Sunday, 4 November 2012

Credit - The year of the empty hand

"Men occasionally stumble over the truth, but most of them pick themselves up and hurry off as if nothing had happened." - Winston Churchill

"This is the year of the empty hand 
Oh you hold on to what you can 
And charity is a coat you wear twice a year 

These are the days of the guilty man 
Your television takes a stand 
And you find that what was over there is over here"
George Michael - Praying For Time

"emp·ty-hand·ed (mpt-hndd) adj.
1. Bearing nothing.
2. Having received or gained nothing."
source the American Heritage Dictionary

While we recently looked into Spain's record surge in Nonperforming loans making a comparison with storm surges and Hurricane Sandy versus the 1991 "Perfect Storm", and looking at the epic performance in credit pointing towards a record year in similar fashion to 2009 (performance now close to 11% in Total Return), we thought this week we would be using part of the lyrics from George Michael's 1990's single hit "Praying for Time" for our title. James Hunter of Rolling Stone magazine described the song as "a distraught look at the world's astounding woundedness".We think our title is appropriate given the astounding woundedness caused by Balance Sheet Recessions (BSR). Looking back at the level of support provided in Europe to the financial system in conjunction with drastic austerity measures for some, the performance in the financial credit space has been epic while yielding no benefits to the real economy. The irony of our chosen title lies in the extraordinary returns for credit in 2012 with admittedly a very clear disconnect with valuations and fundamentals which we discussed last week and as indicated by the below graph from BNP Paribas:

Expensive credit markets you think? You bet!

But, given the on-going "Yield Famine" in the credit space, the theme in the cash market remains the same. Investors are underinvested and full of cash, and with the latest pause in issuance in the corporate space, there is technically no natural supply. As a market maker commented recently on this market context:
"So bonds remain bid and it is difficult to buy bonds even as corporate cash looks expensive. CDS remains quiet but generally feels a little weak in low beta."

In this week conversation, we will look at how to play credit in a deleveraging environment, as well as the upcoming pain for Spanish junior subordinated bondholders and we will finish with the future for credit returns after a record year for the asset class.

In a world facing "Yield Famine" and "River of No Returns" courtesy of a deleveraging environment, what is the investment recipe one should follow?
"All real-world investors face funding constraints such as leverage constraints and margin requirements, and these constraints influence investors’ required returns across securities and over time. Consistent with the idea that investors prefer unleveraged risky assets to leveraged safe assets, which goes back to Black (1972), we find empirically that portfolios of high-beta assets have lower alphas and Sharpe ratios than portfolios of low-beta assets. The security market line is not only flatter than predicted by the standard CAPM for U.S. equities (as reported by Black, Jensen, and Scholes (1972)), but we also find this relative flatness in 18 of 19 international equity markets, in Treasury markets, for corporate bonds sorted by maturity and by rating, and in futures markets." - source Betting Against Beta, Andrea Frazzini and Lasse H. Pedersen - October 9, 2011.

"These are the days of the beggars and the choosers" - George Michael - Praying For Time

The BAB factor (Betting Against Beta) explain the returns of some investors such as Warren Buffett:
"Leveraged buyout funds and Warren Buffett’s firm Berkshire Hathaway, both of whom have access to leverage, buy stocks with betas below 1 on average, another prediction of the model (BAB). Hence, these investors may be taking advantage of the BAB effect by applying leverage to safe assets and being compensated by investors facing borrowing constraints who take the other side. Buffett bets against beta as Fisher Black believed one should". - source Betting Against Beta, Andrea Frazzini and Lasse H. Pedersen - October 9, 2011.

The on-going forced deleveraging for large parts of the European financial system, which have been "begging" for liquidity and provided vast amounts of it, courtesy of our "Generous Gambler" aka Mario Draghi, is no doubt a golden opportunity for cash rich "choosers".

"And you find that what was over there is over here" - George Michael - Praying For Time

Europe is indeed finding out that the deleveraging (which has started earlier in the US) is accelerating over here in Europe hence the tremendous deflationary forces at play and the traumatic effect on the real economy with the EBA (European Banking Association) forcing banks to reach a target of 9% of Core Tier 1 capital in June 2012 in conjunction with austerity measures and unrealistic deficit targets but we ramble again...

As we reminded ourselves in our previous conversation Chadburn, on Full Ahead?:
"One of the most important indicator we think in relation to our Credit Chadburn and the growth divergence between the US and Europe is the evolution of the Loans-to-Deposit ratio progress."

The growing divergence between US and European PMI indexes - source Bloomberg:
US PMI versus Europe PMI from 2008 onwards.

Which as we pointed out recently, this growth difference can be seen in the credit prices between the USA and Europe. The divergence of growth between the US economy and the European economy is reflected in credit prices such as the US leveraged loan cash price index versus its European peer - source Bloomberg:

For Europe, the deflationary forces at play are tremendous. When looking at Spain, one can see the correlation of rising unemployment and rising nonperforming loans - source Bloomberg:

We could go even further by looking at the evolution of the Spanish misery index (inflation + unemployment) in conjunction with nonperforming loans- source Bloomberg:

As far as the Spanish hurricane is concerned, the amount of funding needed for 2013 is significant - source Bloomberg:

One could as well posit that our title could be a veiled reference to a game of high stake poker being played out in Europe. The beggars are indeed not the choosers when it comes to our chosen title and Europe. Pushing the analogy further, we would like to quote Dr Jochen Felsenheimer from his latest credit letter for November 2012 from credit asset management house "assénagon" :
"There are two games in particular whose mechanism is closed to that of capital market: Poker and chess. The development of recent years sadly suggest that the former has gained the upper hand. The central banks have shown their aces of spades, the European Union is using the Spanish Opening to fight for the center of the euro, investors are checking if they don't have anything in their hand after the flop, and the markets are using the Queen's gambit to bet on the same gameplay being repeated again and again. But there is also the possibility that it will be different this time. The financial markets are facing changes which might change the rules of the game for ever. Traditional investment approaches are about to be superseded and long decades of valid mechanisms will be influenced by new developments."

While the political game being played is a game of Chess (see our conversation "The Game of the Century"), we agree with Dr Jochen Felsenheimer's assertion relating to financial markets being currently a game of high stake poker:
"Having the ace and the king as your hole cards is somewhat disparingly know in Texas hold'em as an "Anna Kournikova" - "looks great but never wins". That describes the current situation in the markets extremely aptly. The markets' first reaction to the concerted action by the ECB (Draghi effect) in combination with the political developments (Spanish banks, ESM, etc.) was, of course, positive. The imminent breaking up has been averted for now, even if the fundamental problems are far from solved. The thin line between austerity and growth will continue to dominate the political discussions in Europe and regulatory measures are limited to a few segments and are seamlessly merging into the tradition of combating the symptoms, while the causes largely persist. The European monetary union's basic problem is due to nothing more than the heterogeneity of the member states. This is just what is causing the current problems - the necessity of transfer payments which are currently reflected in the massive TARGET2 balances. The close ties between the banking sector and governments are not solved by Basel III and a banking union - but only raised to another (European) level. And ultimately the economic environment will continue to represent the greatest challenge, as this makes the elegant escape of "growing out of the crisis" seem highly unlikely. Necessary structural reforms (which are known to take time) and the long-drawn-out reconstruction of the European architecture confirm us in our assumption that we are currently on the "Japanese path". And this is more similar to the Way of St. James than a walk in the park."

Indeed, European politicians have been praying for time, we think, and so is the Spanish financial  system!

The Spanish bad bank SAREB will have between 45 billion euros and 90 billion euros in assets. The estimated of assets to be transferred to SAREB taking into account Group 1 of banks (BFA-Bankia, Catalunya Banc, Novagalicia Banco and Banco de Valencia) is 45 billion euro. The average haircut for the transferred assets is between 46% and 63% based on Oliver Wyman's baseline scenario plus an additional discount. What amounts, we think, into wishful thinking from the Spanish government is that it ambitions to keep its stake in the structure below the 50% threshold so that SAREB stays private and Spain's public accounts are not affected and to avoid taking a hit on its public debt level. What caught our attention is that the Spanish government is already facing "mutiny" in the sense that BBVA has already balked at investing into the bad bank. Angelo Cano, BBVA's CEO has already voiced is concern and said last Wednesday he had no interest in investing in the bad bank in true Banker's algorithm fashion:
"When the system receives a request for resources, it runs the Banker's algorithm to determine if it is safe to grant the request. The algorithm is fairly straight forward once the distinction between safe and unsafe states is understood."
Request denied...from BBVA. "We have no real obligation"  - Angelo Cano, BBVA CEO.

Supposedly most of the funding for the SAREB is to come from private investors (8% equity) with an expected ROE of 14-15% (according to FROB). Three main sources of funding are envisaged:
-State-guaranteed senior debt
-Perpetual subordinated debt
-Common equity
Both the perpetual debt and the common equity will be subscribed in part by the restructuring Spanish fund FROB (Fund for the Orderly Restructuring of the Banking Sector) but with a majority subscribed supposedly by private investors.

Why has the request has been denied by BBVA, simply because of pending provisions to comply with the two RDLs (Royal Decrees relating to real-estate provisioning for banks) as displayed in the Exane BNP Paribas table below from their recent report on the Spanish Bad Bank SAREB from the 30th of October:
Only 31% of provisions have already been booked by BBVA, hence the rejection...

As far as losses are projected in relation to real estates exposure (all credit - performing or not - + foreclosed) - RD1 + RD2 versus Oliver Wyman's adverse scenario versus the Bad Bank Sareb and Deutsche Bank estimates versus NAMA, the below table from Deutsche Bank indicate the expected losses:

"Hanging on to hope when there is no hope to speak of" - George Michael - Praying For Time

Hanging on hope is exactly what Banco Popular Espanol junior subordinated boundholders are hanging onto. They are counting on being rescued by the Spanish lender's equity investors from avoiding being wiped out on 6.4 billion USD of junior debt as reported by Estaban Duarte from Bloomberg on the 1st of November in his article -  Popular Bond Wipe-Out in Shareholder Hands:
"The bank wants to raise as much as 2.5 billion euros ($3.2 billion) in shares to avoid seeking state aid that would trigger losses on subordinated bonds under European Union rules. Popular’s 5.702 percent junior notes due 2019 rose 15.8 percent in the past month to 7O cents on the euro, according to Bloomberg prices, compared with an average 1.93 percent increase for securities in the Bank of America Merrill Lynch Euro Financial Subordinated & Lower Tier-2 Index. Failure to raise funds through a share sale could mean Popular having to conduct a restructuring under the eyes of regulators, cap salaries and dispose of assets. The lender is a victim of Spain’s real estate collapse, failing the latest government stress tests which revealed the Madrid-based lender has a 3.22 billion-euro capital shortfall. “The share sale is the last hope for Popular subordinated bondholders since a failure would mean that the state would have to step in,” said Ignacio Victoriano, head of fixed-income at Renta 4 SGIIC, which manages 1.5 billion euros of assets including some Popular subordinated bonds. “We are confident that they will get the deal done.”" - source Bloomberg.

We " agree" to disagree", with the above statement from Ignacio Victoriano and we would rather side with the comment from Jean-Luc Lepreux, senior bank analyst at Societe Generale SA in Paris from the same Bloomberg article:
"Raising 2.5 billion euros when your market capitalization is 2.6 billion euros will be hard without running the extra mile,” Lepreux said in an interview. “Subordinated debt holders should be prepared to face high haircuts for banks needing public funds, up to 100 percent for fully nationalized institutions."

Banco Popular Espanol share price evolution since 1989- source Bloomberg:
"Popular wants its customers to buy 60 percent of the new shares being offered because Chief Financial Officer Jacobo Gonzalez-Robatto said Oct. 1 that “the bank has enormous goodwill of its customers.” The stock was at 1.20 euros today and has slumped 29 percent since the day before the share-sale announcement on Oct. 1, valuing the lender at 2.6 billion euros.
Bankia followed the same strategy in July last year when it tapped about 347,000 individual investors as it was seeking to boost capital. Bankia stock has fallen almost 70 percent since then.
Popular’s third-quarter profit fell to 75.6 million euros from 98.6 million euros in the same period a year earlier, the lender said Oct. 26. That surpassed the 42 million-euro median estimate in a Bloomberg survey of nine analysts." - source Popular Bond Wipe-Out in Shareholder Hands, Bloomberg.

As far as asset quality is concerned for Banco Popular in general, and Banco Popular's shareholders in particular, Banco Popular has still some significant provisions to book based on the two RDLs (4.9 billion euro) as reported by Nomura on their recent note on Banco Popular:
"Popular still has significant provisions to book based on the new legislation introduced this year of c.EUR 4.9bn. These provisions, plus additional ones highlighted by management, making a total of EUR 9.3bn will be booked following the upcoming rights issue." - source Nomura

This is exactly how our story is unfolding for junior subordinated bondholders:
"At some point, as we argued recently (Peripheral Banks, Kneecap Recap), losses will have to be taken."

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.

"Oh, you hold on to what you can" George Michael - Praying For Time

Moving on the subject of future returns for credit, it is indeed a question of holding on what you can.

Nomura in their recent Quantitative Strategies update from the 31st of October ask the following important question:
"Will future credit returns be a trick or a treat?"

Following up on the concept of "Betting on Beta" earlier in our conversation, one has to remember these fundamentals concepts when approaching credit as indicated by Nomura's note:
"Many investors understand that what they get from credit exposure depends on how high credit spreads are when they buy.
But relatively few grasp just how high credit spreads have to be to earn decent risk-adjusted returns. Only top-quartile spreads will do- "above-average" -is not good enough as shown below:
Spreads in 2009 were in the top decile, and credit has performed well since then. Spreads today are above-average but not top quartile. Adjusted for regulatory changes, they would probably be even lower.
The trick: average credit returns (stripping out funding and duration) are mediocre, as spreads barely cover the cost of fallen angels or defaults.
The treat: credit returns are semi-predictable, due to their links with trends in corporate fundamentals, rating actions, and business cycles. This makes credit a good fit for systematic long/short strategies.
Balancing carry, momentum and value investment styles to position long/short in credit indices outperforms, with a Sharpe ratio of 1.01." - source Nomura

Is buying and holding an issue in credit? Nomura indicates these empirical elements:
"Long-only credit returns have been poor over time 
In Figure 2 we show the cumulative duration-adjusted excess returns of US corporate bonds since 1997 and the bonds‘ average OAS":
"A long-only investor would have received very little additional return for the extra risk they were taking in this 15-year period. In our paper Making credit beta work for real we show how credit spreads tend not to compensate investors for the costs of fallen angels and defaults – investors sell bonds as they are removed from indices at a substantial loss to par. Even a small number of fallen angels or defaults can wipe out the positive carry from performing names. While there are periods where excess returns are positive, these tend to follow periods of spread widening."

Finally how does one generate future credit returns going forward? Combining long/short strategies makes credit perform as indicated by Nomura:
"A styles-based strategy combining carry, momentum and value to position in a basket of CDS Indices delivers solid returns since 2006. The index has a Sharpe of 1.01, Calmar of 0.92 and skew of 0.86 (vs. long-only Sharpe of 0.36, Calmar of 0.13 and skew of -0.7)." - source Nomura

"Nothing is enough for the man to whom enough is too little." - Epicurus 

Stay tuned!

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