Markets update - Credit - Modicum of relief

mod·i·cum (m d -k m). n. pl. mod·i·cums or mod·i·ca (-k ). A small, moderate, or token amount. - The American Heritage, Dictionary of the English Language.

"Thus, the questions we should ask here are what makes the current economic upswing different from the past two recoveries, and whether such differences are sufficient for the economy to reach the sustained growth path."
Toshihiko Fukui - 29th Governor of the Bank of Japan from March 20, 2003 to March 19, 2008.

Given everyone is awaiting the results for the Greek PSI, Collective Action Clauses and CDS trigger, we thought using "Modicum of relief" as a title was, somewhat, an appropriate title in relation to the most recent LTRO program and continued rally in the equity space (Euro Stoxx 50 index reaching a seven-month high) as well as the significant tightening in peripheral bond spreads. While in our previous conversation "Schedule Chicken" we touched on the importance of tracking deposits levels in conjunction with lending surveys, this time around we would like to focus our attention on systemic risk diagnosis. Domestic deposits are essential in defining the default path in a credit cycle (it was the case for Argentina...). But before we jump into more in depth analysis of the latter, it is time for our usual credit overview.

The Credit Indices Itraxx overview - Source Bloomberg:

Following the second round of the LTRO, there has been a raft of new issues in the primary market: 1.1 billion GBP and 1.85 billion euros worth of investment-grade corporate bonds with an average maturity of 4.5 years for euro-denominated investment grade corporate bonds.
The iTraxx SOVx Western Europe Index of sovereign credit-default swaps (15 governments) remains elevated, even after the second round of LTRO. The big beneficiaries of the second round of support remains the financial sector given Itraxx Financial Senior 5 year CDS index  (representing Senior risk level for European banks and financial institutions) is approaching once again the 200 bps level while Itraxx Financial Subordinate 5 year CDS index is marginally tighter, one week on, at around 343 bps (20 bps tighter than last week).

The spread between the Itraxx Financial 5 year CDS index versus the SOVx Western Europe is still indicating the divergence of support courtesy of LTRO 2 and at a record level (138 bps) impacted by the still widening trend of Greek CDS and elevated levels of peripheral CDS sovereign spreads - source Bloomberg:

"Flight to quality" picture, Germany 10 year Government bond yields remain well below 2% yield and falling 5 year CDS spread for Germany, confirming our previous call, namely that demand for precautionary assets remains elevated and the widening for the 10 year German benchmark bond remain somewhat capped - Source Bloomberg:

The current European bond picture with Italy and Spain 10 year government yields accelerating their fall in yields, courtesy of the LTRO 2 effect this time around - source Bloomberg:

While yields are falling, support for peripheral debt is coming from peripheral banks which are in effect encouraged by the LTRO in purchasing their domestic debt, other European banks are not participating to the party.

As indicated by Lucy Meakin in her Bloomberg article - Banks Miss Best of Bond Gains as Fear Trumps Greed: Euro Credit, major European banks are missing out on the big rally in peripheral bonds:
"Italian securities have handed investors a return of 11 percent this year, the most among 26 bond indexes tracked by Bloomberg and EFFAS as of March 1. Ireland’s debt has returned 9.9 percent, Belgium’s 3.8 percent and Spain’s 3 percent, the indexes show. Germany’s bonds, the European benchmark, have gained 0.2 percent, beating only Greece among their euro zone peers. Italian two-year note yields fell below 2 percent for the first time since October 2010 yesterday.
RBS cut its holdings of Italian, Irish, Portuguese, Spanish and Greek government debt by 90 percent in 2011 while boosting those of German bunds, according to a Feb. 23 investor presentation."

We keep saying this:
"It is all about capital preservation rather than a hunt for yield".

From the same Bloomberg article:
"As the credit ratings of countries such as Ireland, Portugal and Greece have been cut, those nation's bonds have also become too risky to remain in many developed-market government indexes, reducing the number of institutions willing to buy the securities. Standard & Poor's downgraded nine euro- area countries, including Italy and Spain, on Jan. 13."

Spain 5 year Sovereign CDS versus Italy's 5 year sovereign CDS level finally moving above Italy - source Bloomberg:

Back in our conversation "Lather, rinse, repeat", we indicated our contrarian stance on Spain versus Italy:
"Given the ongoing deleveraging, in the light of the recent Sovereign CDS convergence between Italy and Spain, we might be viewed as contrarian but looking at 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 in the lights of its housing hangover"

We think Spain Sovereign CDS will drift wider, indicating increasing default risk perception given:
-Italy's shrinking budget deficit to -3.9% in 2011 from -4.6% in 2010,
-Spanish unemployment level expected to reach 24.3% in 2012,
-Spanish Prime Minister Mariano Rajoy has decided to side step the 4.4% deficit target for 2012, for 5.8%:
“I didn’t communicate the deficit target to the heads of state, nor do I have to. This is a sovereign decision taken by Spain.”
Yet another political surprise in true "Greek referendum" style. We think you can reasonably expect more similar "political surprises" with upcoming elections and the European "Schedule Chicken". We all know by now how frantic politicians become when it is election time (Spanish local elections in March).
It will be interesting to see if the European Commission will strictly pursue sanctions under its recent enhanced powers granted in 2011.

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:

ECB Says Overnight Deposits Surge to Record on 3-Year Loans - Jana Randow -source Bloomberg:
"Financial institutions parked 776.9 billion euros ($1.03 trillion) with the Frankfurt-based ECB. That’s the most since the euro was founded in 1999 and up from 475.2 billion euros a day earlier. Banks get 0.25 percent on the deposits."
The jury is still out there to decide whether the new raft of 36 months lending via LTRO 2 will avoid a credit crunch, and we will be closely monitoring the ECB's lending surveys as well as deposits movements in the European banking system.

“The banks that have borrowed liquidity from the ECB are not the same as those that are using the deposit facility of the ECB,” - Mario Draghi
We think the "modicum of relief" of LTRO 2 will be relatively neutral to risky assets compared to LTRO 1. Nomura's recent take on the 36 months LTRO, was the following:
"Market impact is likely to be relatively neutral
Market participants expecting "risk-on" may be mildly disappointed, with some in the market looking for €1trn+ take-down from the operation for the rally to continue. The market is in a more neutral state now than it was in December, with positioning seemingly light in most segments, which should lead to a more muted reaction to this operation than we have seen since the last 36-month operation.
In general, we would expect investors across instruments and curves to remain segregated. The bid to periphery front-end is likely to continue from domestic institutions, though the strength of the rally since December in Italian and Spanish front-ends may leave limited upside potential without an altering of the credit profile of these countries.
We think Bunds are likely to remain tied to the more acute risks in the euro area, such as the developments in Greece, Irish referendum and the French elections. France is likely to be a low beta against difficulties in Italy and Spain, though political risks may provide uncertainty as we approach the early-May elections.
Euribor should continue its downward trend in the short term given the additional liquidity, with Eonia little changed unless the ECB adjusts the deposit which we think is unlikely."

Our good credit friend and we confabulated around the latest round of liquidity injections by the ECB:
"In order to keep the big picture in mind, the global economy now faces higher commodity prices, austerity budgets in Europe, and households decreasing disposable income. The “cocktail” could prove toxic for risky assets, as well as for sovereign bonds. Earnings and credit metrics will be affected by various factors, and budgets targets may not be met, endangering the recovery in the sovereign bond market.
Remember: credit dynamic is based on Growth! No growth or weak growth can lead to defaults and asset deflation."

Moving on to this week subject of systemic risk diagnosis, wholesale bank deposits flights and tracking the loan-to-deposit ratio of banks can be used as a simple gauge of risk profile. It is as well a good indicator of banks 'capacity in supporting lending in their respective economy. Maintaining lending and credit flows is paramount to avoid a credit crunch which would essentially impair GDP growth in the process (as per our "car" analogy used in our previous conversation).

Hungary has been our pet subject in various conversations ("Hungarian dances"). The reason behind our choice is that it appears to us as very good case study for systemic risk diagnosis from a macroeconomic point view (after all our blog is called Macronomics).
Hungary Banks’ Credit Capacity Drops to 2008 Level - Edith Balazs, Bloomberg:
"Hungarian banks’ lending capacity fell in the fourth quarter to a level last seen in September 2008, when the financial crisis engulfed the country, because of tighter and more expensive funding, the central bank said.
“The deterioration in lending capacity was last reported by such a proportion of banks upon the outbreak of the September 2008 crisis,” the Magyar Nemzeti Bank said in a survey published today in Budapest. The drop in lending capacity is driven by shrinking external funding and rising foreign-currency funding costs, it said.
Hungary’s banking industry turned unprofitable for the first time in 13 years in 2011 because of losses from foreign-currency mortgage repayments, rising bad loan provisions and a special industry tax. Regional competition for external funding is becoming more difficult for the Hungarian banks, the central bank said."

From the same Bloomberg article:
"A net 70 percent of banks involved in the survey expect funding conditions to worsen in the first half of 2012, according to the study. Banks plan to further tighten credit criteria for corporate loans in the first half of 2012, it said.
Commercial banks posted a combined loss of 92.6 billion forint ($428 million) last year, the financial supervisory authority, or Pszaf, said on Feb. 23. OTP Bank Nyrt., the country’s largest lender, competes with Italy’s Intesa Sanpaolo SpA and UniCredit SpA, Austria’s Erste Group Bank AG and Raiffeisen Bank International AG, and Germany’s BayernLB."

Looking at Erste Bank Hungary's latest results, it is not a surprise to see how impaired its lending capacity is given its:
-loan-to-deposit ratio of 192%, the highest in the sector.
-the proportion of non-performing loans in the bank's portfolio rose to 20.5% in 2011 from 11.7% in 2010 (The rate in the retail portfolio increased to 16.3% from 11.4%, while the rate in the corporate portfolio climbed to 29% from 12.5%) according to Bloomberg.

A liquidity crisis happens when banks cannot access funding (LTRO helped a lot in preventing a collapse). A solvency crisis can still happen when the loans banks have made turn sour, which implies more capital injections to avoid default (hence the flurry of subordinated bond tenders we have seen). Rising non-performing loans is a cause for concern as well as rising loan-to-deposit ratios.

As a follow up to our previous conversation, the race is on in Europe to improve the loan-to-deposit ratio for peripheral banks given wholesale funding is more challenging, yet improved nevertheless by the two rounds of LTRO. For instance, Lloyds banking group is still a recovery story when it comes to its loan-to-deposit ratio, compared to rock solid Standard Chartered with its 76.4 loan-to-deposit ratio and 11.8 Core Tier 1 capital. Lloyds banking group loan-to-deposit ratio for 2011 was 135%, versus 154% in 2010 and 169% in 2009. Part of the ongoing deleveraging process for banks is supported by the liquidity support and central bank sources (Lloyds took 11.4 billion pounds from LTRO 2).

In relation to systemic risk, credit risk conditions can significantly and persistently be decoupled from macro-financial fundamentals as indicated by Bernd Schwaab, Siem Jan Koopman and André Lucas in their December 2011 paper "Systemic risk diagnostics: coincident indicators and early warning signals":
"We demonstrate that a decoupling of credit risk conditions from macro financial fundamentals has preceded financial and macroeconomic distress in the past with non-negligible lead time (about four quarters).

We mentioned Argentina at the start of our conversation, prior to Argentina defaulting in 2002, as indicated by CreditSights in their 31st of July 2001 paper "Defining the Default Path", they are some interesting similarities to the current Greek and Hungarian situation:
"Should trade finance dry up, the associated reduction in economic activity could be devastating for a country trying to emerge from a deep recession. The second key issue is the behavior of depositors, who have pulled a little over 6 billion US dollars out of the banks this month and are, if press reports are accurate, sending it abroad or stuffing it into the mattresses.
Given Argentina's long history of confiscating wealth (the last time was under ex-president Menem in 1989), the most puzzling aspect of the crisis so far is the relative complacency of the public. This is starting to be tested. The term structure of deposits doesn't bode particularly well, especially as the government has tried to force the banks out longer on the curve than is ideal given deposit withdrawals. We estimate that almost 2/3 of deposits are eligible to be withdrawn in the next 30-60 days and we would be surprised if those deposits that extend in the system were put in time deposits. In addition to the obvious potential of a run on the banks, the lack of liquidity in the system has forced the central banks to provide unprecedented level of repos to the system and also relax reserve requirements. The problem is that this is very unclear whether that additional liquidity is funding anything but capital flight at this point."

Any similarity to actual countries, is purely coincidental...

On a final note, we leave you with Bloomberg Chart of the day, indicating that the induced "LTRO Alkaloid" is at odds with bunds and gold:

"The CHART OF THE DAY compares the Euro Stoxx 50 Index with 10-year German borrowing costs and an inverted gold price. Government bonds and gold are perceived as safe assets in times of financial-market downturns. The equities gauge has gained 9.2 percent this year while gold has climbed 14 percent. Bund yields are little changed since the ECB’s first tender on Dec. 21."

“We cannot have equities at these levels if the European economy needs a further 530 billion euros. People are taking on risk only because the ECB is happy to provide liquidity to banks that are in a dire situation.” - Alberto Espelosin, Ibercaja Gestion.

"There are things known and there are things unknown, and in between are the doors of perception."
Aldous Huxley

Stay tuned!

Markets update - Credit - Schedule Chicken

"Every man prefers belief to the exercise of judgment."
Lucius Annaeus Seneca

"The practice of schedule chicken often results in contagious schedules slips due to the inner team dependencies and is difficult to identify and resolve, as it is in the best interest of each team not to be the first bearer of bad news. The psychological drivers underlining the "Schedule Chicken" behavior are related to the Hawk-Dove or Snowdrift model of conflict used by players in game theory." - source Wikipedia.

Given everyone is focused now on the results for the much awaited PSI in relation to the ongoing Greek debt resolution process, Greek CDS trigger or not, courtesy of Collective Action Clauses (knowing that the IMF assumes a 95% participation rate to the PSI...), we thought this time around, we would use an analogy relating to project management linked closely to the famous game of chicken, namely the Nash equilibrium concept. Looks like we are rambling again as usual.

In this week credit conversation, we will once again discuss the LTRO effect, and the importance of deposits levels and credit cycles,  touching on the latest Commerzbank debt to equity swap (not really a surprise to us as we hinted it would happen on the 29th of November in our conversation "The Eye of the Storm"), and the impact the PSI will have on Greek banks and more.

But as always, time for a credit overview!

The Credit Indices Itraxx overview - Source Bloomberg:

The iTraxx SOVX Western Europe Index of sovereign credit-default swaps(15 governments) although tighter by 4 basis points to 344 bps, remains elevated on the 24th of February, compared to the Itraxx Financial Senior 5 year CDS index representing European Banks and Insurance institutions.

The strength of support brought around by the previous LTRO to the Itraxx Financial Senior index is clearly indicated by the spread of the index versus the SOVx 5 year CDS index representing sovereign risk in Europe, still around the highest level reached - source Bloomberg:

"Flight to quality" picture, Germany 10 year Government bond yields remain below 2% yield and falling 5 year CDS spread for Germany - Source Bloomberg:

In our conversation the "LTRO Alakaloid", we indicated that ongoing concerns surrounding the European crisis meant that the widening potential for 10 year German government bonds was indeed somewhat capped given the demand for precautionary assets.
We indicated: "It is all about capital preservation rather than a hunt for yield".

The current European bond picture with Italy and Spain 10 year government yields falling still, given the LTRO effect is encouraging Italian and Spanish banks in buying their respective domestic debt - 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 ECB 3 years LTRO has had a significant effect on the three months Libor OIS spread in 2012, a clear indicator of risk in the banking sector. As Nomura indicated in their note from the 20th of February entitled - ECB 3yr LTRO: Fixing what's broken:

"Low money market rates and ample liquidity provision by the central bank went a long way towards easing funding tensions in the money markets in 2008. This is evidenced by the drop in the Euribor-OIS spread, one indicator of systemic credit risk in the banking system, after the ECB's emergency rate cuts. Euribor is the rate for 3m uncollateralised interbank lending and OIS refers to a 3m swap contract whereby one exchanges EONIA(floating leg) for the 3m OIS rate (fixed leg). Despite the fact that the volume of uncollateralised lending between banks has shrunk significantly since the global financial crisis, Euribor remains a reference rate that can be used to gauge aggregate credit risk in the banking sector."

But we have a cause for concern, namely that the LTRO is addressing liquidity issues for cut-off peripheral banks but in no way solvency issues and availability of credit to the real economy (see our post, "Money for Nothing"). In fact, we are currently witnessing a dangerous phenomenon of flight of deposits from peripheral banks to Germany as indicated by John Glover in his Bloomberg article - Bank Deposit Flows Show Money Leaking to Germany:

"Money is leaking out of banks in southern Europe as customers scoop deposits out of Greece, Spain and Italy to move cash to less indebted nations such as Germany.

Greece’s total deposits plunged 28 percent from the peak in June 2009 to 169 billion euros ($225 billion) at the end of December, according to data compiled by Bloomberg. In Spain, deposits slid 5 percent in the five months through November to 934 billion euros, the least since April 2008. Italian banks held 974 billion euros in November, the lowest in 18 months.

Deposits in Germany have climbed by almost 10 percent since May 2010, when Greece was granted its first bailout. Deposits have risen every month except five since the end of 2009, and reached 2.15 trillion euros at the end of 2011, Bloomberg data show. The deteriorating growth outlook in the euro region risks exacerbating those flows, according to Dario Perkins, an economist at Lombard Street Research in London.

“The biggest systemic risk is if people lose confidence in keeping their euros in Spain, Portugal or Italy,” Perkins said. “It makes sense to put your cash into Germany just to be safe and that’s where the real systemic danger lies. That contagion isn’t priced in, and bank deposits are the place we’d spot it.”

This flight of deposits will have a significant impact in economic growth. We agree with Nomura, from their recent report, namely that:
"Monetarist economics is back in vogue; we are watching deposit growth".

Indeed, our European Flutter's narrow money (sum of currency in circulation and overnight deposits), namely M1 growth, is displaying different speed, a leading indicator when it comes to future economic activity. While in our previous conversations, we focused on the importance of the ECB's lending surveys, it is essential, we think, to follow the flight of households deposits in Europe, which is a phenomenon, that is not only affecting peripheral countries, but Emerging Eastern Europe countries as well, such as Hungary, which has been a recurring item in our recent conversations ("Hungarian Dances"):

The ongoing shift in households funds across Europe has not only implications in relation to future economic activity, the shift from short-term to longer terms deposits, as displayed in Nomura's graph will have direct implication on consumptions levels:

"We are also seeing some movement of household funds from short-term to longer-term deposits across the euro-area banking system. This reflects banks' desire to close their funding gaps by relying more on stable, longer-term retail deposits. This shift in the composition of bank funding has implications for the short-term demand outlook. If households are increasingly locking up their assets for a longer time, the money is not accessible to spend on consumption."

It is also important to note the ongoing great competition between banks in peripheral countries, offering higher deposits rates in search for longer-term deposits. There is as well a growing divergence between deposits rates across the European banking sector, indicating a growing disconnect with money markets rate.

For more on the subject:
"Savings Wars From Italy to Portugal Drive Bank Costs Higher" - Charles Penty and Sonia Sirletti - Bloomberg
"The average interest rates on new retail deposits for up to one year have jumped almost 60 percent in Portugal and 72 percent in Italy this year (2011), a sign of how Europe’s debt crisis is driving up the cost of capturing savings."

Throughout our conversations, we have been discussing at length the importance of liquidity and bank funding, in relation to credit cycles. Availability of credit is depending, as well on the level of bank deposits.
In a recent conversation we made the following comment:

"In relation to the current situation let us use this analogy. Imagine you are driving a car called Europe, now it is winter and snow has been piling up on the roads making your driving risky and prone to an accident (liquidity issues). Then comes the LTRO (ECB grit truck) to clear the road ahead of you. Now, you think the road is clear, but, as any car owner knows, what makes your engine running smoothly is the amount of oil lubricating the engine (credit conditions)."

We also added:

"You need to track the ECB lending survey, when it comes to monitoring your oil level. Lack of oil (credit), could seriously damage your engine (growth), and therefore stall your engine (recession) and seriously damage your car (economy). Now let's suppose you drive your car to make a living, and you've borrowed money (sovereign debt) to purchase your car. How are you supposed to make the repayments if your car finally breaks down because your engine has been damaged because of your negligence in maintaining a proper oil level (credit) in your engine (economy)?"

We do agree completely with the following, "Credit growth is positively correlated with GDP growth". According to Nomura:

"Households and firms are highly dependent on the availability of bank lending in the euro area. Firms – in particular small and medium-sized firms – rely almost exclusively on bank lending as a source of external funding. Households use banks for mortgage finance and unsecured borrowing. Hence, bank lending to households and firms is a critical part of the monetary transmission mechanism.

We have empirical evidence that credit growth is positively correlated with GDP growth, especially in the euro area (see Zhu, 2011). The intuition is clear: rapid lending growth boosts economic activity as funds are available to increase consumption and investment. In contrast, times of deleveraging are usually associated with low or negative activity growth as households and firms focus on debt repayment rather than consuming and investing."

Nomura indicated as well in their recent note the following important point relating to credit cycles:

"The non-synchronised credit cycles across the euro area are problematic for the ECB: There are countries which clearly require a loose monetary policy stance to offset the deflationary impacts of deleveraging (Ireland, Portugal and Greece). But looser monetary policy may also postpone the deleveraging process which is necessary in some countries (Spain). And keeping monetary policy loose for too long may fuel excessive credit growth in other countries (Germany) leading to the build up of unsustainable private sector imbalances."

Moving on to our next item, namely the recent debt to equity swap announced by Commerzbank, as we indicated at the beginning of our conversation, it was not really a surprise to us.
Commerzbank announced, in true Banco Espirito Santo style ("Subordinated debt - Love me tender?"), a debt to equity swap. The exchange offer period starts February 23 and is expected to end on March 2nd.

The latest rise in Commerzbank share price, allows Commerzbank to benefit more from exchanging hybrid capital for equity - source Bloomberg:

Following the announcement on Thursday, the shares fell as much as 9.6% to 1.95 euros.

The announced offer to swap hybrid debt covers 3.16 billion euros worth of securities. The German government owns a minority stake of just over 25% and will participate to the operation. The operation if successful could boost its core Tier 1 capital by 1 billion euros.

"The Silence of the Lambs" or more accurately "The Silence of the Subordinated bondholders and equity holders".
The capital increase equates to a maximum of 10% minus one share of Commerzbank current subscribed capital.
Last year, Commerzbank also bought back subordinated bonds trading below face value last year to boost core Tier 1 capital. The income generated from the bond tender buoyed fourth quarter profit by 735 million euros.

Commerzbank Can' t Pay Dividend, Service Silent Participations, by Aaron Kirchfeld and Nicholas Comfort
Feb. 23 (Bloomberg) --
"Commerzbank AG said it won't pay a dividend for 2011 and can't service silent participations held by the country's Soffin bank-rescue fund after posting a loss under German HGB accounting rules.
"It remains our goal to service the silent participations of Soffin in the future and also pay a dividend again," Chief Executive Officer Martin Blessing said at a press conference in Frankfurt today, according to a copy of his speech."

Silent participation is a form of non-voting capital used in Germany that is not accepted by the European Banking Authority as core Tier 1 capital.
As a reminder from our conversation relating to bond tenders on the 25th of October:
"So, in our debt to equity swap, courtesy of the subordinated bond tender, not only the subordinated bond holder is taking a hit, but our shareholder as well. Love me tender?"

In relation to this latest bond tender, our good credit friend and we commented:
"What is happening to Commerzbank could well happen to other financial institutions: swapping debt for equity is neither good for shareholders, neither for bond holders."

On a final note, and in relation to the "Schedule Chicken", Greece in the coming days will remain firmly in the spotlight given the expectations surrounding the results of the PSI and CACs impact (CDS trigger or not a CDS trigger, that is the question...). The immediate write-down of the remaining 53.5% of principal on Greek debt equates to a net present value loss of over 70%. Given Greek banks have the largest exposure to their domestic debt, you can expect a lot more of additional pain for the likes of National Bank of Greece. Taking a 75% coverage on their Greek bond portfolio (12.9 billion euros as of June 2011) implies an additional pre-tax charge of just over 8 billion euros, or around 6.5 billion euros allowing for a tax credit according to CreditSights. National Bank of Greece's core tier one capital was only 6.3 billion euros in September 2011. The 30 billion euros capital shortfall derived from the EBA (European Banking Association) exercise in 2011, was based on 50% private sector value loss. An impairment of 70 to 75% loss would equate to an additional 45 billion euros worth of aggregate recapitalisation for the Greek banking system. Oh dear...

Greek debt ownership - source Bloomberg:

"Schedule Chicken" - source Bloomberg:
Feb. 27: Germany’s Bundestag will vote to approve the Greek
bailout package.
Estonia’s parliament will vote to approve the package no later than this date, according to Taavi Roivas, the head of the legislature’s European Union affairs committee.

Feb. 28: Finland’s parliament will vote on the second Greek rescue program at 2 p.m. local time, according to Seppo Tiitinen, the Helsinki-based legislature’s Secretary General.

March 1: The Dutch parliament will have voted on the Greek bailout package by this date, according to Finance Minister Jan Kees de Jager.
The Greek parliament will also have approved the implementation law.

March 1-2: European Union leaders will hold a summit meeting in Brussels. They will discuss a possible increase in Europe’s so- called firewall, including possible concurrent operation of the temporary European Financial Stability Facility and the permanent European Stability Mechanism.

March 9: Bids for private creditors’ swap transactions are expected to close.

March 11: Private creditors’ swap transactions will take place by this date.

March 12-13: EU finance ministers will meet in Brussels.

March 20: Greece is scheduled to pay off 14.5 billion euros of maturing debt.

April 20-22: The IMF will hold a meeting in Washington.

"When people are taken out of their depths they lose their heads, no matter how charming a bluff they may put up."
F. Scott Fitzgerald

Stay tuned!

Markets update - Credit - The European Opprobrium

"Everyone has his faults which he continually repeats: neither fear nor shame can cure them."
Jean de La Fontaine

Opprobrium:
1. the state of being abused or scornfully criticized
2. reproach or censure
3. a cause of disgrace or ignominy
Collins English Dictionary – Complete and Unabridged

"AMONG the numerous advantages promised by a well constructed Union, none deserves to be more accurately developed than its tendency to break and control the violence of faction." James Madison (The Union as a Safeguard Against Domestic Faction and Insurrection) From the Daily Advertiser. Thursday, November 22, 1787.

The recent Greek opprobrium (definition number 1) makes us reflexionate on the structure of our "European flutter", namely the current European Union. In terms of analogy, we could only think about the wise words of the Father of the United States Constitution, namely James Madison, who became as well fourth president of the United States.

In his 1787 essay, James Madison also wrote:

"When a majority is included in a faction, the form of popular government, on the other hand, enables it to sacrifice to its ruling passion or interest both the public good and the rights of other citizens. To secure the public good and private rights against the danger of such a faction, and at the same time to preserve the spirit and the form of popular government, is then the great object to which our inquiries are directed. Let me add that it is the great desideratum by which this form of government can be rescued from the opprobrium under which it has so long labored, and be recommended to the esteem and adoption of mankind."

James Madison - (The Union as a Safeguard Against Domestic Faction and Insurrection)

"Whatever is begun in anger ends in shame."
Benjamin Franklin

But once more, we are caught in our philosophical thoughts, as we witness the unraveling of the Greek Opprobrium and wondering on the future of the European Union. Time for our credit conversation. Following a quick overview, we will review our recurring theme the LTRO effect on credit. We will as well review our bond tenders favorite theme, this time focusing on the amounts and results so far, and the ongoing pain in Spain, with the deleveraging process.

The Credit Indices Itraxx overview - Source Bloomberg:

A volatile week in the credit space, plagued by the ongoing Greek Damocles overhang. On the 16th of February Itraxx Financial Senior 5 year CDS index (tracking European Banks and Insurance credit risk) intraday range was 25 bps, reaching a one month high level of 252 bps, before dropping on Friday towards the 223 bps level. As a market maker opined, the price action in the credit space lately has been driven by headlines, in true 2011 fashion. As the European Greek game of chicken goes on ahead of the March 20 14.5 billion euro bond redemption payment, volatility is elevated.

Itraxx Crossover 5 year CDS index (50 European High Yield names), reached 647.5 bps on the 16th, closing around 600 bps on Friday. "Lather, rinse, repeat" in true 2011 style - Source Bloomberg:

The Itraxx Financial senior 5 year index (representing 25 European banks and insurance companies), indicates the strength of the support brought by the LTRO on their spreads compared to the SOVx 5 year Sovereign CDS index (15 countries), which, this week rose for seven days in a row, the longest streak since November 2010, reaching 355 bps on Thursday before receding at the end of the week around 340 bps - source Bloomberg:

Spain 5 year Sovereign CDS versus Italy's 5 year sovereign CDS level converging still - source Bloomberg:

The current European bond picture with Italy and Spain 10 year government yields converging as well - 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 started on the 15th of February and will last 28 days (not 22, erratum from previous post) for deposits earning 0.25%.

In relation to the significant amount of deposits still sitting at the ECB, CreditSights makes the following important points in their note Eurozone Inc. - LTRO FAQs:

"The reserves only have an impact on asset prices to the extent that banks try to get rid of those reserves and use them to buy higher-yielding assets instead. As each bank pushes the problem of low-yielding reserves onto the next bank, then it creates an additional demand for bonds.

But banks that are domiciled in say Italy or Spain will be more likely to undertake a portfolio shift out of reserves and into Italian or Spanish domestic assets than a German bank.

A German bank faced with an excess reserve position might find it more appealing to leave the money at the ECB and receive a 25 bp rate of interest, versus taking on Italian risk or buying German T-bills at a yield of close to zero."

Moving back to the hot topic of the second round of LTRO expected at the end of the month, what do we think is going to be the impact in terms of risk allocation?

The LTRO so far is enabling banks to face most of the 2012 wall of maturing debt and part of 2013. We agree with Natsuko Waki from Reuters in his article - "Corporate debt to get boost from ECB's new cheap loans" , namely that the big beneficiary of the second round of the LTRO could be corporate debt:

"The second dose of cheap cash from the European Central Bank at the end of this month should spread more broadly across financial markets than the first, sweeping money into non-bank corporate bonds.

This is in part because banks are expected to use the proceeds from the Feb 29 auction to pay down their own debt even further than they have done already. Long-term investors, big holders of bank bonds, will be pushed elsewhere as a result.

Peripheral euro zone government bonds, such as those in Spain and Italy, have been by far the biggest visible beneficiaries of the ECB's offer of nearly half a trillion euros in December. Benchmark Italian borrowing costs have fallen as much as 150 basis points.

But the banks have actually used most of the cheap ECB money to pay off their own debt."

What we are currently seeing therefore is a significant tectonic shift in the credit market, namely that banks are using the proceeds to repay their bondholders, shrinking in effect the massive pool of existing bank debt. Italian banks and Spanish banks are using as well the LTRO to repay their debtors: domestic bank bondholders and other banks, it is estimated that 52% of bank debt is hold by other banks.... Also, they seem to be encouraged so far in buying up the domestic debt of their respective countries.

From the same article, and according to a Goldman Sachs note:

"Insurance companies, pension funds and large asset management firms would need to find alternative investment opportunities. The scale of European bank bonds, as an asset class, is so large that it is comparable only to sovereign bonds or the combined size of all other non-financials corporate bonds outstanding."

So not only, there is an economic growing North and South growth divide within Europe, as indicated by the latest economic data releases but the differentiation in allocation in credit markets will also be increased by the impact of the second round of the LTRO, namely that peripheral countries are encouraged in soaking up their domestic debt, while institutional investors are already encouraged in seeking other investment opportunities than government debt and bank debt (in relation to recent banks downgrades by rating agencies and pending ones).

Following up on our favorite theme of subordinated bond tenders, it is important we think, to give an update of the results so far of the ongoing exercise and its signification.

By buying back hybrids and subordinated bonds, at deep discount to par, the capital gains are in effect boosting their Core Tier 1 capital ratios, which is a necessary exercise in relation to the EBA (European Banking Association) June 2012 deadline for European banks to reach 9% Core Tier 1. According to CreditSights in their note "European Banks in Buyback Bonanza", in the last four months, we have seen tender offers for almost 76 billion euro of face value of European banks subordinated and hybrids bonds launched by more than 20 banks.

Benefits of the exercise are obvious. For the bondholder, it offers less "opprobrium"  (definition number 2 - censure) given the significant premium in the bond tender offer in comparison to prices in the secondary market (for more see "Subordinated debt - Love me tender?"). The dangers being for the institutional investor are to remain in a smaller and illiquid lower rated issue which could be dropped off a specific benchmark, triggering in effect force selling at bigger loss.

For the banks, it enables them to take advantage of current low prices, booking a capital gain and transferring capital to their Core Tier 1 ratio. It also helps them reducing as well interest expenses given some of this hybrids or subordinated bonds sometimes offer higher coupons: As we highlighted in our conversation "Lather, rinse, repeat" in relation to Intesa's bond tender:

"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."

The tender choice is indeed easier to make for the mark to market brave punter who bought the securities at a lower cash price.

According to CreditSights, acceptance rate, while varying significantly, so far for these bonds tenders have been in the region of 50%.

In relation to Spain, which we have been discussing at length in recent conversations, according to Bloomberg:

"Spanish banks' average borrowings from the ECB hit new highs of more than 130 billion euros in January, while bank lending to Spanish businesses fell and bad debt hit highs not witnessed since 1994. With unemployment of 22.9% at 1996 levels, continued troubles in the real estate sector will likely drive lending lower."

Given Spanish banks ratio of non-performing loans to total loans came in at 7.61% in 2011 which is the highest percentage since 1994, the LTRO effect amounts to "Money for Nothing", at least to the real economy...and we are not the only ones.

"Bank crisis looms as Europe’s debt woes deepen" - Charles Dumas, chairman & chief economist at Lombard Street Research:

"In Spain, and even more in Portugal, the heavy private-sector debt burden is in business. For Portugal, non-financial company debt is 16 times pre-interest cash flow, in Spain, 12 times. In the mergers and acquisitions business, 10 times is the threshold for “junk”: not a pretty description for an entire country’s business sector. In addition to this debt burden, which forms a large part of the banking system’s assets, the Iberian asset values that collateralise the debt in many cases have hardly adjusted to post-crisis realities. Spanish commercial property, for instance, in total-value terms is only down some 10 per cent from end-2007 highs that were well over twice 2000’s.

Spain’s new government appears committed to “do the full Monti” in one year instead of two – a 4 per cent-of-GDP fiscal deflation, with the added twist of requiring banks to write their assets down to realistic levels. This shock treatment is more likely to kill than cure. It is axiomatic that a recession does more harm to profits than personal income – just as they rise faster in booms.

Spain’s domestic-demand recession (starting from unemployment of 23 per cent, 49 per cent among the young) will be compounded by falling GDP in Germany and the rest of Europe. The profit “denominator” of the debt-to-cash-flow ratio could dive, causing the debt ratio to soar. With asset values potentially sinking fast, the chances of inducing a bank crisis are high. In Spain, even more than in Greece, austerity will probably reduce, not increase, the cents in the euro collected by creditors. The Spanish bond spread deserves to shift back to well above Italy’s, as eurozone orthodoxy destroys the continental economy."

Hence the convergence in both CDS and bond Yields between Italy and Spain we have been highlighting in recent weeks.

On a final note, our good credit friend and ourselves have been discussing the following in relation to the ECB swapping its Greek bonds for new bonds, to ensure it isn't forced to take losses and exempted from Collective Action Clauses (CACs).

Will subordination of private bondholders versus the ECB lead to insubordination?
"If true, here are the questions you should ask yourself:

1-Will the new bonds be senior to the old bonds? If so, expect private investors to go on strike and buy much less sovereign bonds as they will be subordinated to the ones owned by Public institutions in the future. Also, some private investors may decide to try their chance in Court and argue against the subordination de facto.

2-If the old bonds are bought back by the issuer at Par against new bonds, expect private investors to ask for the same treatment (pari passu) and go to Court on the basis that holders are not treated “equally”!

Basically, if such a swap is in the pipe, we think there will be collateral damages which will affect drastically the sovereign bond market."

Good bye pari passu!

Pari passu is a Latin phrase that literally means "with an equal step" or "on equal footing." It is sometimes translated as "ranking equally", "hand-in-hand," "with equal force," or "moving together," and by extension, "fairly," "without partiality." In finance, this term refers to two or more loans, bonds, classes of shares having equal rights of payment or level of seniority - source Wikipedia

"ECB Said to Swap Greek Bonds for New Debt to Avoid Loss" - Jeff Black - Bloomberg:
“If this ECB plan goes ahead it may appear that the ECB is receiving preferential treatment, raising questions about whether the ECB is senior to private-sector bondholders, not only in the case of Greek debt, but also regarding the debt of other euro-zone nations that the ECB may be purchasing.” - Chris Walker, foreign-exchange strategist at UBS AG in London.

Is preferential treatment for the ECB not the real "opprobrium" we have been discussing all along, namely definition number 3: a cause of disgrace or ignominy?

Stay Tuned!

"What do you regard as most humane? To spare someone shame."
Friedrich Nietzsche