Saturday 26 May 2012

Credit - St Elmo's fire

“But now St. Elmo's fire appeared, which they had so longed for, it settled at the bows of a fore stay, the masts and yards all being gone, and gave them hope of calmer airs.” - Ludovico Ariosto's epic poem Orlando furioso (1516).

"St. Elmo's fire is named after St. Erasmus of Formiae (also called St. Elmo, the Italian name for St. Erasmus), the patron saint of sailors. The phenomenon sometimes appeared on ships at sea during thunderstorms and was regarded by sailors with religious awe for its glowing ball of light, accounting for the name. Because it is a sign of electricity in the air and interferes with compass readings, sailors also regarded it as an omen of bad luck and stormy weather." - source Wikipedia

We decided once more to follow on one of our favorite theme of maritime analogies looking at the recent evolution of events. After all, our recent post of the 8th of May "The Tempest" was a reference to Shakespeare's late masterpiece of 1623. Our title "The Tempest" was also a closely affiliated to our chosen post title Saint Elmo's fire, displaying a more negative association than our opening quote, as evidence of the tempest inflicted by Ariel according to the command of Prospero in Shakespeare's play:
"Hast thou, spirit, Perform'd to point the tempest that I bade thee?"
"To every article. I boarded the king's ship; now on the beak, Now in the waist, the deck, in every cabin, I flamed amazement: sometime I'ld divide, And burn in many places; on the topmast, The yards and bowsprit, would I flame distinctly, Then meet and join."

As we ramble again in the opening of our post, in our usual habits, one of the earliest references to the St Elmo's fire phenomenon appeared apparently in Alcaeus's Fragment 34a (Ancient Greek lyric poet - 6 BC) about the Dioscuri, or Castor and Pollux. Why are we making a reference to the Dioscuri again you might wonder? Because in our conversation "Leda and the (Greek) Swan and why Europe matters more for Emerging Markets" in reference to the Dioscuri we argued back in early November 2011 the following:
"So now the ECB has a stark choice, similar to the one Pollux was given by Zeus, to save his dying brother Castor by sharing his immortality with his mortal brother (namely European peripheral countries) or spend his time in Olympus (letting Europe fail, one country after another). The ECB is the only institution that can step in and become the lender of last resort, effectively becoming in essence a FED like entity which should be backed by a central treasury (and we discussed this point in our last conversation), or doing nothing and our Greek swan might take us to another path...
We know that Pollux made the right choice and enabling in the process, the two siblings to become the two brightest stars in the constellation (Gemini).
And the Dioscuri "characteristically intervened at the moment of crisis, aiding those who honored or trusted them." - Source Wikipedia."

St. Elmo's Fire is also a 1985 American coming-of-age film directed by Joel Schumacher, a prominent movie of the Brat Pack genre, revolving around a group of friends that have just graduated from Georgetown University and their adjustment to their post-university lives and the responsibilities of encroaching adulthood. Looking at the attitude of our "European Brat Pack", one has to wonder if our European Politicians will ever adjust to their respective responsibilities and embrace somewhat adulthood which would in effect determine whether our Saint Elmo's fire evolves towards a positive outcome in Ludovico Ariosto's fashion, (leading to the rise of the Dioscuri), or to the negative association of Saint Elmo's fire, namely disaster and tragedy. So for Europe, we think it's graduation time but we clearly divagate..."Misery Loves Company" we wrote in October 2011, and in similar fashion many asset classes have recently experienced similar pain due to the ongoing crisis particularly once again in Emerging Markets. In our long conversation, we will look at the broader impact and consequences following our usual credit overview.
The Itraxx CDS indices picture on Friday - source Bloomberg:
Yet another tale of ongoing volatility and a day of two halves. It started on a positive tone with Itraxx Crossover 5 year CDS index (50 European High Yield entities - High Yield credit risk gauge) tightening significantly in the morning before widening in the afternoon on the back of the negative news flow in the afternoon leading the indices to widened slightly further more than Thursday. The SOVx index representing the CDS gauge risk for 15 Western European countries (Cyprus replaced Greece recently in the index) remains at elevated levels and so does the Itraxx Financial Senior Index, a further indication of the existing correlation between financial and sovereign risk.
As indicated by Senior Strategist Divyang Shah's recent article in IFR, severing the financial/sovereign link is easier said than done:
"In the US this has been made easy by the post-Lehman concerns over money market funds and temporary government insurance on non-interest bearing checking accounts that has helped to see total insured bank deposits rise to US$7.3tn at the end of June last year compared with US$5.9tn in the second quarter of 2008 (Fitch).
In the eurozone the insurance of deposits took the form of state guarantees which is why what had started out as a banking crisis also turned into a sovereign crisis for some eurozone states starting with Ireland.
The ECB’s Peter Praet today points towards the need to disconnect the banks from sovereign debt, but this is proving a little difficult. The focus on Spain currently and Bankia especially is about a more general concern that the sovereign does not have the resources in order to overhaul the Spanish banks/financials and thus external assistance in the form of ESM/EFSF funds will be required."

The risk of course of deposit flights is indeed a very serious cause for concerns as indicated in the same note by Divyang Shah:
"A Greek exit has simply accelerated concerns over the outlook for financials as investors question the viability of the euro. The FT this morning highlights how funds are dumping euro assets (“Big European funds dump euro assets”) but what matters is the trickle of deposits leaving the periphery.
Data shows that on a y/y basis (March 11–March12) corporates reduced their deposits in Spanish banks by €31bn while retail investors have reduced theirs by €11bn. The point at which this trickle turns into a flood is uncertain but it’s a risk that the eurozone does not want to flirt with especially as sovereign and financial risk is still intertwined."

Deposits flows are indeed key factors in determining the stability of any financial system in peripheral countries as indicated by Bloomberg:
"With an 18 billion euro recapitalization of Greece's banks agreed and access to standard ECB facilities set to reopen, May's 700 million euros of announced deposit withdrawals may reverse. In 2006, household deposits were 45% of total liabilities vs. 32% in March, while deposits from banks were 6% vs. 25%. Retail funding remains key for future stability." - source Bloomberg.

In relation to Banks' "viability" and connection to sovereign risk, we have been sounding the alarm for a while in relation to subordinated bondholders about the very real risk of debt-to-equity swaps occurring in the financial bond space, meaning more pain and losses for both bondholders and shareholders alike. Time has come to warn senior unsecured creditors as well, as reported by Jim Brunsden and Ben Moshinsky in Bloomberg on Friday:
"The European Union will seek to give regulators the power to impose writedowns on senior unsecured creditors at failing banks as part of measures to prevent taxpayers from footing the bill for saving crisis-hit lenders.
The writedown powers would apply to senior unsecured debt and derivatives, while some other claims, including secured debt and deposits that are protected by government guarantee programs, would be shielded from the losses, according to draft plans obtained by Bloomberg News."
The plans are scheduled to be published on the 6th of June. The plans will have to be agreed on by finance ministers from the EU’s 27 member states and members of the European Parliament before they become law and the bail-in powers must be in place across the EU by the start of 2018.
So yes, our long standing assumptions are indeed correct, namely that debt-to-equity swaps are coming, it is part of the "liability" exercise needed to recapitalize ailing banks in Europe:
"As well as writing down claims, national regulators would also have the power to convert them into equity, according to the draft rules." - source Bloomberg.

When it comes to financial institutions in distress, it seems that more and more financial institutions are relying on ELA (Emergency Liquidity Assistance), which according to Bloomberg is increasingly being tapped - Frozen Europe Means ECB Must Resort to ELA for Banks:
"The first rule of ELA is you don’t talk about ELA.
Each ELA loan requires the assent of the ECB’s 23-member Governing Council and carries a penalty interest rate, though the terms are never made public. David Owen, chief European economist at Jefferies estimates that euro-area central banks are currently on the hook for about 150 billion euros ($189 billion) of ELA loans.
The program has been deployed in countries including Germany, Belgium, Ireland and now Greece. An ECB spokesman declined to comment on matters relating to ELA for this article.
The ECB buries information about ELA in its weekly financial statement. While it announced on April 24 that it was harmonizing the disclosure of ELA on the euro system’s balance sheet under “other claims on euro-area credit institutions,” this item contains more than just ELA. It stood at 212.5 billion euros this week, up from 184.7 billion euros three weeks ago.
The ECB has declined to divulge how much of the amount is accounted for by ELA."
When it comes to European Banking woes, which have been as well a regular feature in our conversations, Bankia share were suspended on Friday - source Bloomberg:
Bankia restated its 2011 results - saying it made a 2.98 billion euro loss for 2011 rather than the 309 million euros in profit it announced in February - and asked for the aid from Spain's bank bailout fund, FROB requesting 19 billion euro of financial support. Late Friday, rating agency Standard and Poor's downgraded Bankia, along with four other banks, to "junk" status: Bankinter, Banco Popular Espanol, Banca Civica, Banco Financiero y de Ahorros S.A.
Formed in December 2010 from merger of seven troubled banks, Bankia's most toxic assets were moved into holding company BFA.
Listed on the Madrid stock exchange in July 2011. Chairman Rodrigo Rato resigned earlier in the month before Bankia was "part-nationalized". Two weeks ago, the government intervened and awarded Bankia a 4.47 billion euro loan.

In our conversation "The Raft of the European Medusa", we discussed the ill-fate Bankia IPO which occurred in July 2011. Rodrigo Rato was the former Managing Director of the International Monetary Fund (IMF) from 2004 to 2007 and declared in relation to the July 2011 IPO for Bankia that it “has been considered a reference point for the Spanish banking industry” and was completed “in the middle of a true storm in the markets that imposed the toughest financial conditions of the last decade,” in a speech on July 20 2011.
Individual investors bought about 60 percent of the shares on sale in the IPO we indicated previously.
How can one expect Spain's to restore investor confidence when:
-as we indicated in our conversation "The road to hell is paved with good intentions‏", Spanish Economy Minister expected Bankia to only need 7 billion to 7.5 billion euro to meet provisional rule and declared he did not expect Spain Mortgage defaults to rise much. Total bill amounts now to 23.47 billion euro and counting for Bankia so far...
-the former 9th IMF Managing Director Rodrigo Rato led a very questionable July 2011 Bankia IPO based on "irregular" and "insincere" financial accounts leading to significant losses for already rattled Spanish individual investors.
One has to wonder. We do.

Meanwhile the price action in the European Bond Space has been volatile to say the least.
The current European bond picture, a story of ongoing volatility for Italy and Spain, but with France, joining the fray with a significant drop in yield over two days, dropping more than 20 bps - source Bloomberg:

French OAT 10 year Government Bond Yield receding significantly on the 24th of May - source Bloomberg:
French bonds falling towards their lowest level of 2.50%, experiencing a significant "flight to quality" move which so far Germany had benefited mostly.

The "Flight to quality" picture as indicated by Germany's 10 year Government bond yields (well below 2% yield), with 5 years Germany Sovereign CDS above 100 bps - source Bloomberg:
"Demand at almost record highs for German bunds and the insurance to hedge against default on the securities indicates that investors are increasingly betting on the breakup of Europe’s monetary union.
The CHART OF THE DAY shows 10-year German bund yields at all-time lows and the cost to insure the benchmark European debt close to record highs. Yields on the securities fell as low as 1.35 percent today as investors seek a refuge while European leaders seek to keep Greece within the euro and the currency bloc’s debt crisis from worsening.
“The signals are counterintuitive, but the market is pricing in an increasing probability of a euro zone breakup,” said Jürgen Odenius, chief economist at Prudential Financial Inc.’s Prudential Fixed Income unit in Newark, New Jersey. “And betting that even though the German balance sheet will take a big hit, that their new currency, which doesn’t yet exist, would
appreciate tremendously.” Credit-default swaps on 10-year German debt rose to 126.09 on Friday, according to data compiled by Bloomberg." - source Bloomberg
This graph has indeed been a regular feature in our conversations for obvious reasons...

Another interesting graph we have been tracking with much interest displays the ongoing relationship between Oil Prices, the Standard and Poor's index and the US 10 year Treasury yield since QE2 has been announced - source Bloomberg:
We do expect the SPX index to fall further in conjunction with Oil prices. We saw that "Misery loves company" back in 2011. In similar fashion, many various asset classes are experiencing significant correlation on the downside, following a similar pattern.

Oil prices are poised to fall further because drilling-rig use and stockpiles are at their highest levels in decades, according to Michael Shaoul, Oscar Gruss & Son Inc.’s chief executive officer as reported by Bloomberg:
"The CHART OF THE DAY compares weekly data on the number of oil rigs, as compiled by Baker Hughes Inc., with the Department of Energy’s weekly figures on crude inventories. Last week’s rig count of 1,382 was the highest in 30 years, Shaoul wrote yesterday in an e-mailed note. The number increased 45 percent from a year ago. Oil stockpiles totaled 382.5 million barrels, the most since mid-1990.
“Even though demand has remained steady, it has been overwhelmed by supply,” the New York-based analyst wrote. “The clear risk is that this will be resolved by sharply lower prices in the coming months.” Oil has tumbled 14 percent on the New York Mercantile Exchange this month. The loss exceeds an 11 percent decline in Brent crude, another benchmark, and would amount to the biggest monthly loss in two years." - source Bloomberg.
Commodities, like in 2011, experienced as well some significant retracement with Cash silver losing as much as 1.3 percent to $27.9275 an ounce and to around $28.30. The metal is 1.5 percent lower this week for a fifth weekly drop, the longest losing streak since July 2011. Raw materials slid to a five-month low this week and more than $4.3 trillion was erased from the value of global equities this month on concern that Greece will exit the euro as the region’s debt crisis deepens according to Bloomberg.

Emerging-markets stocks as well, have seen the longest string of weekly losses since 1994 according to Bloomberg:
"The MSCI Emerging Markets Index sank 0.4 percent to 898.57 at 12:42 p.m. in Hong Kong. The gauge has fallen 0.9 percent this week, poised for a 10th weekly decline, on concern that Europe’s debt crisis and China’s economic slowdown will curb demand for riskier assets."

So yes, "Misery" does indeed, love company, and in 2012 like it did in 2011:
"Emerging-market equity funds posted outflows of $1.5 billion in the week ended May 23, Markus Rosgen, Hong Kong-based analyst at Citigroup Inc. said in a report today. Overseas investors sold $5 billion of emerging-market stocks in Asia, the biggest weekly outflow this year, according to the report." source Bloomberg.
"Emerging-market dollar bonds may start to match declines for developing-nation stocks as the
Greek debt crisis further weakens the risk appetite of investors, according to Mizuho Securities Co.
The CHART OF THE DAY shows JPMorgan Chase & Co.’s Emerging Market Bond Index has dropped 2.4 percent this month, while the MSCI Emerging Markets Index of stocks plunged 12 percent. During a sell-off that started Sept. 8, the indexes fell in tandem, with dollar debt declining 5.5 percent in two weeks. The lower panel shows emerging-market credit-default swaps have being gaining since March, mirroring a rise in the cost to insure against losses leading up to early September."
  - source Bloomberg.
Dollar-denominated fixed-income securities from emerging-market nations have returned 4.2 percent so far in 2012.

"Emerging-market bond funds attracted $633 million in the week to May 16, taking inflows this year above $20 billion, according to U.S. research company EPFR Global. Some $15 billion of that was invested in dollar notes. About $2.3 billion was pulled from equity funds, the second week of withdrawals, paring inflows this year to $20.5 billion, EPFR said." - source Bloomberg
We've seen this movie before...

In relation to European economic data, it is hard to find any comforting news with euro-area unemployment rate climbing to 11 percent in April, the highest in data compiled by Bloomberg back to 1990, and worrisome PMI numbers coming clearly on the weak side.

The divergence between US and European PMI indexes - source Bloomberg:
Widest level reached since 2008, 9.80 between both PMI indexes.

On a final note, our good cross asset friend indicated to us an interesting correlation between the Japan Nikkei index and Japan's sovereign 5 year CDS since the beginning of March. The index has been falling whereas at the same time, Japan's sovereign CDS is rising. The bottom graph indicates so far a fairly muted volatility for the Nikkei index:

If Europe is moving towards a Japanese decade, there might be at least some solace for Spanish Golf players given that according to Bloomberg there has been a high correlation between Golf Membership fees and Tokyo land prices - source Bloomberg:
"The CHART OF THE DAY compares an index of commercial land prices in the Tokyo metropolitan area, compiled by the Japan Real Estate Institute, with the average membership price among Japan’s three most-expensive golf clubs. The average joining fees at Koganei Country Club, Tokyo Yomiuri Country Club and Yomiuri Golf Club this year have fallen about 40 percent compared to the full-year average in 2011, according to prices compiled by Nikkei Golf Corp., a Tokyo-based broker for membership trades.
Tokyo’s office vacancy rates increased to a record high of 9.23 percent in April from 9 percent a month earlier, pushing rents to a record low, according to Miki Shoji Co., a closely held office brokerage company. The vacancy rate was also 9.23 percent in January. The commercial property index peaked in early 1991, about a year after average prices for the country clubs reached a record high of 288 million yen ($3.62 million), the data show. Golf-membership prices soared in Japan during the 1980s bubble economy, then slumped as the country suffered through series of recessions the past two decades. At least 800 golf clubs went bankrupt since 1991, according to Meiji Golf, a Tokyo-based broker. Some of the most expensive clubs in Japan don’t allow memberships for women or foreigners."

"Markets can be as treacherous as the sea". - Macronomics

Stay tuned!

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