Friday 9 September 2011

Markets update - Credit - Chandrasekhar limit

"The Chandrasekhar limit is an upper bound on the mass of a stable white dwarf star. The Chandrasekhar limit is the mass above which electron degeneracy pressure in the star's core is insufficient to balance the star's own gravitational self-attraction. Consequently, white dwarfs with masses greater than the limit undergo further gravitational collapse, evolving into a different type of stellar remnant, such as a neutron star or black hole."
Looks like I am having difficulties finding new entertaining titles in all that excitement...

What a day it has been in credit. While CDS indices keeps reaching new records, some of the action has been in the cash markets. This is going to be another long post.
As a follow up on my post "Markets update - Credit Terminal Velocity?", one of my very good friend in the credit space, indicated:

"European banks seems to be facing a US dollars funding problem as no investors is willing to lend (buy a CP/CD) with a duration over 1 week. That information, if confirmed, is of significant importance as it has major implications not only in the money market (the spread OIS/Libor is at the widest for almost 2 years and keeps on worsening- 1rst confirmation), but also FX basis market (the basis swap between currencies has been deteriorating significantly and stands at -60 bps versus -10 bps 4 months ago -2nd confirmation). IF the trend remains unchanged in the coming weeks, the casualties may be the following:
  • 1- a US dollar rally against most currencies as there is both a lack of US dollars in the funding market, but also because most of the players are short US dollars versus currencies with higher yields ( Haaa … the famous carry trade may suffer a blow, and unwinding positions may be costly and create dislocations).
  • 2- a leg down in the commodities universe (except for Gold) as a most of those are US $ denominated.
  • 3- a leg down on the equity market as the losses from a higher US dollar will have to be offset by some unwinding on liquid assets (Welcome margin calls !!!). In addition, a higher US dollar versus Euro means lower earnings for the US corporations (non-withstanding slower growth in Europe, a major trade partner for the USA).
  • 4- a worsening credit market as banks funding problems have a direct effect on the overall spectrum of the economy."
Liquidity indicators, the picture today:
The Euribor-OIS spread, which is a measure of banks’ willingness to lend to one another, reached the widest the level in 2 1/2 years, a sign of mounting financial-market pressures in the euro zone: 83 bps. Highest level since March 2009, up from 74.85 bps yesterday. While by no means we are at levels reached in 2008, namely 206 bps as Lehman defaulted, we know that the ECB is pumping liquidity in the system so far.

OIS FRA level:

But, in relation to my friend's comment relating to the shortage of US dollar we know courtesy of Bloomberg that:

"The eight largest U.S. money-market funds halved investments in German and U.K. banks over the past 12 months, eliminated their lending to Italian and Spanish firms and reduced investments in French banks, data compiled by Bloomberg and published in today’s Bloomberg Risk newsletter showed."

Hence the basis swap premium mentioned above. In fact the premium European banks pay to borrow in dollars for one year has increased the most since December 2008. In fact the one-year cross-currency basis swap, fell to 65.5 bps below the euro interbank offered rate (Euribor). So, US dollars are indeed becoming more expensive and the Euro is therefore falling:

And the deposits at the ECB keeps piling up:

Update on my previous graph from my post - "Macro and Markets update - It's the liquidity stupid...and why it matters again..." on Eurostoxx 50 (SX5E), Itraxx Financial Senior 5 year CDS index, German Bund (10 year Governement bond, GDBR10), and at the bottom Eurostoxx 6 month Implied volatility:
Flight to quality is the name of the game with the bund touching new lows.

In terms of credit indices, we have seen, once again, new records broken today, but this time with a clear deterioration in liquidity, not a good sign:
Itraxx 5 year CDS Financial Senior index:

Itraxx 5 year Financial Subordinate index, broke easily the 500 bps barrier:

In terms of market activity, a dealer commented he was seeing in the financial space buyers of protection accross the board. Spanish second tier banks finally widened significantly on renewed weakness in their loan books. FROB (Fondo de Reestructuracion Ordenada Bancaria - Spanish Restructuring Fund) will inject 2.465 billions euro in NovaCaixa's capital with a discount of around 75 to 85% price to book.

And my good friend in the credit space to add another comment today:

"The alarm is ringing in the credit market … As credit derivatives (CDS & Indexes) keep on widening, the cash market is suddenly reacting with vengeance. As mentioned in my previous emails, cash is way too expensive versus CDS…. So the re-pricing has to occur one way or the other. I mentioned the risk linked to the roll in the derivatives… it did not happen, so now re-pricing of subordinated bank debt (lower prices … much lower prices) has to occur. Basically, there is “No Choice”… and the funding issue (see my email from yesterday) may well be the catalyst (Euro down versus US Dollar this morning again …. US Dollar up versus most currencies …. Goodbye Carry trade).

The equity market corrected slightly yesterday, but remains at a very high level considering what is happening in the other markets. Valuations are over-optimistic as they are based on past earnings and unsustainable assumptions of growth and consumption. Very soon, in the next 1 to 6 months, investors will open their eyes and re-price the entire equity universe."

The game is called deleveraging:
Worlwide debt as a percentage of GDP has continued to rise last two years from 250% in 2008 to 266% in 2010 (source McKinsey Global Institute). Growth of debt doubled in the last 10 year while GDP growth increased by only 66%.
Problem is that rising debt is no longer offset currently by rising assets (goodbye QE2 and the wealth effect...).

And valuations will have to come down, as austerity bites and we get slower growth - "When it looks like a bear, feels like a bear and sounds like a bear...., it's a bear" - Exane BNP Paribas - Strategy calls 9th September 2011:
The key message of the table according to Exane BNP Paribas is that lower trend growth has a significant impact on equity valuations. (sorry equity friends...):
"A trailing market P/E of 10.3x may look cheap by historical measures. But when ones assume long term nominal EPS growth of 4% (an assumption we make in calculating the equity risk premium) and a CoE of 10%, then the market P/E would be worth only 7.5x, 27% below current levels."

and Exane BNP Paribas to provide the following estimate:

But I digress, back to credit. As I posited previously in my post "The curious case of the disappearance of the risk-free interest rate and impact on Modern Portfolio Theory and more!", it is all about repricing of risk and that is exactly what we are seeing at the moment in most asset classes.
This is what Societe Generale's latest Credit Strategy - Euro Credit Weekly - 9th of September 20011, had to say:
"A 100bp index move to either 200bp or 400bp has never been so difficult to predict. The credit markets are currently gripped by fear and there seems to be no respite in sight from daily swings between risk reduction/aversion. Investor cash positions are high by any measure and the Street is defensive, with cash spreads gapping - and we haven't even capitulated. We've even found a clearing level for new issues of 25-50bp, but it's done little to help; it has just repriced credit significantly wider. Eurozone political event risk is at maximum levels and choppy equities/iTraxx showcase our dilemma. No confidence, poor liquidity, a poor bid and few flows - it's like a slow death. Stay sidelined.

We have a very dislocated market with investors unwilling to add in secondary, although they piled into KPN's deal. However, RCI reopened the market with a €250m tap and the 40bp concession repriced over €10bn of its and Peugeot's debt. That's what we call an expensive deal. Still nothing in senior financials prolonging a 10-week drought. Fresenius reopened the HY market, but it's a special name and unlikely to be a bellwether for the sector. The pipeline is building, but we think issuance will be sporadic, at best."
RCI being Renault Credit International.

So, not yet complete capitulation, thanks to very real sovereign fears on Greece, but getting there...

Itraxx Europe 5 year Main (Investment Grade) versus Itraxx Financial Senior 5 year index:
Current Itraxx levels imply very high default rates ahead, using 40% recovery rate, forecast for Itraxx Main Europe 5 year is 3% of defaults within a year (around 4 names in the 125 strong index), according to Societe Generale. The serious deterioration in the sovereign outlook is weighting more on the financial sector as indicated by the Itraxx Financial senior index, due to liquidity concerns mentioned previously.

Itraxx Crossover (High Yield) 5 year index versus Itraxx Europe Main (Investment Grade):
Crossover is implying a default rate of 11.5% in a year's time according to Societe Generale, about the same as the worst level seen following the 2008 debacle.

Truth is a lot of companies are in a better position than in 2008 to face a downturn given the enormous pile of cash which has been accumulated since 2009.

So, yes, everything is depending on the resolution of the sovereign crisis and the prospects don't look great to say the least, as we all know by now.

SOVx 5 year index (15 European Western Europe countries including peripherals:
Wider still and a new record.

New interesting disconnect in the peripheral sovereign space, Italy 5 year Sovereign CDS is now wider than Spain.
Italy 456 bps versus 424 bps for Spain. In December Spain was 132 bps wider than Italy. Italy has very big refinancing needs in 2012, around 16% of its debt, the elephant in the European room.
It used to be the other way round:

Portugal 5 year Sovereign CDS versus Ireland 5 year Sovereign CDS - the great escape from Ireland?

But the "fear factor" story of the day was Greece.
One year Government Greek bond yield - close to 100%:
Can you spell default? One year Greek CDS level:
Greek Credit Swaps Surge to Record, Signal 91% Chance of Default with 5 year CDS at a record 3,045 basis points according to CDS data provider CMA.
No surprise with GDP contracting 7.3% compared to a year ago.

and my good credit friend to comment:

"Greece foreign lenders have made disbursement conditional on the government’s adoption of new measures that will target the collection of 1.7 billion euro. The government is facing the possibility of not being able to pay wages and salaries in October if its international creditors do not approve the pending 8-billion-euro sixth installment immediately. Without the sixth tranche, the public purse will be 1.5 billion euro short on October 17.

The prospect of a freeze in payments appeared even more serious on Thursday, after Greek commercial banks failed to cover the sum of 300 million euro of supplementary, noncompetitive bids for Tuesday’s auction of T-bills, providing only 155 million. The shortfall is interpreted as a clear message by banks to the government that they are unwilling to fund future issues of T-bills.
The gravity of the situation is indicated by the fact that the government has frozen all disbursements apart from salaries and pensions."

And finally, the icing on the cake:
Sept. 9 (Bloomberg)- Alan Crawford:
"Chancellor Angela Merkel’s government is preparing plans to shore up German banks in the event that Greece fails to meet the terms of its aid package and defaults, three coalition officials said.
The emergency plan involves measures to help banks and insurers that face a possible 50 percent loss on their Greek bonds if the next tranche of Greece’s bailout is withheld, said the people, who spoke on condition of anonymity because the deliberations are being held in private. The successor to the German government’s bank-rescue fund introduced in 2008 might be enrolled to help recapitalize the banks, one of the people said."

Could the Greek default happen this week-end?

Stay tuned!

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