Markets update - Credit - Crash Test for Dummies

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

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

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

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

Greek 2 year bonds yielding 63.4%:

Greek 10 year bonds, 21.87% yield:

Greece's fate is signed, sealed and delivered.

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

And liquidity indicators were still worsening today,

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

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

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

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

Itraxx Financial Subordinated 5 year index, widening faster:

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

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


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


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

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

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

In 2009, the game was for weakly capitalised banks to quietly retire bonds at distressed levels to create/boost Core Tier 1 capital, which was precious as long as they could finance the purchase with term debt.

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

If a financial entity is able to buy back its LT2 debt below par, it generates earnings (the beauty of FAS 159, on that subject see my post "Statement 159 - Debt Valuation Adjustments - Déjà Vu 2008.") and then Core Tier 1 capital. It's a kind of magic...because this way a bank's total capital base goes down (by retiring LT2 debt) and given regulators care most about the Core Tier 1 ratio, everyone is happy (probably note the subordinate bondholder).

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

Survival of the fittest.

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

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

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

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

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

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


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

Stay tuned!

Markets update - Credit - Chandrasekhar limit

"The Chandrasekhar limit is an upper bound on the mass of a stable white dwarf star. The Chandrasekhar limit is the mass above which electron degeneracy pressure in the star's core is insufficient to balance the star's own gravitational self-attraction. Consequently, white dwarfs with masses greater than the limit undergo further gravitational collapse, evolving into a different type of stellar remnant, such as a neutron star or black hole."
Looks like I am having difficulties finding new entertaining titles in all that excitement...

What a day it has been in credit. While CDS indices keeps reaching new records, some of the action has been in the cash markets. This is going to be another long post.
As a follow up on my post "Markets update - Credit Terminal Velocity?", one of my very good friend in the credit space, indicated:

"European banks seems to be facing a US dollars funding problem as no investors is willing to lend (buy a CP/CD) with a duration over 1 week. That information, if confirmed, is of significant importance as it has major implications not only in the money market (the spread OIS/Libor is at the widest for almost 2 years and keeps on worsening- 1rst confirmation), but also FX basis market (the basis swap between currencies has been deteriorating significantly and stands at -60 bps versus -10 bps 4 months ago -2nd confirmation). IF the trend remains unchanged in the coming weeks, the casualties may be the following:

• 1- a US dollar rally against most currencies as there is both a lack of US dollars in the funding market, but also because most of the players are short US dollars versus currencies with higher yields ( Haaa … the famous carry trade may suffer a blow, and unwinding positions may be costly and create dislocations).
• 2- a leg down in the commodities universe (except for Gold) as a most of those are US $ denominated.
• 3- a leg down on the equity market as the losses from a higher US dollar will have to be offset by some unwinding on liquid assets (Welcome margin calls !!!). In addition, a higher US dollar versus Euro means lower earnings for the US corporations (non-withstanding slower growth in Europe, a major trade partner for the USA).
• 4- a worsening credit market as banks funding problems have a direct effect on the overall spectrum of the economy."

Liquidity indicators, the picture today:

The Euribor-OIS spread, which is a measure of banks’ willingness to lend to one another, reached the widest the level in 2 1/2 years, a sign of mounting financial-market pressures in the euro zone: 83 bps. Highest level since March 2009, up from 74.85 bps yesterday. While by no means we are at levels reached in 2008, namely 206 bps as Lehman defaulted, we know that the ECB is pumping liquidity in the system so far.

OIS FRA level:

But, in relation to my friend's comment relating to the shortage of US dollar we know courtesy of Bloomberg that:

"The eight largest U.S. money-market funds halved investments in German and U.K. banks over the past 12 months, eliminated their lending to Italian and Spanish firms and reduced investments in French banks, data compiled by Bloomberg and published in today’s Bloomberg Risk newsletter showed."

Hence the basis swap premium mentioned above. In fact the premium European banks pay to borrow in dollars for one year has increased the most since December 2008. In fact the one-year cross-currency basis swap, fell to 65.5 bps below the euro interbank offered rate (Euribor). So, US dollars are indeed becoming more expensive and the Euro is therefore falling:

And the deposits at the ECB keeps piling up:

Update on my previous graph from my post - "Macro and Markets update - It's the liquidity stupid...and why it matters again..." on Eurostoxx 50 (SX5E), Itraxx Financial Senior 5 year CDS index, German Bund (10 year Governement bond, GDBR10), and at the bottom Eurostoxx 6 month Implied volatility:

Flight to quality is the name of the game with the bund touching new lows.

In terms of credit indices, we have seen, once again, new records broken today, but this time with a clear deterioration in liquidity, not a good sign:
Itraxx 5 year CDS Financial Senior index:

Itraxx 5 year Financial Subordinate index, broke easily the 500 bps barrier:

In terms of market activity, a dealer commented he was seeing in the financial space buyers of protection accross the board. Spanish second tier banks finally widened significantly on renewed weakness in their loan books. FROB (Fondo de Reestructuracion Ordenada Bancaria - Spanish Restructuring Fund) will inject 2.465 billions euro in NovaCaixa's capital with a discount of around 75 to 85% price to book.

And my good friend in the credit space to add another comment today:

"The alarm is ringing in the credit market … As credit derivatives (CDS & Indexes) keep on widening, the cash market is suddenly reacting with vengeance. As mentioned in my previous emails, cash is way too expensive versus CDS…. So the re-pricing has to occur one way or the other. I mentioned the risk linked to the roll in the derivatives… it did not happen, so now re-pricing of subordinated bank debt (lower prices … much lower prices) has to occur. Basically, there is “No Choice”… and the funding issue (see my email from yesterday) may well be the catalyst (Euro down versus US Dollar this morning again …. US Dollar up versus most currencies …. Goodbye Carry trade).

The equity market corrected slightly yesterday, but remains at a very high level considering what is happening in the other markets. Valuations are over-optimistic as they are based on past earnings and unsustainable assumptions of growth and consumption. Very soon, in the next 1 to 6 months, investors will open their eyes and re-price the entire equity universe."

The game is called deleveraging:

Worlwide debt as a percentage of GDP has continued to rise last two years from 250% in 2008 to 266% in 2010 (source McKinsey Global Institute). Growth of debt doubled in the last 10 year while GDP growth increased by only 66%.
Problem is that rising debt is no longer offset currently by rising assets (goodbye QE2 and the wealth effect...).

And valuations will have to come down, as austerity bites and we get slower growth - "When it looks like a bear, feels like a bear and sounds like a bear...., it's a bear" - Exane BNP Paribas - Strategy calls 9th September 2011:

The key message of the table according to Exane BNP Paribas is that lower trend growth has a significant impact on equity valuations. (sorry equity friends...):
"A trailing market P/E of 10.3x may look cheap by historical measures. But when ones assume long term nominal EPS growth of 4% (an assumption we make in calculating the equity risk premium) and a CoE of 10%, then the market P/E would be worth only 7.5x, 27% below current levels."

and Exane BNP Paribas to provide the following estimate:

But I digress, back to credit. As I posited previously in my post "The curious case of the disappearance of the risk-free interest rate and impact on Modern Portfolio Theory and more!", it is all about repricing of risk and that is exactly what we are seeing at the moment in most asset classes.
This is what Societe Generale's latest Credit Strategy - Euro Credit Weekly - 9th of September 20011, had to say:
"A 100bp index move to either 200bp or 400bp has never been so difficult to predict. The credit markets are currently gripped by fear and there seems to be no respite in sight from daily swings between risk reduction/aversion. Investor cash positions are high by any measure and the Street is defensive, with cash spreads gapping - and we haven't even capitulated. We've even found a clearing level for new issues of 25-50bp, but it's done little to help; it has just repriced credit significantly wider. Eurozone political event risk is at maximum levels and choppy equities/iTraxx showcase our dilemma. No confidence, poor liquidity, a poor bid and few flows - it's like a slow death. Stay sidelined.

We have a very dislocated market with investors unwilling to add in secondary, although they piled into KPN's deal. However, RCI reopened the market with a €250m tap and the 40bp concession repriced over €10bn of its and Peugeot's debt. That's what we call an expensive deal. Still nothing in senior financials prolonging a 10-week drought. Fresenius reopened the HY market, but it's a special name and unlikely to be a bellwether for the sector. The pipeline is building, but we think issuance will be sporadic, at best."
RCI being Renault Credit International.

So, not yet complete capitulation, thanks to very real sovereign fears on Greece, but getting there...

Itraxx Europe 5 year Main (Investment Grade) versus Itraxx Financial Senior 5 year index:

Current Itraxx levels imply very high default rates ahead, using 40% recovery rate, forecast for Itraxx Main Europe 5 year is 3% of defaults within a year (around 4 names in the 125 strong index), according to Societe Generale. The serious deterioration in the sovereign outlook is weighting more on the financial sector as indicated by the Itraxx Financial senior index, due to liquidity concerns mentioned previously.

Itraxx Crossover (High Yield) 5 year index versus Itraxx Europe Main (Investment Grade):

Crossover is implying a default rate of 11.5% in a year's time according to Societe Generale, about the same as the worst level seen following the 2008 debacle.

Truth is a lot of companies are in a better position than in 2008 to face a downturn given the enormous pile of cash which has been accumulated since 2009.

So, yes, everything is depending on the resolution of the sovereign crisis and the prospects don't look great to say the least, as we all know by now.

SOVx 5 year index (15 European Western Europe countries including peripherals:

Wider still and a new record.

New interesting disconnect in the peripheral sovereign space, Italy 5 year Sovereign CDS is now wider than Spain.

Italy 456 bps versus 424 bps for Spain. In December Spain was 132 bps wider than Italy. Italy has very big refinancing needs in 2012, around 16% of its debt, the elephant in the European room.
It used to be the other way round:

Portugal 5 year Sovereign CDS versus Ireland 5 year Sovereign CDS - the great escape from Ireland?

But the "fear factor" story of the day was Greece.
One year Government Greek bond yield - close to 100%:

Can you spell default? One year Greek CDS level:

Greek Credit Swaps Surge to Record, Signal 91% Chance of Default with 5 year CDS at a record 3,045 basis points according to CDS data provider CMA.
No surprise with GDP contracting 7.3% compared to a year ago.

and my good credit friend to comment:

"Greece foreign lenders have made disbursement conditional on the government’s adoption of new measures that will target the collection of 1.7 billion euro. The government is facing the possibility of not being able to pay wages and salaries in October if its international creditors do not approve the pending 8-billion-euro sixth installment immediately. Without the sixth tranche, the public purse will be 1.5 billion euro short on October 17.

The prospect of a freeze in payments appeared even more serious on Thursday, after Greek commercial banks failed to cover the sum of 300 million euro of supplementary, noncompetitive bids for Tuesday’s auction of T-bills, providing only 155 million. The shortfall is interpreted as a clear message by banks to the government that they are unwilling to fund future issues of T-bills.
The gravity of the situation is indicated by the fact that the government has frozen all disbursements apart from salaries and pensions."

And finally, the icing on the cake:
Sept. 9 (Bloomberg)- Alan Crawford:
"Chancellor Angela Merkel’s government is preparing plans to shore up German banks in the event that Greece fails to meet the terms of its aid package and defaults, three coalition officials said.
The emergency plan involves measures to help banks and insurers that face a possible 50 percent loss on their Greek bonds if the next tranche of Greece’s bailout is withheld, said the people, who spoke on condition of anonymity because the deliberations are being held in private. The successor to the German government’s bank-rescue fund introduced in 2008 might be enrolled to help recapitalize the banks, one of the people said."

Could the Greek default happen this week-end?

Stay tuned!

Markets update - Credit - Crossing An Event Horizon

Following Andrew P's comment on my post "Credit Terminal Velocity?", this post title refers to credit crossing an event horizon and indeed it has.
"Once an object crosses an event horizon of a black hole, its fate is sealed. No matter what path it takes, it is destined to be crushed at the center. There is no way out", Andrew P.

The markets were not pretty to say the least.
Itraxx Crossover (High Yield) index 5 year CDS morning snap:

and ended up the day much wider, 61.5 bps wider to 755.5 bps.

All credit indices broke new records today.

Itraxx SOVx Western Europe, representing 15 countries rose 18 bps to 328 bps.
Here was the morning picture for SOVx:

Itraxx Financial Senior Index 5 year linked to senior debt of 25 banks and insurance rose 24 bps to 270 bps. A new record.
Here was the picture in the morning and it got worse in the afternoon:

In relation to German 10 year Government Bond, we have reached a new record today as well in terms of yield, we flew through the 2% barrier we touched Friday to close at 1.84% level.
Here is a graph displaying German 10 year Goverment bond yield and German 5 year CDS level:

And German 10 year Bund today's price action viewed differently:

Massive flight to quality movement today as risk-off is even more apparent.

An update on my previous graph from my post - "Macro and Markets update - It's the liquidity stupid...and why it matters again..." on Eurostoxx 50 (SX5E), Itraxx Financial Senior 5 year CDS index, German Bund (10 year Governement bond, GDBR10), and at the bottom Eurostoxx 6 month Implied volatility:

You can notice the correlation between the sell-off in the Eurostoxx index and the flight to quality with the drop in the 10 year German Bund yield.

And in relation to Greek yields, I give you Bloomberg chart of the day:

Default looms. The yield on two year Greek bonds rose above its price for the first time. Even after the July 21st meeting pledging 159 billion euros of support with 50 billion expected from the PSI (Private Sector Involvement), based on a 90% participation rate, the yield managed to climb 15%. Markets are expecting a default when you have 49.85% yield, jumping 265 bps on a day (face value 49.82 cents to 100 euros).

In terms of liquidity indicators, the situation is worsening as clearly indicated by the FRA-OIS spread:

Here is the picture compared to 2008:
Top panel: Swap Spread 4 year / Eur FRA-OIS spread / Spread 10 year Italy/Germany
Bottom Panel: Itraxx Financial Senior 5 year / Crossover and SOVx

Only FRA-OIS and Crossover are below the highest level reached following Lehman's collapse in 2008. All of the others are above.
The yield on 10 year Italian government bonds has risen for 11 days in a row, the longest streak since the euro started in 1999. It’s now at 5.28%, less than one percentage point away from its level before the ECB started buying the country’s securities as of the 8th of August.

Today's full liquidity picture:

"The difference between the three-month euro interbank
offered rate, or Euribor, and the overnight indexed swap rate, a
measure of banks’ reluctance to lend to each other, rose to 71.3
basis points today, the widest gap since April 2009" - Source Bloomberg.

As I previously commented on liquidity issues and the consequences of lack of issuance, in August the cost of insuring European debt reached a record level while bond issuance was extremely light:

Although banks recently came furiously to issue covered bonds (bonds backed by pools of loans) during the small tightening period we witnessed on the 31st of August("Markets update - Credit Ripcord? Update on markets move and review of the CDS market and more"), the largest market being the unsecured market has been effectively closed since early July.
Truth is banks have had to pay higher prices to issue their bonds, triggering in effect a repricing of previous secondary issues:
ING sold AAA bonds at 80 basis points over midswaps but Unicredit paid 215 bps the following day, reflecting sovereign concerns.

Lenders, by using prime assets are willing to do whatever is necessary to get funding, as other sources, such as unsecured issuance have dried up, clearly reflected by the very high level reached by the Itraxx Financial Subordinate 5 year index:

As indicated by Morgan Stanley, referenced in my previous post regarding liquidity and why it mattered again, "Europe's leading banks are on average issued around 90% of their term funding needs for 2011 with significant liquidity pools, better solvency and resolute ECB commitment to support the system".
The big concern depends on how long the current issuance "shutdown" will go on.

In relation to weaker issuers from the peripheral countries "unlimited loans from the ECB are keeping them alive".

According to Bloomberg, banks have 152 billion euros of deposits parked at the ECB:

In terms of the deflation scenario playing out (and paying out), according to Bloomberg, Deflation floor contracts, instruments that pay investors when consumer prices fall have risen by more than 50% since the end of June.

In relation to the risk of a double dip, it is nearly guaranteed, zero freight rates fuel default risk for the third-largest container line CGM CMA, according to Bloomberg. The probability of default for CGM CMA on 5 year is around 90%.
About CGM CMA (rated B+) from the same Bloomberg article:
"The company posted an 8 percent increase in first-half sales to $7.3 billion and had $675 million of cash at the end of July, according to a statement on its website. CMA CGM said it had $5.3 billion of net debt at the end of June and recorded $685 million of earnings before interest, tax, depreciation and amortization in the first half of the year.
That means debt is more than three times Ebitda, compared with a ratio of about less than one time at Maersk, according to that company’s earnings report on Aug. 17.
CMA CGM also issued 325 million euros ($461 million) of 8.875 percent bonds maturing in 2019 in April, which were quoted at 51 percent of face value on Sept. 2, Bloomberg Bond Trader prices show."

Facts on current freight charges - source Bloomberg:
"Freight charges collapsed on the Asia-to-Europe lines, the world’s second busiest route, as a capacity glut combines with the slowest growth in trade since 2009. Rates excluding fuel surcharges were “practically” zero in July and little changed last month, the worst run ever, according to Menno Sanderse, an analyst at Morgan Stanley in London."

Industry losses:
"The industry may lose $2.5 billion to $3 billion this year, said Philip Damas, director of liner shipping and supply chains at Drewry Shipping Consultants Ltd. in London. Owners and operators lost $20 billion in 2009, when the global container trade contracted for the first time ever, he said." - Source Bloomberg.

And if you think about the decoupling story between Emerging Markets and Developed countries, well, so far Chinese banks are trading tighter CDS wise than their European peers, the big question is how long is it going to last?


Stay tuned!