Sunday 11 December 2011

Markets update - Credit - The Generous Gambler

If it hadn't been for the fear of humiliating myself before such a grand assembly, I would willingly have fallen at the feet of this generous gambler, to thank him for his unheard of munificence. But little by little, after I left him, incurable mistrust returned to my breast. I no longer dared to believe in such prodigious good fortune, and, as I went to bed, saying my prayers out of the remnants of imbecilic habit, I said, half-asleep: "My God! Lord, my God! Please make the devil keep his word!"
Charles Baudelaire, French poet, "Le Joueur généreux," pub. February 7, 1864

While we already referred to Baudelaire's "Generous Gambler" in our post "Complacency" in conjunction with Verbal Kint's adapted quote from the Usual Suspects, the latest European summit and ECB statements inspired us, this time around, to refer to this great text from Charles Baudelaire.

But before we delve ourselves in another long credit conversation, it is time for a usual quick credit market overview.

The Credit Indices Itraxx overview - Source Bloomberg:
Sovereign CDS 5 year index (15 European countries sovereign CDS) led the widening on the back of the European summit, reaching around 366 bps, a weekly advance of more than 40 bps (the most since July according to Bloomberg), with Italy breaking ranks yet again, rising 20 bps to 545 bps, with ECB buying 10 year bonds at 6.54% yield.

The interesting point is that the SOVx Western Europe index on the 5 year is again wider than its Central Europe and Middle East counterpart, namely SOVx CE as per the below graph - source Bloomberg:

Itraxx Financial Senior 5 year index (linked to senior debt of 25 banks and insurers) and Itraxx Financial Subordinate 5 year index remains stubbornly elevated - Source Bloomberg:

The current European bond picture, a story of poor liquidity and volatility - source Bloomberg:

German 10 year government yield rising in lockstep with German 5 year sovereign CDS on ongoing European issues - source Bloomberg:

Our flight to quality indicator, the spread between 10 year Swedish government yields and German 10 year government yields. It looks like this relationship is breaking up again - source Bloomberg:

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:
The new reserve period for deposits at the ECB will start on the 14th of December and last 35 days.
The ECB awarded a significant extension of its liquidity facilities for Eurozone Banks from 13 months to 3 years, so that they could somewhat provide credit to the real economy. The European credit crunch has already started given the European Banking Association planned 9% Core Tier 1 by June 2012, means deleveraging on a massive scale. The EBA is also indicated banks need to raise 114.7 billion euros in new capital when it was only 9 billion needed following the July European banks "stress" test...
Broader collateral has been allowed for Asset Backed Securities, a looser rule, from AAA paper, now single A paper allowed.
25 bps rate cute given deteriorating growth prospects.

Our CPDO/EFSF yield on the rise again, courtesy of Standard and Poor's negative watch on the fund, following the agency's decision to put all 15 European countries (of our SOVX CDS 5 year index) on review for downgrade - source Bloomberg:
European Council President Herman Van Rompuy announced on Friday the EFSF would be rapidly deployed.
Fact: The EFSF has only raised 16 billion euros from four bonds this year and looking at the amount that needs to be raised in 2012, the prospect of raising more money is looking slimmer by the day.
We already discussed the flawed EFSF in our conversation "EFSF - If you are in trouble - double". Recent developments relating to the European summit were interesting, namely because the latest proposal seems to have the "transitional" EFSF rescue fund and the "permanent" rescue fund the European Stability Mechanism (ESM due to start in July 2012) running alongside each other.
In our previous October conversation this is what my good credit friend had to say about the proposed combine structure as a reminder:

"Main talks were about E.U. combining the EFSF and the ESM by mid-2012 to create 1 Fund with 940 billion euro (1.3 trillion US $) firepower.
Well, obviously there are a number of issues about such a conclusion….
The 500 billion Euro ‘permanent” bailout fund (ESM) was slated to replace the 440 billion "Temporary" European Financial Stability Facility (EFSF) fund. Well, the latest proposal that has the stock markets excited is to merge the two funds…. But there is a bias; it is double counting the money.
The total overall cap is 500 billion euros, of which 160 billion have already been committed or spend to help Greece. Therefore there is only 340 billion left! So how can you get 940 billion euros? This would raise the permanent fund above the agreed upon amount…. And the German Supreme Court has stated this cannot be done without a popular vote (referendum) !!! Also bear in mind that the German Supreme Court has ruled there should not be a permanent bailout fund at all…. Which add to the already constitutional issue."

Germany still remains against combining both structures.
On the latest headlines relating to the ESM, here is what my good credit friend had to say:

"The ESM is to be implemented as soon as July 2012, and the EFSF running in parallel for 1 year (please note that the combined firepower of the ESM/EFSF 500 billion euros only that might be revised in March 2012. Which means it will not be over 500 billion euros!"

We also had the agreement from European politicians to lend 200 billion euros to the International Monetary Fund via national central banks to be used for loans to troubled states and limiting so-called private-sector involvement (PSI) to the terms accepted in IMF bailouts was part of the package. The PSI was a major blunder which led to the questioning of "risk-free" status which we discussed in "The curious case of the disappearance of the risk-free interest rate and impact on Modern Portfolio Theory".

As a reminder, this is what Arnaud Marès, from Morgan Stanley in his publication of the 31st of August -Sovereign Subjects had to say about the PSI:
"'Private sector involvement' in the restructuring of Greek debt was in our view a major policy error, which has changed in a quasi-irreversible way the perception of sovereign debt in advanced economies as risk-free and therefore as safe haven assets. This has broadened the channels of contagion across Europe.
Does it matter that sovereign debt is risk-free? It very much does. If sovereign debt is no longer a safe haven, then the ability of governments to implement counter-cyclical policies is impaired. Fiscal policy is becoming at best neutral, at worst pro-cyclical. At a time when growth is rapidly slowing, the economic cost may be high.

Weakening the quality of government credit means weakening the fiscal backstop from which banks benefit. This risks resulting in an accelerated de-leveraging of bank balance sheets, with equally costly economic consequences.

Pandora’s Box has been opened. Only fiscal integration accompanied by centralised financing of governments can bring about full stabilisation of the market in Europe, in our view. The alternative could eventually be a resumption of the run on governments and a wave of public and private defaults.
The ECB can provide protection against a run, temporarily. While the ECB has the capacity to act as a lender of last resort, doing so exacerbates political tensions and is not a lasting solution, we think."

In relation to the IMF bilateral loans agreement, my good credit friend added:
"Provision of additional resources to the IMF of up to 200 billion, in the form of bilateral loans, to ensure the IMF has adequate resources to deal with crisis. Very interesting indeed! If the EU has 200 billion euros to spend, why not using them to increase the size of the ESM? Why do they need the IMF?"

As we pointed it out in our credit conversation "The European issue of circularity", "Nothing is more frequently overlooked than the obvious" (Thomas Temple Hoyne). The latest European agreements do not resolve the European issues!

As a follow up on our "Tale of Two Central banks", we would like to repeat Martin Sibileau's view we indicated back in October when discussing circularity issues:

"What would be a solution for the EU? We have repeatedly said it: Either full fiscal union or monetization of the sovereign debts. Anything in between is an intellectual exercise of dubious utility."

A Tale of Two Central Banks - according to Martin Sibileau:
“…The Fed was financing what we call in Economics a “stock”, i.e.( mortgages) “…a variable that is measured at one specific time, and represents a quantity existing at that point in time, which may have accumulated in the past…”
"The ECB is financing “flows”, deficits, or “…a variable that is measured over an interval of time…” Therefore, by definition, we cannot know that variable until the interval of time ends…When will deficits end? Exactly!! Nobody knows! Thus, it is naïve to ask more clarity on this issue from the ECB. The only thing that is clear here is that the Euro, i.e. the liabilities of the ECB will necessarily have to depreciate as long as that interval of time exists, until a clear reduction in the deficits is seen…”.

My good credit friend and I came to the following conclusion:

"We remain fundamentally negative on European markets for 2 reasons: a) the negative impact on the European economies from austerity measures which will be implemented by the governments, and b) the financial institutions’ deleveraging which will drastically reduce the funds available to the various agents of European economies. 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."

In relation to the deflation story playing out in Europe, here is an update on 30 year Swiss bond yields compared to Japan 30 years yield - source Bloomberg:

On a final note, I give you Bloomberg Chart of the day, showing bank US treasury holdings surging in echo of Japan:
"The CHART OF THE DAY shows bank ownership of U.S. Treasury and agency debt climbed to a record $1.71 trillion in the two weeks through Nov. 23, the latest period for which Federal Reserve data are available. It also tracks deposits at banks rising to the most ever. The lower panel charts an index of Treasuries maturing in 10 years and more.
Investors are snapping up Treasuries after Europe’s debt crisis slows global growth, helping send benchmark U.S. 10-year yields to a record low of 1.67 percent on Sept. 23. The trend echoes developments in Japan, where demand from lenders helped keep rates on 10-year government bonds, so called JGBs, at 2 percent or less since 1999."
Treasure treasuries?

"The greatest trick European politicians ever pulled was to convince the world default risk didn't exist"
Martin - Macronomics.

Stay tuned!

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