Sunday, 6 May 2012

Credit - From Hektemoroi to Seisachtheia laws?

Seisachtheia (Greek: σεισάχθεια, from σείειν seiein, to shake, and ἄχθος achthos, burden, i.e. the relief of burdens) was a set of laws instituted by the Athenian lawmaker Solon (c. 638 BC–558 BC) in order to rectify the widespread serfdom and slaves that had run rampant in Athens by the 6th century BC, by debt relief. - source Wikipedia

"Under the pre-existing legal status, according to the account of the Constitution of the Athenians attributed to Aristotle, debtors unable to repay their creditors would surrender their land to them, then becoming "hektemoroi", i.e. serfs who cultivated what used to be their own land and gave one sixth of produce to their creditors.
Should the debt exceed the perceived value of debtor's total assets, then the debtor and his family would become the creditor's slaves as well. The same would result if a man defaulted on a debt whose collateral was the debtor's personal freedom.
The seisachtheia laws immediately cancelled all outstanding debts, retroactively emancipated all previously enslaved debtors, reinstated all confiscated serf property to the hektemoroi, and forbade the use of personal freedom as collateral in all future debts. The laws instituted a ceiling to maximum property size - regardless of the legality of its acquisition (i.e. by marriage), meant to prevent excessive accumulation of land by powerful families." - source Wikipedia.

As many in Europe are awaiting the much anticipated results in France for the second round of presidential election, we thought, given Greece is as well having important elections on the very same day which could well decide its European fate, we would like this time around refer to the Athenian policy followed by Solon. Debt relief existed in many ancient societies and many religions. More recently Brady Bonds were a way of tackling the Latin American debt crisis. We do expect to see more debt to equity swaps for some weak peripheral banks but we ramble again. In this long credit conversation, we will look at an updated Eurozone scenario courtesy of our Rcube Global Macro Research friends. But first a much needed long credit overview with a focus on upcoming downgrades, Basel III regulations indicating clear additional "unintended consequences"...

The Credit Indices Itraxx overview - Source Bloomberg:
The cost of insuring against default in Europe is on the rise again as we towards an increasingly risk-off scenario in 2011 redux fashion. First weekly increase in three weeks and 3 days of consecutive rise in three days. Itraxx Crossover 5 year CDS index of 50 High Yield companies rose to 648 bps whereas Itraxx Main Europe 5 year CDS index (125 investment grade entities in Europe) rose to around 142 bps compared to around 138 bps a week ago.

As far as the financial sector is concerned, since February Moody's has put 114 European banks on downgrade review, meaning "Real Money" is bracing for a "May impact". There is some solace for our European banks as 17of the largest banking names are as well in the "iron sight" of the rating agency: Citigroup, Bank of America, Goldman Sachs, JPMorgan Chase, the Royal Bank of Canada and Morgan Stanley.
At the same time European Union Finance ministers are in a bind. On the 3rd of May they failed to reach an agreement to toughen bank capital rules facing stiff British resistance and aiming for a deal on the 15th May at the next meeting. The Basel Committee on Banking Supervision deadline is 1st of January 2013. Denmark is holding the current EU rotating presidency is offering a compromise with a risk buffer of 5% on banks' domestic and non-EU exposures against the initial 7% core capital requirements of their risk-weighted assets proposed by Michel Barnier, the EU's financial services chief.

But the challenge for the financial sector does not end thanks to cheap term-funding provided by the ECB twice. As Nomura indicated in their note Eurozone and Basel III - Fears for Tiers, from the 4th of May:
"Subordination is a recurring aspect of the eurozone debt crisis. This has taken the form of private sector investors in government debt being junior to not just the IMF into a debt restructuring, but also to the ECB and its SMP. It also takes the form of unsecured bank creditors being effectively subordinated by the growing reliance of banks on secured funding, as assets are pledged as collateral and balance sheets grow increasingly encumbered. The ECB's 3yr LTRO collateralised loan facility has accelerated balance sheet encumbrance and exacerbated a shortage of collateral in Europe. Unsurprisingly, eurozone monetary data confirm that banks are still struggling to raise term-funding.
The challenge that many banks face in raising term-funding is particularly problematic as over the coming years the eurozone banking sector will need to implement the Basel III liquidity framework. This forces institutions to increase the maturity of their funding profile. (The EBA estimate the Basel III funding shortfall at EUR1.9trn, which is around 75% of the size of the European senior debt market, and we use simplifying assumptions to calculate the demand for term-funding from the eurozone banks at around EUR4.9trn.) Early adopters of Basel III (most notably banks in Australia and New Zealand) have shown that this process leads to sharply rising bank funding costs, wider lending rate spreads to the policy rate, and as a consequence a lower "neutral" central bank policy rate. This latter point in turn has notable consequences for the conduct of monetary policy and the behaviour of yield curves, which tend to flatten and shed curvature at lower yield levels.
We already expected Basel III to spur these changes over the coming years, but the impact will be magnified if the unsecured financing markets do not recover. This will increase the extent to which Europe experiences a war for deposits among banks, the extent to which lending rates rise and the extent to which balance sheets shrink."

Basel III proposals - BIS ratios to manage liquidity risk:
"-The Liquidity Coverage Ratio (LCR).
The LCR requires that a bank has sufficient liquidity to survive for 30 days under a stressed scenario when global financial markets are assumed to be in crisis, all wholesale funding has dried up, unsecured lines of credit provided by other financial institutions are withdrawn and banks experience partial deposit flight. To mitigate this risk, the LCR requires that banks hold a liquidity buffer of high quality, liquid, central bank repo eligible, unencumbered assets, which are at least equal to the amount of net cash outflows a bank may face over a 30-day period.
-Liquidity buffer.
The liquidity buffer can comprise a minimum 60% of Level 1 assets (cash, excess reserves with a central bank, government, multilateral and selected agency debt) and a maximum 40% of Level 2 assets, which are highly likely to be spread products with for instance a 20% Basel II risk weighting. However, regulators are still debating what assets can be classed as eligible Level 2 assets (in Europe the EBA is suggesting a broader definition that would include highly liquid RMBS and – potentially – non-repo eligible assets such as listed equities and gold).
-The Net Stable Funding Requirement (NSFR).
This is a longer-term liquidity ratio and is aimed at ensuring that banks have sufficient liquidity to meet their funding needs during a stressed scenario for a period of 12 months. In short, a bank’s "stable funding" over a 12-month timeframe must be greater than the amount of required funding (cash requires less stable funding than unencumbered loans to retail and small business customers, which have a residual maturity of less than one year)." - Source Nomura - Eurozone and Basel III - Fears for Tiers, 4th of May.

We think upcoming downgrades means more collateral posting and more haircuts on collateral that can be pledged for funding at the ECB and dwindling "quality assets" therefore even lower German Bund Yields...

"Unintended consequences" as indicated by Nomura in their note:
"-Increased bank demand for government bonds. Banks will need to structurally increase their exposure to government bonds as they accumulate the liquidity buffer.
-Banks disincentivised from relying on short-term funding. In calculating the LCR and NSFR, banks are penalised for relying on short-term wholesale funding as only a portion of this liquidity can be used in calculating liquidity thresholds. Banks are therefore incentivized to issue longer-term debt or take in longer-term deposits.
-Increased demand for fixed deposits. Banks are incentivised to increase the proportion of their deposit funding, which is fixed for a long period of time, and are disincentivised from relying on financial sector deposits, which are ineligible.
-The LTRO is not a long-term solution. Only normal central bank liquidity provisions focused on open market operations can provide liquidity that is Basel III compliant. Non-standard liquidity measures such as the ECB's LTRO operations cannot be included in the calculations.
-Bank funding requirements increase as less liquid assets are held on bank balance sheets. This directly conflicts with the desire of regulators in selected European countries such as the UK to increase bank lending to SMEs and the consumer sector. These loans are less liquid than investment in government bonds or credit products and hence will incur a higher Basel III funding requirement.
-First mover advantage. The bulk of the Basel III liquidity framework needs to be implemented over the next five years and in its entirety by 2019. However, there is a distinct first mover advantage.  In the eurozone alone, the scale of long-term funding needed is larger than the market can realistically provide at yields that are economically viable. Hence, the sooner a bank can increase its long-term debt issuance, raise its term deposit funding, or unwind its balance sheet before its competitors do the same, the cheaper its funding costs will be and the less pressure it will face to reduce its balance sheet. In this respect, the current effective subordination of unsecured creditors of eurozone banks due to the balance sheet encumbrance issue allied to a general aversion of creditors to increase exposure to banks is particularly worrisome as this impedes the ability of banks to obtain term-funding."

We keep repeating this, but it is still very much a game of survival of the fittest....Cash is clearly king in the Basel III framework and, as Nomura put it, will therefore could lead to a war for deposits in Europe...The British stiff resistance to the latest regulatory proposals come from the fact that banks are very large in the UK relative to their GDP:
"The upward pressure on deposit rates is likely to be unequal between countries. In particular, countries with banking systems that are large relative to the domestic deposit base may face particular upward pressure on deposit funding costs and/ or pressure to pare back balance sheet. Clearly, this is an issue in the UK, where the banking sector is extremely large relative to GDP and the pool of domestic savings. Excluding the Bank of England, the combined balance sheet of UK MFIs measured GBP8.3trn in March, more than five times the value of GDP, and deposits only consisted of 37.5% total liabilities." - Nomura

The "Flight to quality" picture as indicated by Germany's 10 year Government bond yields (well below 2% yield) are falling below the lowest level reached in 2011, dipping below 1.60%. It's deflation (デフレ). - source Bloomberg:
Another fresh record low for the German Bund helped by the miserable recent PMI surveys in Europe and the rise in joblessness in Europe reaching 10.9% in the process with European politicians making a dash for a "Growth Pact". Wishful thinking definition: "the erroneous belief that one's wishes are in accordance with reality" - Collins English Dictionary.

As stated above in relation to Basel III, increased demand for government bonds from banks (60% of the liquidity buffer) means more German bund buying...
Prior to the LTROs, banks had been scaling back their exposure to European sovereign debt as well as Sovereign funds as indicated by Josian Kremer in Bloomberg on the 4th of May - Norway Dumps Ireland, Portugal Bonds on Euro Crisis Concern:
"Norway’s sovereign wealth fund sold all its Irish and Portuguese government bonds after rejecting the Greek debt swap and warned that Europe faces considerable challenges.
The $610 billion Government Pension Fund Global returned 7.1 percent, or 234 billion kroner ($41 billion), as measured by a basket of currencies, in the first quarter, the Oslo-based investor said today. Its equity holdings gained 11 percent while its fixed-income investments rose 1.6 percent.
The fund, which voted against Greece’s debt swap this year because it disagreed with being subordinated to the European Central Bank, also said it reduced debt holdings in Italy and Spain amid a broader strategy to cut investments in Europe. The fund added government bonds from emerging markets such as Brazil, Mexico and India."
When the trend is your friend...

The current European bond picture with the recent rise in Spanish and Italian yields - source Bloomberg:
We recently commented peripheral banks in both Italy and Spain have been soaking up their domestic bonds courtesy of LTRO 1 and LTRO 2, the dramatic decline in foreign holdings of Italian and Spanish debt increases concentration of risk in these two countries banks.

Following our focus on Basel III unintended consequences, it is time to move on to the Eurozone Scenario update courtesy of our friends at Rcube Global Macro Research.
"As the positive impact of both the LTRO and the ESM on Eurozone sovereign spreads seems to be fading, we think that it is time to revisit our main scenario for the Eurozone. This year, it appears that Spain and/or Italy are going to be the culprits of a third summer of Eurozone distress."
As stated by Rcube in our note "The European Overdiagnosis" (20/01/2012):
"We believe in a muddle through scenario for the Euro, at least for the next few years. The Euro’s existence solely depends on the willingness of European authorities to pursue the experiment. In the short and medium‐term, there’s just too much political capital invested in the Euro project. Consequently, the path of least resistance will most likely consist in resuming last summer’s emergency summits, probably featuring Merkollande instead of Merkozy.
As Spain’s or Italy’s yields approach levels that triggered previous EFSF intervention, it is becoming clear that the size of the current firewall (€700Bn = €200Bn from the EFSF ‐ some of which is already being used, and €500Bn from the ESM) is largely insufficient. If Italy and Spain were to lose access to the bond market, the current setup would barely cover the PIIGS’ refinancing needs until the end of 2013."

Spain and Italy dwarf other PIIGS’ bond payments:

"In a way, Europe was fortunate that the first endangered countries (Greece, Ireland and Portugal) collectively amounted to only 7% of the Eurozone GDP. Now that Spain (10.6% of the Eurozone GDP) and maybe Italy (16.8%) are also reaching the point where they need assistance from the rest of Europe, the only solution will have to come from the ECB, maybe in a more direct manner than through LTROs. The taboo of large direct ECB interventions will probably fall at some point during the next quarters. The uncertainty surrounding the timing and modalities of these interventions will probably provide interesting trading opportunities.
That said, we have to keep in mind that, in the long‐term, these interventions will do nothing to restore a balance between Eurozone countries’ competitivity." (see Rcube's related comments in "The European Flutter" – The Eurozone’s Other Problem: Unit Labor Cost Divergence).
"Therefore, we believe that some countries will eventually choose to exit the Euro, not because they are forced to do so by the markets, but because it will be the only way to exit the negative spiral of austerity-driven recessions." - source Rcube Global Macro Research.

Rcube's Eurozone breakup model (where recovery values are based on relative Unit Labor Costs), currently gives us the following implied exit probabilities:
We can see that 5 year implied exit probabilities remain very elevated (and at all time highs for Spain).

"However, unlike many, we do not consider a Euro breakup as a doom and gloom scenario. The path leading to the breakup will indubitably be painful, but the end result could offer interesting buying opportunities." - Rcube Global Macro Research

We agree with our friends and clearly indicated it in our post "Equities, there's life (and value) after default!". Hence our "provocative" title "From Hektemoroi to Seisachtheia laws?".

"Indeed, when we look at historical examples of countries that broke their peg with a currency that was too strong relative to the competitivity of their economy, we can see that their equity market performances were quite juicy after their currencies reached to a new equilibrium level." - source Rcube Global Macro Research.

Argentina's stock market performance post peso - source Rcube:

Russia's stock market performance post ruble devaluation - source Rcube:
 Mexican stock market performance post peso devaluation - source Rcube:
Korean stock market performance post won devaluation - source Rcube:

"Devaluations are never easy." - Jeffrey Sachs

Stay Tuned!

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