Friday, 7 January 2011

European Psycho - Bond Haircuts and the current financial bonds sell-off

If you are in an emergency and need haircuts on your bonds, please contact Patrick Bateman...

Big sell-off in Financial bonds in the last two days.
Reason being, the EC Proposals for resolution regime relating to the treatment of senior financial bonds holders in the case of a bank facing difficulties in the Eurozone.

Only new senior debt will be exposed to losses outside a liquidation of a bank, through a debt-write down resolution tool. This process is to allow rapid restructuring in Europe of a bank's liability structure. The differences in insolvency laws in Europe did not allowed for a rapid wind down.
It is a move in the right direction given restructuring on a financial institution needs to be executed rapidly. It is also to alleviate the risk of government taking on the full brunt of the banks in difficulties and over-exposing taxpayers.
The example of Ireland clearly showed the issue, where Ireland's public finances were put in disarray due to the massive bail out need of its financial sector (please see previous posts on that subject: The European Vortex, The Irish Black Hole, Ireland in the need of a lucky Shamrock). The resolution of distressed banks lacked flexibility in the legal framework in Europe and put too much risks on already strained European public finances.
It is the application of a resolution regime which was supported by the G20. No firm should be too big to fail or too complicated to fail and taxpayers should not bear the cost of the resolution of the distressed bank as emphasized by the G20 previously.

The commission will report by the end of 2011 on appropriate measures for other kind of financial companies including insurance companies.

It's likely to raise the cost of debt for EU banks which ultimately has to be negative for bank equity. In a deleveraging environment given banks are leveraged play on the economy, one can expect the ROE (Return On Equity) of banks to be weaker in this new regulatary environment as well as smaller GDP growth period.

But why the sell-off?

Because it seems the language protecting existing debt is a bit weak in the working paper.

As I indicated in my previous post, the race for funding, and the risk of crowding out, will penalise weaker bank in the short term.

This is already happening on the widening of CDS spreads on peripheral banks for both senior and sub CDS, for instance, on the 7th of January, you can already see Spanish Banks spreads widening significantly:

Source: Anonymised CDS run from the market, sent on Bloomberg.

Spanish Banks CDS from the 8th of October 2010 until the 7th of January 2011:

European Banks CDS from the 8th of October 2010 until the 7th of January 2011:

Also note the spread between Itraxx Main 5 year and Itraxx Financial Senior, made new highs as well, 102 Itraxx Main 5 year versus Itraxx Fin Senior at around 204 bps.

As a reminder from a previous post:

Itraxx Western Sovereign Index 5 year is around 215 bps.
Normal Risk is inverted.
Corporate risk is tighter than Financial Senior risk which is also tighter than Sovereign Risk in Western countries.

"Deutsche Bank AG’s recent 1 billion USD of five-year, 3.25 percent notes fell 0.04 cent to 99.87 cents on the dollar, Trace data show."

"Allegheny Technologies Inc.’s 500 million USD of 5.95 percent notes due in January 2021 have risen 1.9 cents to 101.8 cents on the dollar, Trace data show. The Pittsburgh-based producer of specialty metals sold the debt on Jan. 4, Bloomberg data show". And Allegheny Technologies is rated BBB-...

Forget about hedging via the SOVX Index Option market with Volatility at 98%...It isn't cheap anymore...

Also in the news, Swiss National Bank confirmed it hasn't taken Portugal's foreign-currency bonds as collateral. It said the bonds were never part of its list of SNB eligible collateral due to settlement reasons.

At the same time you have VIX at 17.4%...and given NFP came at a disappointing 104K (unemployment rate at 9.4% down from 9.8%, please note you have 1.32 million discouraged workers...and that is a new record), complacency is the word to use (definition of complacency: "self-satisfaction accompanied by unawareness of actual danger or deficiencies").

VIX, one year graph as of the 7th of January 2011.

Bottom line, it seems there is less short term risk and more value in selected corporate bonds, than in financial ones or European Sovereigns at the moment.

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