Sunday, 18 March 2012

Markets update - Credit - Plain sailing until a White Squall?

"It takes a real storm in the average person's life to make him realize how much worrying he has done over the squalls."
Bruce Barton

While, the rally so far this year in risky assets has been very solid, we thought this week, we would venture in our usual ramblings towards sailing analogies. Indeed, the "slush funds" courtesy of LTRO 1 and LTRO 2, have avoided what would have been a very nasty financial disaster in the making with the growing liquidity issues we witnessed in 2011. But, although, plain sailing has been so far the course in 2012, it does not mean problems in Europe have gone away, as the saying goes in true maritime style: "You may tell that to the marines, but the sailors will not believe it".

Looking at the US data so far in 2012, it appears to us that there is indeed a different "cut of jib" between the US ship and the European one.
Indeed, while, the ECB intervention via LTROs has "pushed the boat out" (Push the boat out, to, a boat work term used to imply paying for a "round of drinks" - Royal Navy Slang) and avoided many financial institutions to "walk the plank", in this week credit conversation, we will discuss the interesting disconnect between German 10 year Bond Yields and US Treasury 10 years yields, as well as some of our previous calls, namely credit flows in European peripheral countries and goodwill write-downs.

Time for our usual credit overview!

The Credit Indices Itraxx overview - Source Bloomberg:
One week on and the Markit Itraxx Crossover index (European High Yield names - 40 most liquid sub-investment grade entities) is 50 bps tighter, following on the continuous rally seen in risky assets. SOVx Western Europe is now around 224 bps (14 countries left, following Greece credit event, out of the original 15). The 20th of March will see a rebalancing of all Markit Europe Itraxx Credit indices (every 6 months), with Bouygues SA, Rolls-Royce PLC and HSBC Bank PLC all added to the larger index for Investment Grade, namely Itraxx Main Europe CDS index (125 Investment Grade and above companies). HSBC will replace Banco Popolare (BSPC) in both the Itraxx Main Europe index comprising 125 names and the Itraxx Financial Senior CDS index (25 European Financial institutions).

The trend is your friend - Itraxx Crossover falling in tandem with Eurostoxx Volatility - source Bloomberg:

Itraxx Financial Senior 5 year CDS spread falling with the Eurostoxx surging and volatility falling as well, indicating the strength of the rally so far year to date and the positive impact of the 2 LTROs on Financials in Europe - source Bloomberg:

The pain in Spain - Spain 5 year Sovereign CDS versus Italy's 5 year sovereign CDS widening to around 43 bps above Italy, (27 bps a week ago) - source Bloomberg:

Our"Flight to quality" picture. Germany's 10 year Government bond yields spiking above 2% yield and 5 year CDS spread for Germany still falling, ending somewhat the capped in the rise in yield which had prevailed since the beginning of the year - source Bloomberg:

What we have been monitoring closely has been the acceleration of the drop in the correlation between the US 10 year yield and the German 10 year bund, falling below 60%. Since the end of December 2011, the correlation has been falling significantly - source Bloomberg:
Could this disconnect be a manifestation of the reasons behind the growth difference between the US and Europe data we have been wondering recently? ("Shipping is a leading deflationary indicator").

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:
Given the ECB has "pushed the boat out" with its two LTRO rounds, it is no surprise to see a much improved liquidity picture.

The current European bond picture with Spain yields rising above Italy10 year government yields - source Bloomberg:
While Total Return fund managers have enjoyed a steady rally in German bunds for the last 6 months, the latest rise in German bund might see some of them concerned about their holdings of long dated corporated  bonds. It could entice them to reduce their duration and sell some of their long dated corporate bonds exposure in the rally to ease the pressure.

While it still "Plain sailing" so far in 2012, European political uncertainties in conjunction with weak lending surveys could indeed trigger a "White Squall". As we argued in our conversation "Ecce Creditor":
"Going forward, we think you should be focusing on the ECB's monthly lending surveys, loan-to-deposit levels, deposits flights from peripheral countries as well as the rise in nonperforming loans."

Back in our conversation "Modicum of relief" we argued:
"Maintaining lending and credit flows is paramount to avoid a credit crunch which would essentially impair GDP growth in the process."

The latest quarterly BIS March 2012 report has indeed confirmed our November call ("Leda and the (Greek) Swan and why Europe matters more for Emerging Markets"), namely that the deleveraging in European banks has affected more significantly Emerging Markets in Central and Eastern Europe:
"European banks also cut lending to emerging markets. Their consolidated foreign claims on emerging Europe, Latin America and Asia had already started to fall in the third quarter of 2011. New syndicated and large bilateral loans from EU banking groups to emerging market borrowers then fell in the final quarter of the year. This was in contrast to lending to western Europe and other developed countries, which was essentially unchanged. At the same time, banks tightened terms on new loans to corporations and households in emerging markets. The more pervasive tightening in emerging Europe than elsewhere may have reflected the widespread ownership of banks in the region by EU banking groups. Reduced lending to emerging Europe may also reflect lower demand, however, as the region’s economic growth forecasts fell by more than those for any other during the final quarter of 2011."
"Emerging Europe, the region most dependent on euro area banks for foreign credit, saw the largest drop (Graph 3, bottom left-hand panel). The $35 billion (4.3%) overall decline was led by a $21 billion (4.6%) fall in interbank claims. Lending to non-banks also shrank (–$15 billion or –3.9%).
The countries most affected were Poland (–$13 billion or –8.6%), Hungary (–$5.5 billion or –7.0%) and Turkey (–$9.1 billion or –5.1%). Euro area banks account for more than 80% of all foreign credit to the first two of these countries. They are also responsible for approximately two thirds of all foreign claims on Turkey, whose susceptibility to sudden capital withdrawals is further increased by the fact that more than half of all international claims on its residents have a maturity of less than one year." - source BIS - Quarterly report, March 2012.

In our conversation "Modicum of relief", we indicated why Hungary has been our pet subject ("Hungarian dances") as a very good case study for systemic risk diagnosis:
"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."

Moving to the subject of Goodwill write-downs, one of our previous warnings came in our conversation form November 2011 in "Goodwill Hunting Redux":
"Tip for “banks friends”: First came dividends cuts, then bonds haircuts. Next, we will see some massive write-off (Goodwill ?). UniCredit started, others will follow. The path will be very painful for both shareholders and bondholders."

Yes, UniCredit started, and it was not a surprise for us to see Italy's second largest bank Intesa posting a fourth quarter loss of Eur 10.1 billion on Goodwill write-down on the 15th of March:
Intesa Reports Fourth-Quarter Loss After Goodwill Writedown, by Sonia Sirletti and Francesca Cinelli, Bloomberg
"Intesa Sanpaolo SpA, Italy’s second-biggest bank, posted a fourth-quarter net loss because of a 10.2 billion-euro ($13.3 billion) writedown of goodwill related to mergers and acquisitions.
The net loss was 10.1 billion euros, compared with net income of 505 million euros a year earlier. Excluding one-time items, the quarterly profit was 265 million euros, the Milan-based lender said in a statement. Analysts expected profit of 633 million euros, according to the average of 10 estimates compiled by Bloomberg. The bank cut its dividend by 3 cents to 5 cents per share.
Intesa joined UniCredit SpA, the country’s biggest bank by assets, in reducing the value of intangible assets related to acquisitions. The lender’s purchases included a 29.6 billion-euro takeover of Sanpaolo IMI, merged into Banca Intesa in 2007."

Intesa's stock price evolution year on year  as of 16th of March 2012 - source Bloomberg:

Intesa took 11 billion euro from the LTRO to cover its 2012 wholesale funding needs.
Yet again "analysts" had not included the potential writedown in their forecasts (it was already the case for BBVA's writedown we discussed in our post "Money for Nothing"). Another fine job by analysts... (Analysts expected profit of 633 million euros, according to the average of 10 estimates compiled by Bloomberg).
What is concerning us in Intesa's case is that loan loss provisions more than doubled to 2 billion euros in the quarter. Rising Nonperforming loans (NPLs) will be a drag on Intesa's ability to provide support to the real economy via credit channels namely loans.

On a final note given Portugal has been on the receiving end lately in our conversations ("SOVx Western Europe - And Then There Were 14..."), we will leave you with Bloomberg's Chart of the Day from the 16th, indicating that Portuguese banks will contract credit conditions further to meet comitments made to secure the 78 billion euro aid program, providing fewer loans to the real economy (businesses) and therefore impacting economic growth in the process.
"The CHART OF THE DAY shows that a slowdown in savings growth may make it harder for banks to reduce the ratio of loans to deposits to 120 percent as pledged in the bailout. Deposits rose 0.4 percent in January, the same as the previous month and a fraction of the 1.4 percent pace in November. That’s putting pressure on banks to trim the ratio by curbing new lending.
“The pace of deposits growth seems to be stabilizing,” Andre Rodrigues, an analyst at Caixa Banco de Investimento in Lisbon. If banks are to reach the expected loans-to-deposit ratio by 2014 “it will have to be done mainly through loans.”
Portugal’s five biggest banks had a combined median loan-to-deposit ratio of about 140 percent at the end of 2011, with Banco BPI SA having the lowest at 109 percent. Banco Comercial Portugues SA, Portugal’s second biggest by market value, with the highest ratio, of 145 percent.
The loan-to-deposit goal may end up countering efforts by the European Central Bank and the Portuguese government to get banks to step up lending." - source Bloomberg

By now you can probably "Fathom out" (To ascertain something; to deduce from the facts) in true Royal Navy slang fashion, the consequences a credit crunch will have on Portugal's economy.

"I could not tread these perilous paths in safety, if I did not keep a saving sense of humor."
Horatio Nelson

Stay Tuned!

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