Tuesday 27 September 2011

Markets update - Credit - Surf's up ! Much ado about nothing and CPDO redux in European Style

"No one loves the messenger who brings bad news".
Sophocles in Antigone

So what?

We have an epic rally in the equity space because of some news of a possible plan to leverage up the EFSF, CDO-SIV style? What has materially change today? Not much.
And my good credit friend to comment:
"Another volatile day in the equity market …. On rumors, rumors and more rumors of EFSF, ESM, EIB, ECB …. And overall leveraging of the existing system …. It may make the trick for a while, but I tend to think it will not be long before Mr Market rejects that “too complicated to work” puzzle."

The plan so far is sketchy at least and fraught with danger.

Why? Because it eerily reminds me of the halcyon days of the structured credit space, namely CPDO structures. A CPDO (Constant Proportion Debt Obligations) structure was a fixed income instrument with cashflows that had a high and rated likelihood of payment, in theory. At least that was the plan, when ABN AMRO launched its 1 billion euro CPDO called SURF in January 2007. Trouble was that the widening wave got too big to surf and SURF 100 got wiped out.

Its death came in October 2008:

"Requiem for the CPDO" - FT Alphaville - Sam Jones

October 13, 2008 (Bloomberg):
"ABN Amro Holding NV had the ratings on three constant proportion debt obligation funds totaling $305 million cut to D by Standard & Poor’s as the transactions were forced to unwind."
So much for the "Deal of the Year" awarded in February 2007 by Risk Magazine...

Sam Jones commented at the time:
"The CPDOs, funds that use credit-default swaps to bet on company creditworthiness, were downgraded because of “spread widening and increasing volatility” in the credit derivatives market."

"CPDOs, a structured finance post-mortem" - FT Alphaville - Tracy Alloway - Februrary 5 2010:

"Remember that these things, which basically used credit-default swaps (CDS) to bet on company creditworthiness, began popping up in the summer of 2006. ABN Amro’s Surf was the first to be issued, with an AAA rating."

Why did I chose to dicuss the CPDO example in relation to the proposal of the leverage EFSF proposal and not a Credit CPPI note?

Here is why:

The Credit CPPI note is an investment whose principal is protected by a low-risk portfolio (zero-coupon bonds or cash deposits) where the return is increased by leveraging the exposure to a risky portfolio of CDS names, when losses are incurred in the CPPI, the SPV (Special Purpose Vehicle) must decrease leverage to protect the principal.
But, when losses are incurred in our CPDO, the SPV must increase leverage in order to make up the increased shortfall in NAV (Net Asset Value), and by the way principal is not protected.

So, in the CPPI you have limited downside and unlimited upside, in the CPDO, you have limited upside and unlimited downside, kind of.
So in our levereraged EFSF play, the lower volatility in interest rates, the lower likelihood of default. But in a CPDO/Leveraged EFSF, there is a risk of failure of repayment of full principal at maturity.

Could it be the explaination for the apparent reluctance of our German friends to leverage/increase the EFSF given their first hand experience with structured credit?

In a CPDO/leveraged EFSF, when multiple dowgrades happen, creating significant widening in spreads/higher interest rates, the loss in NAV can be significant.

But back to our market overview:

The liquidity picture:

Bank deposits at the ECB still climbing. EUR 3 months Libor, a little bit better.

Italy Sovereign CDS 5 year versus Spain, same story as before, spread between both countries widening:
And Spanish Central bank to take on three more savings banks in distress. The Fund for Orderly Bank Restructuring controlled by Bank of Spain (FROB), will inject 5 billion euros in Catalunya Caixa (90% stake), Unnim and Nova Caixa Galicia according to WSJ.

Portugal 5 year Sovereign CDS versus Ireland 5 year Soveeign CDS:
The luck of the Irish.

10 year German Government bond versus 5 year German CDS:
Some welcome respite in the flight to quality with German 10 year yield moving back towards the 2% level.

In relation to European bank funding, it is not getting better. For the last three months, we know by now that banks have been unable to sell debt at affordable prices, apart from covered bonds, costly for some, backed by pools of prime loans. This quarter, only 34 billion dollars of senior unsecured debt has been issued in Europe by financial institutions, which will probably be by month end "the smallest of any quarter in more than a decade" according to Dealogic.

In relation to the ongoing European debt crisis and the Bundestag vote of the 29th of September, the whole game rest on Germany. Exane BNP Paribas in its latest report Strategy calls published on the 27th of September, goes through interesting points relating to German politics - frequently asked questions:
  • "Merkel is safe (for now)
Despite some regional election defeats Angela Merkel remains popular (near 50% approval rating), as does her party (32% in recent polls). Her junior coalition partner(FDP, liberal) has suffered heavy losses while Merkel’s CDU has held an uninterrupted lead in polls since the last general election. Länder election losses are no direct threat through at least mid 2012."
  • Germans like Europe (for now)
Despite euro-sceptic gains in Finland, Germans remain unwavering in their support of Europe and 64% are in favour of further integration. Sentiment towards Europe has not changed with the euro crisis. Reflecting this mood, opposition parties are more pro-Europe than Merkel and even support Eurobonds. In the recent Berlin election, voters rejected euro-sceptic election tactics by the FDP."
  • It’s the economy, stupid
German voters’ opinions and Merkel's position could quickly change in a recession. Polls suggest Germans are happy to support the periphery as long as they are doing well themselves, i.e. their jobs are safe. When GDP growth turns negative the German economy begins shedding jobs, changing the dynamics within Germany. Merkel’s sudden about-face on nuclear power shows that she can quickly reverse long-held positions if the situation demands it."

And Exane BNP Paribas to add:
  • "Will EFSF reform pass the Bundestag?
When it comes to Europe, all parties have a clear commitment to Germany being actively involved in the European Union, to keep the euro currency and support closer European fiscal integration.
More specifically, EFSF reform is generally supported by the government,but some CSU and FDP politicians in particular (but also some CDU MPs) have called for an open debate on an orderly default procedure instead of an open-ended transfer union.

  • What about Eurobonds?
Eurobonds are a more contentious topic. The current coalition government is opposed to the principle of Eurobonds, particularly the smaller coalition partner (FDP). Within Merkel’s CDU, however, opposition to Eurobonds has begun to crumble with some MPs arguing for an open debate on the topic. The two largest opposition parties (SPD and Greens) in principle support the idea of Eurobonds as a key part of the solution to the sovereign debt crisis.
Taking a step back from the day-to-day political debate, Eurobonds seem to have much greater political support in Germany than is often assumed. Also note that in recent polls, 64% of Germans were in favour of closer fiscal integration in Europe, an important pre-condition to Eurobonds."

So far so good, but as Exane BNP Paribas add in the report:
"The main obstacle to Eurobonds perhaps comes from a recent ruling of the German constitutional court. The court in principle approved EFSF as a temporary measure, but at the same time said parliament must not introduce a permanent mechanism; Eurobonds would be."

So yes, right now, the German constitution is a serious obstacle to Eurobonds gathering momentum.

But Germans are still for more integration - Source Exane BNP Paribas:

And according to this report from Exane BNP Paribas, what is saving so far Merkel is the economy and the labour market, which is key in relation to "electoral fortunes". And Exane BNP Paribas to comment:
"As long as Germans feel their jobs are safe and the euro crisis does not hurt them directly, sentiments towards the European Union and European integration stays supportive. But with its export-driven economy Germany would be highly sensitive to any slowdown in global growth. And if unemployment rises, the willingness of German voters and thus German politicians to support their southern European neighbors could quickly dwindle. Our economist estimate that the German economy begins shedding jobs when GDP growth falls below 0%."

And given Merkel's big u-turn relating to the Japanese nuclear disaster this year, and that next general election in Germany are to be held in September 2013, and we know that Merkel is already committed to a third term, I would really follow closely the German economy in general and the German labour market in particular.

And I as previously posted as a final quote in my previous post - "Markets update - the EM contagion":

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

German unemployment rate - January 2007 to September 2011:

German GDP growth rate from January 2007 to September 2011:

Stay tuned!

Saturday 24 September 2011

Markets update - Debit Trading - the EM contagion.

"If you don't have a functioning financial system the world economy won't be revived. All the major economies have their responsibility to assist at a pace which is required to clean up the balance sheet of the banking system and to ensure that credit flows are resumed."
Manmohan Singh

Contagion we have in Emerging markets:
Daily Focus Graph

Source CMA:
The trend is Ukraine:
Daily Focus Graph

No more Viagra ((Pfizer (PFE) long-term rating cut to A+ from AA- by Fitch; Outlook Stable) for China, as one stimulus after another is getting pulled out – this time around, it is not like Haier Electronic Group as we discussed previously with subsidies for home appliances. Instead, loan approvals are getting withdrawn:
China’s Squeeze on Property Market Nearing ‘Tipping Point’ - Bloomberg - 23rd of September:
"The squeeze on China’s property market may be reaching a “tipping point” that drives growth lower just when exports are under threat from a global slowdown and investor confidence is plunging, said Zhang Zhiwei, Hong Kong-based chief China economist at Nomura Holdings Inc.
Land transactions in 133 cities tracked by Soufun Holdings Ltd., the country’s biggest real-estate website, fell 14 percent by area in August from a month earlier. Prices of new homes declined in 16 of 70 cities last month compared with July, according to government data."

Pop goes the real estate bubble in China, from the same article:
"Property construction is a mainstay of investment that last year drove more than a half of economic growth while land sales contributed 40 percent of revenues earned by local authorities that have amassed 10.7 trillion yuan ($1.67 trillion) of debt.
A funding squeeze on developers risks a “domino effect” as companies needing cash cut prices, forcing others to follow, Credit Suisse Group AG said yesterday.
“We’re reaching a tipping point where land sales are dropping much faster than before, developers are losing more access to bank financing, and housing prices are showing weakness,” Nomura’s Zhang said in an interview in Beijing yesterday."

And Bloomberg to add:
"The price of land in Beijing slumped 76 percent in August from a month earlier, while in Guangzhou it plummeted 53 percent, according to Soufun. Land auction failures surged 242 percent in the first seven months of this year because of government curbs on the property market, the Beijing Times reported Aug. 3."

A Chinese Subprime crisis in the making?
"Some developers have turned to trust firms for financing, usually in the form of loans that are repackaged into investment products and sold to retail investors. The debt is typically funded by banks or investors themselves, according to Samsung Securities Asia Ltd."

Worst Asia Currency Drop Since ’97 Spoils Debt - Source Bloomberg:
So, no safe haven anymore even in Asia, its redemption/liquidation time for some global macro players.
Source Bloomberg - Kyoungwha Kim and Jiyeun Lee - 23rd of September:
"The Bloomberg-JPMorgan Asian Dollar Index slumped 4.3 percent this month, heading for its biggest loss since December, 1997, led by a 9.6 percent decline in South Korea’s won. Korea Exchange Inc. prices show the yield on 10-year government debt soared 27 basis points, or 0.27 percentage point, to 3.82 percent, from an all-time low on Sept. 14. The yield on similar Indonesian debt jumped 68 basis points this month to 7.47 percent, after touching a record low on Sept. 9."

And EM for Global Macro players is a crowded trade according to Bank of America Merrill Lynch research, hence the liquidation we started to see and mentioned in the post "Markets update - Credit - Anterograde and Retrograde amnesia":

Emerging Markets, which until recently had been preserved from the onslaught, have been affected as well by the revised growth picture published by the IMF, cutting its forecast to 4% from 4.3% in June 2011 - Source Bank of America Merrill Lynch Research:

So Australia and Australians banks please beware:
[Graph Name]

And given commodities based countries are in the frontline in relation to a Chinese slowdown, it is of no surprise commodities based currencies are taking a beating in the process:
AUD/USD, 2008 until the 22nd of September picture - Bloomberg:

Canadian dollar is exposed as well:

And my good credit friend to comment:
"The equity market finally realized what the credit market was” flashing” for a while… and reacted accordingly. But the race to catch back with the credit market has still a long way to go…and the path may not be a straight line. Bottom line, equities will go lower as the new “norm” of slow economy worldwide will be accepted…

Which means lower prices for commodities (goodbye Canadian dollar and Australian dollar carry trade), higher US dollar (a higher US dollar and slower growth will be the poison pill for the international US corporations)…"

No more safe havens, even in Switzerland, as the country now flirts with deflation, Japanese style:
Source Bloomberg.

Like Japan, Switzerland is suffering from currency appreciation, tipping it towards deflation in the process, with 30 year Swiss Government bonds yielding less than Japanese 30 year bonds, with a yield at around 1.30%.
The Swiss National Bank is warning that its Consumer Prices may decline 0.3% in 2012.

As a follow up on our last post where we discussed the sell-off in Emerging Markets currencies, we have now 4 countries trying to prop up their currencies, namely, Russia, India, Argentina, and now Brazil.
According to Bloomberg in relation to Brazil:
"The central bank sold 55,075 currency swap contracts in auctions, which was equivalent to selling dollars in the futures market. The last time policy makers entered the derivatives market to weaken the dollar was in June 26, 2009, according to the central bank. Yesterday’s measure marked a reversal of a 28-month-old strategy of buying dollars to weaken the currency."
Brazil Sovereign CDS climbed 23 bps on the 22nd of September to 219 bps according to CMA.

No, inflation is not the immediate threat, deflation is. US treasuries returned so far 1.7% in September, 8.9% gain year to date.

And my good credit friend added on this:
" “No more risk free assets” may result in a big re-pricing of all asset classes.

When there is too much debt in a system and when everybody is reluctant to erase the debt, the only solution is to deflate the value of the debt and the capital in order to bring them in line with the value of the assets or collateral… The trend will be “to deflate”, because we are in “deflation” … even if nobody wants to hear it."


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

Stay Tuned!

Thursday 22 September 2011

Markets update - Credit - Anterograde and Retrograde amnesia.

"Anterograde amnesia refers to the inability to remember recent events in the aftermath of a trauma, but recollection of events in the distant past is unaltered.
Retrograde amnesia is the inability to remember events preceding a trauma, but recall of events afterwards is possible."

Another day in the trenches in the credit space, and given the acceleration in the deterioration of the market context, yet another long post starting with a quick review of the price action.
The Itraxx credit indices overview:
The Itraxx SOVx 5 year CDS Western Europe index (15 countries) broke a new record to around 362 bps.
The Itraxx Crossover 5 year CDS index (High Yield) soared to 846.5 bps, highest level since April 2009, a 59 bps increase on the day. Intraday it was almost up by 70 bps.
The Itraxx Main Europe 5 year index (Investment Grade) passed the 200 bps level.
And Itraxx Financial Senior 5 year CDS index as well as Itraxx Financial Subordinate 5 year index widened significantly as well. 318 bps at some point before receding a bit to 302 for the Senior index and 555 bps for the subordinate index, receding in the end to around 540 bps level. Truly nasty price action.

The significant moves today were on the Sovereign CDS space with Germany breaking through 100 bps to 109 bps (39 bps in July) and France breaking the 200 bps level to 205 bps.

Spain 5 year Sovereign CDS versus Italy 5 year Sovereign CDS - we know the story by now. Spain is decoupling:

Another session marked by flight to quality with the 10 German Government bond reaching a new low in terms of yield::
Source Bloomberg - morning snap.
The Bund reached a record low yield of 1.67% and even 30 years reached a record low to 2.47%.

10 year Sweden government bonds versus 10 year German bund, still a correlation of 1:

The liquidity picture, still on the weak side:

But the interesting development we have seen today has been coming from the accelerated deterioration of emerging markets, which so far up had been spared to a certain point.
The SOVX western europe 5 year CDS index versus the SOVx CEEMA (Central Europe and Middle-East and Africa) tells the story:
From divergence back to convergence for both credit indices.

The trigger has been the clear slowdown in Chinese manufacturing, meaning China will not be strong enough to counterweight the US and European slowdown we are seeing.
So, we get a sell-off in emerging equities (down by 4%, a 15 months low), a sell-off in credit, a sell-off in currencies (currencies backed by commodities taking a serious beating in the process), and a sell-off in commodities.

A sell-off in Emerging debt - JP Morgan EMBI Global Diversified:
The J.P.Morgan Emerging Markets Bond Index Global ("EMBI Global") tracks total returns for traded external debt instruments in the emerging markets:

A sell-off in equities - HAIER Electronics Group Co, one of the world's leading white goods home appliance manufacturers. We know it is relevant from the previous post - "Markets - Credit - Controlled demolition" and it follows the decision from the Chinese government to pul its subsidy program it had in place in four Chinese regions:

A sell-off in commodities - pop goes the bubble in copper artificially inflated prices, with China having pulled on the 31st of August another artificial stimulus, namely letters of credit which funded the cash-for-copper collateral game (used as financing instrument...). And copper is closely linked to economic activity as well as fluctuations in Chinese demand, so with a PMI at 49.4 that is what you get:

A sell-off in currencies:
Russian Ruble in trouble:

Indian rupee:

As a reminder from previous post:
"But it isn't only Russia trying to sustain its local currency by buying rubles, it is also happening in India with the regulators also starting to buy local currency and selling dollars and Argentina as well."

Brazilian real - BRL:
Here is the reason:
From Bloomberg - Ye Xie and Josue Leonel.
"The real’s biggest five-day plunge since 2008 is fueling speculation Brazil will sell dollars to shore up the currency, reversing a 28-month-old strategy aimed at stemming gains.
Brazil’s currency has lost 8.6 percent against the dollar since Sept. 14, the most since the global financial crisis drove it down 10.9 percent in the five days through Dec. 3, 2008, according to data compiled by Bloomberg. The slump handed investors in real-denominated bonds a loss of 13.5 percent in dollar terms this month, the worst performance in emerging markets, according to data compiled by JPMorgan Chase & Co.
Speculation is mounting that the real’s slide may deepen, pushing up import prices and adding to the highest inflation rate in six years, if the central bank fails to deploy some of its $352 billion in reserves to defend the currency. Concern policy makers’ surprise rate cut last month signals they are giving up on their goal of slowing inflation is compounding the real’s decline as Europe’s debt crisis erodes demand for emerging-market assets."

From the same Bloomberg article we learn the following:
"The central bank hasn’t bought dollars in the spot market since Sept. 13, breaking a practice it adopted since May 2009. It bought $47.6 billion in the first eight months of this year, surpassing the $41.4 billion it purchased in 2010. It last sold dollars on Feb. 3, 2009, when the real closed at 2.3052 per dollar. It closed yesterday at 1.8756."

Also from Bloomberg:
"Brazil’s central bank yesterday decided not to roll over reverse-currency swap contracts expiring in October, which will lead to the unwinding of $2 billion worth of bets against the dollar. It’s the first time policy makers refrained fromrenewing the contracts since January."

Which led to a surge in Brasil Sovereign CDS of 23 bps to 196 bps on the 5 year. At the same time, Argentina's reserves, following the same path, is seeing its dollar reserves depleted:
"Policy makers on Sept. 20 sold around $700 million in futures contracts due through October to show investors they are maintaining a policy of sustaining the peso and to discourage speculation in the currency, said a central bank official who asked not to be named because of the institution’s policy. The bank buys and sells dollars in futures markets on a regular basis, he said." - source Bloomberg - Camila Russo and Katia Porzecanski - 22nd of September.
Argentina's bonds are now yielding 972 bps more than US treasuries with the 5 year CDS trading at 983 bps according to CMA.

And contagion we have now in emerging markets.
[Graph Name]

Sovereign CDS 5 year wideners on the 22nd of September - source CMA:

In relation to the credit funding issues story in the European space with have been discussing in various credit related posts, the consequences of the deterioration in liquidity are reaching alarming levels. While we know from the post "Macro and Markets update - It's the liquidity stupid...and why it matters again...", that European banks are on average issued 90% of their term funding needs for 2011, with significant liquidity pools and ECB support, the impossibility for banks to issue term funding and in particularly issue unsecured funding is a big concern given funding needs for 2012.
As Bloomberg points out in an article published by John Glover and Ben Martin:
"It’s been 2 1/2 months since a bank managed to sell a conventional bond in Europe’s public markets, the longest period without a deal ever and another example of the sovereign crisis choking off funding.
UniCredit SpA was the last non state-owned bank to issue senior, unsecured benchmark notes in Europe with a 1 billion-euro ($1.4 billion) sale on July 13, according to data compiled by Bloomberg. That compares with deals worth 41.9 billion euros in the third quarter of last year."

And Bloomberg to add:
"The extra yield investors demand to hold banks’ senior bonds instead of benchmark government debt has soared to 320 basis points, from 202 at the end of July, according to Barclays Capital’s Euro Aggregate Banking Senior Index. The gauge reached an all-time high 325 basis points on Dec. 30, 2008."

From "Markets update - Credit - Crossing An Event Horizon", we know that banks have only managed to issue recently covered bonds, backed by pools of prime loans:
"Lenders, by using prime assets are willing to do whatever is necessary to get funding, as other sources, such as unsecured issuance have dried up, clearly reflected by the very high level reached by the Itraxx Financial Subordinate 5 year index."

Covered bonds - Bloomberg:
"Pioneered in 18th century Prussia, covered bonds give holders first call on a pool of assets that’s managed by the borrower, with the debt given preferential treatment in a default to senior, unsecured notes.
Covered bond issuance rose to 287 billion euros this year, up from 268 billion euros in the same period of 2010, Bloomberg data show."

And we know:
"The recent significant increase in credit spreads for many financials have been driven by the markets concerned about the ability of the weaker players to access credit at reasonable rates."

Given ongoing market concerns on potential losses on sovereign bonds, banks prefer to deposit their cash at the ECB (135 billion euros in the last 10 days). So access to term funding for banks in Europe being very weak is a clear and present danger.

And on a final note, last chart of the day, following the downgrade of US banks by Moody's, this is the picture between Bank of America 5 year CDS and Citi 5 year CDS:

“Panics do not destroy capital – they merely reveal the extent to which it has previously been destroyed by its betrayal in hopelessly unproductive works” - John Mills, “Credit Cycles and the Origins of Commercial Panics”, 1867

Stay tuned!

Monday 19 September 2011

Markets - Credit - Controlled demolition

"Demolition is the tearing-down of buildings and other structures, the opposite of construction. Demolition contrasts with deconstruction, which involves taking a building apart while carefully preserving valuable elements for re-use."

The respite was short lived in the credit space and the tone, was once again about widening spreads.
Itraxx 5 year crossover index (High Yield, wider by 41 bps to 756 bps:
What is interesting is the fact that tomorrow is the 6 months roll for the credit indices. The Itraxx crossover index will comprise 50 entities instead of previously 40 names. 12 new entries in the index for two names dropping including Rhodia. The big change comes from the fact that a previously less liquid name can be included in the index, provided: the company has issued 500 million euros of bonds in the last 12 months and if the company is as well present in the Iboxx Liquid HY index in euros or in dollars.

Itraxx Financial Senior 5 year index widening today by 27 bps to 292 bps:

and the Itraxx Financial Subordinate 5 year index moving touching again 500 bps on the day, up by 35 bps:

The liquidity picture as per Bloomberg:
And my good credit friend to comment:
"Central bankers’ intervention is finally analyzed the right way, i.e. the US $ funding problem is worst than what people have in mind and liquidity provided versus collateral will only be accessible for those which are the stronger …. Explanation: In order to get the needed US $ funds, banks have to pledge collateral to the Central Bank for a defined period of time -3 months. If the value of the collateral decreases (bad mortgages or loans), a haircut on the collateral principal is applied and the bank will get less US $ per nominal.

Therefore, the Central Banks’ action is not an unlimited source of liquidity. It will help, but not be enough as the banks will still have to find some US $ funding … and the worst the assets, the bigger the funding gap to be filled!"

In relation to the liquidity issues now facing Russia we discussed in the post "Markets update - Credit - After all tomorrow is another day", Jack Jordan and Jason Webb in Bloomberg indicated today the following:
"Russia’s central bank provided the biggest cash injection for lenders in two years to ease a shortage of rubles and avoid a repeat of 2008, when policy makers had to grant more than $131 billion in aid to banks.
Bank Rossii lent 149.8 billion rubles ($4.9 billion) to local banks on Sept. 16 in the biggest auction of repurchase loans since December 2009, according to central bank data. The overnight MosPrime rate, the average banks charge to lend to each other, jumped to 5.29 percent, the highest since January 2010."

Cash crunch we have. From the same Bloomberg article:
"Russia is experiencing a cash crunch as the ruble’s 9.6 percent drop versus the dollar since the start of August erases the need for the central bank to stem its appreciation by buying dollars in exchange for local currency, UralSib Financial Corp. said. Concern European banks, hobbled by the region’s debt crisis, will prevent Russian companies from refinancing the $48 billion of debt due before the end of 2011 is also spurring outflows of capital, according to Alfa Bank."

But it isn't only Russia trying to sustain its local currency by buying rubles, it is also happening in India with the regulators also starting to buy local currency and selling dollars and Argentina as well. According to Bloomberg: "Argentina's central bank has been sellingg foreign currency every trading day since August 15, according to data compiled by Bloomberg."

As reminder for what happened to Russia in 2008 and from the same source:
"Russia saw record capital outflows of $130 billion during the credit market crisis three years ago, forcing the government to provide emergency funding to banks and take over Svyaz Bank and Globex Bank, two of
the country’s top 50 lenders by assets."

It looks like Russia is heading towards another credit crunch. 2008 redux?

The liquidity is still very poor hence another session of flight to quality as displayed by the German 10 year bund and Swedish 10 year government bond moving in perfect tandem (correlation still at 1):

The greek jitters goes on with two year Greek bonds creeping up higher:

Tomorrow is payment day on Greece 4.5% 2037 9 billion euros issue, currently trading at around 31 in cash price (bid side):
The last coupon ever to be paid on that issue? It might well be a collector's issue fairly shortly...

While all the focus seems to be on Europe these days, another credit friend of mine, brought to my attention some interesting developments in the Chinese space (where all is going well, at least from an official point of view).
Source: Bloomberg
" The Ministry of Finance, the Ministry of Commerce and the Ministry of Industry and Information Technology have notified Shandong,Qingdao, Henan and Sichuan that the home appliance subsidy program in the above regions will expire on 30 November 2011.
From 1 December 2011, the above three provinces and one city will no longer enjoy subsidies on home appliances purchases."

And following this announcement HAIER Electronics Group Co Ltd shares in Hong-Kong took a severe beating:

Why is it relevant?

"Founded in 1984, Haier Group is headquartered in Qingdao, Shandong Province, the PRC and is today one of the world's leading white goods home appliance manufacturers. The products of Haier Group are now sold in over 100 countries. In October 2009, Haier was ranked first in Fortune Magazine's "China's Most Admired Companies"."

"Haier Electronics Group Co., Ltd. is an investment holding company engaged in manufacture and sales of washing machines, water heaters and provision of logistics services, as well as sales and distribution of home appliance and other products. It has three segments: washing machine segment, which manufactures and sells washing machines; water heater segment, which manufactures and sells water heaters, and the integrated channel services segment, which provides logistics services, as well as sells and distributes home appliance and other products."

So you can start thinking about the "decoupling story" with China given a consequent artificial stimulus has just been pulled right under the feet of one of the largest white goods manufacturers of the world, namely Haier Group.

While Europe is busy with the demolition, we have China attempting deconstruction. In both case we have an attempt of controlled demolition, it is just a question of style.

Stay tuned!

Sunday 18 September 2011

A proposal for the ongoing European debt crisis involving debt compression.

How do you make four triangles with 6 matches? Most people instinctively think in 2 dimensions when the solution involves changing your thought process and switching to 3 dimensions.

The European sovereign debt crisis is of two levels:
-Current outstanding debt which is unsustainable given weaker growth for some peripheral countries, which will be impacted even more by austerity measures.
-Long term dynamics of debt levels and solvency issues.

The contagion we have seen to Italy and to some extent Spain recently, is directly linked to the amount, at least for Italy, to the considerable size of the existing Italian outstanding government debt stock.

The objective of debt compression is to simplify the outstanding exposures, reducing therefore credit risk, which is currently plaguing the European Financial system.
While I see it as alleviating funding issues in the near term for both sovereign countries and to their respective domestic financial institutions, it has to be part of a bigger plan involving Euro bonds.
The long term solution is a proper central treasury for Europe as proposed by some, including George Soros.

As a reminder:
European debt map:

European countries cross border exposure:

The process of European debt compression would consist in certain number of market participants voluntarily giving information to a 'compression institution' about their sovereign exposures.

About trade compression already existing and provided by vendors in the Credit Default Swaps space:
"Trade compression is the reduction of the notional amount of trades outstanding in the market, with particular focus towards the credit default swap market. Methodologies include index netting, tear-ups, and trade composting. The specific details of these methodologies are beyond the scope of this definition. However, in general, the process involves aggregating a large number of trades with similar factors such as risk or cash flow into fewer trades with less capital exposure.

Trade compression is a fairly new strategy with few applicable platforms prior to the credit default market crash. Since then the strategy has gained momentum with several competitors vying for the market leader position. Two of these companies, Markit and Creditex, seem to have taken the lead as they were selected by the International Swaps and Derivatives Association (ISDA) to create a platform to support trade compression. In August 2008, the joint effort was able to reduce the notional amount of compressible trades involving 14 dealers by approximately 56%.

Overall, trade compression is a promising strategy that is still in its infancy and with technology and regulation that are still in development."

In December 2010, I mentioned debt compression as a part of the solution for the current stock of debt and the interconnections between countries and financial institutions in the post "Europe - The end of the Halcyon day"

In May 2011, Anthony J. Evans, Associate Proffessor of Economics at ESCP Europe realised a study entitled - "The great EU debt write off". The study is available on - "The great EU debt write off". Thanks for ZeroHedge for pointing out this very interesting study.

It is the continuation of what I suggested back in December 2010, ESCP this time is doing a very interesting simulation on the exercise of debt cancellation.
In December 2010 I wrote:
"A way of reducing the burden of debt for peripheral countries, would be to create a European Compensation house and to do some debt compression. They would need to allow creditors to swap the debt of peripheral countries into more solid Euro-bonds issued at the ECB level, provided their is a haircut on the existing peripheral debt. Unfortunately the game of kicking the can down the road is still well alive with French and German politicians. At some point restructuring of the debt for some peripheral countries will have to happen."

The main findings of their simulation is as follows:

"• The EU countries in the study can reduce their total debt by 64% through cross cancellation of interlinked debt;
• Six countries – Ireland, Italy, Spain, Britain, France and Germany – can write off more than 50% of their outstanding debt;
• Three countries - Ireland, Italy, and Germany – can reduce their obligations such that they owe more than €1bn to only 2 other countries.

In addition the simulation revealed that:
• Around 50% of Portugal’s debt is owed to Spain;
• Ireland and Italy can write off all of their debt to other PIIGS countries, and Ireland can
reduce its debt from almost 130% of GDP to under 20% of GDP6;
• Greece can reduce their debt by 20%, with 60% owed to France and 30% to Germany;
• Britain has the highest absolute amount of debt before and after the write off (owed mostly to
Spain and Germany) but can reduce their debt to GDP ratio by 34 percentage points ;
• France can virtually eliminate its debt (by 99.76%) – reducing it to just 0.06% of GDP"

and the results are summarised in the table below:
Source ESCP May 2011 study.

The solution for European sovereign debt issues starts with debt compression as well as the implementation of Euro Bonds via a European central treasury.

Thursday 15 September 2011

Markets update - Credit - After all tomorrow is another day.

"After all tomorrow is another day", is the last line of the American Civil War novel Gone With The Wind.

Like Scarlett in Gone With the Wind, credit markets, though deeply grieved also seems to hold up, so far, under the strain. And if Gone With the Wind has a theme it is survival:

"If Gone With the Wind has a theme it is that of survival. What makes some people come through catastrophes and others, apparently just as able, strong, and brave, go under? It happens in every upheaval. Some people survive; others don't. What qualities are in those who fight their way through triumphantly that are lacking in those that go under? I only know that survivors used to call that quality 'gumption.' So I wrote about people who had gumption and people who didn't."
Margaret Mitchell, 1936

Here is the market picture for Itraxx 5 year credit indices today following the "shock and awe"(a military doctrine based on the use of overwhelming power) coordinated central banks intervention to ease dollar funding issues for European banks (we already knew about these concerns from previous posts):
Itraxx Crossover 5 year CDS index (High Yield), tighter:
Market closed at around 714 bps, 27 bps tighter.

Itraxx Financial Senior 5 year CDS index:
Cooling off as well.

Itraxx Financial Subordinate 5 year CDS index:

The liquidity picture:
The massive fall in deposits at the ECB is due to the start of a new reserve period on the 14th of September until the 11th of October.
The three-month cross-currency basis swap fell to 80.25 bps from a high of 112.6 bps on the 12th of September, thanks to central banks intervention.

So, who has what Margaret Mitchell calls "gumption" in Europe in the peripheral space?

Portugal 5 year Sovereign CDS versus Ireland 5 year Sovereign CDS:
Ireland clearly is decoupling from Portugal.

Spain 5 year Sovereign CDS versus Italy 5 year Sovereign CDS:
Spain decoupling as well. Spain sold today 3.95 billion euros of bonds maturing in 2019 and 2020 at an average yield of 5.156% compared to 5.2% in February and 5.196% on the secondary market before the auction took place.

The liquidity issues we discussed a month ago in "Macro and Markets update - It's the liquidity stupid...and why it matters again...", is not only a European problem anymore. It is as well a Russian problem:
Bloomberg - Maria Levitov and Denis Maternovsky:
"Russia is struggling to contain a cash squeeze at the nation’s banks after cutting lending rates for the first time in 15 months.
Government bond yields surged to their highest level since February, with the rate on ruble notes due in March 2014 climbing 19 basis points to 7 percent yesterday, as Bank Rossii sought to boost the amount of cash available to lenders by lowering the rate charged on repurchase loans by 25 basis points and lifting the rate earned on deposits by the same amount yesterday. The three-month MosPrime interbank rate hit an almost 19-month high.
Russia is following Brazil and Turkey in cutting borrowing costs as a way of shielding the nation’s economy from a global slowdown as the U.S. falters and the European debt crisis continues. While the refinancing rate was left on hold at 8.25 percent yesterday, the changes to the repurchase and deposit rates should “contain volatility of money market” rates, Bank Rossii said in a statement."

And why liquidity always matter, also from the same Bloomberg article:
“Economic growth must be fueled with liquidity,” Vladimir Osakovsky, chief economist for Russia at Bank of America Merrill Lynch, said by phone from Moscow yesterday. “If this doesn’t happen, growth in money market rates could stifle investment and therefore growth.”

Credit Suisse published today a review of European Banks under the title - European Banks - The lost decade.

Given ongoing liquidity constraints we discussed plaguing European banks in general, and dollar funding in particular, at this point, as the story unfolds/evolves, it is important to try to find out who has "gumption" and who hasn't in the European banking space.

In this lengthy report, Credit Suisse analysts tell us:
"Whilst many observers may see these two events as separate, we see them as part of the same process which ultimately, we believe, may force banks to deleverage and restructure in a much more significant way. Further, as a result of the current crisis, given European banks have only reduced about half of their original sub prime exposures according to our estimates, we could again see losses related to these assets come through the P&L.
Overall, based on our analysis we see that whilst overall losses associated with credit market assets are c.€184bn so far, European banks effectively ‘raised and retained’ a much higher amount to reach a tangible equity position of €811bn last reported. We note that the additional capital has also been part of higher capital requirements mandated under Basel III and is an important indication that European banks are in a better position in terms of capital going into the sovereign crisis. It has also however, been a drag on profitability.
We compare these losses with the potential losses from the current sovereign crisis. On our estimates, assuming an accelerated sovereign shock scenario, we could see a further €213bn of losses i.e. higher than the losses experienced thus far with credit market assets.
This includes:
(i) further losses on sub prime assets (€52bn); (ii) sovereign losses of €125bn and (iii) one year of higher funding costs of €37bn. If we were to include risk weighting for sovereign exposure of €22bn then the total would be €235bn."

 And Credit Suisse to add:
"Estimating the capital shortfall for the sector
Going into this crisis, given higher regulatory capital demands and funding markets requiring larger capital cushions, our base case suggests the sector will still have a €165bn capital deficit at year end 2012E. In the core scenario that we present we estimate the sector would have a total recapitalisation requirement of c.€400bn (Figure 3) compared to the current market cap of €541bn."

Clearly Europe needs a European TARP. Could that be the message that Treasury Secretary Timothy Geithner will convey to European finance ministers in Poland?

We know from my post "Macro and Markets update - It's the liquidity stupid...and why it matters again..." that the lack of disclosure of the LCR (Liquidity Coverage Ratio), which unfortunately is not published by the majority of banks is an issue as Credit Suisse put it in their report: "A more significant market dislocation in terms of bank failure e.g., Lehman in the sub prime crisis,would make a liquidity coverage ratio (LCR) analysis more relevant, as it highlights the vulnerability of funding on a 30-day basis."

Unfortunately as we previously discussed, lessons have not been learn from the 2008 onslaught and the lack of disclosure and transparency for the majority of European banks does not really allow for a proper "gumption" assesment process under very adverse liquidity conditions. But a good point Credit Suisse points out in their report is as follows:
"European banks have effectively ‘raised’ a much higher amount—of €835bn—since 2007 i.e. five times the losses incurred. We note that the additional capital is also part of higher capital requirements mandated under Basel III but it is an important indicator that highlights that European banks are in an improving position in terms of capital going into the sovereign ‘sub-prime’ crisis. This is why tangible equity for the European banks has almost doubled from the level at the start of 2007."

Sweden is also bracing for impact should it happen:
Source Bloomberg - Johan Carlstrom - 14th of September:
“There will be facilities in place to support banks that may have problems,” Reinfeldt said in an interview today in Stockholm.

Sweden has a good first hand experience of financial crisis:
"Sweden, which suffered through a banking crisis in the early 1990s and then again in 2008 and 2009, chose to inject capital into struggling banks only in return for equity to avoid raising deficits and burdening taxpayers. The government in 2008 set up a financial stability fund by charging banks an annual fee and enacted various crisis-management measures including a bank guarantee program to help support lending.
The fund will grow to 2.5 percent of gross domestic product by 2023 and stood at 35 billion kronor ($5.2 billion) at the end of 2010, including shares in Nordea Bank AB, according to the Swedish National Debt Office.

On another note, Bloomberg Chart of the day shows that the currency ugly contest is well alive and kicking between the Euro and the Dollar:

And finally, to end up on a less somber note this what I think Ben Bernanke could have said after today's coordinated intervention: I know what you're thinking. "Did the FED fire six shots or only five?" Well, to tell you the truth, in all this excitement I kind of lost track myself. But being this is the FED, the most powerful central bank in the world, and would blow your head clean off, you've got to ask yourself one question: Does the ECB feel lucky? Well, do they, punk?

Stay tuned!
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