Tuesday 17 January 2012

Markets update - Credit - The European Principle of Indifference

"Insanity: doing the same thing over and over again and expecting different results."
Albert Einstein

"In a macroscopic system, at least, it must be assumed that the physical laws which govern the system are not known well enough to predict the outcome. As observed some centuries ago by John Arbuthnot (in the preface of Of the Laws of Chance, 1692):

It is impossible for a Die, with such determin'd force and direction, not to fall on such determin'd side, only I don't know the force and direction which makes it fall on such determin'd side, and therefore I call it Chance, which is nothing but the want of art....
Given enough time and resources, there is no fundamental reason to suppose that suitably precise measurements could not be made, which would enable the prediction of the outcome of coins, dice, and cards with high accuracy: Persi Diaconis's work with coin-flipping machines is a practical example of this." - source Wikipedia

The "Principle of insufficient reason" was renamed the "Principle of Indifference" by the economist John Maynard Keynes (1921), who was careful to note that it applies only when there is no knowledge indicating unequal probabilities - source Wikipedia
Keynes was refuted by Frank Ramsey, but this is another story...

As a follow up to our Bayesian thoughts and following the recent Standard and Poor's downgrade of 9 European countries, our Principle of Indifference analogy relates to the European ongoing crisis. It seems our European politicians are applying the principle incorrectly, not only leading to nonsensical results, but as well as to nonsensical decisions (PSI on Greece, EFSF, and more). In this credit conversation, we will discuss collateral damage to our CPDO EFSF, again on Goodwill impairments ("Goodwill Hunting Redux") and more. But before, we go through the nitty-gritty; it is time for a quick Credit Market overview.

The Credit Indices Itraxx overview, slightly better in a quiet European session even after the downgrades - Source Bloomberg:
A fairly quiet day in the credit indices space with US being out. Overall credit indices were tighter while the Securities Markets Programme (courtesy of ECB) was in for the bid on the sovereign bond cash side.
The Itraxx Crossover 5 year index (50 High Yield companies) fell about 16 bps to close around 710 bps and Itraxx Main Europe 5 year index (125 European investment grade names) was tighter as well, around 167 bps, 5 bps tighter.

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:
Still record holding at the ECB's overnight facility earning 0.25%, one more days until the start of a new reserve period on the 18th.

The current European bond picture with more respite for Italy and Spain courtesy of SMP intervention (ECB) - source Bloomberg:

No change on "Flight to quality", with tighter Germany 10 year Government bond still trending towards record lows - Source Bloomberg:

And our interesting disconnect between the 10 year German Bund and the Eurostoxx is still there, (we first noticed this disconnect in our post "Mind the Gap..." - source Bloomberg:

But the most significant movement we saw today was relating to Sovereign CDS, between Ireland and Portugal, a new record 510 bps between both countries - source Bloomberg:
Ireland 5 year CDS was at 800 bps on the 27th of September 2011 (see our post"Much ado about nothing").

As a follow up on our conversation "Long hope - Short faith", we were expecting Austria's sovereign CDS to trade wider than France at some point, courtesy of the Austrian banking sector Hungarian issues. Following the downgrade of both countries last Friday, we are getting closer to the point - source Bloomberg:

In relation to our CPDO/EFSF, following up on Friday's action, Standard and Poor's has effectively downgraded the leveraged structure from AAA to AA+.
Back in our "European Flutter" conversation we argued:
"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..."

How would a downgrade of a member country affect EFSF? - source EFSF
"There is a credit enhancement structure used under the Framework Agreement which constitutes the EFSF. Therefore a downgrade of a member country would not necessarily lead to a downgrade of EFSF securities."
Time to update the presentation...

Standard and Poor's stated:
"We consider that credit enhancements that would offset what we view as the now-reduced creditworthiness of the EFSF's guarantors and securities backing the EFSF's issues are currently not in place. We have therefore lowered to 'AA+' the issuer credit rating of the EFSF, as well as the issue ratings on its long-term debt securities."

What is the credit enhancement structure?
"In order to ensure the highest possible credit rating, various credit enhancements were put into place:
- an over-guarantee of 120 per cent on each issue.
- an up-front cash reserve which equals the net present value of the margin of the EFSF loan.
- a loan specific cash buffer
Together these credit enhancements ensure that all loans provided by EFSF are backed by guarantees of the highest quality and sufficient liquid resource buffers. The available liquidity is invested in securities of the best quality." - source EFSF

But given's Germany's Supreme Court recent reluctance on increasing the EFSF's firepower without a popular vote, we seriously doubt the credit enhancements expected by Standard and Poor's to reverse their negative outlook will materialise in the near future for the EFSF given:

"Unlike the EFSF, ESM.s structure will comprise paid-in capital, callable capital and guarantees. This therefore means that the ESM would not require the credit enhancements (over-guarantee, cash buffer and cash reserve) that the EFSF requires in order to secure a AAA rating." - source EFSF

We already discussed at length the frailty of the EFSF - "EFSF - If you are in trouble - double".
- source EFSF

Could EFSF be considered as a Collateralized Debt Obligation (CDO)? - source EFSF
"No, EFSF is not a CDO. The essential difference between EFSF and a CDO is that EFSF debt has no tranche structure. There is no seniority and all investors have exactly the same rights. Secondly, EFSF bonds are covered by the guarantees from the euro area countries. However, a triple-AAA rating from all three leading credit rating agencies is not assigned lightly. EFSF has put into place additional credit enhancements through the use of a cash reserve and loan specific cash buffer which are immediately deducted from the loan made to a borrowing country in order to provide additional reassurance to investors. Consequently, all claims on the EFSF are 100% covered by AAA guarantors and cash."

We would have to agree, the EFSF is not a CDO, it is worse. More akin to a CPDO, and given it has no tranche structure and no seniority, as we argued previously "the loss in NAV can be significant", suffices to say, it can just be binary.

Following up on BayernLB's goodwill impairments discussed in our "Bayesian Thoughts", we forgot to mention BBVA which took a Goodwill impairment charge of 1.5 billion euros, which according to CreditSights counter-intuitively helps improve its regulatory capital by generating an immediate tax credit:

"The 400 million Euros tax credit is offset against current taxation and relates to a gross goodwill impairment charge of about 1.5 billion euros rather than 1.1 billion euros, because of rounding differences. 400 million euros equates to an increase in retained earnings flowing into Core Tier One versus the retained earnings that would have been achieved without the goodwill impairment of the tax credit. This is because the gross impairment of 1.5 billion euros does not affect Core Tier 1, since all outstanding goodwill is already discounted in the regulatory number, even though in accounting terms, shareholders'equity will be negatively affected on the balance sheet. The benefit in ratio terms is 14-15 bps worth of Core Tier 1(which stood at euros 25,979 million at 30 September under the EBA Criteria).
Our understanding is that BBVA will be able to offset this against tax payable for the whole of 2011. Although a tax charge is accrued quarterly in the P&L, it is actually paid on an annual basis, so the lack of sufficient pre-tax earnings in the fourth quarter alone should not prevent the group from offsetting the 400 millions euros against the tax that will be payable on the full-year 2011 earnings."

So, no earnings mean no Goodwill impairment impact on earnings and a convenient tax credit in conjunction with an improved regulatory capital.

So yes, "Tracking goodwill impairments will indeed be a necessary exercise in 2012 as they can take a real chunk out of bank earnings in the process."
Indeed an interesting exercise in 2012.

Although Swedbank wasn't as lucky as BBVA, given, according to CreditSights:
"Swedbank: SEK 1.9 (215 millions euros) billion Latvian Goodwill Impairment in Q4 2011, a 49% impairment on the total goodwill of SEK 3,870 millions. The goodwill write-down will make a dent in Swedbank's FY11 profits when it reports on 14 February, but the size is manageable. Latvia remains a key market for Swedbank, but although economic growth revived in 2011, it is likely to show signs of slowdown in 2012."
On a final note, we leave you with Bloomberg Chart of the Day - "Collateral Damage’ to EFSF Fund":

Jan. 16 (Bloomberg) -- "Standard & Poor’s Jan. 13 downgrade of nine euro-area countries, including France and Italy, risks blunting trust in Europe’s main weapon against the debt crisis. The CHART OF THE DAY shows the zone’s average rating, calculated by Bloomberg from the three main evaluators’assessments, worsened to 3.56, implying three grades below the top level, from 3.27 on Dec. 31. The average is calculated by assigning each grading a number, with 1 as the top rating, and adjusting it for each country’s share in the bailout fund called the European Financial Stability Facility."
"In individuals, insanity is rare; but in groups, parties, nations and epochs, it is the rule."
Friedrich Nietzsche

Stay tuned!


  1. There was a highly read article in the FT today about Portugal possibly being on the way to default. As currently stands, analysts are saying Greece will default in March when 14.5 billion Euros come due. Inevitably, this spreads to Portugal, so they are next in the default line. Then what? A firewall between these two and Italy?

  2. Portugal is indeed the most obvious next target for a haircut, given its current situation, debt dynamics, poor growth or lack of, weak productivity and so on. I will touch more on the probability of Portugal leaving the Euro Zone, on my next post which I will hopefully post tomorrow. Divergence in unit labor cost is an issue, but most of all salary growth in real terms particularly in the public sector, have been rising too fast in most peripheral countries. Given they can't adjust via devaluations, it is problematic. The only credible firewall which can be set up, would be massive intervention via ECB, but it seems, the ECB has been less direct in its interventions in relation to debt purchases via SMP in recent weeks, months.


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