Tuesday, 20 December 2011

Markets update - Credit - The European Flutter

"Even as I approach the gambling hall, as soon as I hear, two rooms away, the jingle of money poured out on the table, I almost go into convulsions."
Fyodor Dostoevsky, The Gambler - 1867

As a follow up to our "Generous Gambler" from 1864, our title analogy, this time around has many dimensions.

A flutter is a colloquial term for a bet or a wager in gambling, but, in relation to the European situation, an "Aerolastic" flutter seems more appropriate to the current predicament of the European failing structure.

"An Aerolastic Flutter is a self-feeding and potentially destructive vibration where aerodynamic forces on an object couple with a structure's natural mode of vibration to produce rapid periodic motion. Flutter can occur in any object within a strong fluid flow, under the conditions that a positive feedback occurs between the structure's natural vibration and the aerodynamic forces. That is, the vibrational movement of the object increases an aerodynamic load, which in turn drives the object to move further. If the energy input by the aerodynamic excitation in a cycle is larger than that dissipated by the damping in the system, the amplitude of vibration will increase, resulting in self-exciting oscillation. The amplitude can thus build up and is only limited when the energy dissipated by aerodynamic and mechanical damping matches the energy input, which can result in large amplitude vibration and potentially lead to rapid failure." - source Wikipedia.

And "Flutter" can occur on other structures than aircraft (the 1940 Tacoma bridge failure for example). Indeed, when discussing recently our European Peregrine Soliton, we already touched on nonlinear resonance shift, leading to formations of "rogue" waves and circularity issues.
Therefore, our European flutter could lead to another type of flutter, the "Atrial" type (heart failure)...So, could the European Union face the same outcome as the 1940 Tacoma Narrow Suspension Bridge? But here I go again in my usual rambling habit.

Before we enter in a longer than usual credit conversation, our last for 2011, discussing LTRO, revisiting upcoming goodwill impairments for European banks, IMF, deleveraging and the Eurozone's core issue, courtesy of my global macro friends at Rcube Global Macro Research, namely Unit Labor Cost Divergence, it is time for a quick credit market overview.

The Credit Indices Itraxx overview - Source Bloomberg:
Better tone in the CDS space with German IFO coming better than expected at 107.2 (106.1 expected), but given the absence of liquidity, it is of no surprise to see somewhat some sort of relief rally on the eagerly extended LTRO by the ECB. Yesterday was roll date for single name CDS rolling to March, whereas credit indices roll every 6 months.

Itraxx Financial Senior 5 year index (linked to senior debt of 25 banks and insurers) and Itraxx Financial Subordinate 5 year index still remain elevated as we move towards year end - Source Bloomberg

Most interestingly in the sovereign space is the ongoing divergence between Spanish 5 year Sovereign CDS and Italy - source Bloomberg:
The much expected 3 year LTRO has had a significant impact as well on government bond spreads.

The current European bond picture, a story of ongoing volatility, also displays similar divergence between Italy and Spain - source Bloomberg:
Spain today successfully placed 5.64 billion euros, above the maximum target (4.5 billion euros) at much improved yields of 1.735 for three months compared to 5.11% at the previous auction of November 22nd, at similar demand levels 2.86 times versus 2.85 times last month. 6 months paper was placed at 2.435% down from a previous 5.227%, at a lower bid to cover of 4.06 times compared to 4.92 previously.
Bank of Spain is encouraging Spanish banks to borrow at the ECB and buy Spanish government bonds.

The loosened collateral rules by the ECB is helping the peripheral banking sector in borrowing more at the ECB but the liquidity picture is far from improved - The liquidity picture in four charts. ECB Overnight Facility, Euro 3 months Libor OIS spread, Itraxx Financial Senior 5 year index, Euro-USD basis swaps level - source Bloomberg:

Every cloud has its silver lining?
Truth is the Spanish banking sector is a long way from being out of trouble as indicated by Charles Plenty in Bloomberg on the 19th of December in his article - Spanish Bad Loans Jump to 17-Year High as Lending Falls: Economy

"Spanish banks reported more bad loans and lower lending and deposits in October, hurt by the fallout of the country’s property crash and the European sovereign debt crisis.
The ratio of bad loans as a proportion of total lending climbed to 7.42 percent, the highest level since 1994, from 7.16 percent in September and 5.68 percent a year earlier as the value of borrowings in default rose to 131.9 billion euros($171.9 billion), the Bank of Spain in Madrid said in a statement today. Lending fell 2.5 percent from a year ago, following a record 2.6 percent drop in September, and deposits slid 2.2 percent to their lowest level since 2008.
Rising defaults and declining loans and deposits show how banks are suffering from the fallout of Spain’s property slump and a wider European debt crisis that has shut them out of wholesale debt markets."

When austerity bites...

Also from the same article:

“What we have been saying for a while, and I think the banks themselves have been in denial on this, is that the asset quality decline has not bottomed out yet because unemployment is still going up,” said Inigo Lecubarri, who helps manage about $300 million at Abaco Financials Fund in London. “A non- performing loans ratio of 7.4 percent is already very bad. Ten percent would be catastrophic and it’s not impossible we could get there.”

In our previous conversation we argued the following:

"In addition to this, the sovereigns 2012 massive funding needs will result in a deadly competition between the protagonists to raise whatever money is available, resulting in much higher funding costs and the collapse of those with weaker balance sheets."

Ignacio Lecubarri seems to agree with us as he indicated in the same Bloomberg article:

"Spanish bank deposits are shrinking at a time when lenders are being forced to compete for funds between themselves and also with the government, Lecubarri said."

It is still the same game of survival of the fittest which leads to touch again goodwill impairments for European banks, a subject we discussed back in November in our post "Goodwill Hunting Redux", CreditSights in a note published on the 18th of December entitled - Season of Impaired Goodwill, seems to be sharing our concerns:

"The UK veto impaired a lot of political goodwill, both within the country's coalition government and with its EU partners. But Crédit Agricole (-16%) took the theme directly into the banking sector, announcing large write-downs of financial goodwill across a range of businesses with its profit warning on Wednesday. Coming on top of a €500 mln negative effect on net income from deleveraging, goodwill impairments totalling €2.5 bln will push the quoted entity Crédit Agricole S.A. into an overall net loss for the full year. The negative impacts of €3 bln compare with €1.6 bln earnings in the first nine months and a former consensus forecast of just over €400 mln for the fourth quarter, implying that the FY11 net loss could be €1 bln or more.

While goodwill is already deducted from Core Tier 1 capital and therefore does not affect ratios, the earnings effect can be highly damaging in the equity market, and there are bound to be more goodwill impairments to come in the near future from other banks, as they adjust projections of their subsidiaries' earning capacity to the current business and regulatory environment. The timing of impairment decisions is the hardest thing to second-guess, though."

Large goodwill impairments can affect a company stock price and spreads, as well as its debt ratings.

In this difficult funding environment, as per our previous conversations, not even our CPDO/EFSF has been successful enough in raising much needed funds. The CPDO/EFSF picture - source Bloomberg:
The potential downgrade of both France and the EFSF, would render it useless or far more dangerous as we indicated in our post "Much ado about nothing and CPDO redux in European Style", namely that:

"In a CPDO/leveraged EFSF, when multiple downgrades happen, creating significant widening in spreads/higher interest rates, the loss in NAV can be significant."

This would basically mean, that the more downgrades you get, the more leverage you need in order to make up for the increased shortfall in quality collateral...

Natixis bank in their latest 2012 Credit Yearbook indicated that the EFSF could raise 60 billion euros in 2012, taking into account the first Greek plan (compared to the 16 billion euros only raised in 2011...). Clearly not enough firepower to backstop European Sovereign debt for peripheral countries. ESM which should be deployed by 2012, is also depending on the economic situation of the members of the European Union as well as in the faith of investors.

One the most interesting point from Natixis latest Credit Yearbook was their simulation on Eurobonds and the impact they would have on European government yields:
Emphasis ours (click graph to enlarge). Natixis in their exercise take into account GDP growth projections, deficit and debt levels as well as funding needs for 2012, assuming 10 year Eurobond could be issued at z-spread +30bps (assuming quantitative rating of AA+ for the Euro zone as a whole). This would amount to 10.9 billion euros savings in funding, representing 1.4% of total funding needs.

My good credit friend and I discussed the following in relation to the latest IMF involvement or the rescue funds:
"To repeat what we discussed in our last conversation, neither the IMF nor the rescue funds can sort the solvency problem out. France is about to be downgraded, bringing down the EFSF structure. So anyone who thinks that the EFSF and the ESM will run in parallel has it wrong. Of course the ESM will remain, but its firepower will be far less than the Euro 500 billions earmarked, not enough to rescue all the peripheral countries under pressure. Of course, the IMF may help sovereigns funding issues but, it will do in accordance with specific rules: liquidity issues will be faced, solvency one will not. While we do not foresee major problems right now for the core European countries, the environment could change very quickly."

As the Head of the Canadian Central Bank just declared, “developed economies have regularly increased their debt leverage over dozens of years. But this period is now over. If the deleveraging trend is now clear, the speed and size of the process are not. This process could last and be done in an orderly way, or be abrupt and disorderly.”

Simon Johnson, who served as chief economist at the International Monetary Fund in 2007 and 2008, and is now a professor at the MIT Sloan School of Management and a senior fellow at the Peterson Institute for International Economics, had an interesting column in Bloomberg relating to the IMF involvement in the European Sovereign debt crisis on the 19th of December - IMF Bazooka Is Between Meaningless and Dangerous:
"Today’s proposed bazookas are about providing enough financial firepower so that troubled European governments do not necessarily have to fund themselves in panicked private markets. The reasoning is that if an official backstop is at hand, investors’ fears would abate and governments would be able to sell bonds at reasonable interest rates again.

This idea is just as dubious as Paulson’s original notion. Markets are so thoroughly rattled that if a financial backstop is put in place, it would need to be used -- probably to the tune of trillions of euros of European debt purchases from sovereigns and banks in coming months. Whether or not it is used, a plausible bazooka would need to be huge."

Simon Johnson also adding:
"Even if the IMF went all in for troubled Europe -- an idea with little support in emerging markets -- it wouldn’t make much difference. Italy’s outstanding public debt of 1.9 trillion euros is bigger than that of Greece, Ireland, Portugal and Spain combined. The country faces about 200 billion euros in bond maturities in 2012 and an additional 108 billion euros of bills, according to Bloomberg News. The euro area’s 2012 sovereign funding needs are estimated at more than $1 trillion next year alone, and any credible financing plan needs to fully cover 2012 and 2013 at a minimum. It remains unclear who is willing to fund European banks in this stress scenario.

The idea that the IMF could tap emerging markets for additional capital to lend to Europe is met with polite public demurrals. Behind closed doors, it’s not so polite.

The more innovative ideas involving the IMF include some financing provided by the European Central Bank or national central banks within the euro area to the IMF, with the fund then lending this back to Europe.

This would constitute a misguided or even dangerous form of financial innovation. If the precise arrangement involves the IMF taking credit risk, its membership should be worried about losing their capital. The U.S., as the largest single shareholder, would have the most to lose."

Similar to our "Generous Gambler" conclusion ("The greatest trick European politicians ever pulled was to convince the world default risk didn't exist", Martin - Macronomics), Simon Johnson ends his column with the following points which also resonate with our European Flutter analogy, namely failing structures due to inadequate design:

"Eighty years ago, most prominent officials and private financiers were confident that the gold standard should and would remain in place. Starting in 1931, the gold standard failed as a global financing system, with unpleasant consequences for many.

As 2011 draws to a close, the age of the global bailout also seems to be fading. Perhaps the Europeans will find a way to scale up their own rescues using their own money. Perhaps they will manage to protect creditors fully, and convince investors to lend to Italy again. More realistically, the bazooka standard is about to collapse."

Our European structure suffered from poor design such as the 1940 Tacoma Narrow Suspension Bridge. On a final note, the most evident Euro zone structural problem as highlighted by my macro friends from RCube in their recent paper comes from Unit Labor Cost divergence:

"In addition to being a political symbol, the Euro was supposed to offer two irresistible benefits to its members: (1) the Deutsche Mark’s low interest rates for everyone and (2) no more exchange rate volatility within the Eurozone.
Until 2008, the first benefit (lower interest rates) kept its promises. Italy’s yield spread against Germany went from 12% in 1982 to a mere 20bp in 2007. It actually worked so well for some countries that it led to huge housing bubbles, consumer credit bubbles and fiscal largesses, as deficits were easy to finance. Unfortunately, as we can see nowadays, these were all sources of phantom growth, i.e. growth that resulted from stealing from the future and not from increasing productivity. The debt crisis in the Eurozone is a direct result of this unchecked debt bubble.
The Euro’s second “benefit” (no more currency volatility) created another imbalance that will probably be even more painful to resolve than the first one. Since the last competitive devaluations of the early nineties, we have witnessed a huge divergence of Eurozone members’ unit labor costs (especially against Germany), as evidenced by the following chart 1:

1 We use unit labor costs rather than raw labor costs to take into account changes in productivity.

We start the series in 1995, 2 years after Europe’s last major devaluations.

"While Germany was going through painful social reforms, labor costs increased faster than productivity for many Euro members on a relative basis (average increase vs. Germany: 38% between 1995 and 2012).
The divergence ended during the 2008 financial crisis, as some countries (most notably Ireland) started to converge back towards Germany’s unit labor costs. However, we can see that we are still very far away from levels that could restore Eurozone members’ relative labor competitiveness against Germany.
Interestingly, we can notice that the five countries whose unit labor costs grew the most are the PIIGS. This is probably not a coincidence. Low labor competitiveness hurts the economy, thus lowering tax revenues, while public spending is used to hide the underlying decline of the economy. This leads to a degradation of the fiscal situation.
In a nutshell, labor forces in many Eurozone countries are now getting paid in a currency that is vastly overvalued compared to their productivity (this can also be seen in the degradation of the trade balance of many European countries including France).
To restore to competitiveness of PIIGS (and to a lesser extent France and Belgium), labor costs will therefore have to decrease significantly. There are many ways this could happen. We can think of at least four:
1) Very high unemployment rates combined with a dismantlement of welfare states (due to the debt crisis), would force people to discount the value of their labor.
2) As some economists proposed in the case of Greece during last summer, it could also be enforced through internal devaluations. These would obviously be much more difficult to accept than current austerity plans (which concern mostly public finances). Italy’s welfare minister bursted into tears after she announced an end to pension indexing. What would she do if she had to announce an across-the-board reduction in wages by 5% every year for the next 5 years?
3) Rather than living through a decade of austerity, some countries might end up preferring to leave the Euro. The pain would be very intense in the short-term, as inevitable devaluations would destroy the purchasing power of workers and savers, but it would eventually restore the competitiveness of their labor force.
4) The ECB could crash the Euro. Monetizing huge amounts of sovereign debt would contribute to this (in addition to solving the liquidity situation of PIIGS). However, Germany and other countries that are already competitive will oppose this. Additionally, it would not solve the structural problem of unit labor cost divergence, which would inevitably lead to new crises further down the road.
It is difficult to predict what path (or combination of paths) will be chosen by politicians. The one thing we strongly believe is that, whatever the path, real aggregate demand is going to crash a lot further in large parts of the Eurozone. Growth expectations remain way too optimistic.
This is why we consider that Europe’s P/Es of 8 are not cheap by any standards, and that the Euro is poised to fall against other currencies."
Reproduced courtesy of RCube Global Macro Research.

“I don't attempt to be a poker player before this crowd”
Dwight D. Eisenhower

Stay tuned in 2012! In the meantime we wish you all a Merry Christmas and a Happy New Year!

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