Saturday 28 July 2012

Credit - European Derecho

"Derecho comes from the Spanish word for "straight" (cf. "direct") in contrast with a tornado which is a "twisted" wind. The word was first used in the American Meteorological Journal in 1888 by Gustavus Detlef Hinrichs in a paper describing the phenomenon and based on a significant derecho event that crossed Iowa on 31 July 1877." - source Wikipedia
"A derecho  is a widespread, long-lived, straight-line windstorm that is associated with a fast-moving band of severe thunderstorms. Generally, derechos are convection-induced and take on a bow echo form of squall line, forming in an area of wind divergence in the upper levels of the troposphere, within a region of low-level warm air advection and rich low-level moisture. They travel quickly in the direction of movement of their associated storms, similar to an outflow boundary (gust front), except that the wind is sustained and increases in strength behind the front, generally exceeding hurricane-force. A warm-weather phenomenon, derechos occur mostly in summer, especially during June and July in the Northern Hemisphere, within areas of moderately strong instability and moderately strong vertical wind shear. They may occur at any time of the year and occur as frequently at night as during the daylight hours." - source Wikipedia

Looking at the recent storms which have recently unfortunately hit our American friends, and given the sudden rise in Spanish yields to record levels, touching a euro record high of 7.56%, we thought this time around, our "Derecho" analogy would be appropriate. Although these "Derechos" storms most commonly occur in North America, "Derechos" can occur elsewhere in the world, hence our recurring theme of severe weather patterns (Plain sailing until a White Squall? - 18th of March, The Tempest - 8th of May, St Elmo's fire - 26th of May). After all, "Derechos" in North America form predominantly from May to August and the “Sell in May and go away” has persisted as a profitable market-timing strategy for stock investors. Could it be in similar patterns to "Derechos"? We ramble again:
"The CHART OF THE DAY shows the average percentage-point gaps in stock performance between the six months ended in April and the next six months, as presented in the study. The figures cover MSCI Inc.’s local-currency indexes of 23 developed markets for November 1998 through April 2012.
Every index did better in the November-April period, led by MSCI Ireland, which had a differential of 17.9 points. Fourteen emerging-market indexes were included in the research, and all of them showed the same tendency. “The Sell in May effect occupies a special place among seasonal anomalies,” University of Miami Assistant Professor Sandro C. Andrade and two of his colleagues wrote in the study, posted yesterday on the Social Science Research Network. That’s because it only takes two trades a year to make money, unlike other patterns that require more frequent buying and selling. The research by Andrade, Vidhi Chhaochharia and Michael E. Fuerst followed up on a study published in 2002 by the American Economic Review, an academic journal. The earlier work tracked the disparities in the 37 MSCI indexes from their inception, as early as 1970, through October 1998.
In the earlier period, the gap averaged 8.7 points. The differential climbed to 10.5 points after excluding Argentina and Brazil, which experienced hyperinflation. The overall average in the new study was 9.7 points."
- source Bloomberg.
So in our long credit conversation, given the interesting turn of events of the week, with some very important legal evolution, we think, in the subordinated bond space relating to "Bail-ins" and exit consents challenge (h/t FT Alphaville Joseph Cotterill for pointing this out), we will take a look at implied recovery in bank credit and credit events. This recent interesting legal challenge has indeed significant implication for recovery rates in the subordinated bond space, particularly for Spanish subordinated bondholders (facing the music of haircuts, coercive or not, in true Irish fashion). But first our credit overview.

The Itraxx CDS indices picture, with indices tightening on the back of Mario Draghi's declarations  - source Bloomberg:
The Itraxx Crossover (High Yield CDS risk indicator - 50 European high yield credit entities) tightened by 22bps to 642 bps level. Both the Itraxx Financial Senior 5 year index (25 banks and insurers) as well as the Itraxx Financial Subordinated 5 year index fell significantly in the process, respectively by 12.5 bps and 21 bps. Truth is, during this summer lull, with poor liquidity, market makers are not seeing big sellers of protection (going long credit, being "Risk-On" that is), and are scrambling to bid for protection with no offer available and remain wary of this market movement akin to short covering. We have seen this movie before...
Although French President Francois Hollande and German Chancellor Angela Merkel said Friday their nations are “bound by the deepest duty” to keep the currency bloc intact, following on the commitment made Thursday by ECB President Mario Draghi, we remain deeply concern by the economic situation in the peripheral space with Spain registering a new unemployment record at 24.6% from 24.4% in the prior three months, the most since at least 1976, the year of the democratic transition.

We have indeed reached intervention time given Spanish yields and rising NPLs have as well reached new record highs:
"Spain's ability to fund itself at the shorter end suffered a severe blow as two-year yields breached 6.5% on fears that regional governments beyond Valencia would seek aid, rendering the 18 billion euro bailout fund insufficient. Beyond funding difficulties, bank bad debt will deteriorate faster as debt rollover costs continue to rise." - source Bloomberg.
While Europe’s success in severing the link between Sovereign Risk and Financial risk remain to be seen as indicated by the difference in spreads between the Itraxx SOVx 5 year CDS index (representing 15 Western Europe sovereign CDS including Cyprus) and the Itraxx Financial Senior 5 year index which remains broadly flat - source Bloomberg:
“We have got to cut the fatal loop between sovereigns and banks, which will otherwise bring the euro-zone project as it exists now down,” Adair Turner, chairman of the U.K. Financial Services Authority, said in a London speech as reported by Bloomberg (wishful thinking). The Commission is working against a "self-imposed" September deadline to carve out plans that would give oversight of banks to the ECB as the first step in a campaign to break a cycle of banks and sovereigns fuelling each other's solvency risk.

Truth is time is running out for Spain, probably the reason why Mario Draghi felt compelled to "buy" some time in order to give sufficient time to the market to calm down before the September deadline:
"The CHART OF THE DAY shows the difference in yield between the two securities narrowed this month before flipping on the 26th of July. The five-year note yield surged to as much as 7.785 percent, the most since the euro was created in 1999, and more than three basis points higher than the 10-year rate, which reached 7.751 percent. The selloff also pushed yields on Spain’s two-year securities to more than 7 percent for the first time since September 1996. The bonds subsequently rebounded and the five year rate dropped below 10-year yields amid speculation Spain’s fiscal predicament will convince the European Central Bank to augment the firepower of the region’s bailout fund." - source Bloomberg.

With Mario Draghi's timely intervention, no wonder Spanish yields receded very significantly by more than 100 bps in our European bond picture while German government yields rose back towards higher levels around 1.40% on the close (1.16% on the 20th) with other European core bonds (France, Netherlands) rising as well in conjunction with German yields - source Bloomberg:
Spain's 10-year yield fell 52 bps this week to 6.74%, the biggest weekly drop since the period ended December 2nd according to Bloomberg.

While Spanish banks have been busy lowering their sovereign holdings for a third straight month:
"Euro zone financial institutions increased sovereign debt holdings by more than 145 billion euros during 1Q, as ECB cash was put to work. Spanish banks, having purchased 78 billion euros of sovereign in the four months to end-March, lowered their exposure for a third month in June. A euro-zone wide, sustainable solution is required to stem the crisis." - source Bloomberg.

Looking at Santander 1H deposit mix, Spanish structural funding issues are very clear for these institutions:
"While Santander's total customer deposits grew 3% yoy to 1H, its time deposits fell 22 billion euros. The key delta was growth of more than 38 billion euros in non-resident "other" deposits. As Spain's troubles continue, a shortening of liability duration and withdrawal of mutual and pension fund support will likely continue across banks, pressuring funding costs further." -  source Bloomberg.

Hungary has been long been our pet subject (Hungarian Borscht, Hungarian Dances) in relation to the study of systemic risk diagnosis (Modicum of relief):
"The reason behind our choice is that it appears to us as very good case study for systemic risk diagnosis from a macroeconomic point view (after all our blog is called Macronomics)."
We argued at the time:
"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. "
It was not really a surprise therefore to see Hungary Yields dropping below Spain for the first time this week:
"Hungary’s borrowing costs dropped below Spain’s for the first time as the European Union’s most
indebted eastern member held talks on an international bailout and Spain’s regions requested aid
. The CHART OF THE DAY shows investors this week demanded
lower yields to hold Hungary’s debt than Spain’s after Hungary began talks for an International Monetary Fund credit line and Spain’s Valencia region sought financial assistance. Hungary’s 10-year bond yields were at 7.39 percent on July 23, compared with 7.49 percent for similar-maturity Spanish debt. “The primary reason why Hungarian bonds have been doing well is because anticipation has been building up that the country is moving toward an IMF program,” Arko Sen, a strategist at Bank of America Corp. in London, said in a phone interview yesterday. Hungarian yields were as high as 10.8 percent after Prime Minister Viktor Orban’s government passed legislation the IMF and the EU said threatened the central bank’s independence in December, obstructing talks on aid. Hungarian yields were as much as 539 basis points above Spain’s in January." - source Bloomberg.

Looking at Mario Draghi's speech we could not resist to reminding ourselves our previous December 11th post "The Generous Gambler" where we quoted the wonderful poem by French poet Baudelaire which inspired Verbal Kint in The Usual Suspects:
"The greatest trick the devil ever pulled was to convince the world he didn't exist"
Roger "Verbal" Kint- The Usual Suspects

"My dear brothers, never forget, when you hear the progress of enlightenment vaunted, that the devil's best trick is to persuade you that he doesn't exist!" - Charles Baudelaire, French poet, "Le Joueur généreux," pub. February 7, 1864

"If it hadn't been for the fear of humiliating myself before such a grand assembly, I would willingly have fallen at the feet of this generous gambler, to thank him for his unheard of munificence. But little by little, after I left him, incurable mistrust returned to my breast. I no longer dared to believe in such prodigious good fortune, and, as I went to bed, saying my prayers out of the remnants of imbecilic habit, I said, half-asleep: "My God! Lord, my God! Please make the devil keep his word!"
Charles Baudelaire, French poet, "Le Joueur généreux," pub. February 7, 1864

People are trading on hope: "Please make Mario Draghi keep his word", we could posit in similar fashion to what we commented in our September 2011 conversation "The curious case of the disappearance of the risk-free interest rate and impact on Modern Portfolio Theory and more!"
"So far the devil's best trick has been to persuade us that risk-free interest rates did exist. It ain't working anymore and that is a big cause of concern." - Macronomics.

We could not resist but we chuckled when we read the following comment from a credit desk:
"Equities = Hope, Credit = Reality, unfortunately, Reality follows Hope until the Hope dies, then Reality settles in."
As a reminder from our "Generous Gambler" conversation this is what Arnaud Marès, from Morgan Stanley in his publication of the 31st of August 2011 -Sovereign Subjects had to say:
"Does it matter that sovereign debt is risk-free? It very much does. If sovereign debt is no longer a safe haven, then the ability of governments to implement counter-cyclical policies is impaired. Fiscal policy is becoming at best neutral, at worst pro-cyclical. At a time when growth is rapidly slowing, the economic cost may be high.
Weakening the quality of government credit means weakening the fiscal backstop from which banks benefit. This risks resulting in an accelerated de-leveraging of bank balance sheets, with equally costly economic consequences."
This is exactly what has happened so far with the ill-fated EBA June 2012 request of asking European banks to reach a Core Tier 1 ratio which precipitated the deleveraging as well as the withdrawal of credit, bond tenders and other liability management exercises, hitting hard in the process the real economy in European countries. This withdrawal of credit has also been confirmed by the latest results from British bank Barclays as indicated by Bloomberg:
"The exodus from debt-ridden peripheral Europe continues, with Barclays detailing reduced sovereign exposure of 22% and 5% lower retail lending in 1H. Plagued by liquidity shortages, EU Banks have also rushed to reduce local funding mismatches: Barclays took additional Spanish deposits since 2011 year-end, while taking 8.2 billion euros from the ECB's LTRO in Spain and Portugal." - source Bloomberg.

As we pointed in a "Tale of Two Central banks", we would like to repeat Martin Sibileau's view we indicated back in October when discussing circularity issues:
"What would be a solution for the EU? We have repeatedly said it: Either full fiscal union or monetization of the sovereign debts. Anything in between is an intellectual exercise of dubious utility."

We would like to take the opportunity of debunking further the "efficient market theory" (if there are any believers left out there...) in relation to Draghi's intervention. We agree with a recent note from French broker Aurel, namely that this "theory" has taken yet another blow. The markets did not react to Mario Draghi's declarations  made in an interview last Saturday in French newspaper Le Monde but "only" reacted strongly on Thursday when similar declarations were displayed in bold red on Bloomberg: « Believe me, it will be enough ».
Oh well...
In relation to our recent theme of "Yield Famine",  Unibail has sold this week EUR750m of bonds at 2.25% maturing on 1st August 2018 (6 years). The issue was 4 times oversubscribed with the order book reaching over EUR 3bn in less than 1.5 hours...We saw similar action this week on numerous new high quality issues coming to the market.
The rush for yield and strong appetite for credit is cause for concern and caution particularly in the High Yield space where risk is lurking.
"unintended consequences" of this low yield environment will have to corporate balance sheets, to some extent, it tends to explain, why defaults tend to spike in a low rate deflationary environment such as today", we argued last week.

High Yield is indeed becoming very expensive as indicated by Lisa Abramovicz in her Bloomberg article - BofA Cools on Junk Priciest to Stocks Since ’93:
"Junk bonds are losing their sheen after becoming about the most expensive relative to stocks in at least two decades, prompting firms from Bank of America Corp. to Loomis Sayles & Co. to warn that gains on the debt may wane. Junk bonds are returning less than the highest-rated corporate notes for the fourth straight week, the longest stretch since the period ended Nov. 27, Bloomberg data show".
Time to reduce duration and favor short term High Yield if you are "starving" for yield and can stomach the volatility risk we think.

Moving on to the very important subject of the legal evolution in the subordinated bond space relating to "Bail-ins" and exit consents challenge,  this recent interesting legal challenge has indeed significant implication for recovery rates in the subordinated bond space, particularly for Spanish subordinated bondholders.
 As indicated on the FT Alphaville comment section, Claudio Borghi Aquilini made some very valid comments:
"This is an extremely important ruling. Basically it (rightfully) denies the very concept of forced burden sharing at the basis of the eurodebt disaster. Either you let the bank fail or if you decide to save it you may not kill bondholders (albeit subordinated) ad random. Reducing the burden for taxpayers might seem a good reason to do silly things but debt is based on rules, if you create doubts and "special situations" no wonder if funding costs skyrocket (and if a judge tells you that you can not play with contracts). "
We could not agree more. Debt is based on rules. The capital structure is there for a reason when it comes to bank debt and the difference between junior debt from senior debt as well as the recovery values and credit events triggering CDS contracts relating to the capital structure. Looking at the recent discussions relating to "Bail-in" proposals (a subject we discussed in "Something Wicked This Way Comes"),  Morgan Stanly in their Credit Strategy review from the 27th of July entitled - Implied Recovery in Bank Credit, argued the following:
"One hears every possible argument in the debate over whether senior bank debt in Europe should bear losses. There is the moral (better that bondholders pay for bank rescues than ordinary taxpayers). The practical (senior bonds are a small slice of the capital structure, burning them saves relatively little money). The game theory (country that imposes losses saves money, everywhere else suffers). The theoretical (if the institution’s insolvent, of course its lenders should bear loss). The psychological (debt haircuts will scar funding markets for years to come). The list goes on. We believe that the costs of haircutting senior bank debt in Europe vastly outweigh its rewards."
On that matter, we "Agree to Disagree" with Morgan Stanley, given that, as we posited in "Long hope - Short faith, Hungary and Bank Recapitalization", the study realised by Stanford University Anat R. Admati (Why Bank Equity is Not Expensive) shows that banks have fought bitterly against increasing equity buffers which is the cheapest and easiest way to recapitalize banks. Why? because allowing high payouts to shareholders, namely bank employees in many cases, allows financial institutions to raise their leverage: "Focus on ROE is also a reason bankers find hybrid securities, such as debt that converts to equity under some conditions, more attractive than equity." - Anat R. Admati.

The latest legal spat as reported by FT Alphaville (link above) involving credit asset manager Assénagon and Anglo Irish, is a relative important matter given the latest European Bail-in resolution and, because, as indicated by Morgan Stanley in their research piece:
"Fixing the recovery of subordinated debt and taking the spreads on senior and sub debt observed in the market, it becomes possible to solve for a recovery rate on senior."
"The eight banks in the top of the table provide observations of actual loss severity. Why do we focus on CDS? Our approach provides a simple way to solve for implied recovery, but only if the probability of default between two instruments is similar. This isn’t strictly the case with bank bonds, as the restructuring of Lower Tier 2 bonds in the Irish banks bound holders to a large loss, but left senior debt unscathed. CDS, in contrast, triggers at the entity level, meaning that senior and sub CDS are much more likely to take loss at the same time" - source Morgan Stanley.

In terms of market observations, Morgan Stanley also indicates:
"Although senior bank bondholders have generally been protected in Europe, it has been more common for sellers of senior CDS to face losses when contracts are triggered by restructurings. Recoveries in such events have been generally high, at around 50%.
The range of pricing, however, has been enormous – senior CDS on Bradford and Bingley recovered at 95c, CDS on Landsbanki recovered at 1c – especially with regards to the ratio of loss (or the implied ratio of loss).
Across current banks in Greece, Portugal and Spain, pricing also remains highly disperse." - source Morgan Stanley.
"What’s notable? For most banks, implied senior recovery is surprisingly ‘average’ relative to the last seven years, despite all the recent rhetoric. The range of implied recovery is also very narrow (35% to 57%), in direct contrast with the large variation in senior recovery under stress seen in previous table, although we acknowledge that the banks above are for the most part higher-quality than the names in that data-set.
Per our framework, the UK banks (e.g., Lloyds, RBS, Barclays) as well as Commerzbank enjoy the highest implied senior recoveries (i.e., sub debt trades the widest to senior). This is somewhat odd, given that both the UK and Germany have resolution regimes in place whereby subordinated and
senior bondholders could potentially take losses. One explanation could be that investors feel more comfortable in UK and‘core’ European bank senior debt, yet more cautious on subordinated debt, given the resolution regimes. We’re generally happy to lean against this, and would note that the wide senior/sub differential is consistent with our generic preference for UK LT2 and certain Commerzbank subordinated debt structures.
In contrast, Spain and Italy have among the lowest implied recovery rates. Consistent with what we note on UK and German banks, we suspect that this relates to the high degree of sovereign stress which has pushed out senior spreads to very wide levels. Equally, the potential risks of some form of burden-sharing spreading up the capital structure to even include senior debt are also a source of concern for investors, even if a low-risk tail event, in our view." - source Morgan Stanley - 27th of July 2012.

Using Santander as a proxy in determining "Implied Recovery and Default Rates:
For SANTAN, subordinated CDS spreads are ~1.5x senior, implying 1.5x higher loss severity for the same probability of default. Fixing the potential loss on Lower Tier 2 at 90% (10% recovery), this gives an implied loss on senior debt of 59% (90%/1.5x), for an implied recovery of 41% (1-59%).
Similar to the story in the broader index, implied recovery is only marginally lower than its historical average, while spreads now suggest a near-record probability of default over five years (32%). Stress on the Spanish sovereign has led to an increase in the risk of default, but not a decline in perceived recovery." source Morgan Stanley, 27th of July.

Forced burden sharing and coercive action in similar fashion to the Anglo Irish situation, would indeed, lead lower perceived recovery for Spanish  banks bonds, hence the importance of this legal ruling relating to Anglo Irish.
Morgan Stanley in their note Senior and Sub Financials - Credit Derivatives Insights on the 27th of July point to the following:
"What are the historical examples of senior and sub CDS triggers in Europe?
We now have a few precedents for bank CDS triggers in Europe (see table below): The Icelandic banks, Bradford & Bingley (UK) and now Irish banks are the financials credit events for CDS in Europe in the last five years. The above can be sorted into three groups: i) banks that were not backstopped and allowed to default (Icelandics); ii) banks that had an extremely credible backstop (Bradford& Bingley) and a well-supported senior; and iii) banks that were perceived to have a backstop for seniors but not fully robust (Irish banks)."
"We think the Anglo Irish example is good template for how bank restructurings could evolve from a CDS perspective and how auctions could work. Anglo Irish Bank announced a tender offer following equity injections, offering to exchange all the three existing LT2 bond issues into new 1yr government guaranteed senior FRNs (Euribor +375bp) equivalent to 20c of existing face value. In addition to the exchange offer, the Bank convened meetings to approve the inclusion of a right to redeem all (but not some only) of the existing notes at practically zero to encourage acceptance. This series of events triggered a restructuring credit event for Anglo Irish CDS. The requirements in determining a restructuring credit event were fairly straightforward to establish in the case of Anglo Irish: a loss of principal for a multiple holder obligation, made binding on all holders and which resulted directly from deterioration in credit quality.
While all thee LT2 bonds were restructured ultimately, the timeline was in a staggered fashion in order to avoid a lack of LT2 deliverables if all were restructured in one go. Thus, the auction was conducted in an accelerated timeframe, after the first bond was restructured and triggered CDS, but before the other bonds was restructured." - source Morgan Stanley.

The recent legal ruling for Anglo Irish versus Assénagon (rightfully) denies the very concept of forced burden sharing which has been used in the determination of the recovery during the restructuring credit event for the CDS auction process and the results, a process which will inevitably occur for weaker Spanish and Italian institutions at some point:
"While the recoveries for the senior CDS of different buckets were largely in line with each other, sub CDS had very different recoveries for the 2.5yr bucket (74.5) vs. for the other two buckets (around 18). In practice the recovery for different buckets of senior CDS could also vary considerably, as the dollar prices of a 2.5yr bond could be very different from a 7.5yr bond in a restructuring scenario." - source Morgan Stanley.

As indicated by FT Alphaville in their post,  IFR reports that IBRC, the successor to Anglo Irish, is considering an appeal. The awarding of any damages is yet to come. A truly interesting legal development in the banking space.

On a final note, a weakening of the Euro is likely to be reflected in HSBC, Santander, BBVA 2nd Quarter results as shown by Deutsche Bank's recent profit warning:
"As Deutsche Bank's profit warning demonstrated, the ongoing weakness of the euro can negatively affect results where there is a  mismatch between costs and revenue, or material parts of the business earn and report in different currencies. Euro zone revenue contributions are likely to shrink at HSBC, which has significant euro operations and reports in dollars." - source Bloomberg.
Given Deutsche Bank AG recently announced it would reduce risk to meet a 2013 capital-ratio goal after second quarter profit missed analysts' estimates on expenses tied to a weaker euro (net income fell to 700 million euros), reduced risk will lead to reduced liquidity and inventories provided to the market place. Yet another story of de-risking, deleveraging. No wonder traders are leaving the banking industry for Hedge Funds in this process.

"The greatest trick European politicians ever pulled was to convince the world default risk didn't exist" Martin T - Macronomics.

"Politics is the art of looking for trouble, finding it everywhere, diagnosing it incorrectly and applying the wrong remedies."  - Groucho Marx

Stay tuned!

1 comment:

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