Saturday 30 June 2012

Credit - The European crisis: The Greatest Show on Earth

"We bring you the circus — that Pied Piper whose magic tunes lead children of all ages, from 6 to 60, into a tinseled and spun-candied world of reckless beauty and mounting laughter; whirling thrills; of rhythm, excitement and grace; of daring, enflaring and dance; of high-stepping horses and high-flying stars.
But behind all this, the circus is a massive machine whose very life depends on discipline, motion and speed . . . a mechanized army on wheels that rolls over any obstacle in its path . . . that meets calamity again and again, but always comes up smiling . . . a place where disaster and tragedy stalk the Big Top, haunt the backyards, and ride the circus rails . . . where Death is constantly watching for one frayed rope, one weak link, or one trace of fear.
A fierce, primitive fighting force that smashes relentlessly forward against impossible odds: That is the circus. And this is the story of the biggest of the Big Tops . . . and of the men and women who fight to make it — The Greatest Show on Earth! "
 - Cecil B. DeMille, 1952, opening remarks, source Wikipedia.

In continuation to the theme of Great Classic Movies (which we recently touched in our conversation - River of "No Returns") and looking at the on-going European circus, we thought our reference to Cecil B. DeMille 1952 classic would be more than appropriate. After all, in similar fashion to this Best Picture Academy Award winner, our European circus storyline is supported as well by lavish production values, actual circus acts, and documentary, behind-the-rings looks at the massive logistics effort which made big top circuses possible (ECB's SMP, EFSF/ESM...).
But the similarity of our European circus does not stop there. In the storyline of the movie, the show's board of directors planned to run a short 10 week season rather than risk losing $25,000 a day in a shaky post-war economy. The hero Brad Braden, the no-nonsense general manager, bargained to keep the circus on the road as long as it was making a profit, thus keeping the 1,400 performers and roustabouts who made Ringling Bros. and Barnum & Bailey Circus' the Greatest Show On Earth working.
Unfortunately for us, the European "board of politicians" have clearly decided to take the long run option (19th European summit) in our shaky post-financial crisis economy, very much bargaining in similar style to Brad Braden in trying to keep the European circus on the road as long as it is making a profit (Germany's economy being key). But it looks like we are rambling again...
Time for our credit overview, where we will review the latest European plan as well as looking at some worrying trends in the French economy which needs close monitoring, namely margin ratio in the corporate sector as well as rising delays in Terms of Payments as reported by corporate treasurers in the latest AFTE monthly report (French association of corporate treasurers).

The Itraxx CDS indices picture, a tale of ongoing volatility, and recent short covering - source Bloomberg:
Following some break through at the European summit in Brussels, Friday's month end rebalancing trades triggered a buying spree in the credit market courtesy of Real Money demand, fuelled by tighter swap spreads, bund widening and soaring Eurostoxx (+4.96%), with high beta names such as carmakers and perpetual bonds leading the tightening move on the day.

In the credit indices space, most of the credit indices experienced a similar experience to the equity markets, namely a significant tightening move, no surprise therefore to see Itraxx Crossover 5 year index ((High Yield risk gauge, 50 European entities) receding by around 38 bps on the close towards the 660 bps level. Same applies to Itraxx Financial Senior 5 year index and Itraxx Financial Subordinated 5 year index, receding as well in similar pattern by 27 bps and 34 bps.

The slight underperformance of the Itraxx Subordinated 5 year index versus the Senior Itraxx index can be explained by credit markets expecting additional pain to be inflicted to Spanish subordinated bondholders in the necessary restructuring process that needs to take place. Both  the Itraxx Financial 5 year index and the Itraxx Main Europe 5 year index (Investment Grade risk gauge based on 125 European entities including financial institutions)  indices recorded a fourth weekly decline, and the biggest monthly drop since January.

Interestingly, given the recent downgrades which took place in the financial banking space courtesy of the on-going review of rating agencies, it is not a surprise to see the relative stability in spreads between the High Yield risk gauge index Itraxx 5 year Crossover index  and the Itraxx 5 year Subordinated Financial index - source Bloomberg: 
Given the evolution of subordinated bond debt towards the High Yield frontier (below BBB-) since October last year (courtesy of downgrade rating actions), the spread between both indices is staying in a range between 200-250 bps. As we indicated in our conversation "Interval of Distrust", in reference to Morgan Stanley's note - Who Will Catch the Falling Banks?":
"We appreciate that a number of Tier 1 index dropouts, including large names like UniCredit, have recently happened without much disturbance to the market. However, the sheer volume of bonds dropping out in the next couple of months will be unprecedented – following the Moody’s downgrades, we expect €18 billion of Tier 1 and €17 billion of LT2 to have dropped out of the € IG indices since the start of the year." This explained our "interval of distrust" and cautious stance in relation to subordinated bank debt. At the time we also agreed with Morgan Stanley, namely that traditional Real Money High Yield buyers would probably not come to the rescue of the € iBoxx Tier 1 index dropouts...

"Just cause you got the monkey off your back doesn't mean the circus has left town." - George Carlin, American comedian.
While many pundits are lauding the results of the European summit as an important "inflexion point" in breaking the sovereign/banking death spiral correlation spiral that has plagued the European "circus", we "agree to disagree" with them and have yet to see the results in breaking the aforementioned correlation between both the Itraxx SOVx 5 year index (representing 15 Western European sovereign countries CDS including Cyprus) with the Itraxx Financial Senior 5 year index - source Bloomberg:
As far as we can see, this relationship still holds with a relative stable spread between both indices currently at 23.5 bps, highlighting the on-going relationship between sovereign risk and banking risk. While the performance for some financial CDS such as Banco Santander SA dropping by 40.5 bps from a record closing price to 434, and  BBVA falling 41 bps from an all-time high to 458.5 bps, as well as for European financial stocks and Sovereign CDS spreads on Friday have been significant in terms of performance, it remains to be seen if this relationship can be broken.

Italy's 5 year Sovereign CDS versus Spain 5 year Sovereign CDS, receding in synch - source Bloomberg:
CDS on Spain fell by 46 bps to a one month low of 543 bps according to Bloomberg on Friday to a one-month low of  around 543. Italy fell by around 26 basis points to 513 according to Bloomberg.

Truth is, relating to the on-going relationship between Sovereign CDS spreads and European CDS spreads, additional rating actions on the sovereign could as well trigger a "Big-Bang" for the European High Yield market. If peripheral giant companies such as Iberdrola, Enel, Telefonica and others fell into the High-Yield rating category, overall it would represent an additional 40 billion euros worth of bonds and 30% of the existing size of the European High Yield market crossing the frontier from the Investment Grade space towards the High Yield space.

"The Gap is closed" we indicated on the 16th of June in relation to the European space. Now both the Eurostoxx and German 10 year Government yields seems to be moving in synch, higher that is while credit spreads for financials as indicated by Itraxx Financial Senior 5 year CDS index is moving tighter following the European Summit results - 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:

The current European bond picture with Friday's fall of Spanish and Italian yields - source Bloomberg:
While Spanish and Italian government bond yields fell sharply on Friday and safe-haven German government debt sold off heavily in the morning towards 1.67% yield before receding on the close towards 1.60 after euro zone leaders agreed to re-model the bloc's rescue funds, the relief may be brief in this "Risk-On" episode.

No surprise to see a different display in this "Risk-On" stint in our "Flight to quality" picture, Germany's 10 year Government bond yields rose in the morning towards 1.70% before receding and the 5 year CDS spread for Germany has remained firmly above 100 bps in the process - graph below, source Bloomberg:
In the latter part of the European session German Bunds were off their intra-day lows, as market participants slowly digested the European summit announcements and already highlighting holes in the measures. Market participants are indeed becoming more "cynical" towards our "European circus" in its now 19th show.

Markets participants, like ourselves, have to be more cynical, given that the European Union's two rescue fund namely ESM and EFSF only amount to about 20% of the outstanding debt of Italy and Spain, limiting in effect their ability to effectively lower these two countries borrowing costs as indicated by Bloomberg:
"The CHART OF THE DAY shows the EU’s two rescue mechanisms, the European Financial Stability Facility and the yet-to-start European Stability Mechanism, may have 500 billion euros ($621 billion) available for purchases. Italy and Spain have about 2.4 trillion euros combined of outstanding bonds, bills and loans, according to data compiled by Bloomberg.
EU leaders start a second day of talks in Brussels at the 19th summit since the euro region’s debt crisis began almost three years ago. The 27 members will discuss buying Spanish and Italian government bonds to bring down yields that are near the highest since the shared currency began in 1999, Finnish Prime Minister Jyrki Katainen said yesterday. The EFSF and ESM could buy the bonds in the primary market, he said."
- source Bloomberg.
The EU’s permanent fund, the ESM, has a target start date of July 9 and will have a capacity of 500 billion euros. Its predecessor, the 440 billion-euro EFSF, has about 240 billion euros remaining, which euro area officials plan to phase out as the ESM ramps up. Combined use of the funds is capped at 500
billion euros.

As indicated recently by CreditSights in their report from the 26th of June Eurozone Inc:
"For the moment, the €500 bn capacity of the ESM (which is being added to the €200 bn that the EFSF has already earmarked) will be enough to cover:
-The up-to-€100 bn cost of recapitalising Spain's banks.
-The reported €25 bn cost of funding the recapitalisation of Cyprus's banks,
-And the roughly €275 bn needed to cover the Spanish government's forecasted budget deficit and refinancing requirements until the end of 2014 (assuming that the T-bills can continue to be rolled in the private sector).
But the Italian government, if it lost access to market financing, would need around €425 bn over the same period, an amount that would break the bank. And fears over Italy's ability to fund itself would definitely spread contagion to other Eurozone governments. That will require further expansion in the lending capacity. Additionally, expansions of the ESM won't resolve the political pressures that such programmes create. Therefore, we also expect to see the terms of existing programmes renegotiated and eased over the coming 12 months.
The debt of the ESM is a contingent liability of all the non-bailed out Eurozone countries. It is therefore understandable that covering the borrowing requirements of troubled governments without reducing their spending would be unpopular. But those spending cuts are not only equally unpopular in the bailed out countries, they are also self-defeating. Spending cuts won't improve the ability of the bailout countries to produce goods and services through which they can earn euros that will repay the debts. And they are also spreading the recession to the rest of the Eurozone and threatening an already weak recovery.
So while insisting on austerity plays well in Germany, we believe we will see some easing in the conditions imposed on borrowers. The fact that Italy and Spain, the third and fourth largest economies in the Eurozone, are likely to be the next to request assistance may also strengthen the hand of borrowing countries in renegotiating the terms of any macro-economic adjustment programme."

As a reminder from our previous conversation, as reported by Societe Generale, Spain and Italy have significant funding needs until 2014:

Looking at the first insights relating to the European Summit/Circus, there are indeed binding problem with the proposals as highlighted by Desmond Supple from Nomura in his 29th of June note:
"The main conclusion that sparked market optimism was the decision that the EFSF/ ESM would be able to directly recapitalise Spanish banks and would give up its seniority on this issue. Moreover, there were suggestions that the EFSF/ESM could purchase government bonds and maybe provide a yield cap to non-core debt markets. We have already analysed the possible uses of the EFSF/ESM, and highlight three key problems.
1) The EFSF cannot fund itself in sufficient size in the market. Moreover, for the EFSF to access the ECB, it would require an EU treaty change that would enable it to become a bank. The structure of the ESM is more conducive to it being able to fund in the market, but we similarly doubt that it can issue in the size and at a pace that is required. For the ESM to be relevant as a eurozone TARP or a bond buying entity it will realistically need to be converted into a bank and leverage itself via the ECB. This is not being discussed at present and we believe it is currently a step too far for the ECB at this stage.
2) Even if we assume that the ESM can fund itself, another problem is that the seniority of the ESM in bond buying has not been removed. Subordination of investors by a bail-out entity does not matter if the scale of buying is so large that it represents a solution to a crisis. That is not the case with the ESM as we discuss below.
3) The EFSF/ ESM is sub-scale. The EFSF has around EUR240bn in usable funds, and the ESM has a ceiling of EUR500bn. Raising the ESM ceiling is problematic in that it represents a direct potential fiscal liability for eurozone sovereigns, whereas the ECB balance sheet does not since there is no legal requirement for the ECB to be recapitalised if it suffers losses. The ESM is of sufficient size to represent a TARP, but is far below what is required to be a bond buying entity that could alter the asymmetry of risk facing investors. At its current size it would merely – like the SMP – provide an exit route for investors. This is why we have been highlighting that the ESM – if it receives funding from the ECB – could be valuable as a TARP but would not be effective as a bond buying entity, and could even be negative if its seniority on bond holdings was not addressed.
A practical consideration is that the ESM is unlikely to be ready as planned for 9 July. Italy has suggested it may not ratify the ESM until after the summer recess of parliament.
Given these factors, the announcements regarding the EFSF/ESM do not meaningfully improve the policy response to the crisis. (Italy has said that it does not have any intention of applying for aid through a bond buying programme.) The market reaction – Bund weakness, rally in non-core debt markets – would appear a significant over-reaction. However, we now await Day 2 headlines." - source Nomura

We already highlighted point number 1 made by Nomura in our December conversation "The Generous Gambler":
"The EFSF has only raised 16 billion euros from four bonds this year and looking at the amount that needs to be raised in 2012, the prospect of raising more money is looking slimmer by the day."

At that time our good credit friend indicated:
"Main talks were about E.U. combining the EFSF and the ESM by mid-2012 to create 1 Fund with 940 billion euro (1.3 trillion US $) firepower.
Well, obviously there are a number of issues about such a conclusion….
The 500 billion Euro ‘permanent” bailout fund (ESM) was slated to replace the 440 billion "Temporary" European Financial Stability Facility (EFSF) fund. Well, the latest proposal that has the stock markets excited is to merge the two funds…. But there is a bias; it is double counting the money.
The total overall cap is 500 billion euros, of which 160 billion have already been committed or spend to help Greece. Therefore there is only 340 billion left! So how can you get 940 billion euros? This would raise the permanent fund above the agreed upon amount…. And the German Supreme Court has stated this cannot be done without a popular vote (referendum) !!! Also bear in mind that the German Supreme Court has ruled there should not be a permanent bailout fund at all... Which add to the already constitutional issue."

The constitutional issues are indeed are very important issue to take into account as it has the potential in throwing a major real spanner into the on-going European circus. As reported by Annette Weisbach and Karin Matussek from Bloomberg on the 30th of June - Germany’s ESM Role, EU Fiscal Pact Challenged in Court:
"German lawmakers and a democracy group filed suits challenging the country’s participation in Europe’s fiscal pact and the permanent bailout fund after parliament approved the measures late yesterday.
The group “Europe Needs More Democracy” filed a complaint at the Karlsruhe-based Federal Constitutional Court on behalf of about 12,000 people who signed up via the Internet, it said on its website after the bills were passed. Peter Gauweiler, a lawmaker from the Bavarian sister party of Chancellor Angela Merkel’s Christian Democrats, also filed a petition with the court, he said on his website. Opposition Left Party lawmakers also filed a complaint, spokesman Michael Schlick said by phone today.
The plaintiffs claim that the ESM and the fiscal pact undermine the principle of democratic rule and intrude on the powers of German lawmakers. The new instruments overstep the limits the German constitution sets for European integration. The new rules should only take effect if approved by a referendum, the documents contend.
Germany’s parliament approved the laws last night. The measures won two-thirds majorities in both the lower and upper chambers, the Bundestag and Bundesrat, in sessions that stretched until nearly midnight.
Put on Hold
The two measures now await the signature of German President Joachim Gauck, who said June 21 that he would withhold passage pending potential lawsuits to challenge the new laws, as requested by the Karlsruhe court.
The suits also ask the judges to put both laws on hold while they consider their actions.
The plaintiffs rely on a September top court ruling which, while clearing Germany’s participation in the European Financial Stability Facility temporary bailout fund, said parliament must keep control over “elementary budgetary decisions.” Parliament may not relinquish its budget autonomy by “surrendering” to mechanisms that could lead to unpredictable burdens, the judges said at the time.
The court at the time cleared the EFSF because currency union rules didn’t allow the assumption of liability for financial decisions by other states, “including direct or indirect communitization of government debt.”
Germany’s top court has limited Merkel’s discretion in EU bailout policies in at least three rulings. On June 19, the court said the constitution requires the government to have parliament participate in matters of European Union integration, which also covers the ESM.
The judges in February limited the powers of a parliamentary committee set up to approve emergency actions by the EFSF, saying more lawmakers need to be involved." - source Bloomberg.

"The only possible Nash equilibrium is to always defect" we posited recently when discussing game theory and the German position with our iterated European prisoners' dilemma: "one might as well defect on the last turn, since the opponent will not have a chance to punish the player."

Could this most recent legal challenge indicate a  clear German defection in the making in true Nash Equilibrium fashion? One has to wonder...

"Democracy is the art and science of running the circus from the monkey cage." - H. L. Mencken

Moving on to our growing French economy concerns, two indicators warrant close monitoring:
Indicator number 1:
As indicated by French broker Oddo's recent review by their chief economist Bruno Cavalier on the 27th of June, the very weak margin ratio of the French corporate sector is at its lowest level in more than 20 years:
French statistical official department INSEE is also seeing additional weakening for 2012 in a context were financial pressure is mounting already on already stretched corporates margins as indicated by Oddo. France is already sliding towards a more severe recession, following the path of Italy and Spain. This will mean that while additional fiscal resources can be found in 2012 via increase fiscal pressure, 2013 fiscal adjustments to comply with budget targets for 2013 will need significantly more budget cuts to reach the approved targets. In fact, in our conversation "A Deficit Target Too Far" from the 18th of April, we argued: "We also believe France should be seen as the new barometer of Euro Risk with the upcoming first round of the presidential elections.
Whoever is elected, Sarkozy or Hollande, both ambition to bring back the budget deficit to 3% in 2013 similar to their Spanish neighbor. We think it is as well "A Deficit Target Too Far" on the basis of our previous French conversation (France's "Grand Illusion").

Indicator number 2:
When it comes to credit conditions in Europe, not only do we closely monitor the ECB lending surveys, we also monitor on a monthly basis the “Association Française des Trésoriers d’Entreprise” (French Corporate Treasurers Association) surveys. One particular indicator we follow is the rise in Terms of Payment as reported by French corporate treasurers. The latest report is sending us a clear warning signal indicative of a growing deterioration:
The monthly question asked to French Corporate Treasurers is as follows:
Do the delays in  receiving payments from your clients tend to fall, remain stable or rise?
Delays in Terms of Payment as indicated in their May survey published in June have been reported rising by corporate treasurers. Overall +28.8% of corporate treasurers reported an increase compared to April.

When it comes to raising more revenues to plug the  French deficit, while additional fiscal pressure might bring temporary relief to French public finances for 2012, in 2013, the French government will not be in a position to rely on wave of privatizations as it did in the past to bring in much needed revenues. As reported by Bloomberg, France’s contribution to European sales of shares and equity-linked products has tumbled 83 percent from a 2001 peak as state-stake disposals waned and companies opted for debt funding:
"As the CHART OF THE DAY shows, the value of French equity market operations fell to 6 percent of all western European deals last year from a record 35 percent in 2001. French issuers raised $6.8 billion in equity capital in 2011, while the region as a whole sold $116 billion, data compiled by Bloomberg show. “The wave of privatizations has passed,” said Jean-Michel Berling, who heads equity capital markets for Credit Agricole CIB in Paris. “We don’t have any more of them. The statistics might have been bloated at the time by these big IPOs.” The French government sold shares of Electricite de France SA, Europe’s biggest power generator, and Gaz de France SA in 2005, helping bring the country’s ECM contribution to 20 percent of all western European operations, Bloomberg data show. Also, companies such as Danone SA, the world’s biggest yogurt-maker, are opting for the bond market. Danone sold 500 million euros ($633 million) of five-year notes on Sept. 21." - source Bloomberg.

Our 1952 Circus movie reference ended with the troupe mounting a "spec" to open their improvised performance, which kept their show in the black, and enabled them to continue their tour, a magnificent recovery from disaster...We have our doubts in relation to our "European Circus" being able to end in similar fashion to Cecil B. DeMille's masterpiece.

"Every country gets the circus it deserves. Spain gets bullfights. Italy gets the Catholic Church. America gets Hollywood." - Erica Jong, American novelist.

Stay tuned!

Monday 25 June 2012

Credit - The European iterated prisoners' dilemma

"The only possible Nash equilibrium is to always defect. The proof is inductive: one might as well defect on the last turn, since the opponent will not have a chance to punish the player. Therefore, both will defect on the last turn. Thus, the player might as well defect on the second-to-last turn, since the opponent will defect on the last no matter what is done, and so on. The same applies if the game length is unknown but has a known upper limit." - source Wikipedia

In continuation to game theory references, given we recently touched on the subject in our conversation "Agree to Disagree", we thought this time around we would make a reference to the prisoners' dilemna. After all, in Europe, it is all about game theory, given than many pundits are arguing whether Germany will cooperate or not in resolving the on-going European woes, pledging its balance sheet in the process.
In game theory and in relation to our European iterated prisoner's dilemma we have :
"If it is supposed here that each player is only concerned with lessening his time in jail, the game becomes a non-zero sum game where the two players may either assist or betray the other. In the game, the sole worry of the prisoners seems to be increasing his own reward. The interesting symmetry of this problem is that the logical decision leads each to betray the other, even though their individual ‘prize’ would be greater if they cooperated. In the regular version of this game, collaboration is dominated by betrayal, and as a result, the only possible outcome of the game is for both prisoners to betray the other. Regardless of what the other prisoner chooses, one will always gain a greater payoff by betraying the other. Because betrayal is always more beneficial than cooperation, all objective prisoners would seemingly betray the other.
In the extended form game, the game is played over and over, and consequently, both prisoners continuously have an opportunity to penalize the other for the previous decision. If the number of times the game will be played is known, the finite aspect of the game means that by backward induction, the two prisoners will betray each other repeatedly.
In casual usage, the label "prisoner's dilemma" may be applied to situations not strictly matching the formal criteria of the classic or iterative games, for instance, those in which two entities could gain important benefits from cooperating or suffer from the failure to do so, but find it merely difficult or expensive, not necessarily impossible, to coordinate their activities to achieve cooperation." - source Wikipedia.

For now every European politicians in Europe seem to "Agree to Disagree", it looks to us increasingly probable that the outcome could be different to what is expected from Germany. The outcome for the European project is going to be rather binary. It is either "Federalism" or break-up. In fact it is Germany who has always pushed for more integration, more "Federalism". In September 1994 both Karls Lamers and Wolfgang Schauble from the CDU presented their project of accelerated integration to France. It entailed a faster integration within the European Union for Germany, France, Belgium, Luxembourg and Holland. France at the time was under "Cohabitation", Socialist French President Mitterrand had as Prime Minister Edouard Balladur from the opposing party, having lost ruling majority in the parliamentary elections leading to a political stand-off which lasted for two years. The European game is therefore in the political French camp. President François Hollande having garnered a strong political support in the recent parliamentary elections, it will be interesting to watch if French politicians will indeed accept to lose their powers for the collective good, or, if they decide to cling on their individual mandates and powers and a "Federal Europe" will not happen. Will the French surrender again? We dare to ask, staying politically correct in our conversation ("Cheese-eating surrender monkeys", being a derogatory description of French people that was coined in 1995 by Ken Keeler, then-writer for the television series The Simpsons).
Looking at the "social-clientelism" mentality which has prevailed in French politics in the last 30 years, and given the trauma stemming from the European 2005 referendum, one has to posit the French willingness in moving towards a full lasting Federal European Union.
While many are comparing the need for Europe to evolve in a comparable way to the evolution of the United States towards a full Federal Union. We do not have to go that far to find a more relevant example to the current European plight. In fact as our good credit friend mentioned in one of our most recent conversation, he pointed rightfully towards...Switzerland! The Federal Constitution adopted in 1848 is the legal foundation of the modern Swiss federal state. It is among the oldest constitutions in the world.
There are three main governing bodies on the Swiss federal level: the bicameral parliament (legislative), the Federal Council (executive) and the Federal Court (judicial).
Europe already has all three.

"The Swiss Parliament consists of two houses: the Council of States which has 46 representatives (two from each canton and one from each half-canton) who are elected under a system determined by each canton, and the National Council, which consists of 200 members who are elected under a system of proportional representation, depending on the population of each canton. Members of both houses serve for 4 years. When both houses are in joint session, they are known collectively as the Federal Assembly. Through referendums, citizens may challenge any law passed by parliament and through initiatives, introduce amendments to the federal constitution, thus making Switzerland a direct democracy.
The Federal Council constitutes the federal government, directs the federal administration and serves as collective Head of State. It is a collegial body of seven members, elected for a four-year mandate by the Federal Assembly which also exercises oversight over the Council. The President of the Confederation is elected by the Assembly from among the seven members, traditionally in rotation and for a one-year term; the President chairs the government and assumes representative functions. However, the president is a primus inter pares with no additional powers, and remains the head of a department within the administration." - source Wikipedia.

The Swiss cantons also have a permanent constitutional status and, in comparison with the situation in other countries, a high degree of independence. Under the Federal Constitution, all 26 cantons are equal in status (pari-passu...). Each canton has its own constitution, and its own parliament, government and courts. Switzerland also boasts, in similar fashion to the US, a Federal Supreme Court.
So could it be France derailing the whole European project in the end rather than Germany? We wonder.
But we ramble again, erring on the political side. Time for our credit overview, revisiting our pet subject of bond tenders and the ongoing issues in the peripherals, particularly in Spain, given we recently received the results for the Spanish Bank Recapitalisation independent estimate and 62 billion is the number.

"The Gap is closed" we indicated on the 16th of June in relation to the European space. Now both the Eurostoxx and German 10 year Government yields seems to be moving in synch, lower that is while credit spreads for financials as indicated by Itraxx Financial Senior 5 year CDS index is moving wider following rating agencies multiple downgrades and on-going concerns on peripheral sovereign yield levels - 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:

The current European bond picture with Spanish and Italian yields on the rise again - source Bloomberg:
Last week Spanish risk premium reached a new historical high breaching easily the 7% level, with renewed concerns on Spanish banks given the rise in Spanish bad loans. (reaching 8.72% in April from 8.37% in March).

As Societe Generale clearly indicated in their recent global research alert, the markets have indeed lost confidence in Spain:
The challenge European leaders face at the 28-29th June summit is to come out with a big plan as indicated in their recent note by Societe Generale: "Comprehensive restructuring of the economy/the banking sector is  required to restore market confidence....due to a rise in national and regional public debt...".
Indeed, Government debt to GDP could reach 90% of GDP in 2012:
"Spain’s budget deficit is expected to end 2012 at 5.3%, vs 8.9% in 2011, so government debt could reach 90% of GDP this year. On top of that, Spain holds a rising amount of regional debt (which has doubled since December 2008) and contingent liabilities, such as the FROB (Fund for Orderly Bank Restructuring). Taking into account these two elements and the current recession in Spain, debt could rapidly reach unsustainable levels." - source Societe Generale.

Unfortunately, Spanish property market and bank restructuring go hand in hand and as many pundits have indicated, Spanish property bubble and deleveraging has yet to start effectively as indicated by the below graph from Societe Generale:
"House prices could decline by a further 20-25% in an adverse scenario (see last week’s results of the independent evaluation of the Spanish banking sector)." - source Societe Generale.

The Spanish Test Assumptions:

The Stress Test Property Assumptions may not be aggressive enough - source Bloomberg:
"A 19.9% yoy drop in Spanish house prices for the adverse scenario could easily be exceeded if confidence is not restored by the recently announced bailout. At 1Q, yoy declines ranged between 7% and 12% depending on the source, while from 1Q08 highs, house price declines total 21%. Should this rate of deterioration continue, the 4.5% 2013 forecast decline may prove conservative." - source Bloomberg.

The results from the independent audit, the Spanish Assumptions at least looks credible for retail, for corporate less so, according to Bloomberg:
"A 6.8% contraction of lending supply for 2012 and 2013 looks reasonable for retail lending when compared with experience through the crisis. A 6.4% and 5.3% decline for corporate loan supply looks far less cautious when considering that January 2012 data showed a 6% yoy drop, before sovereign fears heightened." - source Bloomberg.

Another issue with the results from the Spanish Test Assumptions comes from the GDP worst case scenario retained no lower than 2009 experience as shown by Bloomberg:
"A decline of 4.1% in Spanish GDP for 2012, the adverse scenario used in the stress test, is less severe than the 4.4% yoy drop of 1H09. While this scenario is calculated from a lower absolute GDP base, it is key for bad-debt experience, unemployment and credit supply. Coordinated EU action is needed to drive long-term interest rate assumptions lower." - source Bloomberg.

We do not want to be seen as party spoilers, but as we posited in relation to the numerous EBA (European Banking Association) test for financial institutions, no test, no stress, no stress, no test...

No wonder Spanish Financial CDS has been on widening trend - source CMA:
[Graph Name]

Unless significant steps are taken in the next European summit, and we mean "shock and awe", given Spain and Italy have significant funding needs until 2014, the game might be coming to an end leading to the defect of some players in the process of our "European iterated prisoners":
- source Societe Generale.

From this similar Societe Generale note, higher loan delinquencies and low industrial production are the main risks:
"Risk 1: Spanish loan delinquencies, back to the 90s
-Spanish bank delinquent loans increased again to 8.72% in April, from 8.37% in March, thereby reaching an 18-year high. This trend is likely to
persist as unemployment and bankruptcies continue to rise.
-Acceleration in number of delinquent loans means Spanish banks are likely to suffer from increasingly larger losses in the future
-Report carried out by two consulting firms estimates Spanish banks' capital shortfall at up to 62bn euros.
Risk 2: European industry deteriorates
-Eurozone industrial production fell 2.3% compared to the same month last year, driven down by the southern Europe countries.
-If the Eurozone fails to undertake the necessary structural reforms, the northern European countries could get drawn into southern Europe’s downward spiral.
-In contrast, US industry has remained quite resilient since the beginning of the year, with total industrial production in May up 4.7 percent yoy."

We will not delve again into the difference between "Stocks and Flows" central to our thought process namely the United States and Europe growth differentiation as we already touched on this subject in our conversation "Growth divergence between US and Europe? It's the credit conditions stupid...".

Moving on to our pet subject of subordinated bond tenders, as at some point, as we argued recently (Peripheral Banks, Kneecap Recap), losses will have to be taken, it is all going Dutch, Dutch auction that is. While ailing Portuguese bank BCP (Banco Comercial Português) announced on the 20th of June a bond tender relating to mortgage backed securities, BBVA bought back some asset-backed bonds too on 26 senior and 25 mezzanine portions of bonds backed by consumer loans, mortgages and business loans, with prices ranging from 46 to 95%. All part of "liability" management exercises to raise some capital and strengthen the capital base, meaning more pain for bondholders in the process.
While the 62 billion being the estimated amount earmarked by independent consultants Oliver Wyman and Roland Berger, burden sharing is currently being considered with the European Union in respect to a 100 billion euro rescue package for the Spanish financial system.
"The government in Madrid is also considering giving more power to the national regulator to restrict sales of loss-absorbing securities such as preferred stock to individuals, said the person. De Guindos has said that preference shares shouldn’t have been sold to retail investors.
Supervisors “failed” over the sale of preference shares to retail investors, said De Guindos June 5 in the Senate.
Spanish lenders sold 22.4 billion euros ($28.2 billion) of preferred stock to individual investors through retail branches. Banks have offered clients holding most of that amount to swap the securities into common stock or other subordinated instruments, according to data compiled by CNMV, the financial markets supervisor." - source Bloomberg
We correctly foresaw this process for weaker peripheral banks.
"First bond tenders, then we will probably see debt to equity swaps for weaker peripheral banks with no access to term funding, leading to significant losses for subordinate bondholders as well as dilution for shareholders in the process." - Macronomics - 20th of November 2011.

We wrote in October 2011 relating to bond tenders and the move towards debt to equity swap:
"We expected others to follow suit and given the difficulty for the weaker players in the peripheral space to access capital at a reasonable rate, as well as needing to boost their core Tier 1 capital base, it was of no surprise to see Portuguese bank Banco Espirito Santo following French bank BPCE in tendering some of its subordinated debt on the 18th of October, but this time around, we have a debt to equity swap."

It is still a game of survival of the fittest, even for some Italian banks, given Monte dei Paschi di Siena (MPS), Italy’s third-biggest bank, according to December 2011 EBA exercise, had a capital shortfall of Euro 3.3 billion. The bank, which must also repay 1.9 billion euros of state aid provided in 2009... Monte Paschi may use the government’s aid program, the so-called Tremonti bond, as part of its plan to boost capital by end of June 2012 (9% Core Tier 1 Capital), Il Sole 24 Ore reported. Also, S and P put MPS’s ratings on Watch Negative citing pressure on the bank’s financial position from a combination of deteriorating asset quality metrics, weakened earnings, and low financial flexibility. Separately, the main shareholder of MPS, the Monte Paschi Foundation has reportedly reached an agreement with its creditor banks to restructure its debt. S and P placed its 'BBB/A-2' L-T and S-T counterparty credit ratings on Italy-based Banca Monte dei Paschi di Siena SpA (MPS) on CreditWatch with negative implications. Agency also put all of its ratings on MPS' subordinated, junior subordinated, and hybrid debt issues on CreditWatch negative. The rating action reflects S and P’s view as the convergence of various negative pressures on MPS' financial profile. Monte Paschi First-Quarter profit fell 61% on higher write downs and has a market value of around 2.8 billion euros. MPS is considering selling its 2.5% stake in the Bank of Italy to the central bank to reach the June 2012 threshold.
As indicated by Bloomberg, Italian corporate and household bad debt totaled 109 billion euros ($138 billion) in April, an increase of 15 percent from a year earlier, according to Bank of Italy data.
Non-performing loans rose to 5.4% in March, up from 3% in June 2008, according to Italian Banking Association data. Impairments, excluding writedowns, rose to 58 billion euros from 50 billion euros. CDS on UniCredit, (Italy's largest bank) rose to 532 basis points on June 19 from 292 on March 19, according to data compiled by Bloomberg.
With unemployment rate at 10.2% in April the highest in most than 12 years, Italian banks as well as their Spanish peers are facing economic deterioration facing but are not plagued by housing related issues and high household private debt levels.

If it could be of any solace to European Banking woes, the new capital regime for US Banks will as well trigger at some point some "liability" management exercises namely bond tenders as indicated by CreditSights in their note - US Banks - The New Capital Regime - Bonjour Basel - 24th of June 2012:
"US banking regulators released proposals for new capital rules for banks aimed at complying with Dodd-Frank Basel III. The new guidelines apply to all US banks with some variations/differences for banks over 50 billion USD in assets and were mostly in-line with expectations.
The new guideline call for higher levels of capital, which could make the financial system safer but also reduce returns and cause banks to reassess their balance sheets. They believe that new requirements fortify the banks’ ability to absorb losses and withstand a potential systemic shock, which is a positive for fixed income investors and both positive and negative for equity.
US banks will now have a new set of minimum capital requirements, incorporate additional capital buffers and limitations outlined in Basel III and phase-out trust preferred securities in accordance with the Dodd-Frank Act. When the new limits are fully phased-in, banks are required to maintain a common equity Tier 1 ratio of 7% and Tier 1 ratio of 8.5%, including a capital conservation buffer of 250 bps. The limitations and changes to risk weights could influence business decisions including lending and mortgage servicing.
Trust preferred securities are phased-out reflecting the requirements of the Dodd-Frank Act.
Non cumulative preferreds continue to receive Tier 1 capital treatment and could make up the majority of non-common equity Tier 1 capital. As a result, they expect issuers and investors to focus primarily on preferreds to address their non-common equity Tier 1 Capital and yield needs, respectively."

On a final note Money Markets wager ECB will cut deposit rate as indicated by a recent Bloomberg Chart of the day:
"The CHART OF THE DAY shows that the Eonia-OIS measure, which estimates interbank borrowing costs over the next three months, fell below the 25 basis points the ECB pays for deposits. The last two times this happened the central bank cut the rate within two weeks." - source Bloomberg

"There are few ironclad rules of diplomacy but to one there is no exception. When an official reports that talks were useful, it can safely be concluded that nothing was accomplished."
John Kenneth Galbraith

Stay Tuned!

Tuesday 19 June 2012

Yogurts, European Consumer Confidence and Consumption

"Consumption may be regarded as negative production."
Alfred Marshall - Economist

Looking at European company Danone's profitability warning leading to a drop in the share price in conjunction with a dismal German investor confidence Zew index (ZEW institute reported that its monthly confidence index dropped by 27.7 points to a level of -16.9 points — its strongest decline since October 1998) has made us reflexionate around Yogurts, European Confidence level and Consumption.
Danone share price taking a beating - source Bloomberg:

As reported by Dermot Doherty in Bloomberg, Danone, the world's biggest yogurt maker cut its profitability forecast as Spanish consumers switch to less expensive products and raw-material costs rise, sending the shares down the most in three years - Danone Cuts Profitability Goal on Southern Europe, Costs:
"Danone is losing market share in dairy in Spain, where about one in four people are unemployed, and will take measures such as cutting costs and introducing new products to react. That will reduce profitability in southern Europe, Chief Financial Officer Pierre-Andre Terisse said today.
“The competitive environment in Spain is a lot tougher, so they’re having to invest more in promotion and pricing,” said Martin Dolan, head of equity research at Espirito Santo in London. “This is very Danone-specific rather than sector wide because of milk raw-material costs, and Danone’s exposure to Spain is far greater at about 8 percent than for other big food companies.”

Danone also indicated in relation to consumer spending in the same article:
"The French yogurt maker in April said it expected consumer spending to remain “under pressure” this year in western Europe. European companies are wrestling with the fallout from a drop in consumer spending as the sovereign debt crisis rocks the region’s economies. Carrefour SA, the biggest European retailer, last week said it would withdraw from Greece and carmaker Fiat SpA said it would cut investment in the region by 500 million euros ($630 million)."

In similar fashion to the trend in shipping with shipping giant Maersk is in fact shifting its business away from Europe (Shipping is a leading deflationary indicator) while Airlines are benefiting from growth outside Europe where traffic to the Americas have been the biggest beneficiary (Air Traffic is a leading deflationary indicator), Danone said sales growth target of 5-7% was unchanged; with robust performance in Asia, Americas, Africa, Middle-East, CIS offsetting pressure in Western Europe.

Leading us to an interesting exercise, plotting Danone share price against the gauge for consumer sentiment which last came at minus 19.3 (from minus 19.9) at the end of May 2012: Danone share price versus European Consumer Confidence since 2006 - source Bloomberg:
At the end of May Consumer Confidence in Europe fell to a two and half year low, following the previous inconclusive Greek elections, Spanish woes and fears of a euro break up.
Yogurts matter as an indicator? One has to wonder...
As austerity bites consumer spending and with Italy and Spain in recession, companies have been forced to lower cost to protect earnings so far. End of May the ECB also indicated that loans to households and companies in the euro zone grew at the slowest pace in two years as the on-going crisis curbed demand for credit.

We already discussed the difference between the growth differential between the USA and Europe (Growth divergence between US and Europe? It's the credit conditions stupid...), which continue to improve in the USA for now as indicated by my friends at Rcube Global Macro Research:
"The private sector credit growth (one of the most reliable Fed Fund leading indicator) has spiked(15% yoy).
The % of US commercial banks reporting stronger commercial & industrial loan demand is back to 2004 levels."
"As a result, US commercial banks will adjust balance sheets to the rising demand for loans, buying fewer Treasuries in the process. Their stock of government securities has risen from less than 10% of total assets in Q4 2009, to 15% today. While the incentive to do so was large over the last 4 years (extremely steep yield curve, falling inflation, broken credit channel), it is less so today. Their pace of purchase has already slowed from 25% YoY in Q3 2009 to less than 10% today, and should weaken further."
- source Rcube Global Macro Research - 18th of June 2012

As far as European Staples are concerned, according to a recent study by Morgan Stanley, impact of private consumption in Europe could be very significant in "European divorce" scenario playing out  - "European Consumer Testing Defensiveness – Downside Case Priced In?" - 14th of June 2012:
"Better prepared for an even worse scenario? In a “European divorce” scenario, the impact on private consumption in Europe could be worse than in 2009 due to the reduced scope for fiscal and monetary policy and higher unemployment. On the positive side, the Consumer Staples sector could see less of a relative de-rating because a) financial leverage is lower, b)inventory levels are generally at more manageable levels, c) commodity inflation is lower, and d) many companies have also expanded their lower-price point offerings. The relative re-rating has also been more measured this time, as the PE premium (60%) has not yet reached the peak from Nov 2009 (80%)."

It isn't only Danone facing similar exposure to weakening consumption levels in Western Europe with a slowdown in consumption levels in peripheral countries such as Spain. Heineken, L'Oreal, Reckitt and others are also exposed to similar trends as indicated by Morgan Stanley in their recent note:
"Within the region, Southern Europe only accounts for less than 10% of group sales on average across the sector. Imperial Tobacco is the most exposed to the region (Spain accounts for around 2/3 of its sales in Southern Western Europe). It is followed by Diageo and Heineken with more than 15% of group sales in the region (mostly Ireland and Spain for Diageo, and mainly Spain and Italy for Heineken). In Food, Danone has the largest exposure to Southern Europe, as Spain (~14% of group EBIT) is its most profitable market." - source Morgan Stanley - "European Consumer Testing Defensiveness – Downside Case Priced In?" - 14th of June 2012

No surprise Morgan Stanley's conclusion:
"Mix is Key
Our Bear case analysis illustrates the importance of having diversified portfolios and geographic exposures. Geographic mix (which we define as higher-margin regions growing faster than the group average and vice versa for lower-margin regions) plays a crucial role in determining the magnitude of downside risk in our Bear case scenarios."

In regards to European Consumption trends, CreditSights in their recent Euro Consumer Takeaways from the 18th of June made the following interesting points:
"-Italy: Confidence has fallen to its lowest level ever as of May; minus 38.6. Spending had already fallen by 2.4% in the 12 months to the first quarter, which is as large as the fall in the 2009 recession. Consumer spending can only fall so far before households fall back on subsistence levels, and prolonged declines in spending are rare. As such they believe that full-year spending decline will be less negative than the 2.4% fall in the year to the first quarter, but we are still expecting to be at least 1% lower over 2012 as a whole in real terms.
-Households debts in France, Germany and Italy are much lower versus national income; compared to the UK (96% down from 103% of GDP in 2009); respectively 55%, 60% and 45% of those country’s annual GDP. Household debt-to-GDP for the Eurozone as a whole is 65%. But while households in France, Germany and Italy are less encumbered by debts and do not, therefore, have to divert income to servicing that debt, low interest rates should still act as some motivation to bring forward spending by borrowing. They believe that is especially the case of borrowing costs are barely any more than households expect their salaries to grow by.
-Consumer borrowing costs , adjusted for wages, in Germany are roughly in line with the crisis low in 2007 at 2%. However, at 4% in France and 6% in Italy, the interest rates on unsecured debts are well above the lowest rates they reached in the 2000s. Additionally, these lower real borrowing costs have not obviously generated greater increases in household debts.

Wealth holdings – the “housing” conundrum:
"In the UK most peoples’ primary provisioning for retirement is their house, that tends to mean that changes in house prices are closely associated with changes in spending. Therefore the stabilisation in UK house prices is good in that falls are not actively undermining spending any more, but in their view it will be a long time before rampant house price appreciation once again drives a boom in consumer spending.
In Germany and France, house prices have, since 2009, been growing strongly. Prices were not over-inflated by a bubble in mortgage lending in the pre-recession years. And to some extent that growth may feed through to a greater willingness to spend in those countries. But their UK contemporaries and so while booming prices in Germany may provide some inclination to spend less, they believe that more consistent income growth and falling unemployment (leading to greater job security and consumer confidence) will be more important drivers of any increases in household spending.
In contrast to France and Germany, Italian house prices have been falling for some time. And falling incomes, tax-induced increases in prices, rising unemployment and worries about the government’s fiscal position are all likely to ensure that spending by Italian households remain depressed with or without the additional impact of house price declines."

UK wise:
"The government’s attempt to tighten its belts at the same time as the private sector is also cutting spending will not only be self-defeating for the government’s fiscal position but is prolonging the period that it takes UK consumers to reduces their debts and feel confident once again about the outlook for their incomes. They expect UK household spending to be centered around the 0% range this year."

With consumer confidence and investor confidence in the doldrums, in conjunction with struggling Southern Europe no wonder yogurts are taking a beating...

"The shelf life of the average trade book is somewhere between milk and yogurt."
Calvin Trillin

Stay tuned!

Saturday 16 June 2012

Credit - Agree to Disagree

"Politics is the art of postponing decisions until they are no longer relevant."
Henri Queuille

Looking at the growing spat between Germany and France in relation to the on-going European saga, we thought this time around we would use the term "Agree to Disagree", given that the term "agree to disagree" or "agreeing to disagree" is referring to the resolution of a conflict (usually a debate or quarrel) whereby all parties tolerate but do not accept the opposing positions:
"It generally occurs when all sides recognise that further conflict would be unnecessary, ineffective or otherwise undesirable. They may also remain on amicable terms while continuing to disagree about the unresolved issues." - source Wikipedia.

While our European politicians continue to be irrational/irresponsible in their behavior, and "agree" to continue to "disagree" for now; as indicated by Wikipedia, investors can as well follow a similar path:
"Economist Frank J. Fabozzi argues that it is not rational for investors to agree to disagree; they must work toward consensus, even if they have different information. For financial investments, Fabozzi posits that an investor's overconfidence in his abilities (irrationality) can lead to "agreeing to disagree"—the investor thinks he is smarter than others."

When looking at the growing divergence between US stocks and US Bond yields, and softening US economic data, one can wonder our long US investors can "agree" to "disagree" - source Bloomberg:
"Any multiyear rally in U.S. stocks may depend on a signal that the bond market has yet to send, according to Michael Hartnett, Bank of America Corp.’s chief global equity strategist.
Bond yields have to reach “an inflection point” before shares can move into what’s known as a secular bull market if history is any guide, Hartnett wrote in a June 12 report.
The CHART OF THE DAY compares the Dow Jones Industrial Average and the yield on 10-year Treasury notes since 1900, as Hartnett did in his report. The yield figures were compiled by Yale University Professor Robert J. Shiller and obtained from his website.
Hartnett highlighted three inflection points in the past century, as shown in the chart. They foreshadowed stock-market booms during the 1920s, after World War II, and throughout most
of the 1980s and 1990s.

A comparable surge in share prices is unlikely, he wrote, “until Treasury yields rise in response to stronger growth and a healthier global economy.” The 10-year yield fell to a record 1.4387 percent this month.
Even so, lower yields are giving investors more incentive to shift into stocks from bonds, the New York-based strategist wrote. He estimated that it will take a 0.6 percent yield for the 10-year’s return in the next 12 months to match stocks’ 20th-century average of 10.5 percent a year."
- source David Wilson, Bloomberg, 15th of June 2012.

"Mind the Gap" we indicated on the 8th of May in relation to the European space. European investors had agreed to disagree, we thought at the time, for too long, and now it looks like the gap has been closing. - 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:

So, as we go through a credit overview, this time around we will focus our attention on the future of Europe, given that our European politicians, in true "Henri Queuille fashion" are once again playing the "can kicking game". Unfortunately for them, with Spanish yields at 7%, crumbling Spanish Cajas and Greek elections on top of weak economic data, it is decision time.
Henri Queuille was the epitome for "professional politician": he served three times as Prime Minister and was 21 times minister in a French government under the IIIrd and IVth French Republic. He was the symbol of the inefficiency and the failure of the French IVth Republic, but we ramble again (do we really?). Time for our credit overview touching again on our pet subject of "subordinated bond holders" ("Peripheral Banks, Kneecap Recap"), Spanish bondholders are starting to experience similar pain than Irish and Portuguese subordinated bond holders. "Liability" exercises are already leading to some interesting debt-to-equity swaps.

The current European bond picture with the recent rise in Spanish and Italian yields - source Bloomberg:
While Spanish bonds breached 7% on Thursday, Spanish bonds eased 6 bps on Friday to close at 6.90% while Italian yields receded to around 6%, falling 15 bps. Some of the intra-day relief in Italian and Spanish debt was due to short covering.

Indeed Spanish bond yields have reached "intervention" level for the ECB, with Prime Minister Rajoy pleading for additional support, although the SMP (Securities Market Programme) has been on hold since March, after reaching 219.5 billion euros - source Bloomberg:
"The CHART OF THE DAY shows Spain’s 10-year yields climbed to the highest rate since the start of the euro yesterday, reaching 6.998 percent, on the brink of the 7 percent threshold that helped trigger bailouts for Greece, Ireland and Portugal. Yields are rising even as Spain requested as much as 100 billion euros ($126 billion) in aid for its banks on June 9." - source Bloomberg

As far as Credit Markets were concerned on Friday, it was short covering time, as a European credit market maker put it:
"Market caught between fears over the Greek elections and prospect of a new QE on both sides of the pond. Generally speaking spreads closed somewhat better today in low beta probably fueled by tightening swap spreads. Flow was balanced and trading remains very technical."
The Credit Indices Itraxx overview - Source Bloomberg:
Indeed, short covering it is, in both government bonds market and credit markets as investors and traders alike do not want to be short risk with the looming Greek elections. No surprise to see Itraxx Crossover 5 year index ((High Yield risk gauge, 50 European entities) receding therefore by  more than 20 bps towards the close. Same applies to Itraxx Financial Senior 5 year index and Itraxx Financial Subordinated 5 year index, receding as well in similar pattern. The Iraxx Europe index, (which comprises 125 high-grade borrowers, 25 of which are banks and insurers), was at 175 bps, five basis point tighter from Thursday's close.

What remains concerning, as we argued in our conversation "St Elmo's fire" on the 26th of May, is that the SOVx index representing the CDS risk gauge risk for 15 Western European countries (Cyprus replaced Greece in March 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:
In fact the rising spread between Financial risk and Sovereign risk to 38 bps is indicative of the growing solvency fears of some sovereigns which received additional pressure this week with both Cyprus and Moody's seeing their sovereign rating downgrade, with both countries requesting support for their ailing financial system.
-Moody’s downgraded Spain 3 notches from A3 to Baa3 on the 13th of June, and placed Spain on review for further downgrade, following Spain’s announcement that it may seek up to 100 billion euros from the EFSF/ESM to recapitalise its banking system (twice Moody’s previous base case estimate and in-line with its adverse scenario).  FROB was also downgraded from A3 to Baa3 accordingly.  Moody’s is further concerned about Spain’s limited access to markets and its dependence on domestic banks, who in turn rely on the ECB, to support new issues.  Moody’s added it would conclude its review within three months as it awaits clarity on the size/terms of the recap, additional estimates from Wyman/Berger, further euro-area initiatives on a fiscal or banking union, and the impact of the recap package to restore market confidence.
-Moody’s downgraded Cyprus as well by two notches from Ba1 to Ba3, on review for further downgrade, due to a material increase in the likelihood of a Greek exit and its impact on the level of support needed by Cypriot banks.  Moody’s  previously estimated Cypriot banks would need support in the range of 5-10% of GDP but now expects it could be materially higher, with Cyprus Popular Bank alone probably accounting for 10% of GDP.

As we indicated in our conversation "The Spread Also Rises" on the 24th of March following the credit indices rebalancing:
"Replacing Greece by Cyprus is the SOVx series 7 index might not be enough to preserve the 15 member's number status. On the 13th of March, Moody's rating agency joined its peer Standard and Poor's in slashing Cyprus to junk status on heightened concerns over its banking sector’s exposure to Greece. Only Fitch rating agency has maintained its rating for Cyprus one notch above junk."

On the back of Spain's downgrade, Moody's downgraded 12 Spanish Sub-Sovereigns, 2 Gov-Related Entities on Friday.

In relation  to our Flight to quality" picture, Germany's 10 year Government bond yields have been recently rising towards 1.50% and the 5 year CDS spread for Germany has remained firmly above 100 bps in the process. In the recently quoted 24th of March conversation "The Spread Also Rises" we also wondered if the rise in German 5 year CDS was an ominous signs of upcoming stress in the markets, which in retrospect was a good sign - graph below, source Bloomberg
While some "agree to disagree", we, on the other hand "agree to agree" with Nomura in relation to their lower forecasts relating to 10 year German yields. In their 14th of June note they added:
"We are bullish Bunds and in recent months have had a series of lower forecasts for 10yr yields - 1.50%, then 1.25% and currently 1.0%. In all cases, we referred to our forecasts as interim, which reflected our view that as the eurozone crisis nears its denouement, yields could fall far below 1.0% as Bunds came to be traded less as yield instruments and more as collateral instruments with a sizable embedded FX option.
 Such bullishness can be somewhat uncomfortable when the asset you recommend experiences a pronounced sell-off. 10 year Bund yields have risen from 1.127% on 1 June to 1.49% currently! Does this sell-off represent the pricing in of new information or does it provide an opportunity for investors who missed the Bund move to establish fresh longs? We think the latter. Two factors have driven the Bund move, and we do not expect either to persist:
1) Bund “Risk” has been reduced ahead of Greek elections. This could increase the market impact of a “bad” election result, while we fear that even a market-positive election outcome would entail an uncertain period while a coalition was formed. More importantly, the Greek election matters less than it did even a fortnight ago. Then, many investors viewed Greece as a catalyst for the latest market down-leg. But in our view Greece was always a symptom of a European policy mix that is undermining growth, fiscal stability and bank solvency. These broader trends have already led to Spain’s need to request bail-out funds and fuel the growing risk that the country loses market access. A positive Greek election will not assuage these risks.
2) Fears of a fiscal union. Hopes have increased that we will see a European Redemption Fund (ERF) or European Banking Union. However, we do not expect meaningful progress towards fiscal union in a timeframe relevant to the current crisis. Of the various Eurobond proposals, the only one which we believe could generate any period of optimism would be the ERF, but even then only until the market analysed the proposal in detail and concluded – as we do – that it is not a solution and may increase the scale of the crisis. Meanwhile, progress in creating a European TARP would be positive but of limited use unless it was combined with talk of turning the ESM into a bank to allow it to fund the recapitalisation via the ECB. (It is difficult to see another source of sufficient funding for the ESM.)
There is also the risk that the escalation of the crisis means that a truly proportional policy response may be more than can be delivered. After all, the response needs to restart rather than just maintain investment flows from core to non-core countries. While we still expect the ECB to initiate QE in Q3, this may now need to combine with an ECB funded TARP. Even then, we assume that the crisis needs to escalate far further before the ECB/ Germany agree to such options. Given these risks, 10yr Bunds around 1.50% seem attractive."

No wonder in the current European context, there is such a difference between the Spanish and German sovereign yield curve  with a much more flatter German curve - source Bloomberg:

Moving on to the core subject of the future for Europe as we are reaching the end for this extended game of "can kicking", we have been wondering what could make us "agree to agree" rather than continue to "disagree" in relation to our European saga. We think Exane BNP Paribas did a good work in summarizing what is needed to review our negative stance, in their recent note "Crunch time is still not with us" from the 14th of June:
"What policies would we regard as sufficiently radical to upgrade?
Any solution to the Euro area debt crisis is going to have to involve one of three unpalatable policies: a) large scale default, b) mutualisation or c) monetisation.
At present, mutualisation appears to be the most likely solution, with the European Redemption Fund (ERF) under discussion in the German parliament; however aggressive monetary action by the ECB remains a possibility."

In relation to the ongoing issue of circularity, which we discussed in our conversation "Eastern Promises", it means that correlation between Sovereign risk and Financial risk is different between countries since January 2010 - Spain versus Germany:
"Spain 5 year Sovereign CDS versus Santander 5 year Senior CDS, correlation is at 0.92. In Germany, the second graph, since January 2010, Germany's Sovereign 5 year CDS correlation with Deutsche Bank Senior 5 year CDS has only been 0.76.
From the above, one can clearly conclude that the more stress you get on a country's sovereign debt, the higher the correlation with the financial sector."

Exane BNP Paribas in their note added in relation to the 100 billion euros plan for the Spanish banking sector added:
"We do not believe that the Spanish programme will materially alter perceptions of that part of the tail risk which related to the danger of a break-up of the Euro. Furthermore, although, as noted above, the benefits from clearing up the financing issues are considerable, and the difference between the market and official interest rates represents a benefit to Spain, all that has really been done here is to move a liability from the banking sector to the sovereign, in the process potentially introducing a layer of subordination to private sector sovereign creditors. Since it is the sovereign credit which is the driver at present (most major bank CDS have tightened markedly relative to their domestic sovereigns), increasing the sovereign indebtedness in order to recapitalise marginal banks does not necessarily benefit that part of the banking sector which is not directly being assisted."

We have long argued that subordination would lead to insubordination, leading to a buyers strike in the European bond markets which is exactly what has happened courtesy of European politicians meddling.
So what could be the possible solutions for the Eurocrisis? These are the possible outcomes according to Exane BNP Paribas:
"In our opinion, unless one of these major bottlenecks is tackled with a plausible solution, any policy initiative, whether actually implemented or merely suggested, is either a non-solution or simply an exercise in buying time. A number of potential solutions are currently circulating in the policy community, along with a distressingly high number of non-solutions." - source Exane BNP Paribas.

In order to "agree to agree" with Exane BNP Paribas, we think the possible solution for the Eurocrisis goes through mutualisation, default and Official sector involvement:
"Finally, there is the option of default (in a general sense of the word "default", taken to include bail-ins, quasi-voluntary debt tenders, negotiated writedowns and similar operations as well as formal defaults within the meaning of CDS contracts). Sufficiently large debt reduction by official sector creditors is simply another means of mutualisation; more chaotic than Eurobonds, less transparent, setting fewer precedents and in nearly every way less satisfactory, but achieving largely the same goal. As long as the eventual defaults, when they happen, involve a majority of official sector creditors (and/or local banks with similarly few international creditors), the potential for contagion to the wider financial markets could be limited." - source Exane BNP Paribas.

Make no mistake, at some point, as our good credit friend put it, losses will have to be taken.
In relation to the recent European political talks relating to Banking Union, "The road to hell is paved with good intentions", we agree with Exane BNP Paribas that it is a "non-solution":
"Europe needs a short term solution before it can consider a long-term one, and the current nature of the short term problem facing Europe is not necessarily one that is addressed by a banking union."

Indeed, looking at the continuous deposits outflows from Greece, European politicians, while continuously agreeing to disagreeing, are once again utterly and completely behind the curve:
"The problem is that the "failure mode" for Euro exit is most likely to be triggered by a banking system collapse in a peripheral economy such as Greece. And the main stress on the Greek deposit base is not coming from bank-specific concerns related to the credit-worthiness of individual banks, or even related to the ability of individual sovereigns to back up their deposit guarantee schemes in the event of systemic bank failure. Put simply, depositors are worried about getting their savings back in drachma rather than in euros. For this reason, the only guarantee scheme that could persuade them to keep money in the local banking system would be a guarantee of the EUR value of their deposits, which would be payable even in the event of euro exit." - source Exane BNP Paribas.

If our European politicians had studied carefully what had happened in Argentina before their default in 2002, they would not be pressing for a "Banking Union" but should rather be more concerned about a deposit guarantee scheme if they are "really serious" about keeping Greece in the Euro. Back in March we argued the following in our conversation "Modicum of Relief":
"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."

In relation to the similarity of Greece in relation to the Argentina crisis of 2001 leading to its 2002 default, we related to a CreditSights article written at the time of the crisis (CreditSights, 31st of July 2001 paper "Defining the Default Path") :
"the most puzzling aspect of the crisis so far is the relative complacency of the public. This is starting to be tested. The term structure of deposits doesn't bode particularly well, especially as the government has tried to force the banks out longer on the curve than is ideal given deposit withdrawals. We estimate that almost 2/3 of deposits are eligible to be withdrawn in the next 30-60 days and we would be surprised if those deposits that extend in the system were put in time deposits. In addition to the obvious potential of a run on the banks, the lack of liquidity in the system has forced the central banks to provide unprecedented level of repos to the system and also relax reserve requirements. The problem is that this is very unclear whether that additional liquidity is funding anything but capital flight at this point."

As far as Spain is concerned, deposits flights have not yet materially happened:
"There was little evidence from aggregate data that the Spanish banking sector was under any particular funding pressure; aggregate domestic deposit balances have declined by 1.3% since the start of the year, which is broadly in line with loan contraction and is therefore likely to reflect overall deleveraging rather than capital flight. Although there were press rumours of a deposit run on Bankia on 11 May (El Mundo), these were not followed up and the official denials appear to have been largely correct in asserting that the deposit flows were seasonal. The large TARGET2 negative balance of the Bank of Spain in the Eurosystem accounts seems to indicate mainly that the liquidity provided in the ECB's monetary operations over the last year has facilitated an orderly withdrawal from Spain by foreign portfolio investors." - source Exane BNP Paribas.

Following on our pet subject of bond tenders, and pain for bondholders as well as shareholders, we have long been expecting such a pain to materialise:
"First bond tenders, then we will probably see debt to equity swaps for weaker peripheral banks with no access to term funding, leading to significant losses for subordinate bondholders as well as dilution for shareholders in the process." - Macronomics - 20th of November 2011.

Banco Sabadell on the 14th of June offered to buy back 1.6 billion euros worth of preferred shares and subordinated debt issued by CAM, a former savings bank  which was acquired by Sabadell in 2011. Sabadell offered to buy back 1.3 billion euros of preference shares issued by CAM and 321 million euros worth of subordinated debt which will be re-invested by investors in newly issued Sabadell shares. Most of these "preferred" shares had been issued to retail clients...

"We believe additional debt to equity swaps will have to happen for weaker peripheral banks, similar to what we witnessed with Banco Espirito Santo in October 2011, as well as for German bank Commerzbank ("Schedule Chicken" - 25th of February 2012)." - Macronomics - Peripheral Banks, Kneecap Recap.

Spain has yet to apply the full extent of the Irish recipe which we discussed "The road to hell is paved with good intentions":"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..."

Looking at the recent Sabadell "liability" exercise, it looks like Spanish retail investors are bound to be inflicted additional pain. As indicated by Bloomberg in a recent article - "Irish Tell Spain to Imagine the Worst and Burn Bank Bondholders":
"In all, subordinated bondholders suffered about 15 billion euros of losses in Ireland, helped by the direct or threatened use of the new laws, due to expire this year.
Spain may be reluctant to impose losses on holders of junior debt. Bankia Group is among Spanish lenders that sold 22.4 billion euros of preferred stock to individual investors through retail branches, according to data compiled by CNMV, the financial markets supervisor.
Because of capital structure rules, these investors should be wiped out before losses are imposed on junior debt holders, a move Spanish Prime Minister Mariano Rajoy’s government may shy away from unless he introduces laws to protect them."

Unless our European politicians rapidly introduce European laws guaranteeing depositors money ("insurance for depositors against the risk of euro exit" is qualitatively different from "deposit insurance"), capital flight might start in Spain as it has already in Greece.
"It should also be noted that for the ECB to guarantee the Euro deposit base against redenomination risk is not necessarily as radical a policy as it might seem; really, all it amounts to is a guarantee that the Euro will function as a currency union. This can be seen through a thought experiment." - Exane BNP Paribas

CreditSights in their article relating to Argentina clearly indicated the dangers of deposit outflows. While complacency is prevailing so far in relation to Spanish deposits, it cannot be taken for granted, as shown by the situation in Argentina which quickly spiraled out of control and led to its default in 2002:
"the most puzzling aspect of the crisis so far is the relative complacency of the public. This is starting to be tested." - CreditSights, 31st of July 2001 paper "Defining the Default Path".

Clearly while our European politicians are continuing to "Agree to Disagree" the clock is ticking on the Doomsday European device. As Exane BNP Paribas put it, our European politicians need to come fast with the defusal kit:
"How to defuse a nuclear bomb:
Managing such a crisis would require the ECB to carry out policies which differ by orders of magnitude from anything it has attempted so far. As we noted in an earlier section, a deposit insurance scheme cannot guarantee the entire deposit base against redenomination risk; this is another example of the general principle that a basically fiscal entity cannot do the work of a monetary authority. Furthermore, in a case of a run motivated by fears of euro exit, the guarantee required could not realistically be restricted to the insured deposit base. Even for Greece, the total deposits (domestic NFCs and households) total EUR160bn; for Spain the liability would be EUR714bn and for Italy EUR1trn. Clearly, the only body that could credibly backstop a guarantee to pay depositors the Euro value of their euro-denominated deposits would be the ECB."

On a final note, as indicated by Bloomberg Italy could rapidly come back in the spotlight, should European politicians fail to stabilise Spanish woes: "Italian corporate and household bad debt, totaling a combined 107.6 billion euros, is more than 65% higher yoy while remaining stable ytd. Spain's reported bad debts total 148 billion and have risen 6% in 2012, driven by construction and real estate. Italian corporate and consumer bad debt will likely rise should contagion fears spread."

"Even as Spain requested up to 100 billion euros to bail out its banks, yields on Italian and Spanish sovereigns rose 20 bps to 30 bps. Respective sovereign CDS have also tracked each other closely, although Italian banks outperformed Spanish peers since mid-2011, as Spain's real estate troubles worsened. This may reverse if contagion fears spread." - source Bloomberg

"Politics is not the art of solving problems, but to silence those who ask. "
Henri Queuille

"There is no problem urgent enough in politics that an absence of decision cannot resolve."
Henri Queuille

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