Wednesday 2 November 2011

Markets update - Credit - Leda and the (Greek) Swan and why Europe matters for Emerging Markets

"Leda and the Swan is a motif from Greek mythology in which Zeus came to Leda in the form of a swan. According to later Greek mythology, Leda bore Helen and Polydeuces (Pollux), children of Zeus, while at the same time bearing Castor and Clytemnestra, children of her husband Tyndareus, the King of Sparta." - Source Wikipedia.

The Greek referendum, "swan"-tail risk like event, inspired me to use this time around this particular reference to Greek mythology, Leda and the Swan. I found it interesting, as the union of Leda and Zeus in the form of swan, led to the birth of Helen (which ultimately led to the demise of Troy and the Trojan War), but it also led to the birth of Castor and Polydeuces (Pollux), the Dioscuri:
"The Dioscuri were regarded as helpers of mankind and held to be patrons of travellers and of sailors in particular, who invoked them to seek favourable winds." - Source Wikipedia.

So now the ECB has a stark choice, similar to the one Pollux was given by Zeus, to save his dying brother Castor by sharing his immortality with his mortal brother (namely European peripheral countries) or spend his time in Olympus (letting Europe fail, one country after another). The ECB is the only institution that can step in and become the lender of last resort, effectively becoming in essence a FED like entity which should be backed by a central treasury (and we discussed this point in our last conversation), or doing nothing and our Greek swan might take us to another path...

We know that Pollux made the right choice and enabling in the process, the two siblings to become the two brightest stars in the constellation (Gemini).

And the Dioscuri "characteristically intervened at the moment of crisis, aiding those who honoured or trusted them." - Source Wikipedia.

But I digress, once again, time for a Credit Market overview as there are plenty of items to discuss.

The Credit Indices Itraxx overview - Source Bloomberg:
There was some small respite today following the massive surge in credit indices which followed the announcement of the Greek referendum.
The Itraxx Crossover CDS 5 year Index (High Yield gauge) fell about 15 bps around lunch time, following its preceding massive widening of nearly 85bps on the 1st of November (Itraxx Indices summary for the 1st of November: Europe Main at 180 (+22 bps), Sub Financial at 480 (+65 bps) and Crossover at 725 (+85bps). Big widening movement).

While the absolute spread between Itraxx Financial Senior Index 5 year CDS and Itraxx Main Europe 5 year CDS (Investment Grade) seems to be receding somewhat from a wide point of 114 bps reached in September - Source Bloomberg:

The absolute spread between Itraxx Financial Senior 5 year CDS index and Itraxx Financial Subordinate 5 year index has yet to recede to more normal levels, indicating ongoing difficulties for Financial institutions to secure subordinated funding at acceptable level, meaning the only source of funding for core European institutions being Senior Unsecured debt or covered bonds - source Bloomberg:

According to Barclays Capital High Grade Supply update relating to October (23.3 billion Euros unsecured bonds issued, including 9.3 billion Euros of Financial bonds issued); Euro Investment Grade issuance was significantly better in October than in September but here is what they had to say:
"Overall we remain relatively sanguine on the funding needs of European financials. We would expect them to actively exploit any periods when secondary market conditions improve and primary markets open up more fully. However, even if credit markets endure yet another bout of significant volatility, European financial institutions retain a large number of alternative funding options, including covered bonds, MTN placements, the non-Euro debt markets, deposit funding and balance sheet shrinkage.
Alternative funding channels have been further supported by the ECB’s announced resumption of the Covered Bond Purchase Program, and extended by the announced plan to initiate government guarantee scheme for bank liabilities. Further, the ECB has committed to generous liquidity provision until mid-2012. Given all this, we would echo the view of our bank analysts that at this juncture asset quality rather than liquidity is the primary driver of spread performance of European banks."

So, if we have a very negative reaction with heightened volatility at the beginning of 2012, courtesy of a bad outcome for the upcoming Greek referendum, it could become problematic for banks to access term funding, given traditionally, the beginning of the year is a very heavy month of issuance in the credit space.

In fact the funding needs for 2012 are significant. According to Bloomberg article from Ben Martin and David Goodman from the 25th of October citing CreditSights, Europe Banks must find 900 billion dollars in 2012:
"Banks in Europe have to refinance 655 billion euros ($911 billion) of senior bonds next year and may need government backing if the debt crisis continues to block access to markets, according to CreditSights Inc.
Unless funding access eases, we might see banks having to use government guarantees again, and it will add to the pressure on them to reduce assets in order to lower refinancing needs,” said Simon Adamson, an analyst at the independent research firm in London. “I would think only a small proportion has been pre-funded, given that the markets have been virtually closed since July.
Western European lenders raised about 80 billion euros of senior unsecured debt this year, according to data compiled by Bloomberg. That’s down from 97 billion euros for the same period in 2010, as investors worry that banks, the biggest holders of sovereign debt, will face losses as the crisis escalates."
If banks cannot access term funding, given the deleveraging they ambition to do, it could put additional pressure on bank lending, in effect reducing access to credit for the economy, namely triggering another credit crunch in the process.

And my good credit friend to comment:
"European banks are the key to the future, and bank shares are still bleeding with no fundamental improvement to be expected in the near term. Raising capital remains difficult for most actors, even after the EBA (European Banking Association) reduced the capital needs significantly compared to what was initially estimated by various professionals. So we are entering one of these very interesting times in history where we will see banks reducing their balance sheet at the same time when European governments start implementing austerity budgets. Such a combination is definitely not supportive for the European economy as a whole, and will have far reaching impacts on the Global worldwide economy (Yes, European banks lend worldwide, not only to Europe)."
Here are some important facts to bear in mind - Source Bloomberg - Allison Bennett and Ye Xie - 7th of October 2010:
"The $3.4 trillion in lending to emerging markets from banks in Europe, including Germany and the U.K., compares with $299 billion from Japan and $727 billion from the U.S., according to BIS data as compiled by Royal Bank of Canada."

From the same article:
"European banks’ lending to Hungary amounted to more than 70 percent of that country’s GDP, according to estimates by Barclays Capital based on BIS data. Lending to Poland reached 40 percent of GDP, and that to Brazil and Mexico was equal to about 20 percent of their economies.
Lenders are already cutting back. London-based HSBC Holdings Plc was the No. 6 arranger of syndicated loans in the Asia-Pacific region outside Japan last quarter, down from No. 4 a year earlier, Bloomberg data show. Montrouge, France-based Credit Agricole SA dropped to 21 from 17, while Royal Bank of Scotland Group Plc, which sold assets in Asia after receiving the biggest bailout in banking history from the British government during the financial crisis, fell to 25 from 19."

Source - Emerging Markets Bank Lending Conditions Survey - IIF

The liquidity picture has not materially improved - Source Bloomberg:

In relation to flight to quality, risk-off came back with a vengeance on the 1st of November with a massive tightening movement on German 10 year government yields (25 bps, biggest decline in a day since 1992) and German Sovereign 5 year CDS widened as well in the process, from convergence, to divergence again:

Truth if the bond picture in the European space is increasingly becoming a concern with Italian 10 year yields reaching 6.24% (and not only for MF Global) - Source Bloomberg:

We also continue to see Italy 5 year Sovereign CDS widening versus Spain 5 year Sovereign CDS - Source Bloomberg:
Yet another record, with 125 bps between Italy and Spain, CDS wise.
French 10 year bonds are not spared either versus their German counterparts - Source Bloomberg:
A new record today, reaching 129 bps.

French bonds were not helped by the suspension of the EFSF bond auction which was supposed to take place today- Source Bloomberg:

Given banks are reluctant to raise new fresh capital by issuing right issues which in effect would dilute existing shareholders, the ongoing deleveraging process threatens economic growth in essence. The issue of circularity we discussed means that the higher government bonds yields rise, the higher premium banks will have to concede via new bonds issuance, the higher the risk of capital shortfall and cost of funding, the higher need to reduce the balance sheet and restrain credit.

There is no cheap option there. Capital injection will have to proceed at some point. As Liam Vaughan and Gavin Finch in their Bloomberg article from the 31st of October stated (Europe Tries to Recapitalize Its Banks Without Injecting Capital):
"Greece’s six banks will need to raise about 30 billion euros, more than any other EU member state, the EBA said. That shortfall is covered by existing backstop arrangements with the EU and International Monetary Fund, so Greek lenders wouldn’t have to tap investors, according to the EBA."
From the same article relating to EBA June 2012 core tier one capital target of 9%, banks need to raise at least 106 billion euros according to the EBA's calculations:
"Southern European banks that can’t raise capital may still need to shrink their balance sheets by as much as 40 percent to meet the new requirements and run the risk of having to rely on state injections, Mediobanca analysts including Alain Tchibozo wrote in a note to clients on Oct. 28."

In effect putting sovereign ratings at risk in the process and crushing economic growth at the same time and affecting Emerging Markets as well.

"Liquidity is a backward-looking yardstick. If anything, it’s an indicator of potential risk, because in “liquid” markets traders forego trying to determine an asset’s underlying worth - - they trust, instead, on their supposed ability to exit."
Roger Lowenstein, author of “When Genius Failed: The Rise and Fall of Long-Term Capital Management.” - "Corzine Forgot Lessons of Long-Term Capital"

We know by now from our many conversations, liquidity does indeed matter.

Stay tuned!

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