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 True to our addictive writing habits, we divagate again, using literary and historical references.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!

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