Tuesday 22 May 2012

Credit - The road to hell is paved with good intentions‏

"The meaning of the phrase is that individuals may do bad things even though they intend the results to be good. An example is the economic policies of the 1920s and 1930s. These were intended to be a prudent response to the economic turmoil following World War I and the Wall Street Crash respectively, but they were one of the causes of the Great Depression and World War II in which millions of people suffered and died." - source Wikipedia
Back in January in our conversation "The European Overdiagnosis", our friends at Rcube Global Macro Research pointed out the inherent flaws of the European currency construct when discussing "The likelihood of a Euro Breakup": "By eliminating currency crises, which were common until the mid-1990s (and at the same time preventing evil “speculators” from making billions on them), the Euro built an economic crisis of far larger proportions. Once again, economics provides a good illustration of the old proverb “the road to hell is paved with good intentions”.
Indeed, while today's price action marked somewhat a respite in the recent sell-off, the unintended consequences of the numerous mistakes made during the ongoing European crisis have yet to be really understand by our European politicians, still struggling to address the many issues of our "European flutter". In our credit conversation we will therefore look at the direct consequences of their actions, as well as looking at the potential outcome for Spanish subordinated bond holders in relation to the necessary exercise of capital increases that will need to take place for the Spanish banking system. But first our credit overview.

The Credit Indices Itraxx overview - Source Bloomberg:
The Itraxx Crossover 5 year CDS index (50 European High Yield companies - High Yield credit risk gauge) was tighter by 33 bps, moving back towards the 700 bps level. It touched 790 bps on Friday. While most indices were overall tighter including Itraxx Financial Senior 5 year CDS index (cost of insuring the senior debt of 25 European banks against default) and Itraxx Financial Subordinated 5 year CDS index, the price action is akin to short covering.

Itraxx Financial Senior index fell to a low of 181 bps in March and has been widening since, reaching 309 bps on the 18th of May, the highest level since the 19th of December - The liquidity picture in four charts. ECB Overnight Facility, Euro 3 months Libor OIS spread, Itraxx Financial Senior 5 year index, Euro-USD basis swaps level - source Bloomberg:

"Mind the Gap" we indicated on the 8th of May - Top Graph Eurostoxx 50 (SX5E), Itraxx Financial Senior 5 year CDS index, German Bund (10 year Government bond, GDBR10), bottom graph Eurostoxx 6 month Implied volatility. - source Bloomberg:
While volatility has somewhat receded slightly in relation to the V2X Eurostoxx, the German 10 year Bund remains tightly below the 1.50% level indicating the "flight to quality" mode experienced so far.

The "Flight to quality" picture as indicated by Germany's 10 year Government bond yields (well below 2% yield),  with 5 year Germany Sovereign CDS above 100 bps. Back in November last year, when Germany's sovereign 5 year CDS went above the 100 bps level, the Bund experienced an impressive widening move above the 2% following the "failed" German auction. Could it be different this time? - source Bloomberg:

The current European bond picture, a story of ongoing volatility for Italy and Spain, with Spain 10 year yields receding towards the 6% level - source Bloomberg:

Truth is, the rising exposure of peripheral banks to government bonds has indeed boosted Sovereign Risk - source Bloomberg:
"While ECB cash injections significantly improved bank liquidity conditions, more than 300 billion euros of announced austerity measures have pressured the budgets of central and local governments. Total euro-zone bank lending to governments has grown 135 billion euros since 2009, tying banks' fates increasingly closely with their sovereigns." - source Bloomberg.

No wonder both the SOVx index (representing the sovereign risk of 15 Western European countries with Cyprus replacing Greece in the index) and the Itraxx Financial Senior 5 year index have moved in synch - source Bloomberg:
The ECB so far has been providing much needed support via LTRO operations to the European Financial sector, avoiding so far direct support of countries and suspending secondary government bonds buying via the Securities Market Programme (SMP). According to Fitch Ratings as reported by Gavin Finch in Bloomberg, a third LTRO operation could take place:
“If a third Longer Term Refinancing Operation is needed, we believe it will be provided,” James Longsdon, a managing director at Fitch’s financial institutions group in London, wrote in a report today. The timing is “unlikely to be imminent without a further significant shock, such as a Greek exit from the euro.”

It could be a possibility given that for weaker peripheral financial institutions, the ECB remains the ONLY source of funding for ailing institutions. The recent downgrades of both Spanish and Italian banks undertaken by rating agency Moody's means that many banks still face funding issues due to the over reliance of many European banks to wholesale funding.  According to Credit Suisse "Q2 issuance has been remarkably light so far, initially driven by earnings blackout periods, but since hampered by volatile market conditions. This lack of supply has been particularly acute for financials.":
"For senior unsecured benchmark deals, we have experienced negative net issuance of approximately EUR94bn since April 2011." - source Credit Suisse

Moody's downgrades of Italian banks were centered on the unsecured Italian Bank Maturities that needs to be replaced:
"Moody's Italian bank downgrade focused on poor wholesale funding access. In 2012 it suggests that only 20% of unsecured maturities will be replaced by new unsecured issues. A structural reliance on market funds poses "one of the biggest challenges for many banks," as Unicredit's 22.5 billion euros of 2012 maturities highlights." - source Bloomberg.

And with soaring Italian bad debt, increasing to 108 billion euros, shadowing Spain, the survival of the weaker players is conditioned by the willingness of the ECB in providing support:
"Moody's cited deteriorating conditions and risk of increasing bad debt in its downgrades of the Spanish and Italian banks. Italy's bad debt has risen 65 billion euros since the start of 2009, close behind Spain's 75 billion increase. Corporate bad debt now represents two-thirds of Italy's total and will likely rise should sovereign yields remain elevated." - source Bloomberg.

In relation to Spain, rising unemployment, rising Non-performing loans and increasing fears of deposit flights (in relation to deposits flight, Greece’s banking system lost 9 billion euros of deposits this year and has seen outflows of 73 billion euros since the 2009 peak according to Bloomberg), reducing therefore the ability for banks in providing credit to support economic growth to the Spanish real economy, doesn't bode well for the its recovery prospects and overly ambitious budget deficits targets. As shown by Bloomberg chart below, Spain's 148 billion euros worth of NPLs dwarf austerity cuts:
"While Spain's bad debt ratio of 8.37% remains below its February 1994 high of 9.15%, its current bad debt outstanding is more than 6x the 1994 equivalent. With provision requirements increasing and a fourth bank clean up underway, further real estate deterioration will materially offset 37 billion of announced austerity cuts". - source Bloomberg.
Many pundits expect that Spain's ability in restoring investor confidence will be determined by the results of the audit of the banks' balance sheets which will be undertaken by Roland Berger Strategy Consultants and Oliver Wyman. While this operation is laudable, we think it is more akin to an operation of damage control and we do not believe it will change investor's willingness in investing in Europe given the growing foreign buyers strike plaguing the European Government market courtesy of "unintended consequences". The Greek PSI created de facto subordination of private sector creditors while protecting both the interests of the ECB and EIB (goodbye "pari passu" - "The European Opprobrium",  classes of bonds or shares having equal rights of payment or level of seniority).
In retrospect, we think our title is uncannily accurate, in relation to Spanish woes, caught in a vicious deflationary spiral: the road to hell is indeed paved with good intentions. We will not comment further on the overly ambitious deficit targets set up by the European Commission as we have been through this exercise previously ("A Deficit Target Too Far"). But, as the explanation goes, in relation to the colloquial expression used in our title, many mistakes were made leading to a flurry of unintended consequences. These errors are forcing our European politicians to try to change tack aboard the "European Bounty" and calling for a "Growth Compact" and asking again for Eurobonds, clearly facing rising risks of mutiny:
-upcoming Greek and Irish elections
-blunt refusal by Germany and Austria in relation to Eurobonds provided the Fiscal compact is not abided by all.
In a note published today by French broker Oddo, Bruno Cavalier indicates clearly the many mistakes taken since the Sovereign debt crisis broke out in 2010:
"The first error was the diagnosis in 2010, namely that the crisis of the euro had its main source, if not unique, in loose fiscal policies. If this point is not debatable in the case of Greece, it is not true for Ireland and Spain. Before 2008, both countries had scrupulously respected the public deficit criteria. Their current difficulties were not caused by an excessive public debt; they appeared when foreign capital financing their housing bubble ended abruptly. In fact, current problems in the euro area therefore reflect as much a fiscal crisis than a balance of payments crisis. However, the policy prescriptions are not necessarily the same in one case or another. Faced with a budget crisis, as in Greece, it is essential to run a thorough reform of the state, forcing us to rethink the tax system to make it more efficient and reduce public funds waste. Faced with a crisis of balance of payments, jeopardizing the banking system, the priority is different. There is  an urgent need to recapitalize institutions in big trouble, if any, by nationalizing them, it should be the priority in Spain. In this country, controlling public deficits cannot  obviously be ignored, but it is secondary to the need of cleaning up the banking system.
The second mistake was to try to subordinate private sector creditors in the context of public assistance programs  for peripheral countries in trouble. This is the famous "Deauville agreement" announced in October 2010 at the end of a Franco-German summit. The ECB, under Jean-Claude Trichet as president at the time, saw its decision immediately criticized. In fact, it resulted in government securities issued by euro area countries ceasing to be considered as "risk-free assets", they were previously even considered "risk-free" when they were not AAA. Risk premiums increased and the appetite for these securities declined, making it more difficult to control debt dynamics."

Of course there is an urgent need to recapitalize Spanish banks, although Spanish Economy Minister expects Bankia to only need 7 billion to 7.5 billion euro to meet provisional rule and doesn't expect Spain Mortgage defaults to rise much.  According to the IMF Spanish Banks losses could reach 260 billion euro and the sector as a whole could need help to the tune of 80 billion euro (5% of GDP). Today saw as well an acceleration in the consolidation of the Spanish banking sector with the replacement of Bancaja Chairman Olivas by Antonio Tirado, the Vice Chairman.

Moving on to our pet subject of subordinated bond holders, Spanish bond holders are likely to experience similar pain than Irish and Portuguese subordinated bond holders given that the need for capital raising will undoubtedly lead to "liability" exercises taking place. In a recent note published by Barclays comparing Spain to Ireland published on the 17th of May, they indicate the following:
"Recent developments in the Spanish banking sector have led investors to draw comparisons between the Spanish and Irish banking systems and analogies between the two are evident, in our view. Most notably, both countries are experiencing severe real estate market adjustments, as large imbalances accumulated over the decade prior to 2008 correct.
Loan losses soared in Ireland: It has been four years since the Irish lending boom came to an end, and the implied loss rate on all Irish bank loans based on the most recent provisioning data is 24%.
Eventually leading to realised losses for subordinated bondholders: The real estate related loan problems at Irish banks eventually caused subordinated bondholders to accept substantial realised losses. On average, subordinated bondholders recovered approximately 20% of par value.
Spanish banks have subordinated debt that could be used for burden sharing: In light of the similarities with Irish banks and the expected need for government capital injections into the Spanish banking system, the question of whether Spanish subordinated bondholders will eventually meet the same fate as their Irish counterparts becomes a legitimate one."

Of course we agree. We have long been warning that, there would be more pain to come for both subordinated bond holders and shareholders alike (see our recent post "Peripheral Banks, Kneecap Recap").

Barclays in their note added:
"Although bank bondholder involvement could help reduce Spain’s debt burden, authorities may avoid coercive burden-sharing because of elevated retail ownership of subordinated bank debt. Nonetheless, we acknowledge that there is downside risk to our base case loss estimates and that the risk of burden-sharing for subordinated bondholders of Spanish banks is material."
The Irish example on a subordinated bond LT2 demise - source Barclays:
"The process was incremental, beginning with the nationalisation of Anglo Irish, advancing with the creation of NAMA, and culminating with the passage of the Subordinated Liabilities Order. Ultimately, subordinated bondholders recovered approximately 20% of par value on average". - source Barclays.
Oh dear...

Ireland also took coercive actions in relation to subordinated bondholders:
"The Credit Institutions (Stabilisation) Act led to the Subordinated Liabilities Order (SLO), which was published on 14 April 2011 and was a key factor in the unfortunate fate of subordinated bondholders. The SLO enabled the State to exercise a wide range of powers over banking institutions, including modifying the terms of subordinated liabilities.
Specifically, the terms of lower-tier 2s were amended such that interest payments became optional and maturities were extended to 2035. The terms of upper-tier 2s were amended to remove all requirements to pay missed coupons. In addition, dividend stoppers were removed from both upper-tier 2 and tier 1s, eliminating the last of the structural leverage previously included in these securities." - source Barclays

In relation to Spain, Barclays indicated:
"Spanish banks have €65bn of subordinated debt outstanding, or €47bn excluding Banco Santander and BBVA. Under our base case scenario, where lifetime loan losses reach €198bn, which would exceed the current stock of provisions by €88bn, the government could be required to contribute €45-50bn to the recapitalisation of the banking sector. The need for public sector support could be reduced substantially through coercive bondholder involvement."

Given the recent outrage by individuals investors relating to the performance of Bankia's share price following its IPO in 2011, it will be interesting to watch the subordinated bond space when looking at the difference in ownership between Ireland and Spain:
One has to wonder if Spanish retail investors will be inflicted additional pain...

On a final note a chart from Bloomberg indicates US Banks CDS track Europe's higher as Spanish yields rise:
"In mid- to late-2007 European bank CDS were driven by liquidity fears and did not track yields particularly closely. As Spanish spreads rose again recently, sovereign fears have this time chased EU bank CDS levels higher. Even with limited sovereign exposure, U.S. banks' spreads are tracking Europe's closely, as fears regarding global growth heighten." - source Bloomberg.

"The safest road to hell is the gradual one - the gentle slope, soft underfoot, without sudden turnings, without milestones, without signposts."
C. S. Lewis -

Stay tuned!

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