Sunday 6 November 2011

Markets update - Credit - Complacency

"Don't let your special character and values, the secret that you know and no one else does, the truth - don't let that get swallowed up by the great chewing complacency."

At this juncture, following our various credit and markets conversations, it is important to revisit some of the points we have discussed in relation to liquidity, funding pressures and deleveraging, and in the process, revisiting some of our calls.

But, before we go through the details (and the truth is in the detail...), it is time for a quick market overview relating to Friday's price action.

The Credit Indices Itraxx overview - Source Bloomberg:
What we have is extreme volatility, with Itraxx Credit Indices experiencing big price movements, in an environment where liquidity is dwindling, as we move towards year end, it will make matters not better but worse. Nearly 90 bps intraday move on Friday for Itraxx Crossover (High Yield indicator). To give you an idea, on a 10 million Euros notional Itraxx Crossover CDS, contract, 1 basis point movement equates to around 3500 Euros (DV01) move in your marked to market Profit and Loss.

And in relation to the European High Yield market, it briefly re-opened, we had Ba3 rated Faurecia coming to the market with a Senior Unsecured 350 million Euros 2016 bond offering at 9.375% yield. Faurecia is one of the largest international automotive parts manufacturers in the world. French car manufacturer PSA Peugeot Citroën is Faurecia's controlling shareholder, holding around 57.4% stake. Faurecia is in a cyclical business. In 2008 it breached its loan covenants.

While Natalie Harrison from Reuters, in the deal review gives us the reason for the financing in her article "DEAL REVIEW: Faurecia debut survives high-yield storm":
"The bond, executed in conjunction with a new syndicated loan facility, will refinance a EUR250m loan that parent Peugeot was forced to put in place three years ago when four banks backed out of lending to the company.
The bond is also part of the company's well-publicised plans to diversify its funding sources away from banks and follows its fund-raising in the schuldshein market the previous week."

There are two important points above, remember the truth is in the detail, the proceeds will be used to repay the facility set up by parent company due to previous funding issues encountered in 2008, lack of funding because banks are deleveraging, meaning credit contraction, which we know by now will have economic consequences. Morgan Stanley published a very interesting paper on the 4th of November - Credit Continuum - Understanding Credit in a Low Yield World:
"HY vs. IG: Owing to callability, economic sensitivity, duration and default risk, we find that high yield tends to have weaker performance than investment grade in falling rate environments."
And in relation to the ECB rate cut, I am afraid, it is coming late and it is "Much ado about nothing" as a senior credit market maker commented:
"The ECB rate cut was another surprise for the market and shows that the mild recession has already reached Europe as I expected."
And added:
"The rate cut will help sentiment but not really the refinancing need for Governments."
 In terms of financing needs for 2012, we discussed this subject with Cullen Roche in his post - "THE IMPOSSIBLE REFINANCING BURDEN...."

The Government Bond picture:
Italian bond yields creeping higher still...

Flight to quality mode is switched on again - "Risk-off", German 5 year sovereign CDS versus 10 year German Government Bonds yield:

But, in a low yield environment, defaults tend to spike.

Morgan Stanley in their note relating to "Understanding Credit in a Low Yield World added:
"Low Yields Tend to Coincide with Higher Spreads and Default Rates: While low yields are often associated with slow growth, thereby justifying wider credit spreads, other factors can keep spreads wide, including the trouble companies have in inflating away their nominal debt (higher default risk). History tells us that if growth eventually picks up while yields stay low (1930s-1950s), spreads can indeed normalize."
Deflation is still the name of the game and it should be your concern credit wise (in relation to upcoming defaults), not inflation as per Morgan Stanley's note:
"While one could argue that default rates could be high during times of higher yields owing to higher debt service cost, the opposite is actually true. High inflationary environments allow corporations to inflate away their nominal debt as their assets (and revenues) grow with inflation, leading to lower default rates. Low inflation environments, like the one we’ve had for the past 25 years, tend to be ones where defaults can spike."

The liquidity picture is Europe is not improving - Source Bloomberg:
We all know by now why liquidity matters...

So, no time for complacency, as my good credit friend put it from our conversations in a couple of sensible points:
"As we move now toward the end of the year and the market still seems to have some momentum to go higher (both in equity and in credit prices), I would like to focus on various news and information that will drive the market in the future.

1-Bank of America Corp. may bolster its balance sheet by exchanging preferred securities for a total of $6 billion of common shares and debt. The proposed transactions may lower interest and dividend costs and improve capital levels, the Charlotte, North Carolina-based lender said in a regulatory filing. The firm may seek to issue as much as 400 million common shares and $3 billion of senior notes in privately negotiated deals...Will other banks follow suit? We have already seen European banks trying to raise capital ahead of the European Summit decision: Tier 1 tender offer at some steep discount (BPCE, Banco Espirito Santo) and Subordinated Debt tender/exchange for equities (Banco Espirito Santo) at a big cost for both bonds and shares holders…I think we will see more banks taking the same path to raise capital in the next 9 months.

2-The EFSF leverage details are still unknown and the SPV supposed to attract investors...has not attracted real money so far. There have been a lot of words and hope, but nothing real. So a lot of assumptions about the efficiency of “The European Backstop” may well appear to be wrong.

3-Greece will not be able to pay its debt with the actual “voluntary 50% haircut” accepted by private investors. I crushed the numbers many times; the Greek total debt reduction will not be bigger than 35% of the country total liabilities, which is far from being enough for the economy to recover. I expect more pain for debt holders in the future, unless Greeks decide on what they can afford to repay.

4-The European economy is already in a mild recession. Even the new ECB chairman acknowledges it. But banks balance sheet deleveraging and austerity budgets throughout Europe will weigh more on the economy, which will have far reaching consequences worldwide. I think the outcome is totally under estimated by market players. As an example, according to the BIS, European banks lend today roughly $ 3.5 trillion to the emerging countries, while the number for the US banks is only roughly $ 975 billion, and for Japanese banks about $ 750 billion.

5-Starting in January 2012, the refinancing needs for States, banks and corporate will be “enormous”. It will occur at a time of economic weakness, with a looming credit crunch. Do not be too complacent as there will necessary be casualties."
We discussed bond tenders from point number 1 in our post "Subordinated debt - Love me tender?":
"We expected others to follow suit and given the difficulty for the weaker players in the peripheral space to access capital at a reasonable rate, as well as needing to boost their core Tier 1 capital base, it was of no surprise to see Portuguese bank Banco Espirito Santo following French bank BPCE in tendering some of its subordinated debt on the 18th of October, but this time around, we have a debt to equity swap"

My good credit friend commented at the time:
"Banco Espirito Santo total market cap is approximately euro 1,743 million…which means 83.5% dilution for the current shareholders!"
And I added:
"So, in our debt to equity swap, courtesy of the subordinated bond tender, not only the subordinated bond holder is taking a hit, but our shareholder as well. Love me tender?"

Here is a recap on the levels for Banco Espirito Santo Tier1 Subordinated bonds as of the 3rd of November:
EXCHANGE LVL @ 1.80 (equity price at the time of exchange...)
BESPL 5.58% 07/14 41/45 (cash price) - 61 (47.5 adj)
BESPL 4.5% 03/15 46/49 (cash price) - 66 (51.3 adj)
BESPL 6.625% 05/12 52/56 (cash price)- 74 (57.6 adj)
Adj. exchange px calculated using current stock price (1.40)

The recent European Banking Association reaction relating to beefing up Core Tier 1 capital to 9% before June 2012 is akin to shooting oneself in the foot. How can you raise private capital in these challenging market conditions and refinance at the same time?

On that very subject, JP Morgan published its Banking Sector Outlook for 2012 on the 4th of November entitled - The Great Bank Deleveraging:
"In our opinion European banks increasingly face the challenge of being stuck between a rock (increased regulatory requirements) and a hard place (pressure to grow lending whilst facing increasing funding pressures). Banks will need to deal with increased funding and solvency pressures, in addition to regulatory constraints on liquidity management, which ultimately should incentivize banks to reduce balance sheets. We think that this strategy will mostly be undertaken by banks rolling over a lower proportion of non-loan assets and loan commitments at maturity, rather than the aggressive pursuit of asset sales."

And JP Morgan to estimate the impact:
"Given these constraints, we have modelled a deleveraging strategy for a peer group of 28 of the largest European banks for which we estimate a net reduction of €834bn in assets over a 12 month period. We highlight that this reduction in balance sheet size is mostly driven by the attrition of loan and non-loan assets as these mature, with limited scope for asset sales given the potentially negative impacts on solvency. In our opinion there is greater scope for deleveraging of non-loan assets such as securities inventories as these reach maturity given that these may not be eligible for the purposes of LCR (Liquidity Coverage Ratio). If we scale up our estimate of balance sheet reduction to the broader European banking sector we derive a total deleveraging outcome of €1,993bn which would represent 4.7% of total sector assets and is in line with the recent guidance from the IIF (Institute of International Finance). It will be difficult to assume that such deleveraging will not have an impact on the broader economic environment."
And in relation to term funding, JP Morgan estimates:
"We expect that term refinancing pressures are likely to persist for the European banking sector in 2012, particularly given the more limited scope for Yankee issuance which was valuable support for the sector in H1’11. In our opinion the implementation of a guarantee scheme will be crucial in achieving some type of market normalization and we think is a preferable alternative to the extension of tenors on ECB liquidity facilities. We think that a guarantee scheme will necessarily have to operate at a supra sovereign level, with the pricing of such facilities being more problematic than they were in 2008/09 given the difficulty in establishing pre-crisis spread levels for the participating banks. While there has been a lot of focus on the reduced access of European banks to US money market funding, we expect that this will be replaced by increased recourse to ECB funding."

JP Morgan also agrees with our previous discussions relating to debt tenders and debt to equity swaps trend:
"Our base case is that the implementation of a statutory bail-in regime will result in the authorities having the discretion to impose losses on the more subordinated parts of the capital structure (Tier I and Tier II) before exposing taxpayers to potential losses. In our opinion there is a lot less resistance to forcing losses on legacy subordinated debt instruments, as we have seen amongst the Irish banking sector where specific legislation provided the flexibility to force such losses, an outcome which in future may be achieved under a standardized resolution regime.
We also highlight increased risks with regard to issuer behavior on the exercising of calls on legacy Tier I and Tier II capital instruments."*
*This is exactly what we previously discussed in our post "Crash Test for Dummies" on the 18th of September:
"But, it is clear that not all banks have the same liquidity/funding costs, particularly today. So the game is going, once again to be as follows, remember: "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." (Macro and Markets update - It's the liquidity stupid...and why it matters again... ), banks with access to cheaper senior term funding than the cost of their outstanding LT2, for them, an early call could make sense, compared to the cost of issuing senior debt. For the others, I am not so sure..."

I concluded at the time:
"So, dear credit friends, I am afraid to say that, skipping calls, are going to happen, and will trigger losses because end of the day, why would you call a bond, if it costs you more to issue a new one?

This time is different? Nope. It is still deleveraging."
As Aesop put it: "the truth - don't let that get swallowed up by the great chewing complacency."

In relation to the EBA's estimate of 106 billion euro of capital shortfall for bank, it is complacent, to say the least...
Here is what JP Morgan had to say relating to the above in their report:
"We therefore subject the 70 institutions defined in the last stress test to the incremental stress from the July exercise as well as the valuation adjustments of the October test to a core Tier I ratio of 9%. While we acknowledge that time may have been a factor for the last EBA stress tests, we think that it would have been relatively straightforward to make the necessary adjustments to derive a more complete picture for the sector’s solvency requirements. Under these scenarios we highlight that the capital shortfall for the sector for the 70 banks goes from a risible €0.9bn in July to the €106bn in October, with our combination of these stress scenarios highlighting a capital shortfall of €280bn. While time may have been a factor in the EBA producing a more limited stress test, we also note the very obvious inconvenience of producing a capital shortfall which may have been significantly beyond the available resources."
No stress, no test; no test, no stress...

As a reminder from our conversation "Long - Hope Short Faith":

"Something has gotta give" - subordinated bondholders or shareholders, or both:

And DVA will bite back shortly as well bank earnings, remember it works both ways, on spread widening, as well as on spread tightening...I call it the boomerang effect.

On a final note, here is what UBS had to say relating to Sovereign CDS in relation to naked ban and CDS not triggering on the 4th of November "Unintended consequences":
"Although the sovereign CDS market is small in terms of net exposure, the consequences could be severe if belief in the instrument’s ability to pay out wavers or there is an outright ban on sovereign CDS. Investment bank counterparty risk management depends on sovereign CDS to hedge sovereign exposure, as does market making of government bonds in the secondary market. A loss of faith in sovereign CDS as a hedge would force market makers to cut their inventory, which would lead to a rise in sovereign yields and funding costs. Sovereigns could be shut out of the OTC market as banks would be unable to hedge their counterparty exposure."
"My dear brothers, never forget, when you hear the progress of enlightenment vaunted, that the devil's best trick is to persuade you that he doesn't exist!"

Charles Baudelaire, French poet, "Le Joueur généreux," pub. February 7, 1864

"The greatest trick the devil ever pulled was to convince the world he didn't exist"
Roger "Verbal" Kint- The Usual Suspects

Stay tuned!

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