Wednesday, 25 January 2012

Markets update - Credit - The law of unintended consequences

"It is easy to dodge our responsibilities, but we cannot dodge the consequences of dodging our responsibilities."
Josiah Stamp

"The law of unintended consequences has come to be used as an adage or idiomatic warning that an intervention in a complex system tends to create unanticipated and often undesirable outcomes." - source Wikipedia

According to Robert Merton Senior there are five causes of unanticipated consequences:
"1.Ignorance (It is impossible to anticipate everything, thereby leading to incomplete analysis)
2.Error (Incorrect analysis of the problem or following habits that worked in the past but may not apply to the current situation)
3.Immediate interest, which may override long-term interests
4.Basic values may require or prohibit certain actions even if the long-term result might be unfavorable (these long-term consequences may eventually cause changes in basic values)
5.Self-defeating prophecy (Fear of some consequence drives people to find solutions before the problem occurs, thus the non-occurrence of the problem is unanticipated.)" - source Wikipedia.

So in this latest post, the latest FOMC's decision has brought to our attention another analogy, the law of unintended consequences. In this credit conversation, while going through our usual credit overview, we will be revisiting some of our calls with some additional subordinated bond haircuts (Unicredit this time around) creating more pain for subordinated bondholders, Portugal in the headlights (which does not come to us as a surprise), and we will attempt to analyse the latest FOMC's decision relative to the existing swap lines agreement between the Fed and the ECB and the consequences that come to our mind.

Time for our Credit overview.

The Credit Indices Itraxx overview - Source Bloomberg:
Not much has changed since our previous post, the Markit Itraxx SovX Western Europe 5 year CDS index (representing 15 countries)  is marginally tighter, around 332 bps points whereas both Itraxx Financial Senior 5 year index and Subordinated index are wider by a couple of basis points. Not a lot of volatility going on.

In relation to the liquidity picture, it is more of the same as well, as per our 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 current European bond picture with Italy starting to widen again slightly in conjunction with Spain - source Bloomberg

Some change in "Flight to quality" picture, with wider Germany 10 year Government bond flirting again with the 2% yield level  and falling 5 year CDS spread for Germany - Source Bloomberg:

 The 10 year German Bund and the Eurostoxx seem to reconnect at least from a directional point of view - source Bloomberg:

It is of no surprise to us to see Portugal taking center stage, following on current Greek negotiations with private bondholders (PSI). In fact we first noticed the decoupling between Ireland and Portugal in August last year in our post "Ireland June trade surplus - A glimmer of hope?":
"But, we are starting to see divergence between Portugal and Ireland, not only in the CDS 5 year space, but also in the 10 year government bond space:
Ireland 5 year CDS versus Portugal 5 year CDS, correlation was one and breaking since a couple of weeks."
Ireland 5 year sovereign CDS versus Portugal 5 year sovereign CDS spread.
Portugal 5 year Sovereign CDS has reached a new record level at 1312 bps, representing a cumulated probability of default of over 67% according to CDS data provider CMA.
The LTRO sparked rally on both financial stocks and senior bonds so far this year. But in relation to Portugal Sovereign CDS versus Portuguese banks financial CDS there is indeed an interesting dislocation as highlighted by a credit trader. Banco Espirito Santo senior 5 year CDS trades around 865 bps, 200 bps tighter year to date, whereas Portugal Sovereign CDS is around 240 bps wider year to date.   This is indeed the direct consequences of the ECB intervention as highlighted by Bank of America Merrill Lynch in our previous conversation, mainly due to the fall in correlation between the banks and the sovereign spreads. This dislocation is only a function of the outlook for peripheral sovereign debt given current banks'exposure to the periphery. While banks have indeed inherited from unconditional support from the ECB courtesy of the three years LTRO, as indicated in Nomura's recent note from the 24th of January entitled "36-month LTROs: A pyrrhic victory?", sovereign so far have not received unconditional support:
"Through these operations the ECB is providing an interim solution to the liability side of bank balance sheets; it is not intended to resolve the significant impairment on the asset side. Although there has been a large repricing of the front-end of sovereign curves into and since the operation, we do not think this demand will persist as the ECB’s operation is not about adjusting the dynamics of the stock or flow demand problems faced by European sovereigns."

We mentioned the problem of stocks and flows and the difference between the ECB and the Fed in our conversation "The European issue of circularity", given that while the Fed has been financing "stocks" (mortgages), while the ECB is financing "flows" (deficits). We do not know when European deficits will end, until a clear reduction of the deficits is seen, therefore the ECB liabilities of the ECB will have to depreciate. It is therefore not a surprise to see the ECB's current reluctance in getting a haircut on their Greek holdings in relation to the ongoing negotiations revolving around the Greek PSI.

But back to the title of our conversation, the law of unintended consequences, given Nomura in their report indicated the following:

"In light of the LTRO-spurred rally, we analyse whether the LTRO has indeed
formed a sea-change in the eurozone debt crisis. We conclude that:
The 3yr LTRO significantly reduced the tail-risk of a liquidity-driven
collapse by a European bank...
...but that the ECB liquidity will have adverse unintended consequences
for private sector financing of banks

...and that it is more expensive funding than commonly viewed
...which provides an effective floor to front-end rates as driven by ECB liquidity...
...both of which will limit the size of next month's LTRO... such, without non-bank investor demand, we do not think the LTRO will lead to a durable flow of liquidity into Europe's non-core bond markets...
...meaning that we retain our bearish strategic view on non-core European bond markets."

Nomura also adding:

"LTROs are increasingly punitive and lead to subordination of senior unsecured bank debt. The haircut structure and increased asset usage effectively means that further ECB liquidity is increasingly punitive, utilising ever more balance sheet. The more the facility is used the greater the degree of subordination to senior creditors, which previously would have partially relied on the assets, now pledged to the ECB, as security against senior debt. This problem is particularly pertinent given that banks have already been using the covered bond markets to raise funds, which require over-collateralisation in order to achieve higher ratings and to meet the criteria laid down by the ECB in order to be deemed eligible collateral for operations."

Meaning dwindling quality collateral to pledge in the process, the law of unintended consequences...which we thing will of course lead the ECB to lower again its collateral standards in the near future.

Which brings us to the most recent subordinated bond tender offer by Unicredit and this is what our good credit friend had to say:
"Unicredit announced this morning a tender offer on Tier 1 and Upper Tier 2 bonds for a total of 3 billion euro. Prices range from 50% to 86% depending on the securities...Which is a nice haircut for subordinated bondholders!

At the same time, the Italian bank plans euro 25 billion covered bond issue (which reminds me of what happened with the Irish Banks covered bonds)."

Nomura expects the second round of LTRO in February to be not only smaller but to have the following effect:

"In aggregate we think that the total level of funds taken down through the ECB operation will be less than the previous round. In our estimation this is likely to be in the €200-300bn range.

If the size is bigger than this, perhaps in the range of €500bn or greater, the effect on bank balance sheets in Europe will be distinctly negative in our view, and would make future wholesale and term funding from private sector sources significantly more difficult."

For more on the subject Joseph Cotterill in FT Alphaville goes into more details about the impact of the LTRO in his post - "Margin call, the LTRO movie"

In "A Tale of Two Central Banks" we argued:

"You cannot ask the ECB to suddenly morph into a Fed. This process will undoubtedly take time and a due process, but a larger involvement of the ECB is so far conditional to stricter fiscal discipline."

This leads us to the latest FOMC's decision in relation to the existing swap lines agreement between the Fed and the ECB and the unintended consequences that come to our thoughts as indicated by Martin Sibileau:

"The institutional weakness of the Euro zone, having failed (back in March 2011) the move towards a unified bond and fiscal integration, triggered the jurisdictional arbitrage of deposits (Euro funding). Deposits were taken from banks in the periphery (Greece, Portugal, Spain, Ireland, Italy) and shifted to the core (Germany, France, Netherlands). This situation generated a funding squeeze that was and continues to be addressed by long-term refinancing operations (“LTROs”) by the ECB. In these operations, the ECB extends collateralized Euros to EU banks. These are loans, assets to the ECB, and liabilities to the EU banks. Since its inception, the ECB has steadily been decreasing the minimum quality of acceptable collateral and increasing the tenor of the financing. Most of these funds have been returning to the ECB as excess reserves, a disturbing fact. But at one point, the repression by the political apparatus and the temptation to use these cheap funds to buy high yielding EU sovereign debt is too strong and we start seeing the use of these funds to monetize (i.e. purchase sovereign bonds in the primary market) EU fiscal deficits."
Hence the difference between the FED and the ECB, with the ECB financing flows (deficits).

Unintended Consequences according to Martin Sibileau:

"With the Fed swaps, as we pointed out on September 12th, the Euro is still artificially stronger than without the swaps, which makes the EU less competitive. Finally, the institutional uncertainty of the EU zone remains unaddressed. All these factors only contribute to prolong the recession and a high unemployment rate."

Given today's decision of the FOMC to maintain US rates low until late 2014, it seems to us that the European recession can only be prolonged as indicated by Rcube Global Macro research in our previous conversation, increasing the likelihood of a Euro Breakup.

Again, like any cognitive behavioral therapist, we tend to watch the process rather than focus solely on the content.

Does the FOMC's latest decision put a floor to the drop of the euro versus the dollar? Are the FED's swap lines and latest FOMC decision delaying a painful adjustment in Europe? We wonder.

"Logical consequences are the scarecrows of fools and the beacons of wise men."
Thomas Huxley

Stay tuned!

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