Credit - Banker's algorithm

"An algorithm must be seen to be believed." - Donald Knuth, Professor Emeritus at Stanford University.

"The Banker's algorithm is a resource allocation and deadlock avoidance algorithm developed by Edsger Dijkstra that tests for safety by simulating the allocation of predetermined maximum possible amounts of all resources, and then makes a "s-state" check to test for possible deadlock conditions for all other pending activities, before deciding whether allocation should be allowed to continue" - source Wikipedia

"The Banker's algorithm is run by the operating system whenever a process requests resources. The algorithm avoids deadlock by denying or postponing the request if it determines that accepting the request could put the system in an unsafe state (one where deadlock could occur). When a new process enters a system, it must declare the maximum number of instances of each resource type that may not exceed the total number of resources in the system. Also, when a process gets all its requested resources it must return them in a finite amount of time" - source Wikipedia

Given the on-going discussions relating to Greece negotiating with its creditors and trying to buy some additional time, as well as the much anticipated Spanish official rescue request, with the ECB waiting on the fateful 12th of September German Constitutional court ruling, we thought this time around we would venture towards computational analogies in our title. In similar fashion to our "Banker's algorithm" analogy, it remains to be seen if our European algorithm will avoid deadlock by denying or postponing the Spanish request if it determines that accepting the request could put the European system in an unsafe state.

In similar fashion to our banker's algorithm analogy, the coming months will indeed be decision time given Europe will have to decide at some point whether "allocation" should be allowed to continue.

In reference to Spain, the recent decision by the Spanish State to "allocate" an urgent transfer of 6 billion euros to its bank rescue fund FROB, which controls stakes in Spanish lenders such as Bankia group, will indeed appear in central government budget data once the payment is made:
"Spain is about to boost the capital of the rescue fund after writing down investments in lenders including Bankia group, according to the fund’s annual report dated July 26. The fund posted a net loss of 10.56 billion euros in 2011, sparking a negative equity of 1.86 billion euros." - source Bloomberg, Angeline Benoit and Estaban Duarte, 24th of August 2012 -

We think our analogy this week is once again appropriate. In our computational reference, namely the Banker's algorithm, in similar fashion to the upcoming Spanish rescue request, in our Banker's algorithm:
"When the system receives a request for resources, it runs the Banker's algorithm to determine if it is safe to grant the request. The algorithm is fairly straight forward once the distinction between safe and unsafe states is understood.
1. Can the request be granted? If not, the request is impossible and must either be denied or put on a waiting list
2. Assume that the request is granted
3. Is the new state safe?
-If so grant the request
-If not, either deny the request or put it on a waiting list.

Whether the system denies or postpones an impossible or unsafe request is a decision specific to the operating system."

On the 31st of August, the Spanish government will detail the rules for the Spanish lenders to access funds from the European bailout of as much as 100 billion euros earmarked in June to support the Spanish financial system. Spain must create a "bad bank" as a condition for accessing the loan from the 16 other European countries. The European Commission has asked Spain to delay by another week the plans to create this very "bad bank" so that its experts in Brussels can review the project. We might be speculating again but maybe the European Commission is as well using the "Banker's algorithm".

The Spanish government is introducing new rules to restructure and, if needed, dismantle non-viable financial institutions according to Bloomberg. One can therefore posit that Spanish FROB could indeed use as well the Banker's algorithm in its allocation process...but here is the catch:

 "Like other algorithms, the Banker's algorithm has some limitations when implemented. Specifically, it needs to know how much of each resource a process could possibly request. In most systems, this information is unavailable, making it impossible to implement the Banker's algorithm." - source Wikipedia
Oh well...

CreditSights in their note from the 9th of August entitled - Spanish Government - We Need to Talk about Cutting made the following points:
"The Spanish government has negotiated with Eurozone partners a budget-deficit target for 2012 of 6.3% of GDP. The plan is then to reduce the deficit to below the 3% Maastricht Criterion by 2014. But this year’s target has already been revised up twice from the original 4.4% illustrating how difficult cutting government spending and raising taxes is when the economy is deep in recession.
Following Spain’s 1990s recession, the budget deficit exceeded the 3% Maastricht Criterion in all but two quarters in the eight years between 1991 and 1998. Since the 2007 recession, budget deficits have been larger, but have so far only exceeded the 3% Maastricht Criterion for three-and-a-half years.
Yet, the problems facing the Spanish economy are this time around much larger than they were in the early 1990s. The private-sector debt position at the start of the 2007 recession was equivalent to 215% of GDP. At the start of the 1992 recession, household and business debt was 65% of GDP.
And in the 1990s, Spain’s exit from the ERM allowed the currency to depreciate and the current account to move into surplus. In this recession, Spain’s membership of euro means there is no ability to recover competitiveness via currency depreciation;
The result is that the Spanish government will need to run budget deficits that are far larger than the targets it has negotiated with its Eurozone partners. But it is impossible to see the market continuing to buy the bonds to fund such deficits, Spain is all but certain to need a full government funding programme from the EFSF/ESM."
The process whereby lenders to Spain are paid back thanks to an implicit loan from the Eurosystem to the Spanish government won’t be allowed to persist indefinitely. And when it stops, the money to repay those Spanish government bonds won’t be available.
Absent the Spanish people tolerating a wrenching reduction in their incomes within an unrealistically short timeframe in, they believe a government request for EFSF / ESM funding is all but inevitable."

We would have to agree to the above key points from CreditSights, both Italy and Spain pose the biggest threat to the survival of the Euro. In fact the Spanish Misery index beats Greece as crisis bites as indicated by Bloomberg:

"Record unemployment is cementing Spain’s position as Europe’s most miserable nation, widening the gap over twice-bailed-out Greece, as the debt crisis deepens.
The CHART OF THE DAY shows a composite gauge of Spanish jobless and inflation rates, known as the misery index, is rising quicker than those of other European economies, and as Greece’s retreats from a 2012 high. Globally, only South Africa is faring worse, according to data compiled by Bloomberg News. Spain’s misery index is 26.83 percent, comprising a jobless rate of 24.63 percent and inflation at 2.2 percent. Greece’s score is 23.9 percent and that of the euro region is 13.6
percent. South Africa, which has an inflation rate of 5.5 percent and 23.2 percent unemployment, has a misery reading of 28.7 percent, according to data compiled by Bloomberg News.
The misery index is calculated by adding the 12-month percentage change in the consumer price index to the jobless rate. Arthur Okun, an adviser to Presidents John F. Kennedy and Lyndon Johnson, created the indicator in the 1960s." - source Bloomberg.

In our credit conversation we would like to focus on the changing corporate bond environment and focus once again on the structural change in market liquidity as well as default risk, in the credit space. But first our credit overview!

The Itraxx CDS indices picture, ending the week on a weaker note in the credit derivatives space - source Bloomberg:

Credit indices were overall wider on Friday, ahead of the long week-end in the United Kingdom. Overall quality cash credit from investment grade core issuers has been the clear outperformer during the summer. While last week Itraxx Crossover 5 year index (High Yield risk gauge based on 50 European entities) came closer last week to its lowest level since March, it widened back by the end of the week towards 600 bps, on the back of weaker economic data (European PMI).

Both the Eurostoxx and German 10 year Government yields seems to be moving are still moving in synch. It seems the short burst of "Risk-On" is marking a pause, with fast falling German Bund yields towards 1.30% yield level and a slightly weaker Eurostoxx 50 at the end of the week  - Top Graph Eurostoxx 50 (SX5E), Itraxx Financial Senior 5 year CDS index, German Bund (10 year Government bond, GDBR10), bottom graph Eurostoxx 6 month Implied volatility. - source Bloomberg:

In relation to the European bond picture, Spanish 10 year yields remain elevated at 6.43, slightly below 7% whereas Italian 10 year yields are below 6% around 5.76% and German government yields fell towards 1.33% - source Bloomberg:

Severing the Sovereign risk / Financial risk link has been the main concern of European authorities as indicated by the difference in spreads between the Itraxx SOVx 5 year CDS index and the Itraxx Financial Senior 5 year index. The recent rise of Itraxx Financial Senior CDS 5 year above the Itraxx SOVx Western Europe 5 year index is only indicative of the respite provided to Sovereign CDS spreads for Italy and Spain provided by the recent discussions surrounding ECB intervention. - source Bloomberg:

 

The widening of Italy and Spain in the sovereign CDS markets has been increasing by the end of the week (Spain back above 500 bps and Italy at 461 bps on 5 year markets) during which both also touched their lowest level since April 2012 - source Bloomberg:

The spread difference since March between both countries has been relatively stable as indicated in the lower graph.

Our "Flight to quality" picture marking a pause in "Risk-On" with Germany's 10 year Government bond yields falling again towards 1.30% and the 5 year CDS spread for Germany rising above 60 bps after having touched a low point as well during the week - source Bloomberg:

Credit wise, while in our last conversation "Desperado" on the 21st of August  we touched on Santander 2 year senior unsecured 2 billion euro new issue, which had been the first Spanish bank to issue since mid-march, we were taken aback by the latest "liability management" exercise which Santander followed immediately after its new issuer with. Banco Santander and Santander Financial Exchanges (each an Offeror and jointly the Offerors) inviting holders of certain Tier 1, Upper Tier 2 and Lower Tier 2 securities to tender such securities for purchase for cash at prices to be determined pursuant to an Unmodified Dutch Auction Procedure (as such term is defined in this Tender Offer Memorandum). The maximum aggregate principal amount of Securities that the Offerors intend to accept for purchase jointly pursuant to the Offers, will be an amount equivalent to €2,000,000,000. The impact of the announcement triggered a rally in some of the securities being proposed for the "liability management" exercise:

As we argued recently (Peripheral Banks, Kneecap Recap), "losses will have to be taken, it is all going Dutch, Dutch auction that is". The moment for losses to be taken has arrived at least for preference shares holders given Spain will impose losses of as much as 80% on owners of preference shares of banks that have received state aid and may be liquidated courtesy of an operation "Banker's algorithm" but we ramble again...In relation to Bankia, being clearly in the crosshair of such "exercise", back in June (Agree to Disagree - 16th of June 2012) we indicated:
"Spain has yet to apply the full extent of the Irish recipe which we discussed in "The road to hell is paved with good intentions":"Given the recent outrage by individuals investors relating to the performance of Bankia's share price following its IPO in 2011, it will be interesting to watch the subordinated bond space when looking at the difference in ownership between Ireland and Spain. One has to wonder if Spanish retail investors will be inflicted additional pain..."
The pain is definitely about to be inflicted.

This latest move reminded us of some of the comments our good credit friend had relating to Spanish banking woes back in April in our conversation "Mutiny on the Euro Bounty":
"Main Spanish banks have so far refused the government suggestion to create a bad bank which would carry all property toxic assets, arguing that they could manage their assets on their own. The dire reality is that the creation of such bad bank will bring transparency to asset prices, which is not what Spanish bankers want! The murkier the market, the better it is to extend and pretend..."

In it is not the first time we have been surprised by Santander, back in April we also indicated:
Moving on to the subject of the Spanish banking sector, quite frankly we have been baffled by Santander CEO Alfredo Saenz deriding Spain defaults surge: "“Mortgages get paid in good times and in bad”. He also added: "“Anyone raising this problem as one of the issues for the Spanish financial system is saying something stupid. (We discussed Spanish issues at length in our conversation "Spanish Denial")."

When it comes to Spanish woes and the difficulties in tackling Spain's economic woes, one might wonder how it can be achieved given when Rajoy came to power he split the finance ministry and decided not to give the title of deputy premier for economy to either Montoro or De Guindos, which is creating additional headaches for wary investors as indicated by Ben Sills in his Bloomberg article from the 23rd of March - Montoro Outburst Highlights Rajoy Paralysis as Cabinet Splits:
"The divisions at the heart of Rajoy’s government have hobbled Spain’s ability to operate on a European level. While De Guindos, who represents the government at European meetings, inspires confidence in the bloc’s other finance ministers, they question his ability to deliver on his promises
because he is often contradicted by Montoro, according to an official who takes part in finance ministers’ meetings. In January, De Guindos’s efforts to persuade investors and officials that Spain was fixed on its budget targets was undermined by Montoro’s calls for more flexibility on the pace of deficit reduction."

Moving on to the subject of the changing corporate bond environment and the structural change in market liquidity, we wanted to tackle again this issue of dwindling liquidity and its implication on the credit markets (which we discussed in our conversation "Yield Famine") given yields on corporate bonds worldwide fell to a record low on the 23rd of August as indicated by Bloomberg in their article -
Global Corporate Bond Yields Decline to Record After Fed Minutes:
"Borrowing costs for the most creditworthy to the riskiest companies fell to an unprecedented 3.76 percent yesterday, from 3.8 percent on Aug. 21, according to Bank of America Merrill Lynch index data. Yields on global investment-grade debt dropped to a record 2.97 percent. The extra yield investors demand to own global corporate bonds of all ratings rather than government debt narrowed to 261 basis points Aug. 21, the lowest level since August 2011, Bank of America Merrill Lynch index data show. The gauge widened 1basis point to 2.62 percentage points on the 23rd of August."

Liquidity risk is a concern we share with Thames River Credit fund which indicated the following in their July 2012 letter:
"A structural decline in liquidity has been taking place in the corporate bond market, which has serious repercussions for credit investors. The term liquidity may sound like an obscure, even technical, word but it reflects the ease with which a security can be bought and sold. The most efficient markets are those that benefit from deep pools of willing buyers and sellers, facilitating the transfer of risk. Unlike the equity market, the majority of trading in the corporate bond market is not transacted through centralised securities (also known as market-making).
One of the reasons why corporate securities have traded off-exchange is their greater complexity compared to asset classes such as equity. Features such as duration, maturity, credit risk and subordination can differ even amongst the debt of a single issuer making credit a highly heterogeneous asset class. The trade-off for the greater customisation of corporate securities is diminished liquidity. Of the US$ 8 trillion US corporate bond market only a small proportion of issues will trade with relative frequency. This highlights the important role banks have played in the corporate bond market. A changed regulatory environment, however, is putting increased strain on banks’ ability to make markets in corporate securities."

Thames River conclude their July letter with the following important point in relation to the issue of liquidity for benchmarked credit funds:
"Regulation and bank deleveraging is forcing change on credit markets. This is most notable in the area of liquidity. Without the lubrication of market-making activity, long-only corporate bond mutual funds stand exposed to the risk of a significant sell-off in credit markets. When combined with weakness in the rates market,such an outcome could create a perfect storm for benchmarked corporate bond funds. This is why the decline in corporate bond liquidity matters."

We could not agree more, the risk is real. We used a reference to Bastiat in relation to liquidity and Credit Markets in our conversation "The Unbearable Lightness of Credit":
"That Which is Seen, and That Which is Not Seen"

The Bond Bubble:
"In 5 out of the past 7 years, inflows to bond funds have exceeded 5% of AUM. Inflows to bond funds are running at an annualized $259bn (versus prior 2010 alltime high of $183bn). Inflows to Investment Grade & High Yield bonds funds thus far in 2012 account for a staggering 63% of total fund flows to all equity, bond & commodities." source Bank of America Merrill Lynch:

"Investor preference for Bonds over other classes is clear to see. Since 2007 there has been $650 billion into Fixed Income. Over the same period, Equities including ETFs saw outflows of $52bn." - source BofA Merrill Lynch.

When it comes to our final subject of default risk, in the credit space, CreditSights in their High Yield Market Trends published on the 20th of August indicated the following:
"The current relationship with HY (High Yield) and HG (High Grade) is more in line with what is seen in high default rate periods in the US such as 2002 and 2009. That still holds true today in both the US and Europe. The 127% quarter-to-date average (113% in 1H12) comes against the current default rate of 3.3% and is dramatically above the 76% long term average. The current HY incremental yield % versus HG is more in line with 2H02 levels of 127% when the trailing default rate declined from 10% to 8%. During the 1H2009 crisis, the 129% average came against a backdrop of 11.5% default rates. In 4Q07, when default rates ran at 1.7% the premium was 50%. Obviously that did not price in a jump in the default rates to over 14% by the end of 2009. There certainly has been a legitimate discussion that the HY market remain cheap by any of these comparisons unless you see a massive spike in defaults ahead.
With respect to the European data, they would add a caveat that the relative lack of depth in the crossover and middle tiers of the corporate universe and the relative absence of industry breadth (i.e. beyond TMT) in the “early years” of the European HY market impairs the usefulness of these metrics in Europe. In terms of framing the very low default rate levels in Europe today with what we saw in late 2007 in HY markets globally, there is an eerie similarity in that systemic is what drove the spike after the subprime mortgage crisis took out Lehman Brothers and the structured finance market while sending banks into a counterparty-driven interbank meltdown. The mere discussion of such risks in the Eurozone could make the risk of a bank system liquidity event more of a threat to the Euro HY market than the US HY market. While all HY markets (and equities) would sell off dramatically in such an event, the fact that actual default rates would more likely spike in Europe (and for a protracted period) would increase the risk of forced realization of such losses. That in theory would be when the price gap between US HY index and Euro HY index would widen more notably and losses would be “crystallized”. While that is a fat tail, they often highlight that still could end more just as a tall tale. The reaction of the HY and equity markets in Europe are voting “tall tail” at this point.
At the end of the analytical process used to frame the relative value of HY assets, it is defaults that matter most, and a material differential in actual defaults will be required to generate a more notable decoupling of returns in the rolling returns over longer time horizons across the US and Euro HY markets. As they look out towards mid-2013, it will take a systemic crisis and more than economic contraction to drive that in their view. To this point the roll-up of individuals credits still shows very manageable defaults in both the US and Euro HY markets."

On a final note, in relation to liquidity and volumes, as far as our equities friends are concerned, Christmas came early volume wise, it came in August as indicated by Bloomberg Chart of the day:

"The CHART OF THE DAY tracks the number of shares changing hands on the benchmark Stoxx Europe 600 Index since 2002, based on weekly data. About 9.34 billion shares were transacted last
week, according to data compiled by Bloomberg. That’s the fewest since 2002 except for during the traditionally slow periods at the end of the year, when business across the continent all but grinds to a halt.
Investors are staying on the sidelines as European politicians and central bankers wrestle with the region’s debt crisis, which has spread to Italy and Spain as it enters its third year, said Graham Bishop, a strategist at Exane BNP Paribas in London. European Central Bank President Mario Draghi said Aug. 2 that the lender would consider buying distressed countries’ bonds to help lower borrowing costs. “Christmas has come early,” said Exane’s Bishop. “We are now in sight of replicating Christmas in August with investors in wait-and-see mode until the ECB does what they said they will do. There’s a combination of policy uncertainty and the normal summer lull.” - source Bloomberg.

"Complacency is a state of mind that exists only in retrospective: it has to be shattered before being ascertained." - Vladimir Nabokov

Stay tuned!

Credit - Optimal bluffing

“It's funny. All you have to do is say something nobody understands and they'll do practically anything you want them to.” - J.D. Salinger, The Catcher in the Rye

Listening amusingly to the positive "spin" put by the French government on French economy smashing expectations, expanding by 0.6% in the first quarter following zero growth in the previous quarter, as well as learning about Benoit Coeuré from the ECB giving Hedge-Fund players an extra "edge" on the central bank's "front-loading" move, we reminded ourselves of  the "Optimal bluffing" strategy in the game card of poker for our chosen title analogy. David Sklansky, in his book The Theory of Poker, states "Mathematically, the optimal bluffing strategy is to bluff in such a way that the chances against your bluffing are identical to the pot odds your opponent is getting." 

We remembered the "whatever it takes" moment of our "Generous Gambler" aka Mario Draghi, which was no doubt a display of "Optimal bluffing" as it requires that the bluffs must be performed in such a manner that opponents cannot tell when a player is bluffing or not. To prevent bluffs from occurring in a predictable pattern, game theory suggests the use of a randomizing agent to determine whether to bluff. Of course, the continuation of the high stake Greek poker game, in our mind is yet another display of "Optimal bluffing". But, the on-going Greek saga is also a perfect illustration of our August 2012 conversation's analogy "Banker's Algorithm". In our computational reference previously used, "The Banker's algorithm" is run by the operating system (OS) whenever a process requests resources. The algorithm avoids deadlock by denying or postponing the request if it determines that accepting the request could put the system in an unsafe state (one where deadlock could occur):

"When the system receives a request for resources, it runs the Banker's algorithm to determine if it is safe to grant the request. The algorithm is fairly straight forward once the distinction between safe and unsafe states is understood.

1. Can the request be granted? If not, the request is impossible and must either be denied or put on a waiting list

2. Assume that the request is granted

3. Is the new state safe?
-If so grant the request-If not, either deny the request or put it on a waiting list. Whether the system denies or postpones an impossible or unsafe request is a decision specific to the operating system."

Looking at the "modus operandi" of the European Commission, or put it simply it's OS, it appears that the Greek request will not be granted for the moment but we ramble again.

Rest assured that when it comes to applying "Optimal bluffing", the US Fed is as well an astute poker player as well in this high stake poker game with global investors, given their latest FOMC comment:

"FED OFFICIALS GENERALLY DIDN'T RULE OUT RATE RISE AT JUNE FOMC"

Perfect illustrations of "Optimal bluffing" given of the chances against the Fed's bluffing are identical to the pot odds the market is getting we think.

In this week's conversation we will look at the challenges facing the Euro area which are indeed more challenging that of the Japan of the 1990s. We will also look at the deterioration of all the indicators in the latest survey from French corporate treasurers, depicting yet another bleak picture for unemployment given the decay in the overall cash position which had been on an improving trend since 2011 but has now turned more negative overall. Finally, we will look at liquidity in US credit with clear signs of vacuum in unexpected places thanks to the effects of central banks meddling aka "Cushing's syndrome" and overmedication.

Synopsis:

• Euro-area is worse than the Japan of the 1990s.
• The deterioration of the latest survey from French corporate treasurers warrants close monitoring
• The liquidity in US credit markets shows clear signs of vacuum in unexpected places
• Final note: Applying the US definition of U-6 under-employment shows Southern Europe is in the doldrums

• Euro-area is worse than the Japan of the 1990s.

In our February 2015 conversation "The Pigou effect", we argued that government bonds had replaced private sector lending on European bank's balance sheet with the significant effect of "evergreening" bad loans in Europe à la Japan. We also touched recently in April 2015 in our conversation "The Secondguesser" on the unattractiveness of the European banking sector particularly Southern European banks due to extensive use of on DTAs (Deferred Tax Assets) in their capital base:

"When it comes to "capital", what matters therefore is the "quality" of the capital. In the case of some Spanish banks, the capital levels made up mostly by DTAs are not sufficient regardless of the AQR. Given in the case of Spain, these DTAs constitute a "credit" against the Spanish government and are exchangeable for Spanish public debt we doubt this marks the end of the banks/sovereign nexus" - source Macronomics, April 2015

In continuation to the Euro-area comparison to Japanese woes of the 1990s we read with interest Nomura's take from their 19th of May 2015 Economic Insight note entitled "Euro area outlook more challenging than that of Japan in the 1990s" showing that indeed the Euro-area failed to learn its fast enough its Japanese lessons compared to the United States:

"Contrary to the US, the euro area failed to draw early lessons from the Japanese experience as it continuously rejected the analogy. But what put the euro area in a more challenging situation to that of Japan is in our view related to factors which are more idiosyncratic to the region (Figure 2). 

Our analysis of how the euro area is faring in comparison to the challenges that Japan faced in the 1990s – which is presented in detail below – suggests that the magnitude of the shocks has been on average less pronounced than in the case of Japan (see Figure 1). 

The area where we find that the euro area has been particularly badly hit relative to Japan is the banking sector, where problems cumulated in a number of countries across the region have been worse than in Japan and the slow policy response in the euro area will likely be remembered as the most important failure to draw lessons from the Japanese crisis. Europe did have the lessons of Japan to draw upon which Japan never had. We believe that there are still major issues in the banking sector that need tackling in earnest if the region wants to turn the page decisively away from the NPL and DTA issues that continue to plague a large swathe of the sector.

On labour markets, while downward nominal rigidities might have prevented the region entering a deflationary spiral for now, the adjustment has taken place on the unemployment side with under-employment today in the region around 20%, twice as much as Japan and the US. On a multi-year basis this will exercise fundamental downward pressures on wage growth of an order of magnitude which we believe is still underestimated by policy makers (the so-called “pent-up” deflationary process as described by Akerlof et al and Daly et al). Some of the symptoms behind the breakdown in nominal rigidities that took place at the end of the 1990s in Japan are also present in the current labour market developments in the euro area, arguing that on the aspect of nominal wages, the jury is still out." - source Nomura

Of course the main reason we had a much vicious recession with an explosion in unemployment in Europe was the ill-fated decision of the EBA to impose banks to reach a core tier one level of 9% by June 2012 which led to an epic credit crunch in Southern Europe.

We have also long argued there was an on-going "japanification" process in Europe. This was as well highlighted by Nomura's report:

"The euro area’s major underperformance

There has been a lot of debate over the past few years on the potential Japanification of the euro area, but most observers and policymakers have concluded that the euro area was unlikely to face a repeat of Japan’s experience and that the region has a higher chance of lifting nominal growth than Japan did. The ECB in particular has provided reasons for thinking that the euro area is in a different place than Japan was in the 1990s and that, while Japan provided some important lessons, the euro area was unlikely to face a similar outturn to that of Japan1.
As shown in Figure 3, euro area GDP was about 2% below that of Q1 2008 at the end of 2014 while Japan was down less than 1%.

Also, when looking at Japanese performance in the seven years following its own banking crisis, which reached its peak in 1997, output was 3% higher than at the beginning of the period and so grew by 5 percentage points more than the euro area over a comparable period (see again Figure 3).

The underperformance is also apparent when looking at other economic measures over different time periods. Figure 4 provides a comparison of productivity growth in Japan and the Big-4 euro area countries as measured by GDP per capita. With the exception of the 1990s and of Germany, productivity growth has been higher in Japan since the beginning of the 2000s.

Consumption per capita (in real terms, see Figure 5) in Japan rose on average by 2.6% per year between 1970 and 2013, higher than any of the Big-4 euro area countries.

Since 2009, Japanese consumption per capita has increased by 1% per year on average in line with the German consumer and higher than the other three countries in the Big-4. The euro area has outperformed Japan to date on nominal variables such as nominal GDP or nominal wage growth, but that is no reason for optimism in our view.

Based on the recent underperformance of the euro area, we believe the question should not be about the risks of Japanification but about whether the euro area can return to a sustainable path of growth that would put it at least on a par with Japan." - source Nomura

Exactly, and we do not think the euro area can return to a sustainable path of growth particularly when one looks at France and the lack of structural reforms recently highlighted by the IMF. 

In earnest, do not expect any major changes given French President François Hollande is already on the campaign trail for 2017. 

France remains in our views the new barometer of risk for core Europe. Back in August 2014 in our conversation "Thermocline - What lies beneath", we discussed the "Optimal bluffing" of the French government in its forecasting skills:

"French Minister Sapin is talking about budget deficit being above 3.8% in 2014, rest assured it will be North of 4%. If you have 0.5% of growth it should equate to 4.3%" - Macronomics, August 2012

For 2014, the budget deficit for France was in fact 4% but debt to GDP increased from 92.3% to 95.6%. We were not that far off in our estimate. The issue in the game of poker when a player bluffs too frequently like French Minister of Finance Michel Sapin, at Macronomics we just had to "snap off" his bluffs by re-raising our budget deficit estimate.

A symptom of European woes has been the very weak aggregate demand caused by the European crisis and the credit crunch triggered by the EBA in 2012 which accelerated the deleveraging of European banks and the lack of credit transmission to the real economy. This can be ascertained by the different trajectory taken between the United States and Europe also highlighted in Nomura's report:

"Leaving aside the Japanese comparison, it is also worth emphasising the extraordinarily weak performance of final demand (as measured by real consumer spending + nonresidential capex) in the euro area both relative to its own past (Figure 6) and relative to the US (Figure 7).

Assuming that euro area private sector demand picks up from now on and follows an uninterrupted recovery path comparable to the one experienced by the US over the past six years (i.e. with the growth rate 16% higher than its previous trend rate), it would take seven years for the euro area to resorb part of the private sector gap that has built up since the onset of the crisis and shrink it to 7%. Even assuming an extraordinary deterioration on the supply side, it is hard not to believe that there is a substantial amount of slack in that economy." - source Nomura

In our conversation "The Secondguesser" we also highlighted the difference between Europe and the US:

"In the US QE was more effective for a simple reason: stocks vs flows as highlighted earlier. The problems facing Europe and Japan are driven by a demographic not financial cycle. Rentiers seek and prefer deflation. They prefer conservative government policies of balanced budgets and deflationary conditions, even at the expense of economic growth, capital accumulation and high levels of employment." - source Macronomics

After all, credit growth is a stock variable and domestic demand is a flow variable. We have long argued that the difference between the FED and the ECB would indeed lead to different growth outcomes between the US and Europe:

"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." The LTRO Alkaloid - 12th of February 2012.

Of course, the availability of credit is only beginning to be restored in Peripheral Europe and has been encouraged by the ECB's recent QE but it is by no means dealing with the stock on Southern European banks impaired balance sheets!

Also, private demand due to high unemployment levels continue to weigh significantly in the euro area private sector as indicated by our musings from our November conversation "Chekhov's gun":

"If domestic demand is indeed a flow variable, the big failure of QE on the real economy is in "impulsing" spending growth via the second derivative of the development of debt, namely the change in credit growth.

QE will not be sufficient enough on its own in Europe to offset the lack of Aggregate Demand (AD) we think.

In textbook macroeconomics, an increase in AD can be triggered by increased consumption. In the mind of our "Generous Gamblers" (aka central bankers) an increase in consumer wealth (higher house prices, higher value of shares, the famous "wealth effect") should lead to a rise in AD.

Alternatively an increase in AD can be triggered by increased investment, given lower interest rates have made borrowing for investment cheaper, but this has not led to increase capacity or CAPEX investments which would increase economic growth thanks to increasing demand. On the contrary, lower interest rates have led to buybacks financed by cheap debt and speculation on a grand scale.

 In relation to Europe, the decrease in imports and lower GDP means consumer have indeed less money to spend. We cannot see how QE in Europe on its own can offset the deflationary forces at play." - source Macronomics, November 2014 

Put it simply, credit growth is a stock variable and domestic demand is a flow variable. Central-bank induced liquidity is pointless without the real economy borrowing and the issue at the heart of the problem is that most Southern European banks are in fact "capital constrained" and plagued by NPLs (Nonperforming loans) and artificially boosted capital by DTAs.

When it comes to the comparison with Japan in the 1990s, Nomura's report makes an important point relating to the size of the problem which has not been dealt with in Europe:

"Figure 14 shows that banks’ conditions in many euro area countries are significantly worse than at the worst point of the Japanese banking crisis between 1997 and 2002, when NPLs peaked at 8.4%.

In particular, NPLs in Cyprus, Greece and Ireland are above 20%, even higher than Japan’s NPLs subject to self-assessment and after the implementation of bad banks in some of these countries. More worryingly, NPLs in Italy and Spain are above the Japanese levels.

The IMF finds in its latest GFSR that banks with a higher ratio of non-performing loans have tended to lend less: for 60 euro area banks over 2010-13, those with the lowest NPLs (1st quantile) expanded their loan supply by six times the national average growth rate, while the credit of those with the highest NPLs (the 4th quantile) contracted at the pace of four times the national average growth rate. This negative relationship is believed to arise because the non-performing assets decrease banks’ profitability, use more capital (to absorb the bad assets), and damp banks’ intention to lend to borrowers with borderline credit quality.

DTA might be another potential risk to the banking sector
Bank equity, or net asset value (NAV), always acts as the first line to defend the financial entity in an adverse event. However, not all the equity is of the same quality as some can quickly lose their value in face of negative shocks and pose significant risks to the financial system. One example is a bank’s “goodwill”. Another important asset whose quality is generally recognised of being of a lower standard is the “deferred tax assets” (DTAs).
A deferred tax asset is an asset used to reduce the amount of tax due in the future. It mostly arises when a bank makes losses, for example by writing off bad loans. The losses, although processed as expenses in corporate accounting, are not tax deductible under tax law. As such, an “overpayment” of taxes emerges. It is then booked under deferred tax assets in the assets section, which correspondingly requires an increase in the bank’s equity. In theory, DTAs can reduce banks’ liability in the future but this only materialises if the bank can make enough taxable profits. That said, for banks that overestimate future earnings, their equity is inclined to be overvalued by DTAs.

This was the case for Japan back in the late 1990s: in 1998 when banks’ other sources of regulatory capital had been depleted, Japan introduced the rule of deferred tax assets and allowed them to be accounted for as regulatory capital. DTAs then became an important source of regulatory capital for Japanese banks. For example, in 2002 the major banks’ DTAs totalled 60% of bank equity (Skinner, 2008), rising quickly from 45% in 2001 and from 29% in 1998. This increase in weak forms of capital is thought to have prolonged the financial crisis (Skinner, 2008).

In the euro area, currently the CRR (Credit Requirements Regulation) allows competent authorities to set the percentage for the deduction of DTAs relying on future profitability at 10% in 2015 for DTAs that existed before 1 January 2014. The deduction rate will increase by 10% each year until 2023. For DTAs created after 1 January 2014 and relying on future profitability, a phase-in approach is applied, i.e. minimum of 20% in 2014, 40% in 2015, 60% in 2016 and 80% in 2017 and 100% in 2018.

For the moment, the ratios of net DTAs to bank equity in some countries are at similarly high levels as in Japan back in 2001-02 (Figure 15).

In particular, the ratio in Greece is higher than the peak level in Japan and that in Portugal is above Japan’s 2001 level. Although for Spain and Italy DTAs have a lower share in total bank equity, 30% is still big enough to pose significant risks in adverse scenarios, in our view." - source Nomura

Exactly! DTA amounts to us as "dubious" capital. As we have shown in our conversation "The Secondguesser" many Southern European banks are still capital impaired  and their banks' capital basis are made up for a large part of Deferred Tax Assets (DTAs).

• The deterioration of the latest survey from French corporate treasurers warrants close monitoring

One particular important indicator we follow is the rise in Terms of Payment as reported by French corporate treasurers. The latest survey published on the 18th of May points to a deterioration in the Terms of Payments, which indicates that the improving trend since mid 2012 has turned decisively negative:

The monthly question asked to French Corporate Treasurers is as follows:

Do the delays in receiving payments from your clients tend to fall, remain stable or rise?

Delays in "Terms of Payment" as indicated in their May survey have reported an increase by corporate treasurers. Overall +18% of corporate treasurers reported an increase compared to the previous month (+22.8%), bringing it back to the level reached in October 2014 (17.9%). The record in 2008 was 40%.

Overall, according to the same monthly survey from the AFTE, large French corporate treasurers indicated that they are still facing an increase in delays in getting paid by their clients. It is therefore not a surprise to see that the overall cash position of French Corporate Treasurers which had been on an improving trend since 2011 has now turned more negative overall according to the survey:

The monthly question asked to French Corporate Treasurers is as follows:

"Is your overall cash position compared to last month falling, remains stable or rising?"

Whereas the balance for positive opinions was 17.9% in November 2014 and still at 6.3% in January 2015, February saw it dip to -5.2% and March's came at -13%, April at -0.5% but provisional May came at -9.5%.

We will restate what we mentioned back in our March 2015 conversation "Zugzwang":

"This warrants significant monitoring in the coming months we think from a "corporate monitoring health" perspective."

The French government policy is based on "hope" and their strategy is based on "wishful thinking". No matter what, we do not see unemployment falling with these deteriorating conditions.

Furthermore, in our March conversation, we indicated the following:

"While the international scene is watching with caution the rise of the French National Front, the political story, we think is the slow dislocation of the unity of the left." 

As we indicated in our conversation as well is that there was a large contingent of public servants supporting François Hollande representing 22% of the working population compared to 11% in Germany. The slow dislocation of the unity of the left is currently being tested given there was a significant demonstration of teachers in France this week. French teachers’ unions, which routinely protest any changes, complained about reforms relating to secondary education. France’s 840,000 teachers have traditionally been a strong base of support for President François Hollande, but the proposed reform has turned many against him and his ruling Socialists. Furthermore the growing rift has been increasing given the proposed reforms where pushed through a decree without consultation during the night, following the day of the demonstration. Given President François Hollande is already on the campaign trail for 2017, it will be interesting to see most of structural reforms requested by the IMF put on the sideline.

Given the on-going negative trend from the AFTE surveys, it will be interesting to both monitor the micro data from a corporate health perspective as well as the evolution of the political mood in France and the lack of progress in the unemployment front in the coming months.

• The liquidity in US credit shows clear signs of vacuum in unexpected places

We share the growing concerns of the lack of liquidity in the fixed income space. On numerous occasions we have indicated our uneasiness with the "yield hunt" and dwindling liquidity in the secondary space thanks to banks deleveraging as well as mounting regulatory pressure on market makers.

A good illustration for the hunt for yield has been happening in the high yielding space such as MLPs, REITS, dividend funds and High Yield as displayed in Bank of America Merrill Lynch's chart from their Thundering Word note from the 17th of May entitled "The Twilight Zone":

"High Yield
Investors are positioned heavily in high yield, high dividend yield and high PE strategies (Chart 15). The quest for high yield (relentless multi-year inflows to dividend funds, MLPs, REITS & HY bonds - $415bn inflows since Mar’09) remains the biggest Achilles’ Heel for positioning, in our view." - source Bank of America Merrill Lynch

What we find of interest from a "Twilight Zone" perspective is that when it comes to the Fixed Income space, the liquidity deterioration is not what it seems and has not been where one would have expected it to be. On this specific matter we read with interest Deutsche Bank's US Credit Strategy note from the 20th of May entitled "Signs of Liquidity Vacuum in Unexpected places":

"Liquidity deterioration has not been uniform across fixed income
While liquidity has deteriorated in all parts of fixed income, the extent of such deterioration has not been uniform, and this represents another area where consensus view is often misguided, in our opinion. Figures 1 and 2 below present trading volumes in HY, IG, and Treasury markets, expressed in a percent of market size terms. 

The scale here is showing us the proportion of each respective market that changes hands on a daily basis, measured as a trailing 12-month average value. In other words, HY traded 0.7% of its market size on an average day in the past year; IG traded 0.4%, and Treasuries traded 4.0%. The degree of deterioration in these metrics since their pre-crisis levels amounted to a 30% loss of trading depth in HY, 50% in IG, and 70% in Treasuries! We are doubtful that most investors realize the presence of this distribution in that the higher quality segments of the fixed income universe have in fact been impacted by liquidity withdrawal to a greater extent. Treasuries still maintain their position as the most liquid set of securities in the world; they are just not nearly as liquid as they used to be pre-crisis.
This last point is critical to properly understanding the current liquidity environment and its implications. While most investors perceive HY liquidity as being inherently poor, and drying up even more around turning points in the market, this in fact has been the normal state of affairs in our asset class. Few investors realize that IG has become a more illiquid portion of the credit universe, even though somewhat misleadingly a given IG cusip usually trades more deeply than a given HY one.Deutsche Bank Securities Inc. Page 3
These findings have significant implications as to how investors should be positioning themselves to take advantage of liquidity vacuum points that undoubtedly await us in the future. Instead of watching HY market for the signs of cracks, they should be spending more time monitoring higher quality portions of the market going all the way up to Treasuries. The experience of last year’s October 15 is very important in this respect in that it serves as a preview of what a liquidity vacuum experience is likely to feel like. The 10yr Treasury yield experienced a seven-sigma intraday move during that session, triggered by temporarily thin volume at some point, and exacerbated by dealers pulling a plug on their electronic trading systems on early signs of volatility. While that particular experience has not registered as much in credit, given its extremely short duration measured in minutes, it is reasonable to assume that it could have more pronounced implications in the future, if it lasts longer than that or repeats itself more frequently.
Furthermore, and we cannot overemphasize the importance of this point, most investors tend to think about the potential impact from reduced liquidity in the context of Fed’s raising of short-term rates and a resulting back up in longer-term Treasury yields. The key lesson from October 15 however is that Treasury yields gapped down, and not up, in seven sigma moves in a perfect example that illiquidity-driven volatility could happen on lower rates as well. We could not have come up with a better example than this to drive home our most important point: it is a point of debate how far and how fast the Fed is going to be able to raise short-term rates, given the prevailing weak macro environment and a potential for negative side-effects of higher volatility. But volatility itself could, and most likely will, materialize from their attempt of doing so, even if a lesson from this experience is that six-plus years of zero rates would make it incredibly difficult to raise rates in early stages of a liftoff without disrupting the market. The point is that failure to raise rates materially does not by itself protect us from higher volatility impacting the Treasury market first and IG/HY market next. In fact such a failure would probably mean that volatility was just too high for the market and the economy to be able to cope with it." - source Deutsche Bank

In this high stake poker game with investors, we hope the Fed will be able to play its "Optimal bluffing" strategy given its bloated balanced sheet and reduced liquidity in the Treasury market.

• Final note: Applying the US definition of U-6 under-employment shows Southern Europe is in the doldrums

Whereas many pundits are expecting a gradual recovery in Europe thanks to the ECB's QE support, we beg to differ and as we indicated previously, in our conversation "Chekhov's gun" back in November 2014:

Current European equation: QE + austerity = road to growth disillusion/social tensions, but ironically, still short-term road to heaven for financial assets (goldilocks period for credit)…before the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…).
“Hopeful” equation: QE + fiscal boost/Investment push/reform mix = better odds of self-sustaining economic model / preservation of social cohesion. Less short-term fuel for financial assets, but a safer road longer-term?

Of course our "Hopeful" equation has a very low probability of success given the "whatever it takes" moment from our "Generous Gambler" aka Mario Draghi which has in some instance "postponed" for some, the urgent need for reforms, as indicated by the complete lack of structural reforms in France thanks to the budgetary benefits coming from lower interest charges in the French budget, once again based on phony growth outlook (+1% for 2015)

When it comes to the damages inflicted by the "credit crunch" in Europe, again as a final point, we would like to point out Nomura's interesting replication of the US BLS methodology to construct broader measures of unemployment in the euro area focusing on the so-called U-6 from their 19th of May 2015 Economic Insight note entitled "Euro area outlook more challenging than that of Japan in the 1990s":

"We also believe that the level of so-called labour under-utilisation, a concept which has recently attracted a large amount of attention in the US, is in the euro area at levels that no advanced economy has seen since the great depression. The rising share of nonregular contracts has been a feature of the Japanese (see Kuroda & Yamamoto 2013) and German (see Toshihiko, 2013) labour markets. This structural change is generally understood as having helped diminish the bargaining power of wage-setters and thus to the surprisingly low wage dynamics in those economies.
Measures of labour under-utilisation in the euro area are not readily available, which is probably the reason why there so little attention has been devoted to this topic.

We have replicated the US BLS methodology to construct broader measures of unemployment in the euro area focusing on the so-called U-6 definition of unemployment (a measure that includes people marginally attached to the labour force, part-time employment for economic reasons, and unemployed).

The results shown in Figure 23 indicate that the euro area U-6 rate averaged slightly above 20% in 2013 (the latest year we have) compared with 13.6% in the US. The last reading for the US which is available on a monthly frequency was 10.9% in March 2015, down from its March 2010 cyclical peak of 17.1%.

The picture across the region is extraordinarily varied, with the German U-6 already below 10% in 2013 and below its 2002-04 average and countries like Spain, Greece and Italy with U-6 levels at or above 30% and more than twice their 2002-04 averages." - source Nomura

QE on its own, rest assured will not cure European woes and particularly the difficult employment situation in Southern Europe, no matter how "Optimal" the ECB thinks it is "bluffing".

"The greatest trick European politicians ever pulled was to convince the world that default risk didn't exist" - Macronomics.

Stay tuned! 

Credit - When causation implies correlation

"All human actions have one or more of these seven causes: chance, nature, compulsions, habit, reason, passion, desire." - Aristotle 

Looking at the dismal economic figures coming out of Europe as of late (PMI, consumer confidence, unemployment in Spain, IFO, etc.), we could not resist using in our title a veil reference to the phrase used in science and statistics "Correlation does not imply causation". Admittedly, a correlation between two variables does not necessary imply that one causes the other, but when it comes to European woes, not only did the ECB's LTROs amounted to "Money for Nothing" given the lack of transmission to the real economy as we posited in February this year, but looking back at the overzealous deficit targets set up by the European Commission which we discussed in our conversation "A Deficit Target Too Far", we are not surprised to see that the economic causation does indeed implies correlation to current European economic woes unsurprisingly due to poor loan growth as displayed by the below Bloomberg graph displaying loan growth in in the Euro Zone with the Euro Zone Money Multiplier at multi-year low:

"Third quarter bank results will shed further light on the outlook and appetite for euro zone bank lending. The money multiplier remains at multi-year lows and recent regulatory steps to soften or defer the implementation of new liquidity and capital rules underscore the pressing need for banks' loan supply to improve, release cash to the economy and support growth" - source Bloomberg.

Yes, some will counter us, by saying that the opposite assumption which we used in our title, that correlation proves causation is a questionable cause of logical fallacy also called "cum hoc ergo propter hoc" ("with this, therefore because of this"). Well, truth is, the economic contraction in Europe is a consequence of the first event sometimes describe in latin as "post hoc ergo propter hoc" (after this, therefore because of this) namely rapid credit contraction due to accelerated bank deleveraging courtesy of the EBA (European Banking Association) objective for most European banks to reach a Core Tier 1 capital of 9% by June 2012.
So dear readers, no, we do not think it is a logical fallacy, "post hoc" supposedly being a "tempting error" because the temporal sequence in Europe appears to be integral to causality namely credit contraction:
A occurred, then B occurred
Therefore, A caused B

Of course as of late, our "Generous Gambler" aka Mario Draghi, ECB's president, has defended is latest OMT (Outright Monetary Transactions) bond buying plan on the 24th of October in front of the German parliament with a warning about deflation risks:
"In our assessment, the greater risk to price stability is currently falling prices in some euro-area countries"
and added:
"In this sense, OMTs are not in contradiction to our mandate: in fact, they are essential for ensuring we can continue to achieve it."

Arguably our dexterous "Generous Gambler" has indeed been highly successful in propelling Spanish bonds gains above Germany as indicated by Bloomberg:

"Investors who held onto Spanish bonds this year as the price of the securities whipsawed amid the euro-area debt crisis stand to earn more than those who sought refuge in German bunds. The CHART OF THE DAY shows Spanish debt has handed investors a 4.2 percent return since Jan. 3, rebounding from an 8.7 percent loss in the period through July, according to data compiled by Bloomberg and the European Federation of Financial Analysts Societies. German bunds, perceived as Europe’s safest sovereign debt, have earned 2.7 percent this year. The Iberian nation’s securities have surged since the European Central Bank said it will buy bonds." - source Bloomberg

Making us reminding ourselves part of the great poem from Charles Baudelaire which we have used in numerous conversations:
"If it hadn't been for the fear of humiliating myself before such a grand assembly, I would willingly have fallen at the feet of this generous gambler, to thank him for his unheard of munificence. But little by little, after I left him, incurable mistrust returned to my breast. I no longer dared to believe in such prodigious good fortune, and, as I went to bed, saying my prayers out of the remnants of imbecilic habit, I said, half-asleep: "My God! Lord, my God! Please make the devil keep his word!"
Charles Baudelaire, French poet, "Le Joueur généreux," pub. February 7, 1864

The most recent table of monthly purchases of sovereign debt is a clear indicator of the faith many investors have put in our "Generous Gambler" - source Bloomberg:

"Euro zone banks purchased an aggregate 33.3 billion euros of sovereign debt in September, following sales of 24.9 billion euros in the preceding two months as yields fell and gains were taken. The ECB commitment to do "whatever it takes" drove the Spanish 10-year yield down to 5.5% from August highs above 7%, and recent bank purchases reflect this new-found confidence." - source Bloomberg

"The greatest trick the devil ever pulled was to convince the world he didn't exist"
Roger "Verbal" Kint- The Usual Suspects

"The greatest trick European politicians ever pulled was to convince the world that default risk didn't exist" - Macronomics.

Our generous gambler also argued the following: 
"OMTs will not lead to disguised financing of governments. All this is fully consistent with the Treaty’s prohibition on monetary financing. Moreover, they will focus on shorter maturities and leave room for market discipline."

But he also said the following:
"The ECB intervenes only in countries where the economy and public finances are on a sustainable path."

Our "Generous Gambler" is indeed kept on a tight leash for now, a German one that is, courtesy of the Banker's Algorithm.

Our "Banker's Algorithm" comes into play when you think about on-going Spanish deflationary vicious spiral given our computational reference which we touched again last week:

"The algorithm avoids deadlock by denying or postponing the request if it determines that accepting the request could put the system in an unsafe state."
So of course, our Banker's algorithm has avoided the deadlock in Europe because of Spain. Clearly by denying or postponing the request, it has determined the Spanish request could put the European system in a clear unsafe state!
For Spain, it is "request denied" courtesy of the Bankers' algorithm."

Question being now, can Europe survive in the current form (number of countries) without making material sacrifices? One has to wonder...

By managing to keep Germany’s liabilities unchanged German Chancellor Angela Merkel has been in fact the clear "winner" of the last European summit in June (number 19...) we argued in our conversation "Europe - The Game of the Century". On the 18th of October, Chancellor Merkel in her address to the German lower-house has indeed craftily defended again Germany's liabilities by declaring:
"Financial aid without conditions attached has in some cases frustrated the drive to streamline economies, and therefore joint liability is the wrong answer"

Given the IMF has cut its euro-region growth forecast for 2013 from 0.7% to 0.2% with the European economy potentially shrinking by 0.4% in 2012 instead of the "projected" 0.1% by the ECB, in this week's conversation we will look at correlations and causation on our European ship given the increasing risks of "Mutiny on the Euro Bounty" in 2013 which we have been highlighting since April this year:
"As well as Fletcher Christian and part of the crew, our European "sailors" (politicians) were attracted to the "idyllic" initial cheap funding environment provided by a single currency umbrella. The recent austerity "harsh treatments" measures imposed by the captain of the ship (European Commission) which we reviewed in our recent conversation ("The Charge of the Light Euro Brigade") seems to be clearly pushing some of the members of the crew towards mutiny. This explains somewhat, why the European ship is attempting to change tack, moving towards growth."

"Prosperity makes friends, adversity tries them." - Publilius Syrus

Unemployment figures in Germany which will be published next week and will be key. So will be economic data from Germany. In September 2011, in our conversation "Much ado about nothing" we argued:
"And given Merkel's big u-turn relating to the Japanese nuclear disaster in 2011, and that next general election in Germany are to be held in September 2013, and we know that Merkel is already committed to a third term, we would really follow closely the German economy in general and the German labour market in particular. "

There is indeed a growing rift between France and Germany in relation to the course that needs to be taken in relation to Europe due to a growing divergence in the political agenda for both France and Germany. We agree with the latest report from Nicolas Doisy - Politoscope number 10  from Cheuvreux which validates our recent analysis Merkel and our Banker's algorithm:
"Delaying the euro federal Big Bang again: the Franco-German “phoney war” (redux):
-While it should be starting, Europe's federal Big Bang is stalling again due to diverging political agendas in Germany and France with regard to the euro institutions. The disagreement is partly real (i.e. of substance) and partly fake (i.e. purely motivated by domestic politics) and likely to drag on for months… if not years.
 -Merkel has timed her agenda in 2013 with a view to the full monty (re-election and a euro to her liking) and thus intends to frame the debate to her advantage. To keep her options open, Merkel wants to have the final say on any decision regarding Spain and the euro: this is why she uses the federal agenda as a red herring.
-To secure her chances for re-election, Merkel needs to keep the Eurozone quiet during the coming year: this is why she has agreed to the ECB's OMT for Spain. For as long as she is leading the electoral polls, she is sure to keep both France and the SPD in check: this is why she is skilfully nurturing German anti-euro feelings.
-Hollande's options are limited, as he can only bank on the SPD or market pressure to break the deadlock: he thus also uses this debate to keep his own left in check. His only potential ace is to use next year's recession in the Eurozone to table his "growth" agenda again, so as to get a more lenient fiscal treatment by Germany. 
-All in all, this Franco-German divide over institutional options looks very likely to lead to a two-speed Eurozone as the periphery will continue entering its debt-deflation." - source Cheuvreux.

Moving on to France and the subject of when causation implies correlation, we noted from the same interesting note from Cheuvreux the following interesting correlation. Namely that Hollande's popularity is 100% correlated with the rise in unemployment since he has taken office: 5,000 more unemployed = 1% less popularity for Hollande, so that (theoretically), according to Cheuvreux's analysis, he should be ousted when unemployment reaches 3.2 million:

"Hollande's first option out of this diplomatic deadlock could be for the social democrats to win next year's election or the leadership of another Grand Coalition. However, after supporting France's stance very vocally on several occasions in the winter of 2011, the SPD has gone mute on the issue of Eurobonds in particular. This clearly is a sign that Merkel has so far won the battle of public opinion on the euro issue." - source Nicolas Doisy - Cheuvreux.

Following up on François Hollande's political strategy of hoping for the social democrats to win next year's election, we could not resist, (given our post title) but refer to "Mierscheid law"!
The Mierscheid law was a satirical forecast published in German magazine Vorwärts on 14 July 1983 which forecasted that the Social Democratic Party of Germany (SPD)'s share of popular based on the size of steel production in Western Germany: "The Vote share of the SPD equals the Index of the crude steel production in the western federal states - measured in millions of tonnes - in the year of the federal election".

"The last corroboration of the law was in the 2002 election, where the West German crude steel production was 38.6 million tonnes, and the vote share of the SPD 38.5%. For the early election in 2005 the vote share was 38.4%, with a mean crude steel value of 40.0 million tonnes. Over the last ten elections, the two values were within two units nine times, and within one unit seven times." - source Wikipedia

- source - the full Wiki.

With German confidence falling to the lowest level in more than two and half years and Europe's composite PMI falling to 45.8 from 46.1 in September, the IFO institute's business climate index unexpectedly dropped to 100.0 from 101.4 in September, indeed accelerated deleveraging and generalized austerity is increasing the causation of economic woes and the correlation with worsening economic outlook. We feel comfortable with our recent call of growing divergence between the growth differential between USA and Europe as indicated by the recent PMI.

We also believe that as economic woes weight on both Germany and France in 2013, so will increasing political rifts arise in the process. We do agree with Nicolas Doisy's take from Cheuvreux, namely that there is indeed a new "phoney war" evolving between both countries:
"This (peaceful) remake of the Franco-German phoney war obeys a purely political logic and forces the Eurozone to continue walking along the abyss for another year. Unfortunately, it can only add to the uncertainty surrounding the fate of the Eurozone by leaving deflationary Spain very much on the hook: there is no clear prospect of Eurobonds any time soon, be it to recapitalise Spanish banks or help Spain's government. Beyond, this phoney war could well turn into another "battle of Stalingrad" when the actual size of the Spanish problem is fully revealed, right after the German election (if not before). It is thus to be hoped that another Grand Coalition wins in Germany, as seems to be the preference of the German electorate. Such an outcome would have the advantage of creating the conditions of a de facto national unity government in Germany. In any event, this Franco-German great divide over institutional options looks very much apt at leading to a two-speed Eurozone of sorts in the not-so-distant future. Indeed, it appears clearly from this debate that the core issue is what to make of the periphery. This amounts to raising the question: (where and how) does the periphery belong in the Eurozone? While still implicit, this theme will surely rise to the front in near future." - source Cheuvreux - Nicolas Doisy

Indeed, what to make of the periphery in general and Spain in particular given the recent Spanish banks earnings which clearly indicate that Oliver Wyman's nightmare scenario could as well play out which therefore clearly justify the retention in the allocation process of our European Banker's algorithm?
Caixabank, the third biggest bank saw its profit fall 42% as it accelerated loss recognition tied up to real estate with 4.41 billion euros of provisions in the first nine months to fully cover the required 2.44 billion euros from the first RDL (Royal Decree Law) and 600 million of the 2.1 billion euros in charges needed from RDL2 passed in May. Bad loans jumped to 8.42% in September from 5.58% in June and 4.9% in December 2011.
It was a similar story for Spanish giant Santander, with third quarter profit felling 94% due to the necessary purge in real estate exposure needed with net income falling to 100 millions euros from 1.8 billion euro a year earlier. Bad loans as a proportion of total lending rose to 4.33% from 4.11% in June. The bad-loan ratio across the Spanish business climbed to 6.38% from 5.98% in June and 5.15% a year earlier.

The rise in bad loans are all a reflection of the rise from bad loans in the construction sector as reported by Bloomberg:

"September's Spanish stress test projected aggregate losses of 270 billion euros for the banks under its adverse scenario, with a 43% loss on real estate developers, identical to Santander's 3Q real estate non-performing loan ratio. Spain's construction and real estate bad debt topped 100 billion euros at 1H and may rise faster and further than stress estimates." - source Bloomberg

No wonder the Banker's algorithm is reluctant in allocating "resources". In that context, the bad bank SAREB which need to be in place by December, will have as much as 90 billion euros of asset based on their transfer price, initially comprising land, developer loans and residential units that went bad according to Bloomberg article "Spain Bad Bank Seen Too Big to Work With $117 Billion: Mortgages" by Sharon Smyth from the 25th of October.
"The Bank of Spain has yet to fix transfer valuations for the assets based on the stress tests of Spanish lenders carried out by management consultants Oliver Wyman and published on Sept. 28. The 90 billion euro number is based on transfer prices, so the original value of the assets is likely to be higher.
In comparison, Ireland’s National Asset Management Agency, set up in 2009, spent 32 billion euros on mortgages with a face value of 74 billion euros to cleanse its banking system.
Lenders that take state aid will have to transfer to the bad bank foreclosed property of more than 100,000 euros, real estate and builder loans of more than 250,000 euros and controlling stakes in property firms, according to the Economy Ministry official. A decree to regulate the entity should be passed on Nov. 16. It may be amplified in the future to include loans to consumers, small and medium enterprises and retail mortgages." - source Bloomberg.

In relation to Bankia, we argued in May 2012 in our conversation "The Tempest the following" with our good credit friend:
"A better solution would be to force a conversion of debt to equity (In a debt-for-equity swap, a company's creditors generally agree to cancel some or all of the debt in exchange for equity in the company). Doing so will not require 7 to 10 billion funds, but would of course dilute shareholders and destroy bond holders (haircut)."

The ECB is now pushing for inflicting losses on junior debtholders as reported by Emma Ross-Thomas, Esteban Duarte and Ben Sills from Bloomberg on October 25 - ECB is Said to Push Bankia Losses as Spain Purges Assets:
"The European Central Bank and European Commission want investors including preference shareholders to swap their securities for new shares to reduce the cost to the taxpayer, according to two people who asked not to be named because the discussions are private. Profit at Banco Santander SA, Spain’s biggest lender, slumped in the first nine months as it took a 14.5 billion-euro charge on real estate losses.
Confronting the toxic legacy of Spain’s 10-year building boom is imposing political costs on Prime Minister Mariano Rajoy as he faces a separatist challenge in Catalonia, protests on the streets of Madrid and a battle to avoid a full bailout." - source Bloomberg.

Back in our May conversation we indicated:
"Transparency in asset valuations would finally help in discovering the extent of the problems plaguing the Spanish Financial sector. The set-up of a "Bad Bank" in similar fashion to Ireland's NAMA, would indeed force price discovery and true valuations provided a third party assessor is drafted."

and we added:
"Without credit growth resuming, the ambitious target deficits will not be met in Spain. The conditions for growth needs credit growth to resume, as shown by the recent credit growth in the US (see our conversation - "Growth divergence between US and Europe? It's the credit conditions stupid..."). Spain has to go through resolving the Spanish banking encumbered balance sheets."

When causation implies correlation...

Credit wise, for Spanish banks, the rise in the issuance for "Puttable bonds" is a cause for concern we think. Puttable bonds are fixed-income securities which investors are able to redeem before maturity. It is a very dangerous option given the funding shock it could create should investors decide in concert to exercise their option. As reported by Bloomberg by Esteban Duarte and John Glover on the 25th of October in their article "Santander Seeks Salvation in Puttable Bonds":
"Banco Santander SA, Spain’s biggest lender, is placing its trust in bondholders by issuing 4.4 billion euros ($5.7 billion) of fixed-income securities that investors are able to redeem before maturity.
Bonds with put options make up 36 percent of Santander’s debt funding this year, compared with 9 percent in 2011, according to data compiled by Bloomberg. While the bonds have lower interest rates, they leave the bank vulnerable to a potential 7 percent increase in the 33.4 billion euros it must repay next year. Investors have already demanded early repayment on 1 billion euros of the notes." - source Bloomberg

Puttable bonds are indeed a typical instrument used by financial institutions under stress. For us, a big red flag.

Another red flag we think for Santander, comes from its dwindling capacity in absorbing potential losses at the parent bank by its increasing policy of partial IPOs such as the one done in Mexico as indicated by CreditSights in their report Spanish Banks - The Value of Empires from the 22nd of October:
"In Santander's case especially, the capacity of equity in its foreign subsidiaries to absorb potential losses at the parent bank is being reduced by its policy of partial IPOs (the goal being to list all the most significant subsidiaries within five years – see Santander: Partial IPO in Mexico). The erosion of loss absorbing capacity that this implies at parent or group level is reflected in the Basel 3 reform that will ultimately prevent banks from including in consolidated CET1 capital any surplus equity contributed by minorities in excess of the subsidiaries' minimum regulatory requirements." - source CreditSights

On a final note, looking at the our "Flight to quality" picture as indicated by Germany's 10 year Government bond yields (well below 2% yield), falling again towards 1.55% versus 5 year Germany Sovereign CDS which has cratered below 25 bps, by avoiding increasing so far Germany's liabilities, Chancellor Merkel has in effect alleviated concerns on Germany's exposure to European woes we think - source Bloomberg:

It's deflation (デフレ) in Europe.

"Correlation is not causation but it is sure a hint" - Edward Tufte - professor emeritus of political science, statistics and computer science at Yale University.

 Stay tuned!