Saturday 25 February 2012

Markets update - Credit - Schedule Chicken

"Every man prefers belief to the exercise of judgment."
Lucius Annaeus Seneca

"The practice of schedule chicken often results in contagious schedules slips due to the inner team dependencies and is difficult to identify and resolve, as it is in the best interest of each team not to be the first bearer of bad news. The psychological drivers underlining the "Schedule Chicken" behavior are related to the Hawk-Dove or Snowdrift model of conflict used by players in game theory." - source Wikipedia.

Given everyone is focused now on the results for the much awaited PSI in relation to the ongoing Greek debt resolution process, Greek CDS trigger or not, courtesy of Collective Action Clauses (knowing that the IMF assumes a 95% participation rate to the PSI...), we thought this time around, we would use an analogy relating to project management linked closely to the famous game of chicken, namely the Nash equilibrium concept. Looks like we are rambling again as usual.

In this week credit conversation, we will once again discuss the LTRO effect, and the importance of deposits levels and credit cycles,  touching on the latest Commerzbank debt to equity swap (not really a surprise to us as we hinted it would happen on the 29th of November in our conversation "The Eye of the Storm"), and the impact the PSI will have on Greek banks and more.

But as always, time for a credit overview!

The Credit Indices Itraxx overview - Source Bloomberg:
The iTraxx SOVX Western Europe Index of sovereign credit-default swaps(15 governments) although tighter by 4 basis points to 344 bps, remains elevated on the 24th of February, compared to the Itraxx Financial Senior 5 year CDS index representing European Banks and Insurance institutions.

The strength of support brought around by the previous LTRO to the Itraxx Financial Senior index is clearly indicated by the spread of the index versus the SOVx 5 year CDS index representing sovereign risk in Europe, still around the highest level reached - source Bloomberg:

"Flight to quality" picture, Germany 10 year Government bond yields remain below 2% yield and falling 5 year CDS spread for Germany - Source Bloomberg:
In our conversation the "LTRO Alakaloid", we indicated that ongoing concerns surrounding the European crisis meant that the widening potential for 10 year German government bonds was indeed somewhat capped given the demand for precautionary assets.
We indicated: "It is all about capital preservation rather than a hunt for yield".

The current European bond picture with Italy and Spain 10 year government yields falling still, given the LTRO effect is encouraging Italian and Spanish banks in buying their respective domestic debt - source Bloomberg:

The liquidity picture, 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 ECB 3 years LTRO has had a significant effect on the three months Libor OIS spread in 2012, a clear indicator of risk in the banking sector. As Nomura indicated in their note from the 20th of February entitled - ECB 3yr LTRO: Fixing what's broken:
"Low money market rates and ample liquidity provision by the central bank went a long way towards easing funding tensions in the money markets in 2008. This is evidenced by the drop in the Euribor-OIS spread, one indicator of systemic credit risk in the banking system, after the ECB's emergency rate cuts. Euribor is the rate for 3m uncollateralised interbank lending and OIS refers to a 3m swap contract whereby one exchanges EONIA(floating leg) for the 3m OIS rate (fixed leg). Despite the fact that the volume of uncollateralised lending between banks has shrunk significantly since the global financial crisis, Euribor remains a reference rate that can be used to gauge aggregate credit risk in the banking sector."

But we have a cause for concern, namely that the LTRO is addressing liquidity issues for cut-off peripheral banks but in no way solvency issues and availability of credit to the real economy (see our post, "Money for Nothing"). In fact, we are currently witnessing a dangerous phenomenon of flight of deposits from peripheral banks to Germany as indicated by John Glover in his Bloomberg article - Bank Deposit Flows Show Money Leaking to Germany:
"Money is leaking out of banks in southern Europe as customers scoop deposits out of Greece, Spain and Italy to move cash to less indebted nations such as Germany.
Greece’s total deposits plunged 28 percent from the peak in June 2009 to 169 billion euros ($225 billion) at the end of December, according to data compiled by Bloomberg. In Spain, deposits slid 5 percent in the five months through November to 934 billion euros, the least since April 2008. Italian banks held 974 billion euros in November, the lowest in 18 months.
Deposits in Germany have climbed by almost 10 percent since May 2010, when Greece was granted its first bailout. Deposits have risen every month except five since the end of 2009, and reached 2.15 trillion euros at the end of 2011, Bloomberg data show. The deteriorating growth outlook in the euro region risks exacerbating those flows, according to Dario Perkins, an economist at Lombard Street Research in London.
“The biggest systemic risk is if people lose confidence in keeping their euros in Spain, Portugal or Italy,” Perkins said. “It makes sense to put your cash into Germany just to be safe and that’s where the real systemic danger lies. That contagion isn’t priced in, and bank deposits are the place we’d spot it.”

This flight of deposits will have a significant impact in economic growth. We agree with Nomura, from their recent report, namely that:
"Monetarist economics is back in vogue; we are watching deposit growth".

Indeed, our European Flutter's narrow money (sum of currency in circulation and overnight deposits), namely M1 growth, is displaying different speed, a leading indicator when it comes to future economic activity. While in our previous conversations, we focused on the importance of the ECB's lending surveys, it is essential, we think, to follow the flight of households deposits in Europe, which is a phenomenon, that is not only affecting peripheral countries, but Emerging Eastern Europe countries as well, such as Hungary, which has been a recurring item in our recent conversations ("Hungarian Dances"):
The ongoing shift in households funds across Europe has not only implications in relation to future economic activity, the shift from short-term to longer terms deposits, as displayed in Nomura's graph will have direct implication on consumptions levels:
"We are also seeing some movement of household funds from short-term to longer-term deposits across the euro-area banking system. This reflects banks' desire to close their funding gaps by relying more on stable, longer-term retail deposits. This shift in the composition of bank funding has implications for the short-term demand outlook. If households are increasingly locking up their assets for a longer time, the money is not accessible to spend on consumption."

It is also important to note the ongoing great competition between banks in peripheral countries, offering higher deposits rates in search for longer-term deposits. There is as well a growing divergence between deposits rates across the European banking sector, indicating a growing disconnect with money markets rate.

For more on the subject:
"Savings Wars From Italy to Portugal Drive Bank Costs Higher" - Charles Penty and Sonia Sirletti - Bloomberg
"The average interest rates on new retail deposits for up to one year have jumped almost 60 percent in Portugal and 72 percent in Italy this year (2011), a sign of how Europe’s debt crisis is driving up the cost of capturing savings."

Throughout our conversations, we have been discussing at length the importance of liquidity and bank funding, in relation to credit cycles. Availability of credit is depending, as well on the level of bank deposits.
In a recent conversation we made the following comment:
"In relation to the current situation let us use this analogy. Imagine you are driving a car called Europe, now it is winter and snow has been piling up on the roads making your driving risky and prone to an accident (liquidity issues). Then comes the LTRO (ECB grit truck) to clear the road ahead of you. Now, you think the road is clear, but, as any car owner knows, what makes your engine running smoothly is the amount of oil lubricating the engine (credit conditions)."

We also added:
"You need to track the ECB lending survey, when it comes to monitoring your oil level. Lack of oil (credit), could seriously damage your engine (growth), and therefore stall your engine (recession) and seriously damage your car (economy). Now let's suppose you drive your car to make a living, and you've borrowed money (sovereign debt) to purchase your car. How are you supposed to make the repayments if your car finally breaks down because your engine has been damaged because of your negligence in maintaining a proper oil level (credit) in your engine (economy)?"

We do agree completely with the following, "Credit growth is positively correlated with GDP growth". According to Nomura:
"Households and firms are highly dependent on the availability of bank lending in the euro area. Firms – in particular small and medium-sized firms – rely almost exclusively on bank lending as a source of external funding. Households use banks for mortgage finance and unsecured borrowing. Hence, bank lending to households and firms is a critical part of the monetary transmission mechanism.
We have empirical evidence that credit growth is positively correlated with GDP growth, especially in the euro area (see Zhu, 2011). The intuition is clear: rapid lending growth boosts economic activity as funds are available to increase consumption and investment. In contrast, times of deleveraging are usually associated with low or negative activity growth as households and firms focus on debt repayment rather than consuming and investing."

Nomura indicated as well in their recent note the following important point relating to credit cycles:
"The non-synchronised credit cycles across the euro area are problematic for the ECB: There are countries which clearly require a loose monetary policy stance to offset the deflationary impacts of deleveraging (Ireland, Portugal and Greece). But looser monetary policy may also postpone the deleveraging process which is necessary in some countries (Spain). And keeping monetary policy loose for too long may fuel excessive credit growth in other countries (Germany) leading to the build up of unsustainable private sector imbalances."

Moving on to our next item, namely the recent debt to equity swap announced by Commerzbank, as we indicated at the beginning of our conversation, it was not really a surprise to us.
Commerzbank announced, in true Banco Espirito Santo style ("Subordinated debt - Love me tender?"), a debt to equity swap. The exchange offer period starts February 23 and is expected to end on March 2nd.

The latest rise in Commerzbank share price, allows Commerzbank to benefit more from exchanging hybrid capital for equity - source Bloomberg:
Following the announcement on Thursday, the shares fell as much as 9.6% to 1.95 euros.

The announced offer to swap hybrid debt covers 3.16 billion euros worth of securities. The German government owns a minority stake of just over 25% and will participate to the operation. The operation if successful could boost its core Tier 1 capital by 1 billion euros.

"The Silence of the Lambs" or more accurately "The Silence of the Subordinated bondholders and equity holders".
The capital increase equates to a maximum of 10% minus one share of Commerzbank current subscribed capital.
Last year, Commerzbank also bought back subordinated bonds trading below face value last year to boost core Tier 1 capital. The income generated from the bond tender buoyed fourth quarter profit by 735 million euros.

Commerzbank Can' t Pay Dividend, Service Silent Participations, by Aaron Kirchfeld and Nicholas Comfort
Feb. 23 (Bloomberg) --
"Commerzbank AG said it won't pay a dividend for 2011 and can't service silent participations held by the country's Soffin bank-rescue fund after posting a loss under German HGB accounting rules.
"It remains our goal to service the silent participations of Soffin in the future and also pay a dividend again," Chief Executive Officer Martin Blessing said at a press conference in Frankfurt today, according to a copy of his speech."

Silent participation is a form of non-voting capital used in Germany that is not accepted by the European Banking Authority as core Tier 1 capital.
As a reminder from our conversation relating to bond tenders on the 25th of October:
"So, in our debt to equity swap, courtesy of the subordinated bond tender, not only the subordinated bond holder is taking a hit, but our shareholder as well. Love me tender?"

In relation to this latest bond tender, our good credit friend and we commented:
"What is happening to Commerzbank could well happen to other financial institutions: swapping debt for equity is neither good for shareholders, neither for bond holders."

On a final note, and in relation to the "Schedule Chicken", Greece in the coming days will remain firmly in the spotlight given the expectations surrounding the results of the PSI and CACs impact (CDS trigger or not a CDS trigger, that is the question...). The immediate write-down of the remaining 53.5% of principal on Greek debt equates to a net present value loss of over 70%. Given Greek banks have the largest exposure to their domestic debt, you can expect a lot more of additional pain for the likes of National Bank of Greece. Taking a 75% coverage on their Greek bond portfolio (12.9 billion euros as of June 2011) implies an additional pre-tax charge of just over 8 billion euros, or around 6.5 billion euros allowing for a tax credit according to CreditSights. National Bank of Greece's core tier one capital was only 6.3 billion euros in September 2011. The 30 billion euros capital shortfall derived from the EBA (European Banking Association) exercise in 2011, was based on 50% private sector value loss. An impairment of 70 to 75% loss would equate to an additional 45 billion euros worth of aggregate recapitalisation for the Greek banking system. Oh dear...

Greek debt ownership - source Bloomberg:

"Schedule Chicken" - source Bloomberg:
Feb. 27: Germany’s Bundestag will vote to approve the Greek
bailout package.
Estonia’s parliament will vote to approve the package no later than this date, according to Taavi Roivas, the head of the legislature’s European Union affairs committee.

Feb. 28: Finland’s parliament will vote on the second Greek rescue program at 2 p.m. local time, according to Seppo Tiitinen, the Helsinki-based legislature’s Secretary General.

March 1: The Dutch parliament will have voted on the Greek bailout package by this date, according to Finance Minister Jan Kees de Jager.
The Greek parliament will also have approved the implementation law.

March 1-2: European Union leaders will hold a summit meeting in Brussels. They will discuss a possible increase in Europe’s so- called firewall, including possible concurrent operation of the temporary European Financial Stability Facility and the permanent European Stability Mechanism.

March 9: Bids for private creditors’ swap transactions are expected to close.

March 11: Private creditors’ swap transactions will take place by this date.

March 12-13: EU finance ministers will meet in Brussels.

March 20: Greece is scheduled to pay off 14.5 billion euros of maturing debt.

April 20-22: The IMF will hold a meeting in Washington.

"When people are taken out of their depths they lose their heads, no matter how charming a bluff they may put up."
F. Scott Fitzgerald

Stay tuned!

Saturday 18 February 2012

Markets update - Credit - The European Opprobrium

"Everyone has his faults which he continually repeats: neither fear nor shame can cure them."
Jean de La Fontaine

1. the state of being abused or scornfully criticized
2. reproach or censure
3. a cause of disgrace or ignominy
Collins English Dictionary – Complete and Unabridged

"AMONG the numerous advantages promised by a well constructed Union, none deserves to be more accurately developed than its tendency to break and control the violence of faction." James Madison (The Union as a Safeguard Against Domestic Faction and Insurrection) From the Daily Advertiser. Thursday, November 22, 1787.

The recent Greek opprobrium (definition number 1) makes us reflexionate on the structure of our "European flutter", namely the current European Union. In terms of analogy, we could only think about the wise words of the Father of the United States Constitution, namely James Madison, who became as well fourth president of the United States.

In his 1787 essay, James Madison also wrote:
"When a majority is included in a faction, the form of popular government, on the other hand, enables it to sacrifice to its ruling passion or interest both the public good and the rights of other citizens. To secure the public good and private rights against the danger of such a faction, and at the same time to preserve the spirit and the form of popular government, is then the great object to which our inquiries are directed. Let me add that it is the great desideratum by which this form of government can be rescued from the opprobrium under which it has so long labored, and be recommended to the esteem and adoption of mankind."
James Madison - (The Union as a Safeguard Against Domestic Faction and Insurrection)

"Whatever is begun in anger ends in shame."
Benjamin Franklin

But once more, we are caught in our philosophical thoughts, as we witness the unraveling of the Greek Opprobrium and wondering on the future of the European Union. Time for our credit conversation. Following a quick overview, we will review our recurring theme the LTRO effect on credit. We will as well review our bond tenders favorite theme, this time focusing on the amounts and results so far, and the ongoing pain in Spain, with the deleveraging process.

The Credit Indices Itraxx overview - Source Bloomberg:
A volatile week in the credit space, plagued by the ongoing Greek Damocles overhang. On the 16th of February Itraxx Financial Senior 5 year CDS index (tracking European Banks and Insurance credit risk) intraday range was 25 bps, reaching a one month high level of 252 bps, before dropping on Friday towards the 223 bps level. As a market maker opined, the price action in the credit space lately has been driven by headlines, in true 2011 fashion. As the European Greek game of chicken goes on ahead of the March 20 14.5 billion euro bond redemption payment, volatility is elevated.

Itraxx Crossover 5 year CDS index (50 European High Yield names), reached 647.5 bps on the 16th, closing around 600 bps on Friday. "Lather, rinse, repeat" in true 2011 style - Source Bloomberg:

The Itraxx Financial senior 5 year index (representing 25 European banks and insurance companies), indicates the strength of the support brought by the LTRO on their spreads compared to the SOVx 5 year Sovereign CDS index (15 countries), which, this week rose for seven days in a row, the longest streak since November 2010, reaching 355 bps on Thursday before receding at the end of the week around 340 bps - source Bloomberg:

Spain 5 year Sovereign CDS versus Italy's 5 year sovereign CDS level converging still - source Bloomberg:

The current European bond picture with Italy and Spain 10 year government yields converging as well - source Bloomberg:

The liquidity picture, 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 new reserve period in relation to the level of deposits at the ECB started on the 15th of February and will last 28 days (not 22, erratum from previous post) for deposits earning 0.25%.
In relation to the significant amount of deposits still sitting at the ECB, CreditSights makes the following important points in their note Eurozone Inc. - LTRO FAQs:
"The reserves only have an impact on asset prices to the extent that banks try to get rid of those reserves and use them to buy higher-yielding assets instead. As each bank pushes the problem of low-yielding reserves onto the next bank, then it creates an additional demand for bonds.

But banks that are domiciled in say Italy or Spain will be more likely to undertake a portfolio shift out of reserves and into Italian or Spanish domestic assets than a German bank.

A German bank faced with an excess reserve position might find it more appealing to leave the money at the ECB and receive a 25 bp rate of interest, versus taking on Italian risk or buying German T-bills at a yield of close to zero."

Moving back to the hot topic of the second round of LTRO expected at the end of the month, what do we think is going to be the impact in terms of risk allocation?
The LTRO so far is enabling banks to face most of the 2012 wall of maturing debt and part of 2013. We agree with Natsuko Waki from Reuters in his article - "Corporate debt to get boost from ECB's new cheap loans" , namely that the big beneficiary of the second round of the LTRO could be corporate debt:

"The second dose of cheap cash from the European Central Bank at the end of this month should spread more broadly across financial markets than the first, sweeping money into non-bank corporate bonds.

This is in part because banks are expected to use the proceeds from the Feb 29 auction to pay down their own debt even further than they have done already. Long-term investors, big holders of bank bonds, will be pushed elsewhere as a result.

Peripheral euro zone government bonds, such as those in Spain and Italy, have been by far the biggest visible beneficiaries of the ECB's offer of nearly half a trillion euros in December. Benchmark Italian borrowing costs have fallen as much as 150 basis points.

But the banks have actually used most of the cheap ECB money to pay off their own debt."

What we are currently seeing therefore is a significant tectonic shift in the credit market, namely that banks are using the proceeds to repay their bondholders, shrinking in effect the massive pool of existing bank debt. Italian banks and Spanish banks are using as well the LTRO to repay their debtors: domestic bank bondholders and other banks, it is estimated that 52% of bank debt is hold by other banks.... Also, they seem to be encouraged so far in buying up the domestic debt of their respective countries.

From the same article, and according to a Goldman Sachs note:

"Insurance companies, pension funds and large asset management firms would need to find alternative investment opportunities. The scale of European bank bonds, as an asset class, is so large that it is comparable only to sovereign bonds or the combined size of all other non-financials corporate bonds outstanding."

So not only, there is an economic growing North and South growth divide within Europe, as indicated by the latest economic data releases but the differentiation in allocation in credit markets will also be increased by the impact of the second round of the LTRO, namely that peripheral countries are encouraged in soaking up their domestic debt, while institutional investors are already encouraged in seeking other investment opportunities than government debt and bank debt (in relation to recent banks downgrades by rating agencies and pending ones).

Following up on our favorite theme of subordinated bond tenders, it is important we think, to give an update of the results so far of the ongoing exercise and its signification.

By buying back hybrids and subordinated bonds, at deep discount to par, the capital gains are in effect boosting their Core Tier 1 capital ratios, which is a necessary exercise in relation to the EBA (European Banking Association) June 2012 deadline for European banks to reach 9% Core Tier 1. According to CreditSights in their note "European Banks in Buyback Bonanza", in the last four months, we have seen tender offers for almost 76 billion euro of face value of European banks subordinated and hybrids bonds launched by more than 20 banks.

Benefits of the exercise are obvious. For the bondholder, it offers less "opprobrium"  (definition number 2 - censure) given the significant premium in the bond tender offer in comparison to prices in the secondary market (for more see "Subordinated debt - Love me tender?"). The dangers being for the institutional investor are to remain in a smaller and illiquid lower rated issue which could be dropped off a specific benchmark, triggering in effect force selling at bigger loss.
For the banks, it enables them to take advantage of current low prices, booking a capital gain and transferring capital to their Core Tier 1 ratio. It also helps them reducing as well interest expenses given some of this hybrids or subordinated bonds sometimes offer higher coupons: As we highlighted in our conversation "Lather, rinse, repeat" in relation to Intesa's bond tender:
"Buying the 9.50% Perp. Subordinated Notes (XS0545782020) €1,000,000,000 at 70% of par on the 19th of January, given the bond tender is offered at 90%, would have landed a 20 points gain on the bond, a rapid 28% gain for the brave punter and a 10 points loss for the subordinated buy and hold bondholder."
The tender choice is indeed easier to make for the mark to market brave punter who bought the securities at a lower cash price.

According to CreditSights, acceptance rate, while varying significantly, so far for these bonds tenders have been in the region of 50%.

In relation to Spain, which we have been discussing at length in recent conversations, according to Bloomberg:
"Spanish banks' average borrowings from the ECB hit new highs of more than 130 billion euros in January, while bank lending to Spanish businesses fell and bad debt hit highs not witnessed since 1994. With unemployment of 22.9% at 1996 levels, continued troubles in the real estate sector will likely drive lending lower."
Given Spanish banks ratio of non-performing loans to total loans came in at 7.61% in 2011 which is the highest percentage since 1994, the LTRO effect amounts to "Money for Nothing", at least to the real economy...and we are not the only ones.

"Bank crisis looms as Europe’s debt woes deepen" - Charles Dumas, chairman & chief economist at Lombard Street Research:
"In Spain, and even more in Portugal, the heavy private-sector debt burden is in business. For Portugal, non-financial company debt is 16 times pre-interest cash flow, in Spain, 12 times. In the mergers and acquisitions business, 10 times is the threshold for “junk”: not a pretty description for an entire country’s business sector. In addition to this debt burden, which forms a large part of the banking system’s assets, the Iberian asset values that collateralise the debt in many cases have hardly adjusted to post-crisis realities. Spanish commercial property, for instance, in total-value terms is only down some 10 per cent from end-2007 highs that were well over twice 2000’s.

Spain’s new government appears committed to “do the full Monti” in one year instead of two – a 4 per cent-of-GDP fiscal deflation, with the added twist of requiring banks to write their assets down to realistic levels. This shock treatment is more likely to kill than cure. It is axiomatic that a recession does more harm to profits than personal income – just as they rise faster in booms.

Spain’s domestic-demand recession (starting from unemployment of 23 per cent, 49 per cent among the young) will be compounded by falling GDP in Germany and the rest of Europe. The profit “denominator” of the debt-to-cash-flow ratio could dive, causing the debt ratio to soar. With asset values potentially sinking fast, the chances of inducing a bank crisis are high. In Spain, even more than in Greece, austerity will probably reduce, not increase, the cents in the euro collected by creditors. The Spanish bond spread deserves to shift back to well above Italy’s, as eurozone orthodoxy destroys the continental economy."

Hence the convergence in both CDS and bond Yields between Italy and Spain we have been highlighting in recent weeks.

On a final note, our good credit friend and ourselves have been discussing the following in relation to the ECB swapping its Greek bonds for new bonds, to ensure it isn't forced to take losses and exempted from Collective Action Clauses (CACs).
Will subordination of private bondholders versus the ECB lead to insubordination?
"If true, here are the questions you should ask yourself:

1-Will the new bonds be senior to the old bonds? If so, expect private investors to go on strike and buy much less sovereign bonds as they will be subordinated to the ones owned by Public institutions in the future. Also, some private investors may decide to try their chance in Court and argue against the subordination de facto.

2-If the old bonds are bought back by the issuer at Par against new bonds, expect private investors to ask for the same treatment (pari passu) and go to Court on the basis that holders are not treated “equally”!

Basically, if such a swap is in the pipe, we think there will be collateral damages which will affect drastically the sovereign bond market."

Good bye pari passu!

Pari passu is a Latin phrase that literally means "with an equal step" or "on equal footing." It is sometimes translated as "ranking equally", "hand-in-hand," "with equal force," or "moving together," and by extension, "fairly," "without partiality." In finance, this term refers to two or more loans, bonds, classes of shares having equal rights of payment or level of seniority - source Wikipedia

"ECB Said to Swap Greek Bonds for New Debt to Avoid Loss" - Jeff Black - Bloomberg:
“If this ECB plan goes ahead it may appear that the ECB is receiving preferential treatment, raising questions about whether the ECB is senior to private-sector bondholders, not only in the case of Greek debt, but also regarding the debt of other euro-zone nations that the ECB may be purchasing.” - Chris Walker, foreign-exchange strategist at UBS AG in London.

Is preferential treatment for the ECB not the real "opprobrium" we have been discussing all along, namely definition number 3: a cause of disgrace or ignominy?

Stay Tuned!

"What do you regard as most humane? To spare someone shame."
Friedrich Nietzsche

Sunday 12 February 2012

Markets update - Credit - The LTRO Alkaloid

"The expense of a war could be paid in time; but the expense of opium, when once the habit is formed, will only increase with time."
Townsend Harris- first United States Consul General to Japan.

Homer conveys the effects of Opium in The Odyssey. In one episode, Telemachus is depressed after failing to find his father Odysseus. But then Helen (ECB)...

"...had a happy thought. Into the bowl in which their wine was mixed, she slipped a drug that had the power of robbing grief and anger of their sting and banishing all painful memories. No one who swallowed this dissolved in their wine could shed a single tear that day, even for the death of his mother or father, or if they put his brother or his own son to the sword and he were there to see it done...".

In a recent conversation we discussed the LTRO impact on liquidity flushed towards the market. While our Greek Calends are still taking center stage (no tears shedding for Greece given the "euphoric" effect of the LTRO alkaloid), we thought comparing the European LTRO to the most famous historical alkaloid, would be appropriate given the significant rally experienced in risky assets through January. True to our addictive writing habits, we divagate again, using literary and historical references.

In this credit conversation, after a quick credit overview, we will again revisit the LTRO alkaloid impact, given the rally is not based on fundamentals, an interesting bond tender courtesy of Greek Bank EFG Hellas, as well as a follow up on Hungary and Egypt in relation to our first post of the year "Hungarian Dances".

The Credit Indices Itraxx overview - Source Bloomberg:
Are the LTRO alkaloid effects waning? Or is it because the markets are getting tired by the Greek Calends? The SOVx Western Europe Index (15 Sovereign CDS) 5 year index has seen its first weekly increase in five weeks, moving back towards the 330 bps level, indicating a rise in risk aversion. But overall, credit indices have been wider across the board, with Itraxx Crossover 5 year index (50 European High Yield names, High Yield credit risk indicator) wider by 32 bps (first weekly increase since December 16) and Itraxx Financial Subordinate 5 year index wider by around 23 bps on the day.
So there goes the Greek spanner in the works as argued by CreditSights from our previous conversation "Lather, rinse, repeat":

"Greece, and the obvious unsustainability of its existing debt position, has been somewhat of a sideshow to the main act of Italy and Spain for some time now. But negotiations over the restructuring still have the capacity to throw a spanner in the works."

Spain 5 year Sovereign CDS versus Italy's 5 year sovereign CDS level - source Bloomberg.
Italy's Sovereign 5 year CDS rose by 24 bps to around 394 bps while Spain widened by 20 bps to around 368 bps.

The current European bond picture with Italy and Spain 10 year government yields converging - source Bloomberg:

The liquidity picture, 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 new reserve period in relation to the level of deposits at the ECB will start on the 15th of February and will only last 22 days this time around for deposits earning 0.25%.

The relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge):

"Flight to quality" picture, with tighter Germany 10 year Government bond and falling 5 year CDS spread for Germany - Source Bloomberg:
The LTRO Alkaloid is in effect capping the widening potential for German 10 years yield. As indicated by Lukanyo Mnyanda and Emma Charlton in their Bloomberg article - ECB Cash Fails to Wean Investors Off German Debt: Euro Credit:
"Investors are sticking with German government debt amid concern that unlimited three-year cash from the European Central Bank won’t end the region’s debt crisis.
The yield on 10-year bunds, perceived to be the among the region’s least risky government debt, has averaged 1.90 percent since Dec. 8, when the ECB announced the three-year loan plan, compared with 3.34 percent over the past five years. Bund yields have held close to their record low of 1.64 percent even as the Stoxx Europe 600 Index has rallied 26 percent from last year’s low and 7.5 percent this year."

So yes, we have to concede, German yields are unlikely to rise, given the ongoing demand for precautionary assets (German bunds, UK Gilts, US Treasuries) in relation to the ongoing European issues. It is all about capital preservation rather than a hunt for yield.

In fact, it ties up nicely with 10 year Sweden government bonds versus 10 year German bund risk-off indicator, moving back in sync - source Bloomberg:

It has been a recurring theme of ours that there is a clear distinction between the FED and the ECB ("A Tale of Two Central Banks"), namely that one has been financing stock (mortgages), while the other, has been financing flows (deficits). We would like to go further, and explain why the LTRO cannot be viewed as QE. Nomura in their recent Rates Insights - How long can we rally - published on the 9th explain the following:
"The LTRO is a repo transaction so there is no initial transfer of risk to the ECB from the transaction with the ECB's risk stemming from a bank default scenario. But the haircut structure is in place to ensure that this does not lead to a transfer of private sector credit risk. In our opinion through the first operation banks are using the ECB LTRO as replacement funding for 2012 refinancing obligations, which is liability replacement rather than asset replacement. The reduction of a form of asset substitution is more at play in the slowing of deleveraging i.e. a substitution of assets for cash."

Whereas the FED dealt with the stock (mortgages), the ECB via the alkaloid LTRO is dealing with the flows, facilitating bank funding and somewhat slowing the deleveraging process but in no way altering the credit profile of the financial institutions benefiting from it! While it is clearly reducing the risk of banks insolvency in the near term, it is not alleviating the risk of a credit crunch, as indicated in the latest ECB's latest lending survey which we discussed in our last conversation.

Nomura also made the following valid comment in relation to why the LTRO is not QE, although perceived as such:
"ECB LTRO is not QE in the traditional sense – there is no risk transfer to the central bank.
Liquidity has seeped into certain parts of the system at a lower rate, which has helped to drive certain asset levels, notably the front end of peripheral curves, but as we have said previously this is more about the perception that the ECB has exacted a more pure form of QE affecting the asset side of balance sheets. The traditional asset allocation shift from QE is stifled in that under LTRO risk is not transferred to the national central banks, which does not immediately change the credit profile of banks. As a result the immediate use of QE cash to purchase instruments further out the credit is somewhat limited."

What the ECB has done is not akin to QE version 1 as enacted by the FED in 2008 given, as indicated by Nomura that:

"Liquefying of bank balance sheets through repo does not constitute a change in their construct. The US efforts of 2008 included forced recap alongside additional collateral provision through multiple programme, which helped banks help themselves. The current ECB action is simply a funding replacement mechanism rather than a mechanism for the facilitation of market based funding."

We have to concur with both Nomura (Nomura being in agreement with Moody's take), in relation to the LTRO Alkaloid namely that it is a credit negative event, not positive:
"In this time of pleasant thoughts with regards to rating agencies we have the unusual honour in that Moody's have joined us in our view that the LTRO is credit negative for banks, which makes the carry trade using this funding source credit negative.
What is needed are new funds, in other words real money stepping in alongside bank buying. Real money have been buying in small sizes, but not the volume required to take down the debt issuance profile without bank/LTRO help. This is because the fundamental issues that drove investors from these markets haven't changed.
With many foreign investors, including those from within the euro area, seemingly away from the bid Italy and Spain are effectively becoming domestic bond markets. The domestic bid size seems reasonable, but it remains to be tested on a longer term basis."

Lather, rinse, repeat:
"We agree with our friends at Rcube, namely that the focus should be going forward, on European economic data and rising unemployment levels."

Therefore, looking at the recent LTRO Alkaloid induced rally, Nomura to add:

"Rallies eventually need to be fundamentally based, can the fundamentals keep pace?"

We do not think so:

"The euro area probably will contract this year by 0.5 percent with recessions in crisis-hit Greece and Portugal, compared with a 2.3 percent expansion in the U.S., according to Bloomberg surveys of economists."

FED versus ECB, stocks versus flows as we reminded ourselves last week:
"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."

"The law of unintended consequences" is taking its toll.

Nomura also commented in their note in relation to fundamentals:
"The fundamentals may be worsening. The damage has been done through procyclical responses.
Political uncertainty, austerity, and regulations (Basel 2.5 and 3, EBA instruction to banks to raise core tier 1 capital to 9%) have driven down growth expectations significantly. Although the negative Spanish Q4 GDP number of -0.3% was somewhat expected the negative implication of Belgium.s -0.2% Q4 GDP, clearly more semi-core, is a negative bellwether for the periphery.
With the continued response to deficit slippages being a further cut in expenditure, the negative fiscal multiplier effect keeps increasing. When the private sector is increasing balance sheet there is some offset, but at the moment with house prices tapering or decreasing rapidly, as the largest component on the private balance sheet, this puts major pressure to deleverage on other aspects such as credit cards and hence consumer spending. This is backed up by the ECB lending survey.
Fiscal slippages could lead to further downgrade risk by agencies. This, the LTRO can do nothing about it."

So the LTRO, we think, could amount to "Money for Nothing".

Moving back to the Greek Calends and bond tenders, courtesy of EFG Hellas Ltd, a member of Group Eurobank EFG, another subordinated bond tender hit the market on the 9th, targeting 3 Tier 1 notes with an aggregate face amount outstanding of €415mn and 1 Lower Tier 2 note with a nominal outstanding amount of €467mn, with similar purposes to previous ones, with a proposed price of 40 cents to the euro:
"The purpose of the Offers is to generate Core Tier One capital for the Offeror and to strengthen the quality of its capital base. If completed, the Offers would generate a gain for the Group and thereby increase Core Tier One capital. The Offers also provide investors with an opportunity to monetise their investments at the relevant Purchase Price."

An opportunity to get out while you can...While the exercise is indeed helping in raising much needed capital, it doesn't alleviate in no way the reliance on emergency funding through ELA and the deterioration of their domestic earnings prospects and deposit flights and rising Non-Performing loans (for more, please refer to our post "Liquidity? The IV Greek Credit Therapy" - August 2011).

My good credit friend had to say the following in relation to the latest Greek austerity plan:

"Now that the political game in changing in Greece, the other political leaders will have a tough time to justify their decision for more austerity. With very high unemployment rate, the country is on its knees. In opening a new front within the domestic political Greek landscape, the LAOS party is putting the other political leaders in a very difficult position : if they support the bailout, they are about to commit a political suicide or at least to face a big defeat in the coming elections (even worst if they decide to postpone the elections). If they decide to play hardball with the creditors (Troika), they endanger the bailout.
I suspect the LAOS MPs will not vote for the bailout, which will put them in a “win-win” position. While supporting Papademos action, the populist party will let “things fall apart”, criticizing openly the decisions of the other leaders and waiting for the right time to provoke elections and win a big part of the seats in the Parliament."

As Napoleon rightly said, "A leader is a dealer in hope". Time has come to become once again a good behavioral therapist and focus on the process rather than the content in relation to the Greek situation.

Moving on to our "Hungarian dances" update, the Hungarian FSA has given new details of the repayment levels of the FX currency mortgages plaguing Hungarian households. The losses on conversions are marginally higher, meaning Erste Bank and OTP will have to increase their provisions levels according to Credit Suisse - Hungarian FX Mortgage scheme - 7th of February 2012:
"HFSA has said that loans with a book value of HUF 1073.7bn were repaid using HUF 776bn, suggesting a loss to date of HUF 297bn for the sector as a whole. This is 19% of the total FX mortgage stock and translates to a 27% loss on the repayment, we calculate. This loss is marginally higher than the loss assumed by the banks – due to the weaker FX rates seen over the later part of 2011, we believe. These repayments were related to 141,976 mortgage contracts. There are a further 19,052 contracts which have been registered for repayment but have not yet been repaid. We expect that some but not all of these contracts will be repaid."

"Mind the Gap...", in November we referred to Geoffrey T. Smith from the Wall Street Journal - "Austria Has a Déjà Vu Moment":
"As a result, the biggest threat to Austrian banks is still what it was in 2009—wholesale capital flight from emerging Europe."

It still is the biggest threat,  as indicated by Exane BNP Paribas in relation to deposits moving elsewhere in their February note relating to Hungary:
There is an existing Bank levy (0.53% of banks 2009 assets to bring EUR580m per year to the State) in Hungary.

Hungary will need a bailout by the IMF, while European banks exposed to Hungary will face additional losses:

Given FX Currency Mortgages are taking a heavy toll on the country's already strained refinancing needs as indicated by Exane BNP Paribas:

According to Exane BNP Paribas:
"In the absence of an IMF/EU agreement Hungary is likely to avoid default in Q1 2012 and little time after. An external financial aid (IMF and EU) agreed within H1 2012 should average EUR25–30bn in order to cover Hungary’s financing needs over the next two years."

Exane BNP Paribas adding in relation to a potential bail out:
"A EUR25bn of second bail-out would increase the total Hungarian debt from
EUR79bn (i.e. ~84% of GDP) to EUR104bn (i.e. ~111% of GDP)."

On a final note, please find Bloomberg Chart of the Day, showing that Hungary is most at risk when borrowing costs rise:
"Hungary is the most vulnerable of the European Union’s Eastern states to a sudden jump in borrowing costs, underscoring the need for a bailout accord and government action to restore investor confidence.
The CHART OF THE DAY compares countries’ projected average interest rate on state debt in 2012 with the so-called critical interest rate, the level that Erste Bank AG estimates would push the share of debt-servicing costs above an unsustainable 10 percent of tax revenue. Hungary has the smallest buffer in Eastern Europe and is closest to that threshold after Greece, Portugal, Ireland and Italy, which already breach the limit."

So upcoming bailout for Hungary, followed closely by Egypt, recently downgraded to single B, with Egypt’s FX reserves lower by more than half since the start of 2011 to 16.4 billion USD in January, and import cover now at 3.3 months and still falling. The IMF plan involves removing gasoline subsidies (114 billion pounds expected budget costs in 2012 compared with 100 billion pounds in 2011) which could potentially trigger more unrest in Egypt if it removes its fuel "Alkaloid" but that's another story...

"Nobody will laugh long who deals much with opium: its pleasures even are of a grave and solemn complexion."
Thomas de Quincey - Confessions of an English Opium-Eater (1821).

Stay tuned!

Monday 6 February 2012

Markets update - Credit - Lather, rinse, repeat

Greek Calends - "To defer anything to the Greek Calends is to defer it sine die. There were no calends in the Greek months. The Romans used to pay rents, taxes, bills, etc., on the calends, and to defer paying them to the “Greek Calends” was virtually to repudiate them. (See NEVER.)" - E. Cobham Brewer 1810–1897. Dictionary of Phrase and Fable. 1898.

In our previous conversation, we reviewed the significant tightening move in credit courtesy of liquidity flushed towards the markets thanks to the ECB's LTRO and FED's FOMC decision. Given market are addicted on liquidity and depending on it, the rally has been of epic proportion. Indeed the year of Dragon has started on a very positive tone. In our conversation "The European Overdiagnosis", we argued that the Year of the Dragon should be rebranded the Year of the Central Bank given the market movement reminiscent of the 2009 rally in risky assets. So far in 2012, we have flying PIIGS with very significant tightening moves in Government peripheral yields, and Greek calends in relation to the ever ongoing discussions surrounding the Greek PSI. But, as per our usual style, we ramble again.

It is time for our credit conversation, we will look at the Greek sideshow and its "unintended consequences", some more pain for subordinated bondholders with additional Italian bond tenders making the headlines, and in extension to our previous conversation "The European Overdiagnosis", Spanish decision to enforce 50 billion euros of charges on banks given the rising growth of Non-Performing loans on banks balance sheet as we discussed in "Money for Nothing".

The Credit Indices Itraxx overview - Source Bloomberg:
Given the ongoing PSI is taking center stage again, it isn't really a surprise to see some widening today in the Credit indices albeit in quiet and thin market.

The relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge):
As commented by one of our macro friends, after a month and half of impressive decorrelation between credit and equities volatility, spreads have finally reconnected towards the absolute level of equities and equities volatility. The 1 year implied volatility dropped by 15% in one month whereas Itraxx Crossover 5 year index (High Yield risk gauge) by more than 30%. On these levels, one should expect relative value trade to unwind given credit doesn't appear extremely cheap versus other asset classes.

As a follow up on previous post, it is interesting to note that Itraxx Financial senior 5 year index (representing 25 European banks and insurance companies), still indicate the strength of the support brought by the LTRO on their spreads compared to the SOVx 5 year Sovereign CDS index (15 countries).

In our last conversation "Money for Nothing", our friends at Rcube Global Macro Research argued the following:
"With European equity markets having rallied almost 25% since last September’s lows (mostly on expectations that the LTRO liquidity injections would ease the credit crunch), we fear that the surprise factor has just changed sides again. Now that numbers north of €1Tn are circulating for the 29/02 LTRO announcement, positive catalysts are drying up. We believe that sensitivity to European economic data has increased a notch."

We commented at the time:
"We agree with our friends at Rcube, namely that the focus should be going forward, on European economic data and rising unemployment levels."

The latest study of the correlation between the Bloomberg Industries EU Bank index and the European PMI manufacturing survey points to some interesting decoupling between EU banks and the PMI survey as indicated by Bloomberg - EU Banks More Macro Sensitive as Liquidity Concerns Abate:
"The correlation between the Bloomberg Industries EU bank index and the European PMI manufacturing survey decoupled significantly from late 2009 to early 2011, having been very strong heading into and through the banking crisis. As the ECB pours liquidity into the market, the PMI indicator is becoming more useful as the correlation returns." - source Bloomberg.

In fact it isn't the only data decoupling recently given the growing divergence between US and European PMI indexes - source Bloomberg:
US PMI versus Europe PMI from 2008 onwards.

We will not venture again in the distinction between the FED and the ECB, namely that one has been financing stock (mortgages), while the other, has been financing flows (deficits), which partially justify our negative stance on Europe, but, as reminder from our post "The law of unintended consequences":
"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."

Moving back to Greek calends, namely the never ending PSI story, CreditSights in their January Credit Review had some interesting points:
"Greece, and the obvious unsustainability of its existing debt position, has been somewhat of a sideshow to the main act of Italy and Spain for some time now. But negotiations over the restructuring still have the capacity to throw a spanner in the works."

CreditSights, in relation to the Collective Action Clause which Germany proposed to introduce into all Eurozone Government bonds, which could lead to a supermajority of bondholders (66%) to impose the same terms on all holders made the following interesting point:
"Greece, and the obvious unsustainability of its existing debt position, has been somewhat of a sideshow to the main act of Italy and Spain for some time now. But negotiations over the restructuring still have the capacity to throw a spanner in the works. For example, introducing a CAC into Greek law won't, by itself trigger the CDS. But if the CACs are used to impose a restructuring on all bondholders, it is difficult to see how that won't trigger any CDS written before the clause was introduced into Greek law (see Sovereign CDS: Collective Action Complications). We believe the primary reason for avoiding triggering the CDS has been to avoid the known unknown of how it will affect other Eurozone governments rather than worries about the cost of payouts to European banks. One concern is that triggering the CDS may encourage leveraged speculation against Spain or Italy. In other words, if sovereign CDS are demonstrated to be an effective hedge against bond default, then there should be a link between the bond spreads and CDS spreads. If speculators are able to drive CDS spreads wider by selling protection on relatively light volumes, then the bond yields may also be pushed up to potentially unsustainable levels.
Secondly, if Greece can't negotiate a restructuring with bondholders, then it will be faced with the choice of either defaulting or repaying the €14.4 billion in bonds (all domestic-law bonds) that come due in March(the debt that matures before March is all bills). A disorderly default has plenty of scope to undermine investors' confidence in Eurozone governments and repaying any holdouts from the bond restructuring in full will make future negotiations much harder and is sure to prompt the kind of political rhetoric that has previously proved so destabilising."

A case study in the making...

While Greece is taking center stage again, it is interesting to see Spain 5 year Sovereign CDS moving closer to Italy's 5 year sovereign CDS level - source Bloomberg.

While Italian banks have risen thanks to an opportune change of bond buy back rules, Spanish banks have been asked to face the music and will bear 50 billion euros of charges, as Spain is forcing banks to take more losses on the 175 billion euros of real estate assets. On the 1st of February according to Bloomberg:

"The Italian central bank’s new regulations meet European buyback rules on hybrid securities. Banks won’t have to simultaneously issue new instruments to replace those being repurchased and don’t need the approval of Italy’s stock market regulator, the Bank of Italy said on its website.
The Bank of Italy will authorize banks to buy back securities that qualify as regulatory capital as long as their financial position isn’t put at risk, it said."

So go ahead, buy back, the ECB's got your back. And, true to form, this is exactly what has happened following the tweak in the rule book, given, Banco Popolare Società Cooperativa (BPIM) is doing a bond tender for Tier 1 bonds and LT2 bonds, while Intesa, as well, announced today tender offers for 3 Series of Subordinated Tier 1 Notes with a face amount outstanding of EUR 3.75bn:

"The invitation on the Subordinated Notes has the objective to strengthen and optimise the regulatory capital composition of Intesa Sanpaolo and the Group, while at the same time offering Holders the possibility to realise their investment in the Subordinated Notes at a price higher than the prevailing market price immediately prior to anouncement."

Buying the 9.50% Perp. Subordinated Notes (XS0545782020) €1,000,000,000 at 70% of par on the 19th of January, given the bond tender is offered at 90%, would have landed a 20 points gain on the bond, a rapid 28% gain for the brave punter and a 10 points loss for the subordinated buy and hold bondholder.

We touched the subject of rising Non-Performing loans in Europe and in Spain in particular recently. By accelerating the realisation of losses, the new Economy Minister Luis de Guindos is trying to overhaul Spain's crippled financial sector and dealing with its "zombie" banks as indicated by Charles Penty and Emma Ross-Thomas in their Bloomberg article - Spain Coaxes Banks to Merge as Extra Time Given to Purge Losses:
"The government will make banks increase the ratio of provisions set aside for urban and rural land to 80 percent from 31 percent, de Guindos said. For unfinished developments, the provisioning level will rise to 65 percent from 27 percent and to 35 percent for other so-called “troubled” assets including finished developments and houses."

The new 50 billion euros charge according to Bloomberg: "compares with 66 billion euros of provisions taken by banks between 2008 and June 2011 to cover specific loan risks, according to the ministry."

So carrot for Italian banks, and just stick for Spanish banks.

It appears to us that given the ongoing surge in Non-performing loans, if the European recession deepens and unemployment rises, non-financial corporates will suffer as well:
Source - SocGen Sees 4 New Worrying Signs In Italy - Business Insider.

Given the ongoing deleveraging, in the light of the recent Sovereign CDS convergence between Italy and Spain, we might be viewed as contrarian but given the ongoing deleveraging process and the sectorial composition of debt as a percentage of GDP, Spain appears to us as being in a less favorable position particularly given its housing hangover:

On a final note and in relation to the ongoing Greek PSI case study and given Portugal's recent widening in both bonds and CDS, please find below Bloomberg Chart of the day indicating the value of English law when it comes to sovereign debt:
"Portugal’s bonds show how investors concerned about losses being imposed on them are willing to pay up for the extra protection given by English law.
The CHART OF THE DAY shows the prices of Portugal’s $100 million of floating-rate notes and 7.8 billion euros ($10.2 billion) of 3.6 percent bonds, both due in 2014. While the dollar notes are governed by English law and have covenants restricting the issuer’s ability to act against lenders’interests, the euro-denominated securities are issued under local law and lack those protections.
Portugal’s bondholders are concerned the nation will follow the example of Greece, which is negotiating a debt exchange to cut the value of its notes by more than half. The Greek government said it may pass a law to insert so-called collective action clauses into the terms of its domestic-law bonds to force holdouts to accept a writedown."

When the game changes, change the rules...

Stay tuned!

"You can't expect to solve a problem with the same thinking that created it". - Albert Einstein

Thursday 2 February 2012

Markets update - Credit - Money for Nothing

"Now, what I want is, Facts. Teach these boys and girls nothing but Facts. Facts alone are wanted in life. Plant nothing else, and root out everything else. You can only form the minds of reasoning animals upon Facts: nothing else will ever be of any service to them. This is the principle on which I bring up my own children, and this is the principle on which I bring up these children. Stick to Facts, sir!"
Charles Dickens - Hard Times - 1854

What a month in credit! The significant tightening move we have seen in credit as well as the rise in risky assets can certainly be attributed to the LTRO factor as well as the FED stepping with the FOMC decision of maintaining rates low for an extended period of time. Given markets are addicted to liquidity, the rally has been significant and could be even more significant as we await the next round of LTRO funding by the ECB.

So why our title "Money for Nothing" you might wonder? Could it simply be us referencing to one of Dire Straits most successful singles? Or just simply because the temptation of "Money for Nothing" courtesy of the ECB in their next round of LTRO operation might be an offer which might be too good to decline even for banks that doesn't even need the money? Even Nordea Bank recently said it would consider participating in the next LTRO simply as the money "looks cheap", according to CreditSights.

So, in this week special credit conversation, grab a cup of tea because in our long conversation we will go through, LTRO impact, worsening credit conditions leading to rise in Non-Performing Loans in banks balance sheet, and why the Baltic Dry Index matter for Nordic banks, more bond tenders, and Spanish Non Performing Loans and more.

First a quick credit overview.

The Credit Indices Itraxx overview - Source Bloomberg:
The SOVx Western Europe (basket of 15 European sovereign borrowers), was marginally tighter at 322 compared to Wednesday.

But comparatively to Itraxx Financial Senior representing the spreads for European banks and insurance companies, clearly indicates the impact of the unconditional support the ECB has provided to banks relative to Sovereign countries given the spread between both indexes is at a high point of 115 bps - Source Bloomberg:

The current European bond picture with Italy and Spain 10 year government yields falling still; and France receding below 3% yield for 10 years government bonds - source Bloomberg:

In relation to Spain and Italy, there is an interesting convergence between Sovereign 5 year CDS levels  between both countries - Source Bloomberg:

Ireland 5 year sovereign CDS versus Portugal 5 year sovereign CDS spread, while the absolute spread has been falling as well as government bonds, Portugal is still pretty much in the danger zone as indicated by its current 5 year CDS spread - source Bloomberg:

The liquidity picture, 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:
From our previous conversations we have discussed liquidity at lengths and its impact credit spreads and markets.

What is interesting to note as indicated by Bloomberg is the following:
"At the end of 2011, the Italian banking system drew over 200 billion euros of gross liquidity from the ECB, just shy of 25% of its total gross lending. This reliance has grown in step with the rising sovereign auction costs in Italy, and investors are likely to want granularity on individual bank usage in forthcoming full-year results."

Bringing us to our main conversation, namely individual bank usage of "Money for Nothing", courtesy of the ECB 36 months LTRO operation. As indicated by CreditSights:

"It looks as though banks were waiting to see if capital markets opened up before deciding how much they need to use their LTRO allocation to refinance near-term maturities, or to what extent some of it might be available to fund new lending or government carry trades. Intesa for example, is reported to have taken €12 bln in the last ECB LTRO. For the stronger issuers such as the Nordic and Swiss banks, which have much easier access to funding markets, recent deals have been opportunistic."

In fact Italian bank Intesa was not the only peripheral bank making good use of previous LTRO, in its fourth quarter call according to Bloomberg, BBVA discussed how the 11 billion euro financing from the ECB covered its 2012 wholesale funding needs and that it might as well take up the second facility offered by the end of February.

But clearly Senior Unsecured markets remains open for core European banks while peripheral banks are still shut out. We argued last year that the race to funding would lead to core European banks issuing at higher cost.
It is indeed the same game we mentioned in our previous conversation "Great Expectations":

"The game is still the same, conceding consequent large premiums in the race to raise capital."

Money for nothing, ECB net lending falling to Euro Area Credit institutions falling but ECB deposits rising - source Bloomberg:

We mean "Money for Nothing" given our friends at Rcube Global Macro, in their latest study of the ECB quarterly bank lending survey indicate a significant worsening of the credit crunch in Europe, meaning plenty of liquidity impact for banks but confirming our 2011 fears of credit contraction for corporates and households ("Money for nothing and the Casino Chips for free..." - Macronomics):

"The ECB has just released its quarterly bank lending survey. Given that it was conducted right after the LTRO announcement, it should have captured part of the macro improvement based on the liquidity injection. Considering this, we think that the results are particularly alarming.
It seems that the LTRO has eased the stress on the sovereign side but did not impact the credit channel to the private sector positively."

As indicated by our friends at Rcube Global Macro Research:

"The credit crunch has intensified further. All lending standards (Firms, Households) have tightened aggressively. Credit to firms in the last quarter has been drastically reduced."
"A net 42% of the 124 banks surveyed have tightened their lending standards to large firms. This is the highest figure since the Lehman bust." - source Rcube Global Macro Research.

"Even more worryingly, the net effect of liquidity position on credit to firms (which historically has a small lead on the actual change in terms of credit) is at an all-time high, hinting at further net tightening in Q1." - source Rcube Global Macro Research:

"The large number of reasons mentioned to justify the tightening of credit availability makes a substantial improvement in coming months significantly less likely. The expectation of general economic activity has massively deteriorated. Similarly, access to market financing, banks’ liquidity position and cost related to banks’ capital position have all experienced stress." - source Rcube Global Macro Research:

"On the household front, we notice that demand for loans has crashed, while banks are now aggressively restraining credit for house purchases. This clearly hints at a much weaker consumption ahead in Europe.
On the positive side, it seems that German banks have remained far more accommodating than their European peers. Ironically, German corporates are also the most self-sufficient in terms of financing..." - source Rcube Global Macro Research:

"As a result, Eurozone growth expectations look way too optimistic.
The survey clearly points towards renewed Eurozone economic momentum weakness.
While this morning’s PMIs were a pleasant surprise, we don’t think it can be repeated. French PMI will slowly move to the mid-30s (please refer to past documents on France for further details), and this will potentially trigger another leg down for global risky assets." - source Rcube Global Macro Research:

And my friends at Rcube to conclude:
"With European equity markets having rallied almost 25% since last September’s lows (mostly on expectations that the LTRO liquidity injections would ease the credit crunch), we fear that the surprise factor has just changed sides again. Now that numbers north of €1Tn are circulating for the 29/02 LTRO announcement, positive catalysts are drying up. We believe that sensitivity to European economic data has increased a notch."

In the continuation to our previous conversation, we agree with our friends at Rcube, namely that the focus should be going forward, on European economic data and rising unemployment levels:
"Unemployment expectations in the euro zone have worsened significantly over 2H11, breaching the 10% level of late November. France has the highest forecast level (outside of Spain and Ireland), and with GDP expectations falling, it is increasingly likely that bad debt formation will exceed current estimates, reversing recent trends." - source Bloomberg.

Although LTRO provides cheap funding to European banks, rising unemployment levels and deteriorating credit conditions should consequently lead to a significant rise in Non Performing Loans (NPLs) on banks balance sheet.

As indicated by Bloomberg:
"IMF data show that while the median NPL ratio for the European banks at FY10 was 4%, by 1H11 it was rising for Ireland and Denmark. Bad debt coverage ratios will fall should the stock of non-performing loans rise, as unemployment grows, economic recovery stalls and the associated lower profitability slows retained earnings growth."
NPLs on the rise in Europe - source Bloomberg.

In the meantime, many pundits have been arguing about the importance of the Baltic Dry Index as a leading indicator. For us, it is just another indicator in the deterioration of credit and for tracking NPLs for the Danish banking sector given, as indicated by Bloomberg:
"Nordea highlighted the weak economic environment in Denmark and decreasing collateral values in the shipping industry as key drivers of the 134% increase in loan losses since 3Q. These trends will likely hurt peers Danske Bank (27% share of total Danish lending) and DNB Bank (11% share in syndicated shipping loans)."

If it was only shipping plaguing our Danish Friends...
"Denmark’s biggest lender, Danske Bank A/S, probably returned to profit in the fourth quarter after reporting its first loss since 2009 in the previous period, according to analyst estimates compiled by Bloomberg.
Banks in the worst-performing Nordic economy face more losses on farming loans as that industry struggles to pay down its obligations, Noedgaard said. Agricultural debt swelled 2.6 percent to 359 billion kroner ($63 billion) in 2010, the Danish Agriculture and Food Council estimates. Commercial farms have lost as much as half their value in some parts of Denmark, leaving 6 percent of the industry technically insolvent, according to the council. “We have an agricultural sector that is somewhat challenged by very high levels of debt and a poor performance currently,” Noedgaard said.
Loans to farming, construction and real estate made up 26 percent of total lending at the end of 2010 at banks with less than 50 billion kroner in working capital, according to a May report by the central bank. For the biggest banks, the corresponding figure was 16 percent.
‘Not Looking Good’
At the end of 2011, loans to farms made up 11 percent of banks’ corporate lending and 23 percent of commercial mortgage lending, the Danish Bankers Association estimates.
Danish banks also face growing losses on loans to small-and medium-sized enterprises, which are struggling to survive the fallout of a faltering domestic economy, Noedgaard said." - source Bloomberg - Frances Schwartzkopff - 31st of January - "Denmark’s Bank Crisis Worsening, More Failures Loom, FSA Warns".

We already know "Misery loves company", it was of no surprise to learn the Spanish origin of our latest subordinated bond tenders likely to generate some upcoming haircuts. Banco Popular Espanol launched a tender for Subordinated bonds as well as Asset Backed Securities, for 3 subordinated Lower Tier 2 bonds and 13 tranches of ABS with an aggregate amount outstanding of 1.14 billion euros. The capped face amount being bought back is up to 250 million euros for the LT2 securities and up to 125 million euros of the ABS (via modified Dutch Auction).

In relation to the evolving Spanish situation, from our previous conversation we know that Spanish unemployment has reached 22.9%. It is not surprising to read that Spanish banking giant Santander took a 1.8 billion euros provision against its Spanish real estate exposure last quarter, bringing its coverage ratio to 50% according to Bloomberg:
"With an estimated 170 billion euros of troubled assets outstanding, real estate NPLs reached 28.6% in Spain in 4Q."

Probably a wise move by Santander unlike BBVA, who hasn't so far adjusted its coverage level. While in our conversation "The European Principle of Indifference", we discussed BBVA's accounting gymnastic relating to its Goodwill impairment. We already know the impact Goodwill impairments can have on bank earnings (see "Goodwill Hunting Redux"). It wasn't a surprise to see BBVA having a fourth quarter loss of 139 million euros, (against a profit of 939 million euros in Q4 2010).
From MarketWatch - "Analysts polled by Dow Jones Newswires were forecasting a profit of €152 million, but apparently not all analysts had included that writedown in their forecasts."

What analysts should be concerned about is that BBVA’s bad loans as a proportion of total lending has remained little changed at 4.07 percent in the fourth quarter given according to Bloomberg:
"The bank reported 15.3 billion euros of assets linked to real-estate development in September, of which 4 billion euros was land and 2.8 billion euros was unfinished buildings. BBVA had 6.63 billion euros of foreclosed or acquired real-estate assets on its books, with provisions to cover 33 percent of that amount."

They also should be concerned as well that its Chief Operating Officer Angel Cano said in April 2010 that asset quality was probably going to be “stable from now on.”

According to Dow Jones Newswire - Christopher Bjork:
"The bad debt ratio of Spain's banking sector rose for the eight consecutive month in November to a new 17-year high, while deposits and loans shrunk further as the country edged towards a double-dip recession, data released Wednesday by the Bank of Spain showed.
According to the data, 7.51% of loans held by banks were more than three months overdue for repayment in November, up from 7.42% in October. It is the highest percentage recorded since November 1994, and contrasts with bad debt levels below 1% of all loans in the years prior to the country's 2008 property bust.
High unemployment, falling house prices and the sluggish economy likely will cause bad loans to continue to rise throughout this year and into 2013, said Goncalo Guarda Garcia, an analyst at Portuguese brokerage BPI."

Christopher Bjork also commenting:
"The November data showed banks had cut lending by 2.54% on the year, while the pool of deposits shrunk at an annual rate of 2.14%.
The new Spanish government said earlier this month that after stalling in the third quarter, the economy had contracted in the fourth quarter of 2011 and is set to shrink further this quarter.
Overall, EUR134.1 billion in loans were non-performing in November, up from EUR131.9 billion in October and EUR104.7 billion a year earlier. Banks had set aside a total of EUR73.82 billion to cover these soured loans at the end of November, up from EUR62.2 billion a year earlier. The amount of provisioning will likely rise sharply next month, as many of the country's lenders are expected to set aside a large chunk of their earnings to cover loan losses.
As of November, Spain's banks had total of EUR1.79 trillion in loans outstanding, down from EUR1.84 trillion a year earlier."

"There is a wisdom of the Head, and ... there is a wisdom of the Heart."
Charles Dickens - Hard Times - 1854

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