Thursday, 6 October 2011

Markets update - Credit - For whom the vol tolls and the return of FAS 159.

For whom the bell tolls
Definition: "An expression from a sermon by John Donne. Donne says that because we are all part of mankind, any person's death is a loss to all of us: “Any man's death diminishes me, because I am involved in mankind; and therefore never send to know for whom the bell tolls; it tolls for thee.”

Rest in peace Steve Jobs.

Today was clearly a day of volatility in the credit space.
Here is the overview.
The range for Itraxx Financial senior 5 year index was between 247 bps to 266 bps and the market closed around 253 bps.
For Itraxx Financial Subordinate 5 year index, the range was between 480 bps to 517 basis points intraday, closing at around 498 bps.

Although the markets in the credit space felt better, it clearly looked like a short covering move.
And my good credit friend to comment:
"Skew basis trades in the credit derivatives universe had for consequence a tightening of the credit indices versus single names (arbitrage selling the indices and buying the underlying single names components). Meanwhile, the cash market barely moved as we still see a lot of sellers and almost no buyers. The ratio seller to buyer was roughly 8:1, and the selling pressure was broad based. Financial bonds as well as corporate bonds are being offered relentlessly and the dislocation we saw in bank bonds and notes is spreading now to almost all issuers.

The name of the game remain Volatility..."

Yes, the markets expect a bazooka of some sort to relieve the pressure in the European space. The ECB's core mandate is price stability and given inflation has been creeping up recently at 3% in the euro zone, a rate cut, which many were expected today, did not materialise. Jean-Claude Trichet's last meeting, did not generate the bazooka, which the market is still hoping at some point.

Itraxx Credit Indices Market overview - Source Bloomberg

Itraxx Financial Senior 5 year CDS index versus Itraxx Europe Main (Investment Grade) 5 year CDS index - Source Bloomberg:

While volatility has been more muted in the CDS corporate space in recent months. The continuous pressure in the financial space means that volatility remains very high as indicated by the absolute spread between Itraxx Financial Senior 5 year CDS index and Itraxx Financial Subordinate 5 year CDS index - Source Bloomberg:
Spread between both indices still at the widest levels at around 245 bps. The unsecured funding market is still utterly shut and most issues coming to the markets from the financial space have been so far, covered bonds backed by pools of prime loans, apart from last week 2 year senior FRN (Floating Rate Note) issued by Deutsche Bank as discussed in previous post.
Access to capital is therefore still limited, no change there, with Nationwide Building Society (rating A+/Aa3/AA-) selling 1.5 billion euros of five-year covered bonds, priced to yield 130 bps than the benchmark mid-swap rate according to Bloomberg. We know from the post "Markets update - Credit - Crossing An Event Horizon", that
"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."
We know ING sold AAA 10 year bonds at 80 bps over midswaps on the 24th of August, and Unicredit at 215 bps over midswaps on the 25th. It seems every new issue coming in the financial space is pricier than the previous one, and given covered bonds are the most senior guaranteed bonds you can find, senior unsecured bonds and subordinated are repriced accordingly in the process.

And although credit indices enjoyed a short squeeze tightening move, and ECB has pledged to buy 40 billion euros worth of covered bonds, to provide extra financing for banks, liquidity in the market, remains weak - Source Bloomberg:
ECB deposits still rising. But following today's ECB meeting, banks will be offered two additional unlimited loans of 12 and 13- month durations. Trichet in his last ECB meeting mentioned that the Central bank would continue to lend banks as much money as they need in its regular refinancing operations at least until July 2012 to alleviate current liquidity issues we previously discussed.

German 10 year Government yield, Eurostoxx, Itraxx Financial Senior 5 year CDS index and volatility - Source Bloomberg:
While volatility remains elevated, you can notice the correlation between the German 10 year bund yield and the Eurostoxx index.

In the Sovereign Index Space, SOVx Western Europe index (15 countries) is now tighter than the SOVx CEEMA (Central Eastern Europe, Middle-East and Africa) - source Bloomberg:

Confirming what we had discussed in "Markets update - the EM contagion" :
"The CHART OF THE DAY shows the Markit iTraxx SovX CEEMEA Index of credit default swaps on 15 governments in central and eastern Europe, the Middle East and Africa now exceeds a benchmark of western European creditworthiness by 14 basis points. Europe’s worsening deficit crisis is hurting manufacturers, eroding demand for commodities and undermining capital flows in developing economies. Investors are pulling money out of emerging-market bond and equity funds as the risk of a Greek default and losses on sovereign bond holdings mounts."

Meanwhile Ireland continues breaking away from Portugal, Sovereign 5 year CDS wise - Source Bloomberg:

While equity markets are enjoying a respite, we have yet to see a break upwards of the 2% yield for the German bond, still consistent with flight to quality in the European space - Source Bloomberg:

Truth is in the credit space, cash bonds felt weak today has commented by a market maker, with clients still reducing risks and selling bonds which, should not be a surprise given that corporate issuance is repricing credit curves. And cash bonds selling is not helping market makers given a lot of them have lost their risk appetite, as vol (volatility), in the credit space has indeed taken its toll.
Bloomberg - Bond Traders Left Adrift as Dealers Reduce Risk - Shannon D. Harrington and Sarah Mulholland - 6th of October 2010:
"Europe’s crisis of confidence is crippling credit-market trading as banks shrink bond inventories to the least since the depths of the last recession.
Federal Reserve data show U.S. primary dealers cut their holdings of corporate debt by 33 percent to $63.5 billion since May, bringing stockpiles to within $4 billion of the five-year low reached in April 2009. Trading in investment-grade company bonds has dropped 27 percent since February, according to Trace data compiled by Barclays Capital, and a measure of the cost to buy and sell debt is at the highest in more than two years."

and the two authors to add, in relation to liquidity in the credit space:
"Evaporating liquidity is contributing to the biggest junk-bond losses since the failure of Lehman Brothers Holdings Inc. three years ago as Europe’s leaders seek to prevent the region’s fiscal imbalances from infecting the global banking system and the U.S. economic recovery struggles to gain footing. Sales of new high-yield securities have all but disappeared and prices in debt markets are swinging by the most since 2008."
Volatility we have indeed and from the same article we learn that:
"Volatility is making it harder for Wall Street to underwrite loans, Julia Tcherkassova, a commercial-mortgage debt analyst based in New York at Barclays, said yesterday.“Originators need to see that stability.”It takes several months to accumulate mortgages to package for sale as bonds, and price swings on the debt mean that lenders may be stuck with unprofitable loans if values decline in the interim."

So dealers are as well de-risking and deleveraging, leading to wider bid-ask spreads, higher volatility and poorer liquidity, and we haven't seen complete capitulation yet as we saw in 2008.

So how do banks expect to sustain earnings in this difficult trading environment with less leverage, smaller balance sheet exposure, weak issuance and so forth?

Here comes again FAS 159!

In July 2010 I commented on the above: "Statement 159 - Debt Valuation Adjustments - Déjà Vu 2008"
"Statement 159, adopted by the Financial Accounting Standards Board in 2007 allows banks to book profits when the value of their bonds falls from par. This rule expanded the daily marking of banks’ trading assets to their liabilities, under the theory that a profit would be realized if the debt were bought back at a discount."

Wall Street's tricky profits - CNN Money - Roddy Boyd:
"Here's how FAS 159 works: A company can assign a fair (or market) value to its financial assets and liabilities - such as bonds - in order to smooth out earnings. Say a bank sells debt, an IOU, at $1,000 par value. Because of broader credit-market concerns and a slowdown in earnings, that debt trades down to $800. The $200 differential, under standard 159, is allowed to be counted as mark-to-market income, without the bank having engaged in any business activity. The bank then details its use of the rule in footnotes to its regulatory filings."

And Roddy Boyd to add:
"Moody's Investors Services has also warned investors about FAS 159, noting that it risks giving false perceptions of a bank's financial strength. The agency says it "does not consider such gains to be high-quality, core earnings.""

So we have a similar pattern than what I discussed in 2010 namely that:
"With the recent increase in volatility in conjunction with a reduction in debt issuance in the second quarter, banks have had a hard time to reap in similar profits they made in Q1."

Bank Profits Depend on Debt-Writedown ‘Abomination’ in Forecast - Bloomberg July 2010:
“What’s on investors’ minds are the macroeconomic issues, as reflected by the interbank market in Europe, the very low yields on U.S. Treasuries and recent data on economic growth, jobs and housing,” Credit Agricole Securities USA analyst Michael Mayo said in an interview. “To the extent that the earnings power is less, the banks would not generate as much capital, so there’s less capital available to absorb future losses.”
Any similarities to today's situation are of course purely fortuitous.

And from the same article we learn:
"In practice, it’s an accounting “abomination” because fluctuations in the value of the debt don’t change the amount the banks owe, said Chris Kotowski, an analyst at Oppenheimer & Co. in New York."

And as David Hendler, Senior Analyst from CreditSights sums it up in the same Bloomberg article:
“When the prevailing winds of credit spreads tighten, they make a lot of money, and when spreads widen, they can’t make as much.”

So, when you have heightened volatility, FAS 159 and Debit Value Adjustment allows banks to increase earnings in bad times but when CDS spreads tighten it works the other way as discussed in "Credit Value Adjustment and the boomerang effect of FAS 159 accounting rules on Banks Earnings".

FAS 159 is the reason why UBS is expecting a "modest" net profit in the third quarter - Source Bloomberg - Elena Logutenkova - 4th of October 2011:
"UBS AG, Switzerland’s biggest bank, expects a “modest” net profit in the third quarter as gains from a widening of its credit spreads and the sale of bonds helped cushion the $2.3 billion loss from unauthorized trading.
The bank expects to book a fair-value gain of about 1.5 billion Swiss francs ($1.6 billion) as its credit spreads widened in the third quarter."

So, in coming bank earnings, you can expect more of the same, courtesy of the perfectly legal FAS 159 accounting trick which was as well very effective in 2008.

On a final note and as a follow up on our discussion about contagion to Emerging Markets and the Chinese slowdown, here is the updated picture for Australian Financials - Source data provider CMA:
[Graph Name]

"All of us might wish at times that we lived in a more tranquil world, but we don't. And if our times are difficult and perplexing, so are they challenging and filled with opportunity."
Robert Kennedy

Stay tuned!


  1. Great article as usual, thanks.

  2. Great post, Guest posting this on MoreLiver's Daily. Keep up the work, it is good.


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