Thursday 27 October 2011

Markets update - Credit - Long faith - Short hope and more on revamped EFSF

"To withdraw is not to run away, and to stay is no wise action, when there's more reason to fear than to hope."
Miguel De Cervantes

Epic capitulation in the Credit space CDS wised. Both dealers and clients were short credit via CDS and basically everyone ran for the hills and the short squeeze was massive. Most of the action was in the CDS space, from single names, to credit indices, to sovereign CDS. In this long post, we will first review today's price action as well as revisiting EFSF revamped and risk it entails.

This was the picture today for sovereign CDS - source CMA:
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The core countries of the euro area - source CMA:
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In the banking CDS space, the rally was significant, as well in equities - source CMA:
Daily Focus Graph

The squeeze was massive in Itraxx credit indices, 23 bps in Itraxx Main Europe 5 year CDS (investment grade credit index) which closed at 150 bps and 72 bps on Itraxx 5 year Crossover CDS index (High Yield credit index) which closed around 630 bps. It was a complete short capitulation and CDS curves steepened massively in the process in the front end of CDS curves - Source Bloomberg:

In the financial space Itraxx Financial Senior 5 year CDS index and Financial Subordinate 5 year CDS index tightened significantly and the spread between both CDS compressed as well - source Bloomberg:

But the most significant compression we have seen between indices has been between the Itraxx Financial 5 year CDS index and Itraxx Main Europe 5 year CDS, meaning financial spreads are converging towards corporate non financial spreads (investment grade)- source Bloomberg:

In terms of flight to quality, we had a widening in 10 year German Government bond yields and convergence again with German 5 year sovereign CDS spread - source Bloomberg:

In relation to EFSF 10 year bonds versus 10 year French government bond yields and German 10 year government bond yields, correlation is still alive and well - source Bloomberg:

The interesting point following last night agreement relating to Sovereign CDS is the fact that the 50% haircut will not constitute according to ISDA, a credit event. So what is the value of a sovereign CDS exposure?

As my good credit friend put it today:
"ISDA may find that 50% haircut is not a credit event…as the decision is “voluntary”.

So banks who bought CDS to protect their Greek bond holdings could endure more losses: 50 % on the bond, and a worthless CDS. To draw a parallel, it would be like finding after a car accident that the insurance you bought to protect the car does not cover you for anything ! Nice !!!"

In relation to last night's agreement relating to the ongoing European debt crisis, like most, I do not see this as the bazooka which will fix once and for all the European issues, hence the title of the post, this time it isn't "Long hope - Short faith" but, I rather see this as market participants desperately wanting to believe in lasting solution to the crisis and welcoming the respite. Call it "battle fatigue", or CSR (Combat stress reaction) in relation to the short squeeze. The only solution for Europe goes through more integration and ECB stepping in as lender of last resort, in the process changing its DNA and becoming more like a FED in effect, backed by a central treasury.

As research analyst David Watts from CreditSights put it in their latest sovereign analysis report - Eurozone Leaders Produce Belgian Waffle:
"It is possible that the measures taken will actually resolve the issues plaguing Eurozone governments. But there are very real risks that this will prove to be just another divet in the road that the "can" is currently being punted down. For the moment stock markets are up and credit markets are rallying. Given that this is at root a crisis of confidence over some Eurozone governments ability to repay their bonds at maturity, a change in sentiment for the better might be sufficient. If enough investors think that Italy (or at least the EFSF / ECB / IMF) will definitely pay them their money back when the bonds mature, they will buy the bonds and the financing become self-fulfilling.

But the markets are in no mood for "possible and "might". And the reality is that the institutions that the Eurozone policy makers have decided to create to underpin confidence in government's financing needs are themselves open to crises of confidence. Unless the backstop is cast iron, in other words, there can be no question over its ability to source and provide liquidity, there is always a risk that the market will lose faith and the house of cards will fall. That is why, we sincerely hope that this convoluted leveraging of the EFSF will prove sufficiently, we suspect that unless the ECB throws its weight behind government's, their liquidity position will always be open to question."

So yes, long faith but short hope.

We already discussed the EFSF structure in depth. In relation to the proposal of the EFSF proposing to write protection on the first loss tranche, effectively transferring first-loss risk from Italian bondholders to EFSF bondholders, we know by now that our CPDO/EFSF is not risk-free from the post "Much ado about nothing":
"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."
and we also know:
"In a CPDO/leveraged EFSF, when multiple downgrades happen, creating significant widening in spreads/higher interest rates, the loss in NAV can be significant."

EFSF fails if Spain or Italy require assistance or if France loses its AAA rating in the coming months. As a reminder, we have upcoming elections in France in May 2012.

And CreditSights commented on their latest note:
"The problem with proposal that first loss insurance is provided to Italian or Spanish bondholders by the EFSF is that it doesn't actually tell investors whether they are truly protected from losses."

We know they are not protected and my good credit friend to comment:
"A boost of the EFSF firepower to euro 1 trillion: This is less than what the market was initially expected, but expectation has been driven lower over the last days. It remains to be seen if the SPV will find some investors (I have strong doubts following Brazil, Russia and India refusals…Of course, everybody is expecting China to fill the gap, like a hero coming to the rescue. It is possible but, I tend to think that the PBOC will not put so much money to work. Also, the first loss guarantee on new primary issues is raising a lot of technical issues, and may not be implemented as it will create a “2 speed” markets (the new issues will be partially guaranteed while the old ones will not), and there will be a lot of conditions to be met by the country issuing to get the first loss absorption insurance…"

The first loss approach has been compared to the monolines which wrote protection on RMBS (Residential Mortgage Back Securities). It did not end up too well for many of them (AMBAC, and others...). But, as CreditSights put it, there is a VERY big difference in the revamped EFSF:
"The monolines wrote protection on the last loss tranche, i.e. the last part of the capital structure to experience losses. The EFSF is proposing to offer to write protection on the first loss tranche, the part certain to take losses in any write-down."

And given the Greek CDS credit event comedy, who gets to determine the recovery? European politicians...

The issue of circularity we previously discussed means that perception of debt sustainability is depending on economic growth. You cannot have growth expansion with fiscal consolidation and too much austerity.

The question now is: Will China buy the equity tranche of the gigantic European CDO and assume first loss? I doubt.

"Faith: not wanting to know what is true."
Friedrich Nietzsche

Stay tuned!

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