Tuesday 21 August 2012

Credit - Desperado

"It's not enough to succeed. Others must fail." - Gore Vidal

"In chess, a desperado piece is a piece that seems determined to give itself up, typically either (1) to sell itself as dearly as possible in a situation where both sides have hanging pieces or (2) to bring about stalemate if it is captured (or in some instances, to force a draw by threefold repetition if it is not captured) (Hooper & Whyld 1992:106–7). Andrew Soltis describes the former type of desperado as "a tactical resource in which you use your doomed piece to eat as much material as possible before it dies." - source Wikipedia.

In continuation of our chess title analogy which we made in our conversation "The Game of the Century", and looking at the recent headline evolution, with Merkel hinting towards concessions for Greece before Greek Prime Minister Antonis Samaras visit, as well as speculation around yield targeting by the ECB being a possible game changer with implicit German approval, we thought we would use this time around yet another reference to the game of chess, in the light of how politically driven markets' behavior have become. Indeed, it appears to us that Angela Merkel has craftily played in our European on-going chess game (like a chess Grand-Master) and successfully applied operant conditioning!:
"By targeting the short end of peripheral yield curves. It will permit the ECB to study behavior conditioning (training) by teaching Italy and Spain to perform certain structural reforms in response to specific stimuli/bond purchases. Truth is cognitive–behavioral therapy has demonstrable utility in treating certain pathologies such as "motivating a 5 years old child" or a European politician (but we ramble again...)." - Macronomics - "Sting like a bee - The European fight of the Century"

Early August in our conversation "Sting like a bee - The European fight of the Century" we indicated the following:
"To summarize, a rate cut is in the cards, bond buying is in the cards if Spain ask for it (tap out in true MMA fashion), and unsterilized outright open interventions are a possibility:
“You shouldn’t assume that we will not sterilize or sterilize” - Mario Draghi.
The markets were too optimistic and do not seem to understand the European decision process, hence the importance, we think of focusing on the process and not the content in true behavioral therapist fashion. Investors should know by now that it takes some time for the ECB to change its policy as its main contributor, namely the Bundesbank, has a different concept of what a sound monetary policy is compared to other central banks.
But more importantly, one must understand that Central Banks ammunitions are scarce and precious, and that their ability to fight a balance sheet recession is limited, and that important decisions are in the hand of the politicians."

In chess games, sometimes it is possible for the inferior side to sacrifice two or three pieces in rapid succession to achieve a stalemate but, we ramble again.

Back in our 4th of August conversation we clearly indicated that you needed to focus on the process and become a behavioral therapist in relation to the on-going European crisis:
"Many pundits have been arguing that by focusing on the short end of the peripheral countries curves, the ECB via Mario Draghi, is in fact steepening the curve for both Italy and Spain which is apparently the opposite effect one needs to help these economies. We think these pundits are focusing too much on the content in their analysis and should be focusing on the process which is the basis for good understanding of Behaviorism. Basically in true MMA grappling/submission analogy, we think that implicitly, the Bundesbank (Weidmann with the support of Merkel) has conceded to bond purchases by the ECB, in order to keep a tight leash on both Italian and Spanish politicians to keep up with the pace of structural reforms. It seems to us, that Germany has learn from the Greek "experiment" in the sense that buying indiscriminately bonds on the whole term structure not only put the ECB's balance sheet under great risk, but, it also alleviates significantly the pressure from politicians to make good on their commitments which they made in order to garner financial support. In fact we think the ECB has set up the stage for an operant conditioning chamber (also known as the Skinner box):"When the subject correctly performs the behavior, the chamber mechanism delivers food or another reward. In some cases, the mechanism delivers a punishment for incorrect or missing responses. With this apparatus, experimenters perform studies in conditioning and training through reward/punishment mechanisms." - source Wikipedia"

In this credit conversation we would like to focus on the following points, the growing disconnect between fundamentals and markets indicating somewhat a reduction in tail risk and the on-going performance of risky assets in the short term. But first our credit overview!

The Itraxx CDS indices picture, a much tighter week with spreads moving towards there March lows in the credit derivatives space - source Bloomberg:
The Itraxx 5 year Crossover Index (European High Yield risk gauge based on 50 entities) was tighter today by around 10 bps closing to the lowest levels of March while the Itraxx SOVx 5 year index (indicative of Sovereign CDS risk, 15 Western European countries including Cyprus) moved towards its lowest level around 228 bps since the latest series started trading back in March where Cyprus replaced Greece in the index (the Itraxx indices are rebalanced every 6 months).

The Itraxx Crossover 5 year index and European volatility, moving back towards March levels with room for some further tightening - source Bloomberg:

Yet, severing the Sovereign risk / Financial risk link remain to be seen as indicated by the difference in spreads between the Itraxx SOVx 5 year CDS index and the Itraxx Financial Senior 5 year index which remains broadly flat - source Bloomberg:

Our "Flight to quality" picture displaying so far "Risk-On" with Germany's 10 year Government bond yields rising again towards 1.60% and the 5 year CDS spread for Germany well below 100 bps in the process, both converging - graph below, source Bloomberg:

Our European bond picture with German government yields rose back towards higher levels around 1.60%, whereas both Spanish and Italian 10 year bond yields have fallen significantly on market expectations of further bond buying on the short end of the curve by the ECB  - source Bloomberg:

Although Spanish government bond yields have recently receded from their record levels, overall Euro Zone leverage continues to rise in line with prior crisis according to Bloomberg:
"The significant growth in public debt that invariably follows a banking crisis is a product of lower revenues, bailout costs and associated stimulus packages. Euro zone aggregate government debt grew 37% between FY07 and FY11, with Ireland's debt up more than threefold and Spain's up 92%, key impediments to a swift euro zone recovery." source Bloomberg.

And so did Euro Zone bank sovereign holdings which grew 30% from 2007 levels according to Bloomberg undermining in effect the efforts in severing sovereign risk from financial risk:
"As government debt swelled across Europe from 2007, total euro zone bank holdings of sovereign debt grew more than 370 billion euros, aligning the fates of banks more closely with their sovereign nation. Spanish, Italian and Portuguese banks represent 95% of this growth, with a 73 billion euro drop in French bank exposures offsetting a similar increase for Germany" - source Bloomberg.

Although European authorities are determined in severing the link between financial institutions and sovereign risk, Spanish banks stopping recently their bond purchases has had circular effect and led to decoupling!:
"Spanish bank sovereign debt holdings rose 50% between November and March, as ECB cash was put to work supporting yields. April and May data show a fall in these holdings, with recent auctions suggesting that domestic banks have stopped this practice. As a result sovereign yields and CDS rose, driving bank funding costs higher and forcing share prices lower." - source Bloomberg.

Spanish bank funding costs have clearly been driven higher as clearly indicated by today Santander 2 year Senior unsecured new issue that came to the market, becoming the first Spanish bank to issue in the unsecured markets since mid-march (it was the last one too). Santander had announced it was issuing 500 million euros at mid-swap +390 bps (coupon 4.375% - 2 year Spain+100 bps) but quickly raised the size of the issue to the billion mark when seeing the interest (3 billion plus in the book), clearly seizing the window of opportunity in this on-going "Risk-On environment.

Truth is non-performing loans in Spain reached 9.42% and are still inching higher pointing towards additional headwinds for the Spanish banking sector as a whole - source Bloomberg:

If Irish banking woes can be used as a proxy for future Spanish banking woes, Bank of Ireland and Allied Irish results clearly indicated they continued to struggle during the first half of 2012 not only because of large loans impairments, but legacy problems, high funding costs and other headwinds meant that both banks were even loss-making on a pre-impairment basis according to CreditSights latest report - Irish Banking Mortgage Mayhem from the 19th of August:
"The foreign banks with large Irish operations also suffered similar losses, although their Irish loan portfolios are relatively small proportion of group credit risk.
The main concern has switched from losses on commercial property lending to a rapid and substantial deterioration in residential mortgage portfolios. A 50% fall in house prices from their peak, combined with a significant increase in unemployment and economic austerity measures, mean that banks’ losses on mortgage lending are at an unprecedented level.
Loans 90 days or more are 14% of total mortgage loans, and around two thirds of mortgages have a loan-to-value ratio of more than 100%. Loan impairments look set to remain high for some time and will possibly be inflated further by new personal insolvency legislation, but they will not be on the same scale as the banks’s losses on commercial real estate." -
source CreditSights

In that context, Irish banks are pressuring the government for easing the seizure for homes bought as investments in order to recoup some of their losses on renting out these properties given the severity of the defaults, as indicated by Joe Brennan in his Bloomberg article - Irish Bailout Masters Press for Rental Home Seizures:
"The Irish government’s effort to overcome legal and cultural obstacles to foreclosures is growing more urgent as delinquencies on rental properties grow, making it harder for banks to increase lending, and slowing the recovery. At Allied Irish Banks Plc, the biggest mortgage lender, more than a third of its loan book for so-called buy-to-let properties is in trouble after home prices halved and unemployment tripled since 2007 amid the worst recession in the country’s modern history. A well-functioning repossession framework is important to maintain debt service discipline and to underpin the willingness of banks to lend, which is crucial for Ireland’s economic recovery,” Craig Beaumont, the IMF mission chief for Ireland, said in an e-mail response to questions. Before December 2009, lenders used a 1964 law as the basis to repossess homes. This was repealed and replaced in 2009, which due to a drafting oversight, applied only to loans taken out after Dec. 1 2009."

"Desperado" Irish Financial system which clearly implies upcoming headaches for the weaker players in the Spanish financial system. From the same  Bloomberg article:
"In all, the state has injected or pledged about 64 billion euros to banks, and five of the six largest domestic lenders are now in government hands. State-owned Allied Irish, the country’s largest mortgage lender, said last month that payments on 37 percent of its Irish buy-to-let mortgage holdings are at least three months behind, compared with about 13 percent for its owner-occupier loans."

Given the uncertainties relating to the Spanish banking bailout and the potential full bailout application for Spain, it is no surprise to see therefore Banking giant Santander taking advantage of the window of opportunity in securing much needed funding alas at much higher cost than previously secured. Spanish banks reliance on ECB is continuing to rise as indicated by Bloomberg:
"Spain's net borrowings from the ECB rose in July to hit a record high of 375.5 billion euros, and gross drawings now represent one-third of the ECB's total gross bank lending. Final details of up the banking bailout and the potential for a full sovereign bailout application are uncertainties that may continue to pressure availability of bank liquidity." - source Bloomberg.

As far as our "European operant conditioning chamber" set up by Angela Merkel is concerned we do agree with Jacques Cailloux from Nomura's recent arguments relating to unconditional yield targets being discussed:
"1. The ECB is attached to conditionality as a guiding principle for any future intervention.
2. The ECB has already restricted its remit in terms of bond buying.
3. Spreads versus yield targets.
4. Same spread for everyone unconditionally?
Overall, we do not believe the ECB is about to embark upon unconditional yield targets across all euro area countries. The only feasible option in the short term, in our view, would be to specify its intervention modus operandi for countries requesting help such as Italy and Spain. We believe this is very likely to take place at the September meeting (as hinted at by Asmussen’s interview in Frankfurter Rundschau this morning)."

One can therefore ponder in our European chess game if Spain is indeed a "desperado piece" that seems determined to give itself up. Oh well...

Moving on to the subject of the growing disconnect between fundamentals and markets indicating somewhat a reduction in tail risk and the on-going performance of risky assets in the short term, we agree with Suki Mann from Société Générale in his 21st of August 2012 in the sense that credit could experience some additional tightening in the short term:
"Fundamentals to take over, but when? Surely, they've got to come more into consideration, otherwise we're doing away with the concept of relative value within IG cash corporate credit. For instance, there's already a long list of casualties where normally we'd see price action reflect the broken limbs. Not anymore. Some of the more recent actions have seen ArcelorMittal being junked, while Banque PSA will be; Telekom Austria's and KPN's operating performances leave much to be desired while the latter's asset sales have been postponed pressuring its creditworthiness; and Heineken is besieged by M&A risk. None of that is putting anyone off. All the bond valuations of the aforementioned entities are flat at worst, but mostly better than when the action/event occurred. That's because technicals are smothering everything. In addition, it is probably convenient also to take the investment stance that the aforementioned credits - national champions and well-known blue chips - are unlikely to default over the next few years. There are some rating transmission risks, but that's manageable. There's an emerging comfort factor that it is relatively safe to park money in these assets, which clipping the yield govvies, for example, do not provide. Few are contemplating a reversal in spreads anytime soon with any volatility in macro taken through the iTraxx indices as the credit markets risk proxy (just as it was in H1). So we could easily get more tightening in fact, we will. That's what we are seeing now, and if we do not get the heavy supply currently being anticipated (unlikely), then the August tightening could pale into insignificance in comparison with what could occur in September."

In addition to the on-going technical support to credit as highlighted by Société Générale, Corporate pension plans shift towards bonds which has occurred in the past five years will sustain the "Yield Famine" and appetite for credit, hence our positive stance towards credit in this deleveraging environment.
"The CHART OF THE DAY displays the year-end percentages of pension-plan assets invested in equities and fixed income since 2003 for companies in the Standard & Poor’s 500 Index. The data were compiled by S&P’s Capital IQ Compustat unit and cited by David Bianco, Deutsche Bank AG’s chief U.S. equity strategist in a report on the 14th of August. Stocks amounted to 46 percent of S&P 500 plan assets at the end of last year. The allocation was 12 percentage points lower than in 2007, during a housing-driven bull market. Bonds were 42 percent of assets, a 10-point increase over the same period. Real estate and other assets accounted for the balance. “It is unlikely that the trend of diminishing equity allocations reverses,” Bianco wrote. He cited two reasons for the conclusion: the closing of many plans to new workers, which limits the amount of time plans have to invest, and accounting changes that make funding gaps easier to track.
S&P 500 pension plans have a $325 billion total deficit, according to Bianco, based in New York. Although this gap has narrowed from $355 billion at the end of last year, lower bond yields are hurting returns, the report said. The yield on the Barclays Capital U.S. Aggregate Bond Index has been as low as 1.71 percent in 2012, down from 2.24 percent when 2011 ended.
Companies outside the S&P 500 may be even less committed to stocks than those in the index. Only 32 percent of pension assets in the U.S. were invested in equities when last year ended, according to the Federal Reserve. Forty percent was allocated to bonds."
- source Bloomberg

As we indicated back in our conversation "Yield Famine":
"Credit is increasingly becoming a crowded trade, forcing yield hungry investors to get out of their comfort zone and reaching out for High Yield as well as Emerging Markets in the process. In that context of falling yields and falling volatility, we do agree with the recent comments our good cross asset-friend made in our recent post "European Credit versus volatility looks increasingly appealing":
"Long 1 year atm (At the Money) volatility on Equity Indexes versus long credit via short CDS Indexes positions looks increasingly appealing on current levels. "

In our conversation "St Elmo's fire", we pointed out we had been tracking with much interest the on-going relationship between Oil Prices, the Standard and Poor's index and the US 10 year Treasury yield since QE2 has been announced - source Bloomberg:
Given the Standard and Poor's 500 is trading close to a multi-year high and that the US data picture appears to be somewhat improving, and looking at the on-going turmoil which has plagued the European markets, we have long argued that the difference in the behavior of financial conditions between Europe and the US had been credit conditions. We discussed at length this point in our conversation "Growth divergence between US and Europe? It's the credit conditions stupid...". Looking at Nomura's recent note entitled "Does Europe Matter?" from the 21st of August, it looks to us that our call has indeed been validated:
"One explanation why the effects of the Euro-crisis have been more localized can be found in the behavior of financial conditions. In the 2009 slowdown, a key feature was a general tightening of financial conditions globally, as banks delevered indiscriminately.
In the context of the Euro-crisis, tightening financial conditions have been much more concentrated in the eurozone, while, remarkably, US financial conditions have been little affected. Figure below illustrates this basic observation: During the global financial crisis, the shock to financial systems was synchronized and hit the US and the eurozone with very similar intensity. During the recent European turmoil, financial conditions have deteriorated much more in the eurozone than in the US, especially in the second half of 2011, which is likely affecting growth dynamics throughout 2012."

Nomura also makes the following important points in their recent note:
"Does Europe Matter: Strategy vs. Economics
European tensions have been a major driver of global financial market volatility since 2010. Lately, however, there has been evidence that global markets have become more resilient to eurozone specific market tension.
This is ironic, given that the Euro-crisis has yet to find a clear resolution. But it can be rationalized by a combination of various factors.
First, the economic spill-over effects from the Euro-crisis have been much more localized compared to what we saw in the global financial crisis in 2008-2009. With a key part of the explanation being that a global credit crunch and a global tightening of financial conditions has been avoided.
Second, various ECB interventions (actual and verbal) have reduced the tail risks for eurozone banks and for sovereign finance. This matters greatly for global risk assets, which are most sensitive to the most extreme forms of tensions, which are now seen as smaller tail risks. Moreover, reduced peripheral exposure in private sector portfolios globally imply that portfolio contagion effects eurozone asset price weakness have been reduced.
This leaves us with a weird new equilibrium, where global risk assets may be able to trade somewhat more independently from eurozone tensions, at least until we see a renewed increase in eurozone risk exposure (which seems a long way off given ongoing changes in benchmarks) or a dramatic escalation of eurozone crisis dynamics in its own right.
The Euro-crisis is obviously not the only risk, which may impact global risk assets. Tension around the so-called fiscal cliff in the US and/or a more pronounced slowing of global growth momentum is a key factor to watch. From a short-term trading perspective, we would argue that those risks are embedded in asset prices. But this could change over time, as the weak growth in Europe will remain a drag on the global cycle until policies which can support growth have been implemented. In addition, a further compression in global risk premia would leave global risk assets more vulnerable to downside growth surprises.
Europe is more globally significant in the long-term than in the short term. From a trading perspective, Europe is likely to be a less dominant driver. However from an economics perspective it is still a drag on global growth and trade. It will certainly matter longer term, especially if the Euro-crisis continues to escalate over time."

"In all instances, we saw peripheral CDS (measured by the average of Spain and Italy's 5-year CDS) widen more than 100bp. To facilitate comparison between the different periods, we have scaled the impacts to measure the impact per 100bp of peripheral CDS widening (Figure below)." - source Nomura

And Nomura to conclude:
"From a strategy point of view, our conclusion is that the current positive performance for global assets could have further to run in coming months. Moreover, we believe global risk assets could remain fairly resilient even in the face of moderate renewed deterioration in the eurozone."

On a final note we leave you with Bloomberg Chart of The Day showing that Italy 150 years ago presaged Euro bond risk:
"Italy’s unification 150 years ago sent bond yields of its strongest state surging more than 100
basis points in an indication of the penalty Germany might endure if the euro region issues common debt, according to Stephanie Collet, a Universite Libre de Bruxelles researcher. The CHART OF THE DAY shows how yields on bonds of the Naples-led Kingdom of the Two Sicilies rose to align with those of the Kingdom of Piedmont-Sardinia in the year before unification in 1861, according to data collected by Collet. Italy at the time was divided into seven states, each with its own currency and bonds. Naples, the biggest economy with the lowest debt, suffered the largest increase in financing costs. “Naples had a really good standing at that time and as investors began to perceive it as part of a unified Italy, it started to pay a high risk premium,” Collet said in an interview. “Based on the Italian unification example, joint euro bonds wouldn’t solve anything. Germany would be the one that would suffer the most, unless a true fiscal union is put in place.”
- source Bloomberg.

"The four most beautiful words in our common language: I told you so." - Gore Vidal

Stay tuned!

No comments:

Post a Comment

View My Stats