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!

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