Tuesday 29 June 2010

The mirage of the recovery is fading

Greece CDS 5 year CDS is now trading at 1000 bps, still trailing Venezuela at 1302 bps, but finally trading above Argentina 5 year CDS, currently at 956 bps.

Greece Cumulated probability of Default on the 5 year point is now at 55%.

At the same time, stocks are getting crushed, particularly on the financial sector, given weaknesses in consumer confidence and an increasingly worrying rising stock of REOs (Real Estate Owned) on banks balance sheets and Euribor tensions are still mounting. This coming thursday, ECB's loan to 1000 banks is expiring. They had borrowed 442 Billions Euros at 1% from the ECB a year ago. Liquidity is therefore a concern which explains the violent sell-off in Financial stocks in the Eurozone.

Bund 10 year Government bond is trading at a yield of 2.552% versus a tight of 2.50% on the 8th of June.

As highlighted in this post's title, the mirage of recovery is fading: also in pending sales of Existing US Homes, a leading indicator. It decreased by 30% in May. Biggest drop in records dating to 2001...

Compared with May 2009, nationwide pending sales were down 16 percent.

"The tax credit, worth as much as $8,000, helped fuel a rebound in demand last year and was extended and expanded in November. The credit required buyers to sign contracts by the end of April and close by June 30. The House of Representatives voted this week to push back the deadline for closing to Sept. 30."

Politicians are trying their best to slow down the other leg down in housing prices. It will not work.

The US labor market is still very weak as highlighted in the recent posts in the excellent blog Calculated Risk.

House prices in the US are still above the historical average and would have dropped down if the tax credits had not been extended by politicians:

New Homes sales is a leading indicator as per this graph, also from the Calculated Risk Blog:

The 300 thousand annual sales rate is a new all time record low. The previous record low annual sales rate was 338 thousand in September 1981. So much for a "V" recovery.

85 banks have already failed this year, already above trend from 2009.

Wednesday 16 June 2010

The writing is on the wall...

Sovereign CDS for Spain is now trading at 257 bps for 5 year, and Portugal has now joined the highest default probabilities list from CMA DataVision. Portugal 5 year CDS trades at 312 bps. The cumulated probability of default for Portugal now equates 22.91%.

Greece Sovereign CDS is trading at 835 bps for 5 year, with a CPD (Cumulated Probability of Default) of 49.72%, just behind Argentina, which trades at 1073.17 bps and has a CPD of 50.06%.

Greece is not like Argentina, it is in a worse shape.

In this post, we will look at some solutions coming from the man who was at the helm of Argentina's finances in 2001, Domingo Cavallo as well as leverage still in the system and the ongoing discussions around banking reforms.

Domingo Cavallo, the fomer minister of finance of Argentina gives a good analysis of what should be followed by Greece, Spain and Portugal to restructure their economy:


"Greek debt woes could spark contagion within and beyond Europe. Argentina’s former finance minister and co-author draw four lessons from Argentina’s crisis: devaluation/exit is not the answer; orderly debt restructuring involving a ‘Brady Plan’ now is better than a disorderly one later; fiscal consolidation that improves external competitiveness is a must; all these must be done simultaneously."

Domingo Cavallo gives in this article make some good points on what should be done:

Three Lessons
"The main lessons for Greece stemming from Argentina are, in our opinion, as follows. First, devaluation (exiting the eurozone) is not the answer, particularly since the post-crisis world outlook is unlikely to be as benign with Greece as it was with Argentina. Re-adopting the drachma and letting it fall in value relative to the euro would cause a sharp deterioration in the balance sheets of both the government and the private sector. On the other hand, a forcible conversion of euro-denominated financial assets and liabilities into drachmas (a replication of what Argentina did in 2002) would, in all likelihood, set in motion a perverse devaluation-inflation spiral, as people would want to substitute away from drachmas into euros to avoid losing purchasing power if they stay in drachmas.

Second, any sovereign debt restructuring must be planned and executed in an orderly manner, with bilateral discussions between creditors and debtors, and with an active support from the international financial organizations, both in Europe and Washington DC (i.e., the IMF). These organizations can get more bang for their bucks if instead of trying to bailout Greece’s creditors over the next two years, they use their limited financial resources to enhance, a la Brady plan, new bonds that are swapped for the old ones in exchange for haircuts in principal, interest or both. A default followed by unilateral and incomplete debt restructuring several years later, as done by Argentina in the previous decade, would be the wrong model to follow.

Third, there must be fiscal consolidation. But, this cannot be limited to cutting spending and raising taxes. It must also include fiscal measures designed to improve external competitiveness so as to ease the fiscal adjustment.

Last but not least, the three ingredients of the recovery plan (fiscal consolidation, debt restructuring, and the enhancement of competitiveness) must take place simultaneously."

Furthermore, Domingo Cavallo raise a very interesting point in relation to VAT versus Payroll Tax:

"In a previous article, we suggested that Greece could achieve the same effect on competitiveness that could be achieved under a 20% real exchange rate devaluation by raising the collection of the value added tax (VAT) while simultaneously reducing payroll taxes. We think that this is an idea that merits consideration not only in Greece, but also in Portugal and Spain. Given the importance we give to this subject, we devote the rest of this note to explain our proposal in more detail.

One characteristic of taxation in many countries—typically in Continental Europe, but also in Latin America and other regions—is that payroll taxes, which finance social security, are extremely high (see Table 1). Of course, this is due to the fact that social transfers are also very high. However, there is no reason why these transfers have to be financed by payroll taxes, especially if there is room to increase other, more neutral, taxes.

Take the VAT, for example. Unlike payroll taxes, which are levied on labour income, the VAT is levied on final consumption. This has two main advantages: it promotes formal job creation and it stimulates private saving. In countries like Greece, Portugal and Spain, this can kill three birds with one stone by helping to reduce unemployment, informality in the labour market, and the current account deficit. Furthermore, the fact that the VAT is levied on final consumption and not on investment or exports (capital goods purchases are deductible as VAT “credits” and exports are tax exempt) makes the substitution of VAT for payroll taxes a competitiveness-enhancing tool. As such, it is like devaluing the local currency, but without the inflationary pass-through to domestic prices or the disrupting balance sheet effects."

In addition to these proposed measure, one could also argue that Spain need to drastically reform its labour market which is critically hindered by its very rigid system.

Many economists blame the high jobless rate in Spain on the high cost of firing workers. This makes employers quite reluctant to hire staff and encourages the use of temporary contracts that have few benefits and rights. 24.3 % of Spanish employees are currently on temporary contracts.

In Spain, workers on full contracts are entitled to severance pay of as much as 45 days per year worked, one of the highest levels in Europe. Under the Spanish government reform it would be reduced to 33 days for some contracts.

Although the Spanish government is pushing ahead with the labor reform plan, it has so far failed to calm markets as reflected in the continuous widening in Sovereign CDS spreads.

Spanish 10 year bonds yielded an all time high against the German 10 year Bund today at 4.87%. This is 2.23% more than German 10 year Bund.

Three-month dollar libor rates rose to an 11-month high of 0.53894% , while euro rates edged up to 0.65563%, exceeding levels reached last week to set a six-month high.

The situation for European banks is getting difficult as highlighted by Georges Soros comments in this article from Reuters:


"European banks had bought large amounts of the sovereign bonds of weaker euro zone countries for a tiny interest rate differential, Soros said.

"That's one of the reasons why the banks are so over-leveraged and why the German and the French banks own Spanish bonds," he said.

"Now ... they have a loss on their balance sheets which is not recognised and it reduces the credibility of those banks so the banking system is in serious trouble," he said.

"The commercial paper market, for instance, in America is now refusing to lend to European banks so there is even a funding crisis and the ECB (European Central Bank) has to step in and the banks are unwilling to lend to each other," he said."

European banks are getting punished for their greed in trying thier quest to capture more yields on riskier government bonds.

Too much greed can be dangerous because it clouds good judgement and good risk management. We have already witnessed the devastating results in the US where the hunt for yield (due largely to Alan Greenspan's low rates environment) led to the financial debacle. Investors in supposedly AAA securitized products (CDOs, etc.) showing promising yields, were wiped out.

A report published by the BIS reviews the role leverage played in the crisis:


"Leverage in structured products and the US housing market downturn
Structured credit products referencing US subprime mortgages exposed investors to much higher leverage and losses than the stress scenario modelling they performed had implied. First, an investment in a subordinated tranche of a subprime residential mortgage-backed security had a leveraged exposure to the underlying subprime mortgage loans (embedded leverage).
Second, re-securitisation compounded the multiplier effect of embedded leverage. For example, mezzanine tranches of mortgage securitisations (which themselves have embedded leverage) were often purchased by CDOs, which in turn issued senior and subordinated tranches, creating additional leverage on top of that embedded leverage in subordinate tranches.
The magnitude of this embedded leverage was estimated by investors with models using assumptions about the likely future path of house prices. Hence, investors could not always be certain about the degree to which their exposure to the mortgage market was leveraged at the time of investment. When delinquency assumptions associated with subprime mortgage securitisations of 2005–07 proved to be far too low, the leverage and losses experienced by investors were much greater than anticipated."

Now European Banks are sitting on hefty losses on their balance sheets, because of their exposure to the weaker parts of Government bonds in Europe. So much for good risk management...

In addition to this behavior, leverage in some European Banks is still higher than their American counterparts which went through the painful process of deleveraging and had to raise massively capital to shore up their impaired balance sheets.

“In the early days of banking, liability was not just unlimited; it was often as much personal as financial. In 1360, a Barcelona banker was executed in front of his failed bank, presumably as a way of discouraging generations of future bankers from excessive risk-taking."

Bank of England Financial Stability executive director Andrew Haldane


"From the earliest times, the relationship between banks and the state was often rocky.
Sovereign default on loans was an everyday hazard for the banks, especially among states vanquished in war. Indeed, through the ages sovereign default has been the single biggest cause of banking collapse. It led to the downfall of many of the founding Italian banks, including the Medici of Florence."

Andrew Haldane describes as well the current issue with State Support:

State support stokes future risk-taking incentives, as owners of banks adapt their strategies to maximise expected profits. So it was in the run-up to the present crisis. In particular, five such strategies were clearly in evidence:

• Higher leverage: The simplest way of exploiting the asymmetry of payoffs arising from limited liability is to increase leverage. For example, if the capital ratio of the hypothetical bank were to halve from 10% to 5%, the beta of the bank’s equity would double (Figure 2). In that event, the imbalance between privatised gains (above the zero axis) and socialised losses (below the zero axis) would increase. Private investors would harvest more of the upside and export more of the downside.
There is clear evidence of this strategy being pursued over long sweeps of history.
UK banks migrated North-West over the past ten years, with balance sheet expansion financed by higher leverage. Because UK and European banks were not subject to any regulatory restriction on simple leverage, there was no effective brake on this leverage-fuelled expansion.Higher leverage fully accounts for the rise in UK banks’ returns on equity up until 2007. It also fully accounts for the subsequent collapse in these returns.

The high-leverage strategy pursued by UK and European banks rather effectively privatised gains and socialised losses.
• Higher trading assets: An alternative means of replicating the effects of higher leverage is to increase the proportion of assets held in banks’ trading books. Trading assets are marked to market prices, thereby increasing their sensitivity to aggregate market fluctuations (beta). To illustrate, assume that a bank holds 90% of its assets in the banking book (with a beta of zero) and the remainder in the trading book (with a beta of one). That gives an asset beta of 0.1 and an equity beta of unity (Figure 1). But if the size of the trading book is doubled to 20% of assets, this doubles the equity beta of the bank."

Andrew Haldane also indicates how to reduce the risk taking habits for banks in his paper

What options best tackle excessive risk-taking incentives? A number suggest themselves, some modest, others more radical.
• Introducing leverage limits: One simple means of altering the rules of the asymmetric game between banks and the state is to place heavier restrictions on leverage. European banks were not subject to a regulatory leverage ratio in the run-up to crisis. They exploited that loophole. Closing it would bring about a clockwise rotation in banks’ payoff schedule, lowering the beta of banks’ equity returns and reducing risk-taking incentives.This is an easy win. Simple leverage ratios already operate in countries such as the US and Canada. They appear to have helped slow debt-fuelled balance sheet inflation. The Basel Committee is now seeking to introduce leverage ratios internationally. To be effective, it is important that leverage rules bite. They need to be robust to the seductive, but ultimately siren, voices claiming this time is different. That suggests they should operate as a regulatory rule(Pillar I), rather than being left to supervisory discretion (Pillar II)."

Finally to conclude this post, relating to Bank reform, Andrew Haldane in his excellent paper says the following:

"Events of the past two years have tested even the deep pockets of many states. In so doing, they have added momentum to the century-long pendulum swing. Reversing direction will not be easy. It is likely to require a financial sector reform effort every bit as radical as followed the Great Depression. It is an open question whether reform efforts to date, while slowing the swing, can bring about that change of direction."

Saturday 5 June 2010

AAA, the most endangered rating, regulating the rating agencies and Basel III

This title sounds like a warning issued from the WWF, relating to endangered species. Truth is the coveted AAA rating ranks have been seriously depleted by the past and current credit crisis we have been through. We will look at what happened in the corporate sector and as well in the sovereign space as well as the role of the rating agencies given the recent turmoils and scandals, regulations and Basel III implications.

Given the latest downgrade of Spain from AAA to AA+ is the latest in an increasing list given the current deflationary environment and credit situation in Europe, we can expect many more downgrades to come.

First we will look at the decline of AAA ratings in the corporate world:

The link below refers to an article which was published in 2002.

1969: 61 American Companies were AAA
1982: 21 American Companies were AAA
2002: 9 American Companies were AAA
2009: 4 American Companies were AAA

As of October 2009 only 4 remains rated AAA by S&P:

Automatic Data Processing (NYSE:ADP)
Johnson & Johnson (NYSE:JNJ)
Microsoft (NASDAQ:MSFT)
ExxonMobil (NYSE:XOM)


In 1979, there were 61 American companies that earned a top-level Aaa credit rating from Moody's. Ten years ago, there were 21. Today, there are only nine.

The decline in triple-A-rated companies is one of the most obvious -- though hardly the most worrisome -- sign of a widespread decline in credit quality.

"Corporate America has become more risky," says James Van Horne, a finance professor at Stanford's Graduate School of Business. "The triple-A decline is a manifestation of the decay of credit ratings in general."

In the same article, Kathleen Pender also review the list of AAA corporate entities in 2002:

The bankruptcies of Enron, Kmart and Global Crossing are refocusing attention on credit ratings and balance sheets.

"We've always focused on the balance sheet. In this environment, we've been even more focused," says Scott Glasser, co-manager of the Smith Barney Appreciation fund.

Glasser's top 10 holdings include five Aaa-rated companies: Berkshire Hathaway, ExxonMobil, General Electric, Pfizer and American International Group.

The other four Aaa-rated companies (excluding government-backed companies such as Fannie Mae) are Bristol-Myers Squibb, Johnson & Johnson, Merck and United Parcel Service.

In 1979, Moody's list of Aaa companies included 12 banks and insurance companies, such as Bank of America, Chase Manhattan, Chemical Bank and Citicorp.

It also included 25 industrial and consumer-oriented companies, such as Minnesota Mining & Manufacturing, General Motors, Ford, IBM, DuPont, Kellogg, Procter & Gamble, Sears Roebuck, Federated Department Stores and the major oil companies.

The remaining 24 companies were telephone and electric and gas utilities.

"The '80s really gutted the list," says Moody's economist Kamalesh Rao.

We all know what happened to the AAA for banks as well as for GM, Ford and we all know the dire situation of Fannie Mae, Freddie Mac and SLM.

From the same article:

"The major reasons cited for the decline in triple-A companies are deregulation, global competition, debt-financed mergers, bad management decisions and a growing tolerance for risk among investors.

Many banks also got hurt by the collapse of real estate in the early 1990s."

You would think the banks would have learnt from the real estate collapse in the early 1990s following the Savings and Loans debacle.

Does that sound familiar? We are talking about the economic environment of 2002...

The article goes on:

"Money managers are not too worried about the long-term decline in Aaa companies, mainly because the difference between a triple-A and a double-A company is slight.

They're far more concerned about a recent, widespread decline in ratings across the credit spectrum.

"You could do a story on the demise of double-A and single-A companies as well," says Putterman."


It is true the reputation of the ratings agencies have been seriously tarnished in the last two years given the evident conflict of interest which came with the business of providing AAA rating to dubious structured credit products.

This is what Bill Gross from PIMCO had to say about the rating agencies and discussion around reforms of their model:


"Credit rating agencies have fallen out of favour with top investors. Bill Gross, founder of Pimco, the world's biggest bond investor, recently said: "Their quantitative models appeared to have a Mensa-like IQ of at least 160, but their common sense rating was closer to 60, resembling an idiot savant with a full command of the mathematics, but no idea of how to apply it."

He added: "I come not to bury the rating services, but to dismiss them. To tell the truth, they can't really die – they serve a necessary and even productive purpose when properly managed and more tightly regulated.""

Truth is all the concerns regarding regulating the ratings agencies were previously discussed and not applied by many authors and Scholars. Below is an example of previous discussions surrounding regulation of rating agencies.

Claire Hill in a paper published in 2004 called Regulating the Rating Agencies


"Less promising are suggestions to begin substantive oversight of rating agency business operations, and to increase the ability of investors and others to sue rating agencies. Finally, conflicts of interest may become a significant problem, especially if the market becomes much less concentrated - an annual certification by rating agencies that they are operating in accordance with procedures to guard against conflicts may be desirable."

The only way to restore trust in ratings, is to remove conflicts of interest which means not an annual certification as suggested above but a review in the way rating agencies operate.
There was a similar issue with Equity Research Analysts during the run up to the Technology bust in 2000. Henry Blodget was barred from the securities industry because of fraudulent activity.

The only way to regulate is to impose accountability to the Rating Agencies, ensuring the risks twart the rewards. If ratings agencies face losing the license of conducting business due to high conflict of interests similar to what we have seen during the build up to the credit crisis, they might do a better job and serve their necessary purpose of independent assessment of credit risk.

Although credit ratings can be a good indicator in measuring the risk of a corporate or country, they always lag the market. Credit spreads and Credit Default Swap (CDS)spreads are better at indicating increased perceived credit risk in issuers.

The implication of ratings downgrade are very important in relation to assessing the risk for financial institutions, when taking into account Basel II regulation. This was particularly the case for structured credit positions in Banks.


"Basel II agreements meant that CDOs capital requirement rose 'exponentially'. This made CDO portfolios vulnerable to multiple downgrades, essentially precipitating a large margin call. For example under Basel II, a AAA rated securitization requires capital allocation of only 0.6%, a BBB requires 4.8%, a BB requires 34%, whilst a BB(-) securitization requires a 52% allocation."

Because of the need for independent assessment of credit risk, Rating Agencies must be regulated in a way that the ratings which are issued enable investors to trust these ratings and use them as a guidance in their investment.

As well as reviewing the role played by the rating agencies in the financial crisis, it is essential that bank regulation takes place.

Basel III proposed reforms are going in the right direction:


The introduction of a leverage ratio is essential to avoid the same mistakes which were done. The Canadian banking system had the leverage capped to around 20 times which meant that the Canadian Banks were in a much better situation than their American neighbours when the financial crisis occurred.

The idea of also promoting the build up of capital buffers in good times, is also a very good one.

There is great resistance from the bank to fully implement Basel III as indicated in this article from The Economist:


If the same idea of capital buffer could be implemented for goverments in relation to public finances, it would be great but given the propensity of our politicians to overspend in good times as well as in bad times, there is a very low probability of seeing it happen effectively.
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