Saturday 3 March 2012

Markets update - Credit - Modicum of relief

mod·i·cum (m d -k m). n. pl. mod·i·cums or mod·i·ca (-k ). A small, moderate, or token amount. - The American Heritage, Dictionary of the English Language.

"Thus, the questions we should ask here are what makes the current economic upswing different from the past two recoveries, and whether such differences are sufficient for the economy to reach the sustained growth path."
Toshihiko Fukui - 29th Governor of the Bank of Japan from March 20, 2003 to March 19, 2008.

Given everyone is awaiting the results for the Greek PSI, Collective Action Clauses and CDS trigger, we thought using "Modicum of relief" as a title was, somewhat, an appropriate title in relation to the most recent LTRO program and continued rally in the equity space (Euro Stoxx 50 index reaching a seven-month high) as well as the significant tightening in peripheral bond spreads. While in our previous conversation "Schedule Chicken" we touched on the importance of tracking deposits levels in conjunction with lending surveys, this time around we would like to focus our attention on systemic risk diagnosis. Domestic deposits are essential in defining the default path in a credit cycle (it was the case for Argentina...). But before we jump into more in depth analysis of the latter, it is time for our usual credit overview.

The Credit Indices Itraxx overview - Source Bloomberg:
Following the second round of the LTRO, there has been a raft of new issues in the primary market: 1.1 billion GBP and 1.85 billion euros worth of investment-grade corporate bonds with an average maturity of 4.5 years for euro-denominated investment grade corporate bonds.
The iTraxx SOVx Western Europe Index of sovereign credit-default swaps (15 governments) remains elevated, even after the second round of LTRO. The big beneficiaries of the second round of support remains the financial sector given Itraxx Financial Senior 5 year CDS index  (representing Senior risk level for European banks and financial institutions) is approaching once again the 200 bps level while Itraxx Financial Subordinate 5 year CDS index is marginally tighter, one week on, at around 343 bps (20 bps tighter than last week).

The spread between the Itraxx Financial 5 year CDS index versus the SOVx Western Europe is still indicating the divergence of support courtesy of LTRO 2 and at a record level (138 bps) impacted by the still widening trend of Greek CDS and elevated levels of peripheral CDS sovereign spreads - source Bloomberg:

"Flight to quality" picture, Germany 10 year Government bond yields remain well below 2% yield and falling 5 year CDS spread for Germany, confirming our previous call, namely that demand for precautionary assets remains elevated and the widening for the 10 year German benchmark bond remain somewhat capped - Source Bloomberg:

The current European bond picture with Italy and Spain 10 year government yields accelerating their fall in yields, courtesy of the LTRO 2 effect this time around - source Bloomberg:

While yields are falling, support for peripheral debt is coming from peripheral banks which are in effect encouraged by the LTRO in purchasing their domestic debt, other European banks are not participating to the party.

As indicated by Lucy Meakin in her Bloomberg article - Banks Miss Best of Bond Gains as Fear Trumps Greed: Euro Credit, major European banks are missing out on the big rally in peripheral bonds:
"Italian securities have handed investors a return of 11 percent this year, the most among 26 bond indexes tracked by Bloomberg and EFFAS as of March 1. Ireland’s debt has returned 9.9 percent, Belgium’s 3.8 percent and Spain’s 3 percent, the indexes show. Germany’s bonds, the European benchmark, have gained 0.2 percent, beating only Greece among their euro zone peers. Italian two-year note yields fell below 2 percent for the first time since October 2010 yesterday.
RBS cut its holdings of Italian, Irish, Portuguese, Spanish and Greek government debt by 90 percent in 2011 while boosting those of German bunds, according to a Feb. 23 investor presentation."

We keep saying this:
"It is all about capital preservation rather than a hunt for yield".

From the same Bloomberg article:
"As the credit ratings of countries such as Ireland, Portugal and Greece have been cut, those nation's bonds have also become too risky to remain in many developed-market government indexes, reducing the number of institutions willing to buy the securities. Standard & Poor's downgraded nine euro- area countries, including Italy and Spain, on Jan. 13."

Spain 5 year Sovereign CDS versus Italy's 5 year sovereign CDS level finally moving above Italy - source Bloomberg:
Back in our conversation "Lather, rinse, repeat", we indicated our contrarian stance on Spain versus Italy:
"Given the ongoing deleveraging, in the light of the recent Sovereign CDS convergence between Italy and Spain, we might be viewed as contrarian but looking at 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 in the lights of its housing hangover"

We think Spain Sovereign CDS will drift wider, indicating increasing default risk perception given:
-Italy's shrinking budget deficit to -3.9% in 2011 from -4.6% in 2010,
-Spanish unemployment level expected to reach 24.3% in 2012,
-Spanish Prime Minister Mariano Rajoy has decided to side step the 4.4% deficit target for 2012, for 5.8%:
“I didn’t communicate the deficit target to the heads of state, nor do I have to. This is a sovereign decision taken by Spain.”
Yet another political surprise in true "Greek referendum" style. We think you can reasonably expect more similar "political surprises" with upcoming elections and the European "Schedule Chicken". We all know by now how frantic politicians become when it is election time (Spanish local elections in March).
It will be interesting to see if the European Commission will strictly pursue sanctions under its recent enhanced powers granted in 2011.

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:
ECB Says Overnight Deposits Surge to Record on 3-Year Loans - Jana Randow -source Bloomberg:
"Financial institutions parked 776.9 billion euros ($1.03 trillion) with the Frankfurt-based ECB. That’s the most since the euro was founded in 1999 and up from 475.2 billion euros a day earlier. Banks get 0.25 percent on the deposits."
The jury is still out there to decide whether the new raft of 36 months lending via LTRO 2 will avoid a credit crunch, and we will be closely monitoring the ECB's lending surveys as well as deposits movements in the European banking system.

“The banks that have borrowed liquidity from the ECB are not the same as those that are using the deposit facility of the ECB,” - Mario Draghi
We think the "modicum of relief" of LTRO 2 will be relatively neutral to risky assets compared to LTRO 1. Nomura's recent take on the 36 months LTRO, was the following:
"Market impact is likely to be relatively neutral
Market participants expecting "risk-on" may be mildly disappointed, with some in the market looking for €1trn+ take-down from the operation for the rally to continue. The market is in a more neutral state now than it was in December, with positioning seemingly light in most segments, which should lead to a more muted reaction to this operation than we have seen since the last 36-month operation.
In general, we would expect investors across instruments and curves to remain segregated. The bid to periphery front-end is likely to continue from domestic institutions, though the strength of the rally since December in Italian and Spanish front-ends may leave limited upside potential without an altering of the credit profile of these countries.
We think Bunds are likely to remain tied to the more acute risks in the euro area, such as the developments in Greece, Irish referendum and the French elections. France is likely to be a low beta against difficulties in Italy and Spain, though political risks may provide uncertainty as we approach the early-May elections.
Euribor should continue its downward trend in the short term given the additional liquidity, with Eonia little changed unless the ECB adjusts the deposit which we think is unlikely."

Our good credit friend and we confabulated around the latest round of liquidity injections by the ECB:
"In order to keep the big picture in mind, the global economy now faces higher commodity prices, austerity budgets in Europe, and households decreasing disposable income. The “cocktail” could prove toxic for risky assets, as well as for sovereign bonds. Earnings and credit metrics will be affected by various factors, and budgets targets may not be met, endangering the recovery in the sovereign bond market.
Remember: credit dynamic is based on Growth! No growth or weak growth can lead to defaults and asset deflation."

Moving on to this week subject of systemic risk diagnosis, wholesale bank deposits flights and tracking the loan-to-deposit ratio of banks can be used as a simple gauge of risk profile. It is as well a good indicator of banks 'capacity in supporting lending in their respective economy. Maintaining lending and credit flows is paramount to avoid a credit crunch which would essentially impair GDP growth in the process (as per our "car" analogy used in our previous conversation).

Hungary has been our pet subject in various conversations ("Hungarian dances"). The reason behind our choice is that it appears to us as very good case study for systemic risk diagnosis from a macroeconomic point view (after all our blog is called Macronomics).
Hungary Banks’ Credit Capacity Drops to 2008 Level - Edith Balazs, Bloomberg:
"Hungarian banks’ lending capacity fell in the fourth quarter to a level last seen in September 2008, when the financial crisis engulfed the country, because of tighter and more expensive funding, the central bank said.
“The deterioration in lending capacity was last reported by such a proportion of banks upon the outbreak of the September 2008 crisis,” the Magyar Nemzeti Bank said in a survey published today in Budapest. The drop in lending capacity is driven by shrinking external funding and rising foreign-currency funding costs, it said.
Hungary’s banking industry turned unprofitable for the first time in 13 years in 2011 because of losses from foreign-currency mortgage repayments, rising bad loan provisions and a special industry tax. Regional competition for external funding is becoming more difficult for the Hungarian banks, the central bank said."

From the same Bloomberg article:
"A net 70 percent of banks involved in the survey expect funding conditions to worsen in the first half of 2012, according to the study. Banks plan to further tighten credit criteria for corporate loans in the first half of 2012, it said.
Commercial banks posted a combined loss of 92.6 billion forint ($428 million) last year, the financial supervisory authority, or Pszaf, said on Feb. 23. OTP Bank Nyrt., the country’s largest lender, competes with Italy’s Intesa Sanpaolo SpA and UniCredit SpA, Austria’s Erste Group Bank AG and Raiffeisen Bank International AG, and Germany’s BayernLB."

Looking at Erste Bank Hungary's latest results, it is not a surprise to see how impaired its lending capacity is given its:
-loan-to-deposit ratio of 192%, the highest in the sector.
-the proportion of non-performing loans in the bank's portfolio rose to 20.5% in 2011 from 11.7% in 2010 (The rate in the retail portfolio increased to 16.3% from 11.4%, while the rate in the corporate portfolio climbed to 29% from 12.5%) according to Bloomberg.

A liquidity crisis happens when banks cannot access funding (LTRO helped a lot in preventing a collapse). A solvency crisis can still happen when the loans banks have made turn sour, which implies more capital injections to avoid default (hence the flurry of subordinated bond tenders we have seen). Rising non-performing loans is a cause for concern as well as rising loan-to-deposit ratios.

As a follow up to our previous conversation, the race is on in Europe to improve the loan-to-deposit ratio for peripheral banks given wholesale funding is more challenging, yet improved nevertheless by the two rounds of LTRO. For instance, Lloyds banking group is still a recovery story when it comes to its loan-to-deposit ratio, compared to rock solid Standard Chartered with its 76.4 loan-to-deposit ratio and 11.8 Core Tier 1 capital. Lloyds banking group loan-to-deposit ratio for 2011 was 135%, versus 154% in 2010 and 169% in 2009. Part of the ongoing deleveraging process for banks is supported by the liquidity support and central bank sources (Lloyds took 11.4 billion pounds from LTRO 2).

In relation to systemic risk, credit risk conditions can significantly and persistently be decoupled from macro-financial fundamentals as indicated by Bernd Schwaab, Siem Jan Koopman and André Lucas in their December 2011 paper "Systemic risk diagnostics: coincident indicators and early warning signals":
"We demonstrate that a decoupling of credit risk conditions from macro financial fundamentals has preceded financial and macroeconomic distress in the past with non-negligible lead time (about four quarters).

We mentioned Argentina at the start of our conversation, prior to Argentina defaulting in 2002, as indicated by CreditSights in their 31st of July 2001 paper "Defining the Default Path", they are some interesting similarities to the current Greek and Hungarian situation:
"Should trade finance dry up, the associated reduction in economic activity could be devastating for a country trying to emerge from a deep recession. The second key issue is the behavior of depositors, who have pulled a little over 6 billion US dollars out of the banks this month and are, if press reports are accurate, sending it abroad or stuffing it into the mattresses.
Given Argentina's long history of confiscating wealth (the last time was under ex-president Menem in 1989), the most puzzling aspect of the crisis so far is the relative complacency of the public. This is starting to be tested. The term structure of deposits doesn't bode particularly well, especially as the government has tried to force the banks out longer on the curve than is ideal given deposit withdrawals. We estimate that almost 2/3 of deposits are eligible to be withdrawn in the next 30-60 days and we would be surprised if those deposits that extend in the system were put in time deposits. In addition to the obvious potential of a run on the banks, the lack of liquidity in the system has forced the central banks to provide unprecedented level of repos to the system and also relax reserve requirements. The problem is that this is very unclear whether that additional liquidity is funding anything but capital flight at this point."

Any similarity to actual countries, is purely coincidental...

On a final note, we leave you with Bloomberg Chart of the day, indicating that the induced "LTRO Alkaloid" is at odds with bunds and gold:
"The CHART OF THE DAY compares the Euro Stoxx 50 Index with 10-year German borrowing costs and an inverted gold price. Government bonds and gold are perceived as safe assets in times of financial-market downturns. The equities gauge has gained 9.2 percent this year while gold has climbed 14 percent. Bund yields are little changed since the ECB’s first tender on Dec. 21."

“We cannot have equities at these levels if the European economy needs a further 530 billion euros. People are taking on risk only because the ECB is happy to provide liquidity to banks that are in a dire situation.” - Alberto Espelosin, Ibercaja Gestion.

"There are things known and there are things unknown, and in between are the doors of perception."
Aldous Huxley

Stay tuned!

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