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!

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