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

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