Markets update - Credit - The Hungarian dances

"Learn from yesterday, live for today, hope for tomorrow. The important thing is not to stop questioning."
Albert Einstein

In a continuation of our previous analogy to the European flutter, as we enter 2012, the recent evolutions of the situation in Hungary which we discussed in our post "Mind the Gap...", warrant us this time around to ramble around how reminiscent the collapse of the Austro-Hungarian dual monarchy and empire (1867–1918) is with our European flutter. Could Hungary be the trigger in 2012? Before we enter yet another long credit conversation, for a change this time around, before our market overview, it is of importance to highlight the current situation in Hungary and contagion to Central Eastern Europe.

Back in October in our post "Long hope - Short faith" we discussed the worrisome Hungarian situation, which was also the main subject of our conversation "Leda and the (Greek) Swan and why Europe matters more for Emerging Markets".

We previously quoted an article by Geoffrey T. Smith from the Wall Street Journal on the subject and as we move into 2012, it will be paramount to monitor the risk of wholesale capital flight with the ongoing buildup of tensions in Hungary - "Austria Has a Déjà Vu Moment":

"the biggest threat to Austrian banks is still what it was in 2009—wholesale capital flight from emerging Europe."

On the 4th of January, Hungary's 5 year sovereign CDS widened by 65 bps, quoted 690-730 bps in the market, with limited liquidity and the CDS curve inverting in the process, meaning short dated protection is becoming more expensive than the 5 year point. We have seen this happening before with Greece, Portugal and others. The situation warrants caution as the Hungarian effect is spreading to other countries according to a market maker, spreading to Poland and Czech sovereign CDS, both trading wider in the process, Poland around 290 bps for the 5 year CDS and around 180 bps for Czech CDS 5 year.

As indicated by Simon Foxman in Business Insider article - Hungary's Currency Hits New Lows Amid More Signs Of Upheaval:
"The Hungarian forint weakened to its lowest value against the euro since last month—near its lowest level ever—at 319.4 amid worries that the political situation there is becoming untenable. Increasing attention is being paid to the small Eastern European country, at the center of Europe's other debt crisis.

The Hungarian government is running short on cash after it passed a law last week that could compromise the independence of its central bank. That law flaunted guidance from the European Union and the International Monetary Fund, who provided the troubled country with €20 billion ($26 billion) a bailout back in 2008. Hungary is paying through the nose to borrow even short-term funding, and the cost of insuring Hungarian debt via credit default swaps hit a new record, at 655 basis points according to Bloomberg. It paid yields of 7.67% to borrow for a three-month term and raise 45 billion forint ($190 million) yesterday.

Domestic turbulence is complicating matters, with protestors taking to the street to protest the government's new constitution (which includes that controversial central bank law). According to the BBC, protests are focusing on three major issues:

·A clause that defends the "intellectual and spiritual unity of the nation," which opponents argue could result in repression of intellectual freedoms

·Inclusion of social issues like the right of the unborn child and the definition of marriage as a union between a man and a woman

·Changes to the electoral system which could empower the leading Fidesz party at the expense of the opposition

Popular support for the Fidesz party hit 18% in a December opinion poll cited by the BBC, although it still leads other parties. If the Hungarian government were unable to pay its bills, it could wreck the Austrian banking system, which has an estimated $226 billion in exposure to Eastern Europe and €1.14 trillion ($1.6 trillion) of assets held in the region. 10-year yields on Austrian government bonds—and indicator of stress on the country—are moving sharply higher this morning. They rose to 3.20%, the highest level since before a central bank stilled their rise earlier in the year."

At the time of our November conversation "Mind the Gap...", we reminded the new legislation which passed by the Hungarian government in relation to the ill-fated currency mortgages which burden Hungarian households:
"Under the new legislation borrowers can repay their mortgage in a single installment at a HUF/CHF rate of 180 or a HUF/EUR rate of 250. Current FX rates are around 239 for HUF/CHF and HUF/EUR is around 297, a 25% and 16% discount according to CreditSights."
In November we commented:
HUF/EUR rate was 297 at the time, and is now much higher (315), meaning losses for European banks and in particular the likes of Austrian Erste Bank exposed to these mortgages will be significantly higher - source Bloomberg. Given HUF/EUR is reaching new highs, Austrian banks exposed to these mortgages face significant additional losses. So yes, contagion to EM, and in particular Central Eastern Europe, which was highlighted as a key risk for 2011, is indeed starting to materialise early in 2012.

But before we delve more into the Hungarian dances (as a reference to the 21 lively Hungarian dance tunes by Johannes Brahms), and discuss some of our previous call for concerns, it is time for a quick market overview.

The 36 months LTRO set up on the 21st of December by the ECB is far from having the expected results in relation to alleviating concerns that banks will use the cheap funding provided to generate generous positive carry by buying peripheral bonds. 455 billion euros are deposited at the ECB earning a paltry 0.50% of interest for now - The liquidity picture in four charts. ECB Overnight Facility, Euro 3 months Libor OIS spread, Itraxx Financial Senior 5 year index, Euro-USD basis swaps level - source Bloomberg:

The Credit Indices Itraxx overview - Source Bloomberg:

Most credit indices remain in the "concern" area, with Itraxx Financial Subordinate 5 year CDS index around 530 bps, still indicating the unsecured subordinated financial market is shut down, while Itraxx Financial Senior 5 year CDS index is rising again towards the 300 bps in a very thin market. As indicated by a market maker, so far both clients and dealers are on the sidelines. The Itraxx SOVx index tied to 15 European Government sovereign CDS is on the rise as well getting closer towards its 385 record set up on the 25th of November. Similar story to what we wrote in January 2010, "European problems not going away in 2011", and not going away in 2012.

The current European bond picture, a story of ongoing volatility, with Spain now rising as well with Italy following recent news of regional funding issues in Spain (Valencia) - source Bloomberg:

So what about our CPDO EFSF? It seems French yields are now rising faster as we start a new year, Investors demanded a yield of 3.29% on the 3.25% OAT due in October 2021, last auction on 1st of December was 3.18% - source Bloomberg:

German 10 year government yield falling (flight to quality) while German 5 years sovereign CDS rising - source Bloomberg:

In relation to the deflation story still playing out in Europe, here is an update on 30 year Swiss bond yields now below 1%, nearly 100 bps lower than Japan 30 year bond yields - source Bloomberg:

But back to our main story, namely the Hungarian situation and contagion to Emerging Markets (EMEA).

During various credit conversations, we argued that the name of the game is survival of the fittest in the race to raise much needed capital. It seems Deutsche Bank is sharing our views as indicated in their Emerging Markets special publications published on the 6th of December entitled amusingly "Survival of the fittest":
EMEA dominates our list of the most vulnerable countries. Five countries (Hungary, Ukraine, Romania, Poland, and Egypt) show up as highly vulnerable, though for different reasons. Egypt’s underlying vulnerabilities, for example, are fiscal first and external second. Ukraine’s risks are mostly external. Hungary’s vulnerability reflects a combination of risks in all four areas."

According to Deutsche Bank, for 2012, EMEA countries will be facing many difficulties and will need IMF support:

"Current account balances have improved in the last few years and central banks have been able to build bigger buffers of foreign reserves. But the large stock of external debt accumulated during the middle of the last decade still leaves the region with large external burden. Much of this borrowing took place in foreign currencies – Swiss franc mortgages in Hungary (20% of GDP) being just one example – the local currency burden of which is now being inflated as those currencies come under pressure. With these debts needing to be serviced on an ongoing basis, many countries still face large external financing needs even as their current account positions have improved. This is particularly true of Hungary and Ukraine, which have gross external financing needs of 30% of GDP or above in 2012 despite a moderate current account deficit in Ukraine and a small surplus in Hungary."

IMF support?

"Three of these countries (Hungary, Ukraine and Egypt) may well need to tap the IMF for financial support next year. Ukraine already has an IMF program (of which USD 12bn or 6.5% of GDP is potentially still available) but is currently looking first to Russia for cheaper gas prices to reduce its external financing needs. Hungary is seeking the reassurance of a precautionary IMF program although negotiation on the policy condition has not yet started and could well be difficult. Egypt had reached agreement in principle on a USD 3bn (1.2% of GDP) arrangement with the IMF but has yet to proceed with the deal for political reasons."

In our conversation "Leda and the (Greek) Swan and why Europe matters more for Emerging Markets", we already discussed at length the Western Europe banking deleveraging impact will have on Emerging Markets and in particular Central Eastern Europe. In their December note, Deutsche Bank also commented:

"The buildup of foreign currency debt was probably largely a reflection of relatively high and volatile inflation in some cases, leading to a large spread between domestic and foreign interest rates. But the availability of foreign currency loans was also facilitated by the rapid expansion of western European banks throughout much of the region. This has left many countries exposed to deleveraging by foreign banks as they seek to meet additional capital requirements imposed by the European Banking Authority. These requirements are largest for Greek, Italian, and Spanish banks, which may be a concern for Romania and Hungary (as well as Croatia, Serbia, and Bulgaria outside our sample) where Greek and Italian banks are most active. But other banks may also be reluctant to maintain their exposures in the region. Germany’s Commerzbank, for example, has indicated that it will temporarily suspend new lending outside of Germany and Poland. Austria’s central bank has also imposed limits on new lending in CEE by the subsidiaries of Austrian banks. And countries without strong parent-subsidiary ownership linkages are also unlikely to be immune. Turkish banks, for example, have substantially increased their short term external borrowing in the last couple of years (from foreign banks) and may face some difficulties in rolling these loans."

As indicated by Deutsche Bank, given Hungary exports to the euro area account for 40% of GDP, Hungary is arguably more exposed to a recession in Europe. The recent failed Hungarian auction and additional pressure on the Forint is definitely not helping.

And my good credit friend to comment on the 5th of January:

"The Hungarian Forint is under pressure again (EurHuf @ 321.50), and the country had problem raising 1 year T-Bills this morning (35 billion HUF instead of the 45 billion planned, the average yield rose to 9.96% versus 7.91% for the same kind of maturity on December 22nd). The cost of insuring Hungary’s debt through CDS reached an all-time high at 750 bps!

Basically, the country is now in a worst situation than Portugal, and without the IMF and EU assistance, the risk of a hard default is rising very quickly. Consequences for European banks exposed to this country are difficult to assess, but Erste Bank, Raiffeisen and some other players should suffer…"

And suffer they already have, not only with the legislation capping the exchange rate on currency mortgages provided to Hungarian households (putting them in a difficult situation) we mentioned above but, also in relation to Goodwill impairments (which we discussed in our conversation "Goodwill Hunting Redux").
As a reminder:

"Erste Bank in fact, wrote down the value of its Hungarian and Romanian units by a combined 939 million euros in October."

"UniCredit wrote down goodwill on assets in its home market, eastern Europe and former Soviet Union countries in its third-quarter earnings report in November (8.7 billion-euro impairment charge)".

It wasn't therefore a big surprise to us and our good credit friend to see a decline of 37% of UniCredit shares in three days following its 7.5 billion right issues priced with a 43% discount (selling shares for 1.943 euros each...).

Back in November in our Goodwill conversation we made the following warning:
"Tip for “banks’ friends”: First came dividends cuts, then bonds haircuts. Next, we will see some massive write-off (Goodwill ?). UniCredit started, others will follow. The path will be very painful for both shareholders and bondholders."


Given we already know that UniCredit made 60 billion USD worth of acquisition between 2005 and 2008, tracking goodwill impairments will indeed be a necessary exercise in 2012 as they can take a real chunk out of bank earnings in the process.

In relation to current bank exposure to Hungary, Deutsche Bank in their latest Hungarian sovereign risk review published on the 6th of December indicated the following:

"During the past days the Hungarian sovereign risk exposure has increased
significantly, taking the development of CDS prices as an indicator. Austrian banks have material exposure to Hungary, both via sovereign bonds and through loans. Erste Group has a total of EUR11bn in assets invested in Hungary (some EUR8bn in loans, some EUR3bn in sovereign exposure) while Raiffeisen Bank International has a total of EUR8bn in Hungarian assets (some EUR6bn in loans, some EUR2bn in sovereign exposure.
According to latest EBA data, as of 30 Sept 2011 the largest European banks have a total sovereign exposure of EUR31bn vis-a-vis Hungary. The data indicates the largest absolute exposures (combined net trading and banking book) are held by KBC with EUR6.9bn (of which EUR2.6bn was due within 3 months, so might have left the balance sheet by now), OTP with EUR4.2bn, Erste Group with EUR3.3bn, BayernLB with EUR2.2bn, Commerzbank with EUR2.0bn, Intesa with EUR1.7bn, ING with EUR1.7bn, RBI with EUR1.6bn. In some cases the maturity profile in the EBA spreadsheet was biased to short-term exposures, in some cases biased towards long-term exposures.
In relation to current market cap, high ratios result for KBC (c.220%), Erste Group (c.70%), RBI (c.40%) and Commerzbank (c.30%). A haircut on Hungarian sovereign exposure therefore would have meaningful implications for these institutions."

Continuing on the same Hungarian theme in Deutsche Bank EMEA Daily Compass published on the 6th of December, we have to agree with their assessment of the situation for Hungary:
"The failure of yesterday’s a12M bill auction has ignited fears that the situation in Hungary may spiral into a solvency crisis triggered by an inability to roll-over upcoming LOCAL debt maturities.
From a medium term perspective, a useful rule of thumb for assessing debt sustainability is to compare the marginal real yield required to roll-over the existing stock of debt and the real growth rate of the economy Over the past 10 years, real growth has averaged 2.4% y/y while yearly inflation stood on average at 5.9%, which suggests that at the current blended (local and external) marginal rate of refinancing (10.5%), a consistent fiscal primary surplus of 2.2% would be required to maintain current public debt levels stable. It is clear to us that such a theoretical outcome is not credible for the market, i.e. paradoxically yields have reached a level that is too high to motivate buyers to participate in the financing of an issuer that is running an unsustainable debt position."

Deutsche Bank to conclude their note making the following point:
"As a conclusion, we expect events to unfold rather quickly in Hungary. It may come down to a choice between a partial loss of sovereignty in economic management or of a debt restructuring, to be made at the highest political level."

And has clearly indicated by Bloomberg's Chart of the day of the 4th of January, we have seen this movie before...

"Hungary’s failure to secure an international bailout has pushed the cost of insuring its debt against default above that of Ireland for the first time since September 2010.
The CHART OF THE DAY shows that credit-default swaps on Hungary rose to 720 basis points in London on the 3rd of January, compared with 709 for Ireland, according to CMA, which is owned by CME Group Inc. and compiles prices quoted by dealers in the privately negotiated market.

Hungary’s default swaps surged to the highest on record on the third of January and the forint weakened to an all-time low versus the euro after Citigroup Inc. said an International Monetary Fund deal is unlikely in the next six months and European Commission spokesman Olivier Bailly said the European Union has no plans to resume aid talks."

"When there's uncertainty they always think there's another shoe to fall. There is no other shoe to fall."
Kenneth Lay - CEO and chairman of Enron from 1985 until his resignation on January 23, 2002.

Stay tuned!

Credit - Hungarian Borscht

"A great empire, like a great cake, is most easily diminished at the edges."
Benjamin Franklin

Given Hungary has been our pet subject in relation to the study of systemic risk diagnosis (Modicum of relief):

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

We thought it would be appropriate, to follow up on our "Hungarian Dances" post with some update on the situation relating to the ongoing stand-off between Hungary and the EU and IMF and, of course, credit conditions.

According to Unicredit and as reported by Bloomberg, Hungary may not obtain aid from the IMF and the European Union before the fourth quarter. It would only happen before that date under severe market drop.

Also reported by Agnes Lovasz, from Bloomberg: East European Deleveraging May Hurt Economic Growth, RBS Says:
"Western European lenders will continue to reduce their eastern exposure to meet stricter regulations, curtailing access to credit and economic growth, Royal Bank of Scotland Group Plc said.

“Distressed deleveraging will likely slow, but European banks are still likely to want to reduce balance sheets,” RBS emerging-markets analysts Timothy Ash and David Petitcolin wrote in an e-mailed note yesterday. “Loan books will continue to shrink in aggregate, which would suggest still a very weak credit growth channel across the region, which will continue to act as a broader drag on growth and recovery.”

Indeed, the ongoing restriction of access to credit is already putting Hungary's economic growth under serious strains as reported by Zoltan Simon in Bloomberg on the 26th of April:

"Hungary faces the rising risk of a credit crunch because of the withdrawal of external funds and the high ratio of non-performing loans, the central bank said.

Lenders replacing external funding with “risky” foreign-currency swaps may be another trigger for a credit crunch and the Magyar Nemzeti Bank will consider regulating such transactions, the rate-setting Monetary Council said in a statement today.

A loan agreement with the European Union and the International Monetary Fund, which Hungary requested in November, may help reduce the probability of a severe credit crunch as it may include the commitment of foreign banks to their Hungarian units, the central bank said. The European Commission authorized Hungary to start bailout talks on the 25th of April. “The risk of a severe credit crunch, mainly in the corporate segment, has increased recently, given the weakening in the banking sector’s lending capacity, in addition to its persistently low willingness to lend,” the Monetary Council said."

Of course the European Union and the IMF have started bailout talks, because, end of the day, the fall of the Hungarian financial system would undoubtedly wreak havoc on Austrian banks and European banks highly exposed to Eastern Europe (Erste Group Bank AG, Raiffeisen Bank International AG, UniCredit SpA, Bayerische Landesbank AG, KBC Groep NV, and Intesa Sanpaolo SpA).

As we have long argued in various conversations, it is after all a game of survival of the fittest. In fact in our conversation "Hungarian Dances", Deutsche Bank already had highlighted the five most vulnerable countries in EMEA in December 2011:
"EMEA dominates our list of the most vulnerable countries. Five countries (Hungary, Ukraine, Romania, Poland, and Egypt) show up as highly vulnerable, though for different reasons. Egypt’s underlying vulnerabilities, for example, are fiscal first and external second. Ukraine’s risks are mostly external. Hungary’s vulnerability reflects a combination of risks in all four areas."

Therefore it wasn't really a surprise to us to learn about the fall of the Romanian center-right government on the 30th of April as political turmoils sank the currency, the Leu. As reported by Irina Savu in Bloomberg:

"The turmoil triggered a sell-off in the country’s currency, which fell to an all-time low against the euro today and may force Romanian policy makers to shield the leu by keeping rates unchanged after lowering borrowing costs one percentage point to boost faltering economic growth."

From the same article:

“Given Romania’s heavy burden of foreign-exchange debt, the exchange rate is a critical factor in the National Bank’s decision process,” Neil Shearing, chief emerging-markets economist at Capital Economics in London, wrote in a note to clients on April 27."

We have heard this story before for Hungary about foreign-exchange debt weighting heavily on households, representing significant headwinds for banks, not only to provide much needed access to the real economy by providing credit, but also hindering in effect the deleveraging process and the healing process of households balance sheet in these countries.

The Romanian Leu depreciated to a record low of 4.4140 per euro in Bucharest, the biggest intraday slum since February 20. Romania secured a 5 billion euro precautionary loan from the IMF and the EU in 2011 to protect it from the debt crisis, triggered by foreign-exchange debt similar to what we have been seeing in Hungary.

We believe a credit crunch is unavoidable in both countries:
"The ratio of non-performing corporate loans reached 17 percent at the end of 2011, a 4 percentage point increase from a year earlier, the central bank said. Including restructured loans, about a quarter of corporate loans were impaired, the bank said. The ratio will probably rise through 2013, the central bank said.
The ratio of non-performing household loans rose to 13.1 percent in 2011 from 9.5 percent in 2010 and will probably peak this year, according to the report." - source Bloomberg, Zoltan Simon - 26th of April 2012.

Hungary Economic Sentiment - Erste Bank indicator - source Bloomberg:

Economic Sentiment indicator deteriorating in Hungary and standing at -19.30.

Rising Non-performing loans in Hungary now at 13.30% - source Bloomberg:

Troubles ahead for Hungarian banks given the rise of Non-performing loans is not accompanied by a rise in provisioning, on the contrary....down to 45% - source Bloomberg:

The ill-fated currency non-performing mortgages plaguing Hungarian households are still rising (in HUF millions) - source Bloomberg:

The impact of the start of the bailouts talks can be seen on both the Hungarian bond markets as well as on Hungary's sovereign CDS market - source Bloomberg.

As well as on EURHUF exchange rate - source Bloomberg:

As a reminder from our conversation "Modicum of Relief", Erste Hungary's lending capacity is deeply impaired by:
-loan-to-deposit ratio of 192%, the highest in the sector.
-the proportion of non-performing loans in the bank's portfolio rose to 20.5% in 2011 from 11.7% in 2010 (The rate in the retail portfolio increased to 16.3% from 11.4%, while the rate in the corporate portfolio climbed to 29% from 12.5%
We argued at the time:
"Rising non-performing loans is a cause for concern as well as rising loan-to-deposit ratios."

Erste Group AG published their results on the 30th of April, and not surprisingly, their results are affected by bad loans in both Hungary and Romania. Erste has therefore cut its outlook as reported by  Boris Groendahl in Bloomberg:
"Erste Group Bank AG said bad loans in Hungary and Romania will remain a drag on profit for longer than it predicted after they cast a pall over first-quarter results at eastern Europe’s second-biggest lender.
Bad debt charges will be about 2 billion euros ($2.7 billion), or about 10 percent more than it predicted Feb. 29, as asset quality continues to worsen in Hungary and Romania, the Vienna-based lender said in slides prepared for an analyst meeting in London today. That also means operating profit will be only stable this year, rather than rising “slightly” from 3.63 billion euros in 2011."

In both countries, about one in four loans on Erste’s Hungarian branch loan book is delinquent. Erste had its first loss since at least 1988 in 2011 because of write-downs in these two countries.

From the same Bloomberg article relating to Erste Bank's results:
"Risk provisions rose 26 percent to 580.6 million euros, more than the 22 percent rise analysts in the Bloomberg survey had estimated. The bank booked extra charges on corporate and real estate loans in Romania, and on Hungarian foreign-currency mortgages. Erste had predicted Feb. 29 that 2012 charges would decline to 1.8 billion euros from 2.27 billion euros last year."
Once again analysts are on the ball...Nice.

The IMF has recently cut Hungary's 2012 economic-growth forecast to zero from 0.3%, predicting a 1.8% growth in 2013. We don't see it happening with unemployment likely to reach 11.5% in 2012 from 11% in 2011. The budget deficit in Hungary may rise to 3.6% in 2013 from 3% in 2012 according to the European Commission, that compares to a target of 2.5% for 2012 and 2.2% in 2013. Was it again a case of "A Deficit Target Too Far"? One has to wonder...

As our good credit friend indicated back in March 2012:
"Credit dynamic is based on Growth! No growth or weak growth can lead to defaults and asset deflation."

In fact the Hungarian government is indeed in a bind and has been resorting to "Argentinian" tricks to bring in much needed revenue. On the 24th of November the Economy Minister Gyorgy Matolcsy nationalised private pensions, in a government drive to bring in 3 trillion forint (14.6 billion dollars), rolling back pension changes as indicated by Zoltan Simon in Bloomberg on the 25th of November:

"Hungary, the most indebted eastern member of the EU, is following the example of Argentina, which in 2001 confiscated about $3.2 billion of pension savings before the country stopped servicing its debt. The government in Buenos Aires nationalized the $24 billion industry two years ago to compensate for falling tax revenue after a 2005 debt restructuring."

Any similarities with actual events will of course be purely fortuitous, as the saying goes...

It is as well not a surprise to hear that recently the Hungarian government has been planning to levy a tax on phone and internet usage as reported by Zoltan Simon in Bloomberg:

"Hungary’s government plans to levy a tax after phone and internet usage, Origo news website reported, citing unidentified people at the Economy Ministry.

The government may raise as much as 50 billion forint ($222 million) from the new tax, which would be part of measures to plug budget holes next year, Origo reported."

Which, of course, led to a big sell-off in Magyar Telekom Nyrt. (MTEL) shares. Hungary’s former phone monopoly fell the most in more than three months after news website Origo reported that the government plans to tax phone and internet usage on the 20th of April.

On a final note, the ongoing delay for Hungary in securing a much needed bail-out funds linked to their ill-fated private sector woes plagued by currency mortgages issued by European banks is choking the economy - source Bloomberg:

"The CHART OF THE DAY shows Hungary’s monetary policy is the most restrictive since at least 2006, after holding the benchmark rate since December. The Monetary Conditions Index for Hungary, which assesses the effect of borrowing costs and currency strength on the economy, is 5.3 percent below its 10-year average, compared with 0.2 percent in the Czech Republic. A negative value shows a tendency toward contraction." - source Bloomberg.

"He who rejects restructuring is the architect of default." - Macronomics.

Stay tuned!

Markets update - Credit - Bayesian thoughts

"In the Bayesian (or epistemological) interpretation, probability measures a degree of belief. Bayes' theorem then links the degree of belief in a proposition before and after accounting for evidence. For example, suppose somebody proposes that a biased coin is twice as likely to land heads than tails. Degree of belief in this might initially be 50%. The coin is then flipped a number of times to collect evidence. Belief may rise to 70% if the evidence supports the proposition." - source Wikipedia

Today's analogy refers to our rising degree of belief courtesy of Bayesian statistics but also to the well-studied "optimism bias" which most of us are affected by:
"The ability to anticipate is a hallmark of cognition. Inferences about what will occur in the future are critical to decision making, enabling us to prepare our actions so as to avoid harm and gain reward. Given the importance of these future projections, one might expect the brain to possess accurate, unbiased foresight. Humans, however, exhibit a pervasive and surprising bias: when it comes to predicting what will happen to us tomorrow, next week, or fifty years from now, we overestimate the likelihood of positive events, and underestimate the likelihood of negative events. For example, we underrate our chances of getting divorced, being in a car accident, or suffering from cancer. We also expect to live longer than objective measures would warrant, overestimate our success in the job market, and believe that our children will be especially talented. This phenomenon is known as the optimism bias, and it is one of the most consistent, prevalent, and robust biases documented in psychology and behavioral economics."
Tali Sharot - The optimism bias - Current Biology, Volume 21, issues 23, R941-R945, 6th of December 2011.

But, here we go again, lost in our thought process once more. It is time for a credit market overview, the improved tone in the credit space and following up on our previous Hungarian story with an interesting goodwill write down, courtesy of BayernLB, what a surprise...

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

While banks are still so far hoarding cash at the ECB's overnight facility earning 0.25% in the process (new reserve period starts on the 18th of January), liquidity picture is improving at least on the Libor OIS spread level, indicating clearly the 30th of November Central banks operation has had its effect on dollar funding issues.

The Credit Indices Itraxx overview, overall a better tone - Source Bloomberg:

Itraxx Financial Subordinate 5 year CDS index falling below the 500 bps level and closing around 480 bps, overall a better tone in the Credit space with a flurry of corporate bonds issuance, Spanish bond auctions, ECB keeping rates at 1% and more. Since the beginning of the year we have seen quite a few issues of Senior Financial Unsecured bonds issuance from core European banks:
Nordea Bank 2.24% 2014 (1 billion euros, quarterly floating) on the 4th of January,
Abn Amro Bank 4.75% 2019 (1 billion euros) on the 4th of January
ING 4.25% 2017 (1 billion euros) on the 6th of January,
UBS 3.125% 2019 (1.5 billion euros) on the 11th of January,
Rabobank 4% 2022 (1.75 billion euros) on the 11th of January,
Standard Chartered 4.125% 2019 (1 billion euros) on the 11th of January.

Itraxx Crossover 5 year index (High Yield gauge) evolution - Source Bloomberg:

The Itraxx Crossover represents 50 companies with mostly high-yield credit ratings. The index decreased by around 21 basis points today to 713 bps.

The most important news reported was by Handelsblatt about the European Banking Authority being likely to postpone the annual stress test for banks initially set up for June and published in 2012. Could it be in order to avoid spoiling the celebration of the London Olympics? It might be more realistically to do with the recent concerns of raising much needed capital in 2012 following the dreadful right issues results of Unicredit which we discussed previously and avoid a dreadful credit crunch for 2012 in the process. Deleveraging bank balance sheets in conjunction with reaching a core tier one capital level of 9% was indeed a recipe for disaster looking at 2012 wall of refinancing (somewhat alleviated by the 36 months LTRO operation conducted on the 21st of December by the ECB).

There is again an interesting disconnect between the move in the 10 year German Bund and the Eurostoxx, a point we touched in our post "Mind the Gap..." - source Bloomberg:

Volatility falling still in the process as shown in the bottom level of the graph displaying 6 month implied volatility and V2X index.

Could the disconnect be different this time?

Flight to quality mode is so far is still on, with Germany 10 year Government bond trending back towards record lows - Source Bloomberg:

One of the indicators we have been following in our various credit conversations has been the spread between 10 year Swedish government yields and German 10 year government yields. It looks like this relationship is coming back following the scary German auction of the 23rd of November (see our post "The song of Roland") - source Bloomberg:

The current European bond picture with some respite for Italy and Spain - source Bloomberg:

Even our CPDO/EFSF is looking healthier in yields term back to the 3% levels - source Bloomberg:

But what made our credit friend and us really chuckle today, following up on our "Hungarian dances" post, was the news regarding BayernLB (Bayerische Landesbank, the second-
biggest German state-owned lender) which as reported today by Stefan Wagstyl in his column "beyondbrics" in the Financial Times has effectively been "bloodied in Budapest":

"Germany’s BayernLB said it would report a net loss for 2011 because it was writing down the value of its Hungarian subsidiary, MKB Bank."

Reminding us exactly of what discussed last time around:

"Tracking goodwill impairments will indeed be a necessary exercise in 2012 as they can take a real chunk out of bank earnings in the process."


BayernLB anticipates net loss for 2011 under German accounting standards (HGB) due to Hungarian government actions - press release:
"12 January 2012
Munich - Due to the need to write down the book value of its holding in its Hungarian subsidiary MKB Bank, BayernLB currently anticipates that it will report a net loss for 2011 in its separate accounts under German accounting standards (HGB).

BayernLB is compelled to take this measure because actions by the Hungarian government, to include the extremely high bank levy and recently passed Foreign Currency Conversion Act, have substantially impaired MKB Bank's earnings prospects.
The writedown on the book value of its holding in MKB Bank will have a significant impact on BayernLB's net income under German accounting standards and thus overshadows the positive performance of its operating business with customers.

As a result of the expected loss in the HGB financial statements, BayernLB does not expect to service its equity capital instruments (profit participation certificates, silent partner contributions and BayernLB Capital Trust 1 securities) for financial year 2011.
As things currently stand, it will not be possible for the profit participation certificates and silent partner contributions to avoid sharing the loss. A definitive statement on the amount of the loss participation is not expected to be possible until the financial accounts have been approved at the end of April 2012."

Consequence: Bayern LB Capital Trust (Tier 1 ) Perp call 2017 – 6.2032% - $ 850 million – Isin XS0290135358. Price: 32/34 Down 7 points...
Ouch!

We have to say it again, like we did in our previous conversation and as well in November in our Goodwill conversation:

"Tip for “banks’ friends”: First came dividends cuts, then bonds haircuts. Next, we will see some massive write-off (Goodwill ?). UniCredit started, others will follow. The path will be very painful for both shareholders and bondholders."

So effectively, BayernLB equity capital instruments holders can kiss their coupon goodbye...

And my good credit friend to comment:

"And this kind of event will affect much more banks than expected by the market. I expect Austrian banks to make similar announcements very soon, with potential worse consequences considering their position in Central Europe."


EUR/HUF currency levels - source Bloomberg:

We were in agreement with Deutsche Bank in our last conversation:

"As a conclusion, we expect events to unfold rather quickly in Hungary. It may come down to a choice between a partial loss of sovereignty in economic management or of a debt restructuring, to be made at the highest political level."

In fact according to Bloomberg, the likely choice seems so far towards partial loss of sovereignty, indeed we argued last time around, we have seen this movie before...

According to Bloomberg:

"London, January 12 (MTI) - There is a "good probability" that the Hungarian government will sign a Stand-by Arrangement with the IMF as early as the first quarter of this year, London-based emerging markets economists said on Thursday.
In its comprehensive 2012 outlook for the CEEMEA region released to investors in London, Morgan Stanley said a two-year programme of 15-20 billion euros would be sufficient to reassure markets about Hungary's funding needs."

But given our current "Bayesian thoughts", and as indicated by Morgan Stanley in the same article:

"We think that the next few months should see Hungary's refinancing risks
fall significantly thanks to assistance provided by the IMF/EU". That said, "we think that even though there are good chances of a deal in the near term, the relationship with the IMF is likely to be rocky to say the least, as long as the current administration is in place... Therefore, the risk of some rift between Hungary and the EU/IMF a few months down the line remains intact", Morgan Stanley said."

So, all in all, we would have to agree with Dr. Constantin Gurdgiev, from his latest post entitle "Great Moderation or Great Delusion":

"when investors "infer the persistence of low volatility from empirical evidence" (in other words when knowledge is imperfect and there is a probabilistic scenario under which the moderation can be permanent, then "Bayesian learning can deliver a strong rise in asset prices by up to 80%. Moreover, the end of the low volatility period leads to a strong and sudden crash in prices."

And to use a baseball analogy from our Americans friends, don't try stealing third base in this market environment!

"Information: the negative reciprocal value of probability."
Claude Shannon

Stay tuned!

Markets update - Credit - The LTRO Alkaloid

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

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

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

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

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

The Credit Indices Itraxx overview - Source Bloomberg:

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

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

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

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

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

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

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

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

Risk-off?

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

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

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

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

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

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

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

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

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

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

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

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

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

We do not think so:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Stay tuned!

Credit - European Derecho

"Derecho comes from the Spanish word for "straight" (cf. "direct") in contrast with a tornado which is a "twisted" wind. The word was first used in the American Meteorological Journal in 1888 by Gustavus Detlef Hinrichs in a paper describing the phenomenon and based on a significant derecho event that crossed Iowa on 31 July 1877." - source Wikipedia

"A derecho  is a widespread, long-lived, straight-line windstorm that is associated with a fast-moving band of severe thunderstorms. Generally, derechos are convection-induced and take on a bow echo form of squall line, forming in an area of wind divergence in the upper levels of the troposphere, within a region of low-level warm air advection and rich low-level moisture. They travel quickly in the direction of movement of their associated storms, similar to an outflow boundary (gust front), except that the wind is sustained and increases in strength behind the front, generally exceeding hurricane-force. A warm-weather phenomenon, derechos occur mostly in summer, especially during June and July in the Northern Hemisphere, within areas of moderately strong instability and moderately strong vertical wind shear. They may occur at any time of the year and occur as frequently at night as during the daylight hours." - source Wikipedia

Looking at the recent storms which have recently unfortunately hit our American friends, and given the sudden rise in Spanish yields to record levels, touching a euro record high of 7.56%, we thought this time around, our "Derecho" analogy would be appropriate. Although these "Derechos" storms most commonly occur in North America, "Derechos" can occur elsewhere in the world, hence our recurring theme of severe weather patterns (Plain sailing until a White Squall? - 18th of March, The Tempest - 8th of May, St Elmo's fire - 26th of May). After all, "Derechos" in North America form predominantly from May to August and the “Sell in May and go away” has persisted as a profitable market-timing strategy for stock investors. Could it be in similar patterns to "Derechos"? We ramble again:

"The CHART OF THE DAY shows the average percentage-point gaps in stock performance between the six months ended in April and the next six months, as presented in the study. The figures cover MSCI Inc.’s local-currency indexes of 23 developed markets for November 1998 through April 2012.
Every index did better in the November-April period, led by MSCI Ireland, which had a differential of 17.9 points. Fourteen emerging-market indexes were included in the research, and all of them showed the same tendency. “The Sell in May effect occupies a special place among seasonal anomalies,” University of Miami Assistant Professor Sandro C. Andrade and two of his colleagues wrote in the study, posted yesterday on the Social Science Research Network. That’s because it only takes two trades a year to make money, unlike other patterns that require more frequent buying and selling. The research by Andrade, Vidhi Chhaochharia and Michael E. Fuerst followed up on a study published in 2002 by the American Economic Review, an academic journal. The earlier work tracked the disparities in the 37 MSCI indexes from their inception, as early as 1970, through October 1998.
In the earlier period, the gap averaged 8.7 points. The differential climbed to 10.5 points after excluding Argentina and Brazil, which experienced hyperinflation. The overall average in the new study was 9.7 points." - source Bloomberg.

 

 

So in our long credit conversation, given the interesting turn of events of the week, with some very important legal evolution, we think, in the subordinated bond space relating to "Bail-ins" and exit consents challenge (h/t FT Alphaville Joseph Cotterill for pointing this out), we will take a look at implied recovery in bank credit and credit events. This recent interesting legal challenge has indeed significant implication for recovery rates in the subordinated bond space, particularly for Spanish subordinated bondholders (facing the music of haircuts, coercive or not, in true Irish fashion). But first our credit overview.

The Itraxx CDS indices picture, with indices tightening on the back of Mario Draghi's declarations  - source Bloomberg:

The Itraxx Crossover (High Yield CDS risk indicator - 50 European high yield credit entities) tightened by 22bps to 642 bps level. Both the Itraxx Financial Senior 5 year index (25 banks and insurers) as well as the Itraxx Financial Subordinated 5 year index fell significantly in the process, respectively by 12.5 bps and 21 bps. Truth is, during this summer lull, with poor liquidity, market makers are not seeing big sellers of protection (going long credit, being "Risk-On" that is), and are scrambling to bid for protection with no offer available and remain wary of this market movement akin to short covering. We have seen this movie before...

Although French President Francois Hollande and German Chancellor Angela Merkel said Friday their nations are “bound by the deepest duty” to keep the currency bloc intact, following on the commitment made Thursday by ECB President Mario Draghi, we remain deeply concern by the economic situation in the peripheral space with Spain registering a new unemployment record at 24.6% from 24.4% in the prior three months, the most since at least 1976, the year of the democratic transition.

We have indeed reached intervention time given Spanish yields and rising NPLs have as well reached new record highs:

"Spain's ability to fund itself at the shorter end suffered a severe blow as two-year yields breached 6.5% on fears that regional governments beyond Valencia would seek aid, rendering the 18 billion euro bailout fund insufficient. Beyond funding difficulties, bank bad debt will deteriorate faster as debt rollover costs continue to rise." - source Bloomberg.

 

 

While Europe’s success in severing the link between Sovereign Risk and Financial risk remain to be seen as indicated by the difference in spreads between the Itraxx SOVx 5 year CDS index (representing 15 Western Europe sovereign CDS including Cyprus) and the Itraxx Financial Senior 5 year index which remains broadly flat - source Bloomberg:

“We have got to cut the fatal loop between sovereigns and banks, which will otherwise bring the euro-zone project as it exists now down,” Adair Turner, chairman of the U.K. Financial Services Authority, said in a London speech as reported by Bloomberg (wishful thinking). The Commission is working against a "self-imposed" September deadline to carve out plans that would give oversight of banks to the ECB as the first step in a campaign to break a cycle of banks and sovereigns fuelling each other's solvency risk.

Truth is time is running out for Spain, probably the reason why Mario Draghi felt compelled to "buy" some time in order to give sufficient time to the market to calm down before the September deadline:

"The CHART OF THE DAY shows the difference in yield between the two securities narrowed this month before flipping on the 26th of July. The five-year note yield surged to as much as 7.785 percent, the most since the euro was created in 1999, and more than three basis points higher than the 10-year rate, which reached 7.751 percent. The selloff also pushed yields on Spain’s two-year securities to more than 7 percent for the first time since September 1996. The bonds subsequently rebounded and the five year rate dropped below 10-year yields amid speculation Spain’s fiscal predicament will convince the European Central Bank to augment the firepower of the region’s bailout fund." - source Bloomberg.

With Mario Draghi's timely intervention, no wonder Spanish yields receded very significantly by more than 100 bps in our European bond picture while German government yields rose back towards higher levels around 1.40% on the close (1.16% on the 20th) with other European core bonds (France, Netherlands) rising as well in conjunction with German yields - source Bloomberg:

Spain's 10-year yield fell 52 bps this week to 6.74%, the biggest weekly drop since the period ended December 2nd according to Bloomberg.

While Spanish banks have been busy lowering their sovereign holdings for a third straight month:

"Euro zone financial institutions increased sovereign debt holdings by more than 145 billion euros during 1Q, as ECB cash was put to work. Spanish banks, having purchased 78 billion euros of sovereign in the four months to end-March, lowered their exposure for a third month in June. A euro-zone wide, sustainable solution is required to stem the crisis." - source Bloomberg.

Looking at Santander 1H deposit mix, Spanish structural funding issues are very clear for these institutions:

"While Santander's total customer deposits grew 3% yoy to 1H, its time deposits fell 22 billion euros. The key delta was growth of more than 38 billion euros in non-resident "other" deposits. As Spain's troubles continue, a shortening of liability duration and withdrawal of mutual and pension fund support will likely continue across banks, pressuring funding costs further." -  source Bloomberg.

Hungary has been long been our pet subject (Hungarian Borscht, Hungarian Dances) in relation to the study of systemic risk diagnosis (Modicum of relief):
"The reason behind our choice is that it appears to us as very good case study for systemic risk diagnosis from a macroeconomic point view (after all our blog is called Macronomics)."
We argued at the time:
"A liquidity crisis happens when banks cannot access funding (LTRO helped a lot in preventing a collapse). A solvency crisis can still happen when the loans banks have made turn sour, which implies more capital injections to avoid default (hence the flurry of subordinated bond tenders we have seen). Rising non-performing loans is a cause for concern as well as rising loan-to-deposit ratios. "
It was not really a surprise therefore to see Hungary Yields dropping below Spain for the first time this week:

"Hungary’s borrowing costs dropped below Spain’s for the first time as the European Union’s most
indebted eastern member held talks on an international bailout and Spain’s regions requested aid. The CHART OF THE DAY shows investors this week demanded lower yields to hold Hungary’s debt than Spain’s after Hungary began talks for an International Monetary Fund credit line and Spain’s Valencia region sought financial assistance. Hungary’s 10-year bond yields were at 7.39 percent on July 23, compared with 7.49 percent for similar-maturity Spanish debt. “The primary reason why Hungarian bonds have been doing well is because anticipation has been building up that the country is moving toward an IMF program,” Arko Sen, a strategist at Bank of America Corp. in London, said in a phone interview yesterday. Hungarian yields were as high as 10.8 percent after Prime Minister Viktor Orban’s government passed legislation the IMF and the EU said threatened the central bank’s independence in December, obstructing talks on aid. Hungarian yields were as much as 539 basis points above Spain’s in January." - source Bloomberg.

Looking at Mario Draghi's speech we could not resist to reminding ourselves our previous December 11th post "The Generous Gambler" where we quoted the wonderful poem by French poet Baudelaire which inspired Verbal Kint in The Usual Suspects:

"The greatest trick the devil ever pulled was to convince the world he didn't exist"

Roger "Verbal" Kint- The Usual Suspects

"My dear brothers, never forget, when you hear the progress of enlightenment vaunted, that the devil's best trick is to persuade you that he doesn't exist!" - Charles Baudelaire, French poet, "Le Joueur généreux," pub. February 7, 1864

"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

People are trading on hope: "Please make Mario Draghi keep his word", we could posit in similar fashion to what we commented in our September 2011 conversation "The curious case of the disappearance of the risk-free interest rate and impact on Modern Portfolio Theory and more!"

"So far the devil's best trick has been to persuade us that risk-free interest rates did exist. It ain't working anymore and that is a big cause of concern." - Macronomics.

We could not resist but we chuckled when we read the following comment from a credit desk:
"Equities = Hope, Credit = Reality, unfortunately, Reality follows Hope until the Hope dies, then Reality settles in."

As a reminder from our "Generous Gambler" conversation this is what Arnaud Marès, from Morgan Stanley in his publication of the 31st of August 2011 -Sovereign Subjects had to say:

"Does it matter that sovereign debt is risk-free? It very much does. If sovereign debt is no longer a safe haven, then the ability of governments to implement counter-cyclical policies is impaired. Fiscal policy is becoming at best neutral, at worst pro-cyclical. At a time when growth is rapidly slowing, the economic cost may be high.
Weakening the quality of government credit means weakening the fiscal backstop from which banks benefit. This risks resulting in an accelerated de-leveraging of bank balance sheets, with equally costly economic consequences."

This is exactly what has happened so far with the ill-fated EBA June 2012 request of asking European banks to reach a Core Tier 1 ratio which precipitated the deleveraging as well as the withdrawal of credit, bond tenders and other liability management exercises, hitting hard in the process the real economy in European countries. This withdrawal of credit has also been confirmed by the latest results from British bank Barclays as indicated by Bloomberg:
"The exodus from debt-ridden peripheral Europe continues, with Barclays detailing reduced sovereign exposure of 22% and 5% lower retail lending in 1H. Plagued by liquidity shortages, EU Banks have also rushed to reduce local funding mismatches: Barclays took additional Spanish deposits since 2011 year-end, while taking 8.2 billion euros from the ECB's LTRO in Spain and Portugal." - source Bloomberg.

As we pointed in a "Tale of Two Central banks", we would like to repeat Martin Sibileau's view we indicated back in October when discussing circularity issues:

"What would be a solution for the EU? We have repeatedly said it: Either full fiscal union or monetization of the sovereign debts. Anything in between is an intellectual exercise of dubious utility."

We would like to take the opportunity of debunking further the "efficient market theory" (if there are any believers left out there...) in relation to Draghi's intervention. We agree with a recent note from French broker Aurel, namely that this "theory" has taken yet another blow. The markets did not react to Mario Draghi's declarations  made in an interview last Saturday in French newspaper Le Monde but "only" reacted strongly on Thursday when similar declarations were displayed in bold red on Bloomberg: « Believe me, it will be enough ».
Oh well...

In relation to our recent theme of "Yield Famine",  Unibail has sold this week EUR750m of bonds at 2.25% maturing on 1st August 2018 (6 years). The issue was 4 times oversubscribed with the order book reaching over EUR 3bn in less than 1.5 hours...We saw similar action this week on numerous new high quality issues coming to the market.
The rush for yield and strong appetite for credit is cause for concern and caution particularly in the High Yield space where risk is lurking.
"unintended consequences" of this low yield environment will have to corporate balance sheets, to some extent, it tends to explain, why defaults tend to spike in a low rate deflationary environment such as today", we argued last week.

High Yield is indeed becoming very expensive as indicated by Lisa Abramovicz in her Bloomberg article - BofA Cools on Junk Priciest to Stocks Since ’93:
"Junk bonds are losing their sheen after becoming about the most expensive relative to stocks in at least two decades, prompting firms from Bank of America Corp. to Loomis Sayles & Co. to warn that gains on the debt may wane. Junk bonds are returning less than the highest-rated corporate notes for the fourth straight week, the longest stretch since the period ended Nov. 27, Bloomberg data show".

Time to reduce duration and favor short term High Yield if you are "starving" for yield and can stomach the volatility risk we think.

Moving on to the very important subject of the legal evolution in the subordinated bond space relating to "Bail-ins" and exit consents challenge,  this recent interesting legal challenge has indeed significant implication for recovery rates in the subordinated bond space, particularly for Spanish subordinated bondholders.
 As indicated on the FT Alphaville comment section, Claudio Borghi Aquilini made some very valid comments:
"This is an extremely important ruling. Basically it (rightfully) denies the very concept of forced burden sharing at the basis of the eurodebt disaster. Either you let the bank fail or if you decide to save it you may not kill bondholders (albeit subordinated) ad random. Reducing the burden for taxpayers might seem a good reason to do silly things but debt is based on rules, if you create doubts and "special situations" no wonder if funding costs skyrocket (and if a judge tells you that you can not play with contracts). "

We could not agree more. Debt is based on rules. The capital structure is there for a reason when it comes to bank debt and the difference between junior debt from senior debt as well as the recovery values and credit events triggering CDS contracts relating to the capital structure. Looking at the recent discussions relating to "Bail-in" proposals (a subject we discussed in "Something Wicked This Way Comes"),  Morgan Stanly in their Credit Strategy review from the 27th of July entitled - Implied Recovery in Bank Credit, argued the following:
"One hears every possible argument in the debate over whether senior bank debt in Europe should bear losses. There is the moral (better that bondholders pay for bank rescues than ordinary taxpayers). The practical (senior bonds are a small slice of the capital structure, burning them saves relatively little money). The game theory (country that imposes losses saves money, everywhere else suffers). The theoretical (if the institution’s insolvent, of course its lenders should bear loss). The psychological (debt haircuts will scar funding markets for years to come). The list goes on. We believe that the costs of haircutting senior bank debt in Europe vastly outweigh its rewards."
On that matter, we "Agree to Disagree" with Morgan Stanley, given that, as we posited in "Long hope - Short faith, Hungary and Bank Recapitalization", the study realised by Stanford University Anat R. Admati (Why Bank Equity is Not Expensive) shows that banks have fought bitterly against increasing equity buffers which is the cheapest and easiest way to recapitalize banks. Why? because allowing high payouts to shareholders, namely bank employees in many cases, allows financial institutions to raise their leverage: "Focus on ROE is also a reason bankers find hybrid securities, such as debt that converts to equity under some conditions, more attractive than equity." - Anat R. Admati.

The latest legal spat as reported by FT Alphaville (link above) involving credit asset manager Assénagon and Anglo Irish, is a relative important matter given the latest European Bail-in resolution and, because, as indicated by Morgan Stanley in their research piece:
"Fixing the recovery of subordinated debt and taking the spreads on senior and sub debt observed in the market, it becomes possible to solve for a recovery rate on senior."

"The eight banks in the top of the table provide observations of actual loss severity. Why do we focus on CDS? Our approach provides a simple way to solve for implied recovery, but only if the probability of default between two instruments is similar. This isn’t strictly the case with bank bonds, as the restructuring of Lower Tier 2 bonds in the Irish banks bound holders to a large loss, but left senior debt unscathed. CDS, in contrast, triggers at the entity level, meaning that senior and sub CDS are much more likely to take loss at the same time" - source Morgan Stanley.

In terms of market observations, Morgan Stanley also indicates:
"Although senior bank bondholders have generally been protected in Europe, it has been more common for sellers of senior CDS to face losses when contracts are triggered by restructurings. Recoveries in such events have been generally high, at around 50%.
The range of pricing, however, has been enormous – senior CDS on Bradford and Bingley recovered at 95c, CDS on Landsbanki recovered at 1c – especially with regards to the ratio of loss (or the implied ratio of loss).
Across current banks in Greece, Portugal and Spain, pricing also remains highly disperse." - source Morgan Stanley.

"What’s notable? For most banks, implied senior recovery is surprisingly ‘average’ relative to the last seven years, despite all the recent rhetoric. The range of implied recovery is also very narrow (35% to 57%), in direct contrast with the large variation in senior recovery under stress seen in previous table, although we acknowledge that the banks above are for the most part higher-quality than the names in that data-set.
Per our framework, the UK banks (e.g., Lloyds, RBS, Barclays) as well as Commerzbank enjoy the highest implied senior recoveries (i.e., sub debt trades the widest to senior). This is somewhat odd, given that both the UK and Germany have resolution regimes in place whereby subordinated and
senior bondholders could potentially take losses. One explanation could be that investors feel more comfortable in UK and‘core’ European bank senior debt, yet more cautious on subordinated debt, given the resolution regimes. We’re generally happy to lean against this, and would note that the wide senior/sub differential is consistent with our generic preference for UK LT2 and certain Commerzbank subordinated debt structures.
In contrast, Spain and Italy have among the lowest implied recovery rates. Consistent with what we note on UK and German banks, we suspect that this relates to the high degree of sovereign stress which has pushed out senior spreads to very wide levels. Equally, the potential risks of some form of burden-sharing spreading up the capital structure to even include senior debt are also a source of concern for investors, even if a low-risk tail event, in our view." - source Morgan Stanley - 27th of July 2012.

Using Santander as a proxy in determining "Implied Recovery and Default Rates:

For SANTAN, subordinated CDS spreads are ~1.5x senior, implying 1.5x higher loss severity for the same probability of default. Fixing the potential loss on Lower Tier 2 at 90% (10% recovery), this gives an implied loss on senior debt of 59% (90%/1.5x), for an implied recovery of 41% (1-59%).
Similar to the story in the broader index, implied recovery is only marginally lower than its historical average, while spreads now suggest a near-record probability of default over five years (32%). Stress on the Spanish sovereign has led to an increase in the risk of default, but not a decline in perceived recovery." source Morgan Stanley, 27th of July.

Forced burden sharing and coercive action in similar fashion to the Anglo Irish situation, would indeed, lead lower perceived recovery for Spanish  banks bonds, hence the importance of this legal ruling relating to Anglo Irish.
Morgan Stanley in their note Senior and Sub Financials - Credit Derivatives Insights on the 27th of July point to the following:
"What are the historical examples of senior and sub CDS triggers in Europe?
We now have a few precedents for bank CDS triggers in Europe (see table below): The Icelandic banks, Bradford & Bingley (UK) and now Irish banks are the financials credit events for CDS in Europe in the last five years. The above can be sorted into three groups: i) banks that were not backstopped and allowed to default (Icelandics); ii) banks that had an extremely credible backstop (Bradford& Bingley) and a well-supported senior; and iii) banks that were perceived to have a backstop for seniors but not fully robust (Irish banks)."

"We think the Anglo Irish example is good template for how bank restructurings could evolve from a CDS perspective and how auctions could work. Anglo Irish Bank announced a tender offer following equity injections, offering to exchange all the three existing LT2 bond issues into new 1yr government guaranteed senior FRNs (Euribor +375bp) equivalent to 20c of existing face value. In addition to the exchange offer, the Bank convened meetings to approve the inclusion of a right to redeem all (but not some only) of the existing notes at practically zero to encourage acceptance. This series of events triggered a restructuring credit event for Anglo Irish CDS. The requirements in determining a restructuring credit event were fairly straightforward to establish in the case of Anglo Irish: a loss of principal for a multiple holder obligation, made binding on all holders and which resulted directly from deterioration in credit quality.
While all thee LT2 bonds were restructured ultimately, the timeline was in a staggered fashion in order to avoid a lack of LT2 deliverables if all were restructured in one go. Thus, the auction was conducted in an accelerated timeframe, after the first bond was restructured and triggered CDS, but before the other bonds was restructured." - source Morgan Stanley.

The recent legal ruling for Anglo Irish versus Assénagon (rightfully) denies the very concept of forced burden sharing which has been used in the determination of the recovery during the restructuring credit event for the CDS auction process and the results, a process which will inevitably occur for weaker Spanish and Italian institutions at some point:

"While the recoveries for the senior CDS of different buckets were largely in line with each other, sub CDS had very different recoveries for the 2.5yr bucket (74.5) vs. for the other two buckets (around 18). In practice the recovery for different buckets of senior CDS could also vary considerably, as the dollar prices of a 2.5yr bond could be very different from a 7.5yr bond in a restructuring scenario." - source Morgan Stanley.

As indicated by FT Alphaville in their post,  IFR reports that IBRC, the successor to Anglo Irish, is considering an appeal. The awarding of any damages is yet to come. A truly interesting legal development in the banking space.

On a final note, a weakening of the Euro is likely to be reflected in HSBC, Santander, BBVA 2nd Quarter results as shown by Deutsche Bank's recent profit warning:

"As Deutsche Bank's profit warning demonstrated, the ongoing weakness of the euro can negatively affect results where there is a  mismatch between costs and revenue, or material parts of the business earn and report in different currencies. Euro zone revenue contributions are likely to shrink at HSBC, which has significant euro operations and reports in dollars." - source Bloomberg.
Given Deutsche Bank AG recently announced it would reduce risk to meet a 2013 capital-ratio goal after second quarter profit missed analysts' estimates on expenses tied to a weaker euro (net income fell to 700 million euros), reduced risk will lead to reduced liquidity and inventories provided to the market place. Yet another story of de-risking, deleveraging. No wonder traders are leaving the banking industry for Hedge Funds in this process.

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

"Politics is the art of looking for trouble, finding it everywhere, diagnosing it incorrectly and applying the wrong remedies."  - Groucho Marx

Stay tuned!