of the ECB 36 months LTRO operation. As indicated by CreditSights:

"It looks as though banks were waiting to see if capital markets opened up before deciding how much they need to use their LTRO allocation to refinance near-term maturities, or to what extent some of it might be available to fund new lending or government carry trades. Intesa for example, is reported to have taken €12 bln in the last ECB LTRO. For the stronger issuers such as the Nordic and Swiss banks, which have much easier access to funding markets, recent deals have been opportunistic."

In fact Italian bank Intesa was not the only peripheral bank making good use of previous LTRO, in its fourth quarter call according to Bloomberg, BBVA discussed how the 11 billion euro financing from the ECB covered its 2012 wholesale funding needs and that it might as well take up the second facility offered by the end of February.

But clearly Senior Unsecured markets remains open for core European banks while peripheral banks are still shut out. We argued last year that the race to funding would lead to core European banks issuing at higher cost.
It is indeed the same game we mentioned in our previous conversation "Great Expectations":

"The game is still the same, conceding consequent large premiums in the race to raise capital."

Money for nothing, ECB net lending falling to Euro Area Credit institutions falling but ECB deposits rising - source Bloomberg:

We mean "Money for Nothing" given our friends at Rcube Global Macro, in their latest study of the ECB quarterly bank lending survey indicate a significant worsening of the credit crunch in Europe, meaning plenty of liquidity impact for banks but confirming our 2011 fears of credit contraction for corporates and households ("Money for nothing and the Casino Chips for free..." - Macronomics):

"The ECB has just released its quarterly bank lending survey. Given that it was conducted right after the LTRO announcement, it should have captured part of the macro improvement based on the liquidity injection. Considering this, we think that the results are particularly alarming.
It seems that the LTRO has eased the stress on the sovereign side but did not impact the credit channel to the private sector positively."

As indicated by our friends at Rcube Global Macro Research:

"The credit crunch has intensified further. All lending standards (Firms, Households) have tightened aggressively. Credit to firms in the last quarter has been drastically reduced."

"A net 42% of the 124 banks surveyed have tightened their lending standards to large firms. This is the highest figure since the Lehman bust." - source Rcube Global Macro Research.

"Even more worryingly, the net effect of liquidity position on credit to firms (which historically has a small lead on the actual change in terms of credit) is at an all-time high, hinting at further net tightening in Q1." - source Rcube Global Macro Research:

"The large number of reasons mentioned to justify the tightening of credit availability makes a substantial improvement in coming months significantly less likely. The expectation of general economic activity has massively deteriorated. Similarly, access to market financing, banks’ liquidity position and cost related to banks’ capital position have all experienced stress." - source Rcube Global Macro Research:

"On the household front, we notice that demand for loans has crashed, while banks are now aggressively restraining credit for house purchases. This clearly hints at a much weaker consumption ahead in Europe.
On the positive side, it seems that German banks have remained far more accommodating than their European peers. Ironically, German corporates are also the most self-sufficient in terms of financing..." - source Rcube Global Macro Research:

"As a result, Eurozone growth expectations look way too optimistic.
The survey clearly points towards renewed Eurozone economic momentum weakness.
While this morning’s PMIs were a pleasant surprise, we don’t think it can be repeated. French PMI will slowly move to the mid-30s (please refer to past documents on France for further details), and this will potentially trigger another leg down for global risky assets." - source Rcube Global Macro Research:

And my friends at Rcube to conclude:
"With European equity markets having rallied almost 25% since last September’s lows (mostly on expectations that the LTRO liquidity injections would ease the credit crunch), we fear that the surprise factor has just changed sides again. Now that numbers north of €1Tn are circulating for the 29/02 LTRO announcement, positive catalysts are drying up. We believe that sensitivity to European economic data has increased a notch."

In the continuation to our previous conversation, we agree with our friends at Rcube, namely that the focus should be going forward, on European economic data and rising unemployment levels:
"Unemployment expectations in the euro zone have worsened significantly over 2H11, breaching the 10% level of late November. France has the highest forecast level (outside of Spain and Ireland), and with GDP expectations falling, it is increasingly likely that bad debt formation will exceed current estimates, reversing recent trends." - source Bloomberg.

Although LTRO provides cheap funding to European banks, rising unemployment levels and deteriorating credit conditions should consequently lead to a significant rise in Non Performing Loans (NPLs) on banks balance sheet.

As indicated by Bloomberg:
"IMF data show that while the median NPL ratio for the European banks at FY10 was 4%, by 1H11 it was rising for Ireland and Denmark. Bad debt coverage ratios will fall should the stock of non-performing loans rise, as unemployment grows, economic recovery stalls and the associated lower profitability slows retained earnings growth."

NPLs on the rise in Europe - source Bloomberg.

In the meantime, many pundits have been arguing about the importance of the Baltic Dry Index as a leading indicator. For us, it is just another indicator in the deterioration of credit and for tracking NPLs for the Danish banking sector given, as indicated by Bloomberg:
"Nordea highlighted the weak economic environment in Denmark and decreasing collateral values in the shipping industry as key drivers of the 134% increase in loan losses since 3Q. These trends will likely hurt peers Danske Bank (27% share of total Danish lending) and DNB Bank (11% share in syndicated shipping loans)."

If it was only shipping plaguing our Danish Friends...
"Denmark’s biggest lender, Danske Bank A/S, probably returned to profit in the fourth quarter after reporting its first loss since 2009 in the previous period, according to analyst estimates compiled by Bloomberg.
Banks in the worst-performing Nordic economy face more losses on farming loans as that industry struggles to pay down its obligations, Noedgaard said. Agricultural debt swelled 2.6 percent to 359 billion kroner ($63 billion) in 2010, the Danish Agriculture and Food Council estimates. Commercial farms have lost as much as half their value in some parts of Denmark, leaving 6 percent of the industry technically insolvent, according to the council. “We have an agricultural sector that is somewhat challenged by very high levels of debt and a poor performance currently,” Noedgaard said.
Loans to farming, construction and real estate made up 26 percent of total lending at the end of 2010 at banks with less than 50 billion kroner in working capital, according to a May report by the central bank. For the biggest banks, the corresponding figure was 16 percent.
‘Not Looking Good’
At the end of 2011, loans to farms made up 11 percent of banks’ corporate lending and 23 percent of commercial mortgage lending, the Danish Bankers Association estimates.
Danish banks also face growing losses on loans to small-and medium-sized enterprises, which are struggling to survive the fallout of a faltering domestic economy, Noedgaard said." - source Bloomberg - Frances Schwartzkopff - 31st of January - "Denmark’s Bank Crisis Worsening, More Failures Loom, FSA Warns".

We already know "Misery loves company", it was of no surprise to learn the Spanish origin of our latest subordinated bond tenders likely to generate some upcoming haircuts. Banco Popular Espanol launched a tender for Subordinated bonds as well as Asset Backed Securities, for 3 subordinated Lower Tier 2 bonds and 13 tranches of ABS with an aggregate amount outstanding of 1.14 billion euros. The capped face amount being bought back is up to 250 million euros for the LT2 securities and up to 125 million euros of the ABS (via modified Dutch Auction).

In relation to the evolving Spanish situation, from our previous conversation we know that Spanish unemployment has reached 22.9%. It is not surprising to read that Spanish banking giant Santander took a 1.8 billion euros provision against its Spanish real estate exposure last quarter, bringing its coverage ratio to 50% according to Bloomberg:
"With an estimated 170 billion euros of troubled assets outstanding, real estate NPLs reached 28.6% in Spain in 4Q."

Probably a wise move by Santander unlike BBVA, who hasn't so far adjusted its coverage level. While in our conversation "The European Principle of Indifference", we discussed BBVA's accounting gymnastic relating to its Goodwill impairment. We already know the impact Goodwill impairments can have on bank earnings (see "Goodwill Hunting Redux"). It wasn't a surprise to see BBVA having a fourth quarter loss of 139 million euros, (against a profit of 939 million euros in Q4 2010).
From MarketWatch - "Analysts polled by Dow Jones Newswires were forecasting a profit of €152 million, but apparently not all analysts had included that writedown in their forecasts."
Seriously?

What analysts should be concerned about is that BBVA’s bad loans as a proportion of total lending has remained little changed at 4.07 percent in the fourth quarter given according to Bloomberg:
"The bank reported 15.3 billion euros of assets linked to real-estate development in September, of which 4 billion euros was land and 2.8 billion euros was unfinished buildings. BBVA had 6.63 billion euros of foreclosed or acquired real-estate assets on its books, with provisions to cover 33 percent of that amount."

They also should be concerned as well that its Chief Operating Officer Angel Cano said in April 2010 that asset quality was probably going to be “stable from now on.”
Really?

According to Dow Jones Newswire - Christopher Bjork:
"The bad debt ratio of Spain's banking sector rose for the eight consecutive month in November to a new 17-year high, while deposits and loans shrunk further as the country edged towards a double-dip recession, data released Wednesday by the Bank of Spain showed.
According to the data, 7.51% of loans held by banks were more than three months overdue for repayment in November, up from 7.42% in October. It is the highest percentage recorded since November 1994, and contrasts with bad debt levels below 1% of all loans in the years prior to the country's 2008 property bust.
High unemployment, falling house prices and the sluggish economy likely will cause bad loans to continue to rise throughout this year and into 2013, said Goncalo Guarda Garcia, an analyst at Portuguese brokerage BPI."

Christopher Bjork also commenting:
"The November data showed banks had cut lending by 2.54% on the year, while the pool of deposits shrunk at an annual rate of 2.14%.
The new Spanish government said earlier this month that after stalling in the third quarter, the economy had contracted in the fourth quarter of 2011 and is set to shrink further this quarter.
Overall, EUR134.1 billion in loans were non-performing in November, up from EUR131.9 billion in October and EUR104.7 billion a year earlier. Banks had set aside a total of EUR73.82 billion to cover these soured loans at the end of November, up from EUR62.2 billion a year earlier. The amount of provisioning will likely rise sharply next month, as many of the country's lenders are expected to set aside a large chunk of their earnings to cover loan losses.
As of November, Spain's banks had total of EUR1.79 trillion in loans outstanding, down from EUR1.84 trillion a year earlier."

"There is a wisdom of the Head, and ... there is a wisdom of the Heart."
Charles Dickens - Hard Times - 1854

Stay Tuned!