Saturday, 28 April 2012

Markets - Credit - Mutiny on the Euro Bounty

"The ship of democracy, which has weathered all storms, may sink through the mutiny of those on board."
Grover Cleveland - 22nd and 24th President of the United States.

Recently in one of our usual credit rambling "Plain sailing until a White Squall", we ventured towards sailing analogies. Looking at the recent developments aboard our European ship, while the weather has clearly been slightly less accommodative in recent weeks with deterioration of economic indicators (Spanish unemployment reaching 24.4%, France unemployment highest since September 1999, Economic sentiment indicator tumbling to 92.8 from 94.5 in March, etc.), we thought our reference to the mutiny which occurred on the Bounty, would be very appropriate in the current context.
The mutiny on the Bounty was a mutiny that occurred aboard the British Royal Navy ship HMS Bounty on 28 April 1789. The mutiny was led by Fletcher Christian against the commanding officer, William Bligh. According to most accounts, the sailors were attracted to the "idyllic life" on the Pacific island of Tahiti and repelled by the harsh treatment from their captain.
As well as Fletcher Christian and part of the crew, our European "sailors" (politicians) were attracted to the "idyllic" initial cheap funding environment provided by a single currency umbrella. The recent austerity "harsh treatments" measures imposed by the captain of the ship (European Commission) which we reviewed in our recent conversation ("The Charge of the Light Euro Brigade") seems to be clearly pushing some of the members of the crew towards mutiny. This explains somewhat, why the European ship is attempting to change tack, moving towards growth, and like our good credit friend put it:
"The word “Growth” will be added to the title of the existing Fiscal Compact. It will make a lot of European politicians happy !
Please celebrate the new name of the "Plan": The Fiscal and Growth Compact!
To paraphrase the famous: “The King is dead ! Long live the King !”...The Austerity is dead ! Long live the Austerity !”

In addition to the rebellion of various crew members aboard our European ship, although the captain is trying to change tack towards growth (with good intent, but growth, like wind speed, cannot be decided solely by political intent...), the Spanish Treasury, in the ship's bunker, might encounter some problems in placing Spanish debt, which until recently had been absorbed by docile domestic banks. The two largest Spanish banks, Santander and BBVA have said they had reached the maximum levels allowed in terms of their policy in risk concentration and consequently will not increase their purchases of Spanish debt from now on, according to their respective CEOs, Alfredo Saenz and Angel Cano according to Spanish newspaper El Confidencial. This is the direct result of the Greek fallout and the disappearance of "Risk-free" ("The curious case of the disappearance of the risk-free interest rate and impact on Modern Portfolio Theory and more!" - Macronomics, September 2011) or political free lunch (we could not resist the irony). The European Banking Association has directed its members to establish a maximum of allocation of capital specifically towards public debt, therefore imposing limits and guidelines. As a reminder, banks are required by the EBA to reach a 9% level of Core Tier 1 Capital by June 2012. Unintended consequences, once more...
Back in our September conversation, we quoted Dr Jochen Felsenheimer from asset management company "assénagon", we would like to quote him again looking at the current context:
 "Banks employ too much debt, because they know that they will ultimately be bailed out. Governments do exactly the same thing. Particularly those in currency unions with explicit - or at least implicit guarantees. It is just such structures that let government increase their debt at the cost of the community. For example, in order to finance very moderate tax rates for their citizens so as to increase the chance of their own re-election (see Italy). Or to finance low rates of tax for companies and at the same time boost their domestic banking system (see Ireland). Or to raise social security benefits and support infrastructure projects which are intended to benefit the domestic economy (see Greece). Or to boost the property market (Spain and the USA). This results in some people postulating a direct relationship between failure of the market and failure of democracy."

So, one has to wonder whether the mutiny aboard our European Ship will lead to our European politicians "sailors" taking control of the ship, sailing away from austerity and conserve popular support, or will  our European banking "sailors" backed by the ECB (courtesy of LTRO 1 and 2) will take control of the ship.
Before we go through our usual quick credit overview and focus on the Spanish banking situation in addition to interesting bond tenders this time in the Spanish RMBS space, here is a final rambling of ours relating to the "Mutiny on the Bounty". The name of the ship sent on the 7th of November 1790 to search for the Bounty and the mutineers was HMS Pandora, under the command of Captain Edward Edwards. Ironically, the fourteen, mutineers and loyal crew alike captured were imprisoned in a makeshift cell on Pandora's deck, which they derisively called "Pandora's Box". Pandora was wrecked on the Great Barrier Reef on 29 August 1791 during the journey home from the South Pacific.  Four mutineers and 31 of Pandora's crew died in the wreck and Captain Edward Edwards was court-martialed on 17 September 1792 for the loss of the ship, but that's another story...(or is it really?). Time for an unfortunate, but necessary (we think) long conversation.

The current European bond picture with the recent rise in Spanish and Italian yields - source Bloomberg:
Spanish 10-year yields briefly topped 6 percent again early on Friday after Standard and Poor's ratings firm late on Thursday cut the country's credit rating to BBB+ (Investment Grade still) on concern about the government's exposure to its ailing banks, ending below 6% at around 5.89% for Spain. Meanwhile Italy sold 5.95 billion euros worth of bonds at higher interest rates than at last month's auction. The yield on the 10-year notes offered at the auction rose to 5.84% from the 5.24% coupon generated in the March 29th auction. Investors bid for 1.48 times the amount offered, down from 1.65 times in March. The Italian Treasury sold as well 2.42 billion euro worth of five-year bonds, with the yield rising to 4.86% from 4.18% compared to a month ago.

The pain in Spain - Spain 5 year Sovereign CDS versus Italy's 5 year sovereign CDS falling to 25 bps (35 bps in our previous post) above Italy, with both countries widening in synch - source Bloomberg:

The "Flight to quality" picture as indicated by Germany's 10 year Government bond yields well entrenched below 2% yield (near the lows of 2011) - source Bloomberg:

Many pundits have recently asked if "Europe was turning Japanese", of course it is. It's D,  D for deflation. German 2 year notes versus Japan 2 year notes - source Bloomberg:
We agree on the Japanese outlook but differ on the reasons they put forward in their conclusion relating to the current strength of the Euro versus the dollar (Sorry George).
We believe the Euro is strong for two reasons, first being swap lines between the FED and the ECB, second being the FOMC decision to delay its interest rate decision until 2014 effectively putting a floor to the Euro. At the beginning of the year many strategists were forecasting a weaker Euro, since the FOMC decision on the 25th of January, it has not happened. In our conversation "The law of unintended consequences" - Macronomics 25th of January 2012, we had already referred to Martin Sibileau's analysis:
Why would we see the Euro flirting with a $1.33 level?
"That should be the case, if the US dollar had been the main funding currency. But we think the game may have changed. Since the LTROs (liquidity lines) from the ECB are in place, and we’re talking about more than trillion Euros, it could well be that the Euro is now the main funding currency within the Eurozone. That would explain a lot of the things we saw.
Indeed, if sovereign debt placed as collateral with the European Central Bank widens, margin is called and banks need to sell first Euro-denominated assets or assets denominated in other currencies, to later buy Euros. This hypothesis would explain why the Euro appreciates as EU stocks fall, commodities fall, US stocks have a hard time appreciating and the cost of USD liquidity falls. In fact, it could also explain why we saw (last week) gold depreciate at the open of the European trading session and appreciate later in the day, as the North American markets open.

There are however unexpected, unintended and negative consequences here, as a result of this fundamental change, namely the implementation of collateralized liquidity lines by the European Central Bank. We drew a graph below to visualize this horrible circularity: As the sovereign risk of EU members deteriorates, margin is called by the ECB, assets need to be sold, Euros have to be bought, the Euro appreciates making the EU members less competitive globally (particularly the peripheral countries) and crowding the private sector out of the Euro funding market. With a more expensive Euro, Germany is less able to export to sustain the rest of the Union and growth prospects wane. At the same time, the private sector of the EU looks for cheaper funding in the US dollar zone, which will eventually force the Fed to not be able to exit its loose monetary stance."  - Martin Sibileau

Europe's horrible circularity case - Martin Sibileau

By tying itself to Europe via swap lines, the FED has increased its credit risk and exposure to Europe:
"If the ECB does not embark in Quantitative Easing, the Fed will bear the burden, because the worse the private sector of the EU performs, the more dependent it will become of US dollar funding and the more coupled the United States will be to the EU." - Martin Sibileau

More downgrades mean more margin calls, more margin calls means more liquidation and more Euros being bought and dollars being sold, with a growing shortage of AAA assets, Europe is moving towards mutiny on the Euro Bounty ship...
"Europe’s economy is faltering as spending cuts across the region undermine hiring and consumer confidence. Investors have favored German government bonds amid rising fiscal tension in Italy and Spain and the resignation of Dutch Prime Minister Mark Rutte this week after failing to garner support for proposed spending cuts." - source Bloomberg. German 2-Year to U.S. Bill Rate: Chart of the Day:
"The CHART OF THE DAY shows the yield on the German note declined on the 26th of April, touching a record 0.089 percent, while the rate on the three-month U.S. Treasury bill was unchanged at 0.0864 percent. The German note yield is down from a 2012 high of 0.357 percent on March 16, and a five-year average of 1.93 percent. The three-month U.S. bill rate rose to a 2012 high of 0.117 percent on Feb. 14, after touching zero on Jan. 10." - source Bloomberg.

Moving on to the subject of the Spanish banking sector, quite frankly we have been baffled by Santander CEO  Alfredo Saenz deriding Spain defaults surge: "“Mortgages get paid in good times and in bad”. He also added: "“Anyone raising this problem as one of the issues for the Spanish financial system is saying something stupid.”
We discussed Spanish issues at length in our conversation "Spanish Denial".
It looks to us, that Alfredo Saenz is, like many, in denial, as a reminder:
"Denial (also called abnegation) is a defense mechanism postulated by Sigmund Freud, in which a person is faced with a fact that is too uncomfortable to accept and rejects it instead, insisting that it is not true despite what may be overwhelming evidence. The subject may use:
-simple denial: deny the reality of the unpleasant fact altogether
-minimisation: admit the fact but deny its seriousness (a combination of denial and rationalization)
-projection: admit both the fact and seriousness but deny responsibility.
The concept of denial is particularly important to the study of addiction." - source Wikipedia
No offense taken, we have heard similar denials before:
"Our liquidity is fine. As a matter of fact, it's better than fine. It's strong." Kenneth Lay - CEO and chairman of Enron from 1985 until his resignation on January 23, 2002.

Time for some facts and "inconvenient truths, as CreditSights put it in their recent report on Spanish banks - We Need to Talk About Real Estate:
"BBVA and Santander reported 1Q12 ROEs that look resilient in the current context, but they are likely to be as good as it gets this year, with the impact of the new real estate provisioning rules postponed into the remaining nine months of the year, and other nonperforming loans still rising."
ROE respectively at 10% for BBVA and 8% for Santander.

Spanish banks actual total return on CDS since the 13th of February: Bankia's CDS was -7.85% (Bankia was formed on December 3, 2010 as a result of the "union" of seven Spanish financial institutions and has been recently facing additional pressure by the Spanish government for another merger...), compared with a negative return of -1.35% on the benchmark, iTraxx Senior Financials. BBVA and Santander are meaningful underperformers, with negative returns of -5.29% and -5.13% respectively over the same period.

The Royal Decree Law enacted in February 2012 established the provisioning needed for the Spanish banking sector at 35 billion euros with another 15 billion of real estate coverage coming in the form of a separate capital buffer to be completed by December 2012. Banks going through an integration process, which expands their balance sheet by at least 20%, can get an extension until June 2013 at the latest but, according to CreditSights, doesn't apply to the major banks such as BBVA, Santander.
And, when it comes to provisioning, as CreditSights put it frankly in their report, the job has not really been done meaningfully:
"In pre-tax terms, BBVA and Santander need to provide around €2.3 bln each in 2012 under the RDL, and neither charged a meaningful portion of this in the first quarter (zero for Santander, and €174 mln for BBVA), postponing the impact to the next three quarters of this year. This contrasts with CaixaBank, which met its 2012 RDL requirement of €2.4 bln in the first quarter, through the combination of a €1.8 bln release of generic provisions and a €601 mln impairment charge through the income statement. BBVA has said that it expects to spread the remaining impairments about evenly through the next three quarters, for a post-tax impact of approximately €500 mln per quarter. Santander is likely to take more than a third of its RDL charge in the second quarter, when it will get the offsetting benefit of around €900 mln capital gains on the sale of a minority stake in its Colombian unit."

Relating to real estate outstanding exposure for BBVA and Santander and transparency, CreditSights added:
"Neither of the major international banks splits out how much of its total 1Q12 impairments are against real estate (either developers or mortgages), and this lack of disclosure about the P and L impact of real estate is frustrating, even if better breakdowns are provided for the balance sheet, in terms of outstanding exposures and accumulated reserve coverage."

Sovereign exposure for Santander and BBVA according to CreditSights:
Santander - "Santander revealed that it had taken €35 bln across both LTROs in Spain, but said that all of this and more remains at the ECB, where it has deposits totalling €37 bln. Nevertheless it did increase its exposure to the Spanish sovereign somewhat, mentioning a €6-7 bln increase during the quarter to €35 bln within the asset/liability management portfolio, which is accounted for as Available-for-Sale."
BBVA - "BBVA said that it took €11 bln in the December LTRO, and then a similar amount again in February, for a total in the region of €22 bln. About two-thirds of this has been allocated to repay other short-term collateralised funding and meet upcoming maturities of covered bonds and other debt. Of the remaining third, about half has been left on deposit at the ECB, and the other half has been invested in the asset/liability management portfolio. However, exposure to the Spanish sovereign has not been increased, and new investments for the portfolio have been concentrated in instruments issued by core eurozone sovereigns or supranationals, plus non-Spanish covered bonds and senior bank paper. BBVA says that it now has €53 bln in Spanish sovereign exposure (both debt and loans)."

There is increased speculation about the creation of a "bad bank" to manage the real estate and other problems plaguing Spanish banks balance sheets. We have indeed, seen this movie before in Ireland as indicated by JP Morgan's recent note "Chronicle of a Banking Crisis Foretold", published on the 26th of April:
"While concerns with the Spanish banking sector have focused mainly on real estate developer exposures, we think that residential mortgage portfolios are potentially the next leg downward in a prolonged banking  crisis where sector solvency remains at risk. Despite the relatively resilient performance of residential mortgage portfolios to date, which can be rationalized by specific factors such as social security support, lender forbearance and mortgage affordability, we think that the readacross from the developments in the Irish mortgage market highlight the scope for a material worsening as unemployment levels increase. In a scenario where the PD (Probability of Default) and LGD (Loss Given Default) in Spain approach those currently witnessed in Ireland, we would expect net post provisioning losses of €59bn for sector mortgage portfolios."

As our good credit friend put it:
"Main Spanish banks have so far refused the government suggestion to create a bad bank which would carry all property toxic assets, arguing that they could manage their assets on their own. The dire reality is that the creation of such bad bank will bring transparency to asset prices, which is not what Spanish bankers want! The murkier the market, the better it is to extend and pretend..."

The ticking bomb of unemployment benefits exhaustion:
"In our mind, the social security net that operates in Spain has therefore done much to initially shield mortgage portfolios from having to recognise significantly deteriorating performance owing to the increase in unemployment. However, owing to the fact that these relatively generous welfare benefits are time-limited, the system has likely provided a postponement in mortgage portfolio performance deterioration rather than a solution to the underlying problem." - JP Morgan

JP Morgan is wondering in their note if Ireland could be used as a proxy for the real estate Spanish woes:
"Ireland: Predictive Paddy Power?
Having attempted to rationalise the behaviour of mortgage NPLs, it is important to determine where these indicators can go to from here and the impact that this can have on sector solvency. In our opinion, the risk posed by the residential mortgage portfolios is of a non-trivial nature given this asset class represents circa 37% of the total loan portfolios for Spanish financial institutions."

For JP Morgan analysts, moving from a Spanish to an Irish scenario could cost the system an extra 55 billion euros. Consolidation of the banking system has been so far the approach to resolving the issues by the regulators in Spain:
"Spanish banks will be given 12 months to comply with the new provisioning requirements, unless they are involved in further sector consolidation in which case they would be allowed 24 months to comply. In our opinion, this is indicative that domestic Spanish policymakers are still adopting the same strategy since the outset of the banking crisis, which is basically using consolidation as a means of improving the robustness of the sector, a strategy which to date has yielded limited results in our opinion." - JP Morgan

JP Morgan also estimates there is material further downside risk in relation to the "Non-Problematic" Real Estate Developer Loans which could potentially lead according to their analysts to an additional losses/provisioning requirements of 68 billion euro against the current non problematic real estate developer portfolio in the event that this would experience significant asset quality issues:
"Downside Risk in the ‘Non-Problematic’ Real Estate Developer Loans:
While the thrust of the provisioning reforms have focused on the problematic real estate developer exposure, which totals €175bn, there has been less attention paid to the real estate developer loans, which are currently deemed performing (€148bn), with only a 7% general provision being required. We think that given the rate of attrition, both in terms of non-performing loans and asset deflation pressures, it would be particularly heroic to assume that a 7% general provision would be sufficient to cover eventual losses for this segment of the loan portfolio. We would have to make the assumption that potentially a material proportion of these assets may already be subject to significant asset quality issues and where the actual losses may require a similar level of coverage as proposed for the problematic assets. As a result, if we contrast the required 7% provisioning rate for the performing real estate developer loans versus the 53% provisioning rate expected by the Bank of Spain for the currently problematic real estate developer exposures, then this would require an additional provisioning requirement of 46%. This would imply that the Spanish banks would require additional provisioning for losses of €68bn in a worst case scenario that the entire real estate developer lending portfolio had to experience asset quality issues."

Spanish Corporate Loan Portfolio Profile - source JP Morgan - Bank of Spain:

Spanish Corporate Loan Portfolio NPLs evolution - source JP Morgan - Bank of Spain:

"While the scale of the NPLs in the real estate developer and construction portfolio have experienced a rapid initial acceleration, mainly as a result of these sectors being at the heart of the crisis, we would expect that with a broadening of economic pressures to other corporate sectors that the level of delinquencies should invariably increase as well. We do not think that the new provisioning regime makes any allowance for this, which is in our opinion a significant weakness given that this would represent a significant part of the overall loan portfolio." - JP Morgan

Interestingly enough, while consolidation is being underway and encouraged by Spanish authorities, this week two bond tenders caught our attention, this time in the Spanish RMBS space, from Banco de Sabadell for an aggregate principal outstanding post amortisation amount of around 1,270 million euro and Banco CAM for 5,693 million euro. The decline in prices for these securities would have been steeper if not for the tender offers...

On a final note, following the rating downgrade of Spain by two notches by Standard and Poor's, Spanish Financial CDS widened on Friday given rating downgrades for these institutions will undoubtedly follow, as indicated by CDS data provider CMA:
[Graph Name]

"Am I a fool? I don't think I'm a fool. But I think I sure was fooled.
Kenneth Lay - CEO and chairman of Enron from 1985 until his resignation on January 23, 2002.

Stay tuned!

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