Saturday 27 October 2012

Credit - When causation implies correlation

"All human actions have one or more of these seven causes: chance, nature, compulsions, habit, reason, passion, desire." - Aristotle 

Looking at the dismal economic figures coming out of Europe as of late (PMI, consumer confidence, unemployment in Spain, IFO, etc.), we could not resist using in our title a veil reference to the phrase used in science and statistics "Correlation does not imply causation". Admittedly, a correlation between two variables does not necessary imply that one causes the other, but when it comes to European woes, not only did the ECB's LTROs amounted to "Money for Nothing" given the lack of transmission to the real economy as we posited in February this year, but looking back at the overzealous deficit targets set up by the European Commission which we discussed in our conversation "A Deficit Target Too Far", we are not surprised to see that the economic causation does indeed implies correlation to current European economic woes unsurprisingly due to poor loan growth as displayed by the below Bloomberg graph displaying loan growth in in the Euro Zone with the Euro Zone Money Multiplier at multi-year low:
"Third quarter bank results will shed further light on the outlook and appetite for euro zone bank lending. The money multiplier remains at multi-year lows and recent regulatory steps to soften or defer the implementation of new liquidity and capital rules underscore the pressing need for banks' loan supply to improve, release cash to the economy and support growth" - source Bloomberg.

Yes, some will counter us, by saying that the opposite assumption which we used in our title, that correlation proves causation is a questionable cause of logical fallacy also called "cum hoc ergo propter hoc" ("with this, therefore because of this"). Well, truth is, the economic contraction in Europe is a consequence of the first event sometimes describe in latin as "post hoc ergo propter hoc" (after this, therefore because of this) namely rapid credit contraction due to accelerated bank deleveraging courtesy of the EBA (European Banking Association) objective for most European banks to reach a Core Tier 1 capital of 9% by June 2012.
So dear readers, no, we do not think it is a logical fallacy, "post hoc" supposedly being a "tempting error" because the temporal sequence in Europe appears to be integral to causality namely credit contraction:
A occurred, then B occurred
Therefore, A caused B

Of course as of late, our "Generous Gambler" aka Mario Draghi, ECB's president, has defended is latest OMT (Outright Monetary Transactions) bond buying plan on the 24th of October in front of the German parliament with a warning about deflation risks:
"In our assessment, the greater risk to price stability is currently falling prices in some euro-area countries"
and added:
"In this sense, OMTs are not in contradiction to our mandate: in fact, they are essential for ensuring we can continue to achieve it."

Arguably our dexterous "Generous Gambler" has indeed been highly successful in propelling Spanish bonds gains above Germany as indicated by Bloomberg:
"Investors who held onto Spanish bonds this year as the price of the securities whipsawed amid the euro-area debt crisis stand to earn more than those who sought refuge in German bunds. The CHART OF THE DAY shows Spanish debt has handed investors a 4.2 percent return since Jan. 3, rebounding from an 8.7 percent loss in the period through July, according to data compiled by Bloomberg and the European Federation of Financial Analysts Societies. German bunds, perceived as Europe’s safest sovereign debt, have earned 2.7 percent this year. The Iberian nation’s securities have surged since the European Central Bank said it will buy bonds." - source Bloomberg

Making us reminding ourselves part of the great poem from Charles Baudelaire which we have used in numerous conversations:
"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

The most recent table of monthly purchases of sovereign debt is a clear indicator of the faith many investors have put in our "Generous Gambler" - source Bloomberg:
"Euro zone banks purchased an aggregate 33.3 billion euros of sovereign debt in September, following sales of 24.9 billion euros in the preceding two months as yields fell and gains were taken. The ECB commitment to do "whatever it takes" drove the Spanish 10-year yield down to 5.5% from August highs above 7%, and recent bank purchases reflect this new-found confidence." - source Bloomberg

"The greatest trick the devil ever pulled was to convince the world he didn't exist"
Roger "Verbal" Kint- The Usual Suspects

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

Our generous gambler also argued the following: 
"OMTs will not lead to disguised financing of governments. All this is fully consistent with the Treaty’s prohibition on monetary financing. Moreover, they will focus on shorter maturities and leave room for market discipline."

But he also said the following:
"The ECB intervenes only in countries where the economy and public finances are on a sustainable path."

Our "Generous Gambler" is indeed kept on a tight leash for now, a German one that is, courtesy of the Banker's Algorithm.

Our "Banker's Algorithm" comes into play when you think about on-going Spanish deflationary vicious spiral given our computational reference which we touched again last week:

"The algorithm avoids deadlock by denying or postponing the request if it determines that accepting the request could put the system in an unsafe state."
So of course, our Banker's algorithm has avoided the deadlock in Europe because of Spain. Clearly by denying or postponing the request, it has determined the Spanish request could put the European system in a clear unsafe state!

For Spain, it is "request denied" courtesy of the Bankers' algorithm."

Question being now, can Europe survive in the current form (number of countries) without making material sacrifices? One has to wonder...

By managing to keep Germany’s liabilities unchanged German Chancellor Angela Merkel has been in fact the clear "winner" of the last European summit in June (number 19...) we argued in our conversation "Europe - The Game of the Century". On the 18th of October, Chancellor Merkel in her address to the German lower-house has indeed craftily defended again Germany's liabilities by declaring:
"Financial aid without conditions attached has in some cases frustrated the drive to streamline economies, and therefore joint liability is the wrong answer"

Given the IMF has cut its euro-region growth forecast for 2013 from 0.7% to 0.2% with the European economy potentially shrinking by 0.4% in 2012 instead of the "projected" 0.1% by the ECB, in this week's conversation we will look at correlations and causation on our European ship given the increasing risks of "Mutiny on the Euro Bounty" in 2013 which we have been highlighting since April this year:
"As well as Fletcher Christian and part of the crew, our European "sailors" (politicians) were attracted to the "idyllic" initial cheap funding environment provided by a single currency umbrella. The recent austerity "harsh treatments" measures imposed by the captain of the ship (European Commission) which we reviewed in our recent conversation ("The Charge of the Light Euro Brigade") seems to be clearly pushing some of the members of the crew towards mutiny. This explains somewhat, why the European ship is attempting to change tack, moving towards growth."

"Prosperity makes friends, adversity tries them." - Publilius Syrus

Unemployment figures in Germany which will be published next week and will be key. So will be economic data from Germany. In September 2011, in our conversation "Much ado about nothing" we argued:
"And given Merkel's big u-turn relating to the Japanese nuclear disaster in 2011, and that next general election in Germany are to be held in September 2013, and we know that Merkel is already committed to a third term, we would really follow closely the German economy in general and the German labour market in particular. "

There is indeed a growing rift between France and Germany in relation to the course that needs to be taken in relation to Europe due to a growing divergence in the political agenda for both France and Germany. We agree with the latest report from Nicolas Doisy - Politoscope number 10  from Cheuvreux which validates our recent analysis Merkel and our Banker's algorithm:
"Delaying the euro federal Big Bang again: the Franco-German “phoney war” (redux):
-While it should be starting, Europe's federal Big Bang is stalling again due to diverging political agendas in Germany and France with regard to the euro institutions. The disagreement is partly real (i.e. of substance) and partly fake (i.e. purely motivated by domestic politics) and likely to drag on for months… if not years.
 -Merkel has timed her agenda in 2013 with a view to the full monty (re-election and a euro to her liking) and thus intends to frame the debate to her advantage. To keep her options open, Merkel wants to have the final say on any decision regarding Spain and the euro: this is why she uses the federal agenda as a red herring.
-To secure her chances for re-election, Merkel needs to keep the Eurozone quiet during the coming year: this is why she has agreed to the ECB's OMT for Spain. For as long as she is leading the electoral polls, she is sure to keep both France and the SPD in check: this is why she is skilfully nurturing German anti-euro feelings.
-Hollande's options are limited, as he can only bank on the SPD or market pressure to break the deadlock: he thus also uses this debate to keep his own left in check. His only potential ace is to use next year's recession in the Eurozone to table his "growth" agenda again, so as to get a more lenient fiscal treatment by Germany. 
-All in all, this Franco-German divide over institutional options looks very likely to lead to a two-speed Eurozone as the periphery will continue entering its debt-deflation." - source Cheuvreux.

Moving on to France and the subject of when causation implies correlation, we noted from the same interesting note from Cheuvreux the following interesting correlation. Namely that Hollande's popularity is 100% correlated with the rise in unemployment since he has taken office: 5,000 more unemployed = 1% less popularity for Hollande, so that (theoretically), according to Cheuvreux's analysis, he should be ousted when unemployment reaches 3.2 million:
"Hollande's first option out of this diplomatic deadlock could be for the social democrats to win next year's election or the leadership of another Grand Coalition. However, after supporting France's stance very vocally on several occasions in the winter of 2011, the SPD has gone mute on the issue of Eurobonds in particular. This clearly is a sign that Merkel has so far won the battle of public opinion on the euro issue." - source Nicolas Doisy - Cheuvreux.

Following up on François Hollande's political strategy of hoping for the social democrats to win next year's election, we could not resist, (given our post title) but refer to "Mierscheid law"!
The Mierscheid law was a satirical forecast published in German magazine Vorwärts on 14 July 1983 which forecasted that the Social Democratic Party of Germany (SPD)'s share of popular based on the size of steel production in Western Germany: "The Vote share of the SPD equals the Index of the crude steel production in the western federal states - measured in millions of tonnes - in the year of the federal election".

"The last corroboration of the law was in the 2002 election, where the West German crude steel production was 38.6 million tonnes, and the vote share of the SPD 38.5%. For the early election in 2005 the vote share was 38.4%, with a mean crude steel value of 40.0 million tonnes. Over the last ten elections, the two values were within two units nine times, and within one unit seven times." - source Wikipedia
- source - the full Wiki.

With German confidence falling to the lowest level in more than two and half years and Europe's composite PMI falling to 45.8 from 46.1 in September, the IFO institute's business climate index unexpectedly dropped to 100.0 from 101.4 in September, indeed accelerated deleveraging and generalized austerity is increasing the causation of economic woes and the correlation with worsening economic outlook. We feel comfortable with our recent call of growing divergence between the growth differential between USA and Europe as indicated by the recent PMI.

We also believe that as economic woes weight on both Germany and France in 2013, so will increasing political rifts arise in the process. We do agree with Nicolas Doisy's take from Cheuvreux, namely that there is indeed a new "phoney war" evolving between both countries:
"This (peaceful) remake of the Franco-German phoney war obeys a purely political logic and forces the Eurozone to continue walking along the abyss for another year. Unfortunately, it can only add to the uncertainty surrounding the fate of the Eurozone by leaving deflationary Spain very much on the hook: there is no clear prospect of Eurobonds any time soon, be it to recapitalise Spanish banks or help Spain's government. Beyond, this phoney war could well turn into another "battle of Stalingrad" when the actual size of the Spanish problem is fully revealed, right after the German election (if not before). It is thus to be hoped that another Grand Coalition wins in Germany, as seems to be the preference of the German electorate. Such an outcome would have the advantage of creating the conditions of a de facto national unity government in Germany. In any event, this Franco-German great divide over institutional options looks very much apt at leading to a two-speed Eurozone of sorts in the not-so-distant future. Indeed, it appears clearly from this debate that the core issue is what to make of the periphery. This amounts to raising the question: (where and how) does the periphery belong in the Eurozone? While still implicit, this theme will surely rise to the front in near future." - source Cheuvreux - Nicolas Doisy

Indeed, what to make of the periphery in general and Spain in particular given the recent Spanish banks earnings which clearly indicate that Oliver Wyman's nightmare scenario could as well play out which therefore clearly justify the retention in the allocation process of our European Banker's algorithm?
Caixabank, the third biggest bank saw its profit fall 42% as it accelerated loss recognition tied up to real estate with 4.41 billion euros of provisions in the first nine months to fully cover the required 2.44 billion euros from the first RDL (Royal Decree Law) and 600 million of the 2.1 billion euros in charges needed from RDL2 passed in May. Bad loans jumped to 8.42% in September from 5.58% in June and 4.9% in December 2011.
It was a similar story for Spanish giant Santander, with third quarter profit felling 94% due to the necessary purge in real estate exposure needed with net income falling to 100 millions euros from 1.8 billion euro a year earlier. Bad loans as a proportion of total lending rose to 4.33% from 4.11% in June. The bad-loan ratio across the Spanish business climbed to 6.38% from 5.98% in June and 5.15% a year earlier.

The rise in bad loans are all a reflection of the rise from bad loans in the construction sector as reported by Bloomberg:
"September's Spanish stress test projected aggregate losses of 270 billion euros for the banks under its adverse scenario, with a 43% loss on real estate developers, identical to Santander's 3Q real estate non-performing loan ratio. Spain's construction and real estate bad debt topped 100 billion euros at 1H and may rise faster and further than stress estimates." - source Bloomberg

No wonder the Banker's algorithm is reluctant in allocating "resources". In that context, the bad bank SAREB which need to be in place by December, will have as much as 90 billion euros of asset based on their transfer price, initially comprising land, developer loans and residential units that went bad according to Bloomberg article "Spain Bad Bank Seen Too Big to Work With $117 Billion: Mortgages" by Sharon Smyth from the 25th of October.
"The Bank of Spain has yet to fix transfer valuations for the assets based on the stress tests of Spanish lenders carried out by management consultants Oliver Wyman and published on Sept. 28. The 90 billion euro number is based on transfer prices, so the original value of the assets is likely to be higher.
In comparison, Ireland’s National Asset Management Agency, set up in 2009, spent 32 billion euros on mortgages with a face value of 74 billion euros to cleanse its banking system.
Lenders that take state aid will have to transfer to the bad bank foreclosed property of more than 100,000 euros, real estate and builder loans of more than 250,000 euros and controlling stakes in property firms, according to the Economy Ministry official. A decree to regulate the entity should be passed on Nov. 16. It may be amplified in the future to include loans to consumers, small and medium enterprises and retail mortgages." - source Bloomberg.

In relation to Bankia, we argued in May 2012 in our conversation "The Tempest the following" with our good credit friend:
"A better solution would be to force a conversion of debt to equity (In a debt-for-equity swap, a company's creditors generally agree to cancel some or all of the debt in exchange for equity in the company). Doing so will not require 7 to 10 billion funds, but would of course dilute shareholders and destroy bond holders (haircut)."

The ECB is now pushing for inflicting losses on junior debtholders as reported by Emma Ross-Thomas, Esteban Duarte and Ben Sills from Bloomberg on October 25 - ECB is Said to Push Bankia Losses as Spain Purges Assets:
"The European Central Bank and European Commission want investors including preference shareholders to swap their securities for new shares to reduce the cost to the taxpayer, according to two people who asked not to be named because the discussions are private. Profit at Banco Santander SA, Spain’s biggest lender, slumped in the first nine months as it took a 14.5 billion-euro charge on real estate losses.
Confronting the toxic legacy of Spain’s 10-year building boom is imposing political costs on Prime Minister Mariano Rajoy as he faces a separatist challenge in Catalonia, protests on the streets of Madrid and a battle to avoid a full bailout." - source Bloomberg.

Back in our May conversation we indicated:
"Transparency in asset valuations would finally help in discovering the extent of the problems plaguing the Spanish Financial sector. The set-up of a "Bad Bank" in similar fashion to Ireland's NAMA, would indeed force price discovery and true valuations provided a third party assessor is drafted."

and we added:
"Without credit growth resuming, the ambitious target deficits will not be met in Spain. The conditions for growth needs credit growth to resume, as shown by the recent credit growth in the US (see our conversation - "Growth divergence between US and Europe? It's the credit conditions stupid..."). Spain has to go through resolving the Spanish banking encumbered balance sheets."

When causation implies correlation...

Credit wise, for Spanish banks, the rise in the issuance for "Puttable bonds" is a cause for concern we think. Puttable bonds are fixed-income securities which investors are able to redeem before maturity. It is a very dangerous option given the funding shock it could create should investors decide in concert to exercise their option. As reported by Bloomberg by Esteban Duarte and John Glover on the 25th of October in their article "Santander Seeks Salvation in Puttable Bonds":
"Banco Santander SA, Spain’s biggest lender, is placing its trust in bondholders by issuing 4.4 billion euros ($5.7 billion) of fixed-income securities that investors are able to redeem before maturity.
Bonds with put options make up 36 percent of Santander’s debt funding this year, compared with 9 percent in 2011, according to data compiled by Bloomberg. While the bonds have lower interest rates, they leave the bank vulnerable to a potential 7 percent increase in the 33.4 billion euros it must repay next year. Investors have already demanded early repayment on 1 billion euros of the notes." - source Bloomberg

Puttable bonds are indeed a typical instrument used by financial institutions under stress. For us, a big red flag.

Another red flag we think for Santander, comes from its dwindling capacity in absorbing potential losses at the parent bank by its increasing policy of partial IPOs such as the one done in Mexico as indicated by CreditSights in their report Spanish Banks - The Value of Empires from the 22nd of October:
"In Santander's case especially, the capacity of equity in its foreign subsidiaries to absorb potential losses at the parent bank is being reduced by its policy of partial IPOs (the goal being to list all the most significant subsidiaries within five years – see Santander: Partial IPO in Mexico). The erosion of loss absorbing capacity that this implies at parent or group level is reflected in the Basel 3 reform that will ultimately prevent banks from including in consolidated CET1 capital any surplus equity contributed by minorities in excess of the subsidiaries' minimum regulatory requirements." - source CreditSights

On a final note, looking at the our "Flight to quality" picture as indicated by Germany's 10 year Government bond yields (well below 2% yield), falling again towards 1.55% versus 5 year Germany Sovereign CDS which has cratered below 25 bps, by avoiding increasing so far Germany's liabilities, Chancellor Merkel has in effect alleviated concerns on Germany's exposure to European woes we think - source Bloomberg:
It's deflation (デフレ) in Europe.

"Correlation is not causation but it is sure a hint" - Edward Tufte - professor emeritus of political science, statistics and computer science at Yale University.

 Stay tuned!

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