Thursday 31 January 2013

Credit / Equity / Volatility - Looking at this week's divergence

"There is something pagan in me that I cannot shake off. In short, I deny nothing, but doubt everything." - Lord Byron 

This week we have been witnessing a significant widening move in credit over the last few days, not only in the CDS space but also in the cash space, with the basis between cash and CDS remaining stable.

Several primary deals which have been priced aggressively since the beginning of the year are underperforming in the secondary market, generating some selling pressure particularly on investment grade credit in a very thin market, liquidity wise.

At the same time equities are not moving significantly, and both realized volatilities as well as implicit volatilities continue to fall day after day.

Itraxx Main Europe (Investment Grade risk gauge in Europe for 125 entities), Eurostoxx 50 index and Eurostoxx 3 month ATM (At The Money) Implied volatility in the bottom graph - source Bloomberg:

Two possible explanations:

1. Credit is predicting a correction in equities (often the case) and the profit-taking we are seeing will spread to equities.

2. There is a real movement behind this "rotation / re-allocation" from credit / fixed income towards equities, which includes a durable inversion in classical correlations between Credit / Equity / Volatilities.

To be continued...

Stay tuned!

Wednesday 30 January 2013

For French corporate treasurers, financing remains difficult and expensive

"Thus, the use of fiat money is more justifiable in financing a depression than in financing a war." - Carroll Quigley, American writer.

In our conversation "The European crisis: The Greatest Show on Earth", we indicated:
"When it comes to credit conditions in Europe, not only do we closely monitor the ECB lending surveys, we also monitor on a monthly basis the “Association Française des Trésoriers d’Entreprise” (French Corporate Treasurers Association) surveys."

One particular important indicator we follow is the rise in Terms of Payment as reported by French corporate treasurers. The latest survey published on the 16th of January points to a slight improvement in the Terms of Payments:
The monthly question asked to French Corporate Treasurers is as follows:
Do the delays in receiving payments from your clients tend to fall, remain stable or rise?
Delays in "Terms of Payment" as indicated in their January survey have been reported a decrease by corporate treasurers. Overall +17.9% of corporate treasurers reported a decrease compared to the previous month (+26.5%), bringing it back to the level reached in August 2011 (18.5%). The record in 2008 was 40%.

According to their latest survey, the decrease is due to collection actions undertaken at the end of the year, which according to the survey warrants confirmation in the coming months in relation to the easing in the delays in Terms of Payments for corporate treasurers in France. Overall, according to the same monthly survey from the AFTE, large French corporates treasurers indicated that they are still facing an increase in delays in getting paid by their clients for 24.4% of them but less than what they indicated in December. (30%).

What remains difficult though for French corporate treasurers according to the survey is access to financing. There is a slight improvement in the latest survey, but conditions remain tough for French companies:
While the rebound from the lows of the end of 2011 (which was due to the acute liquidity crisis faced by the European financial system), the LTROs have somewhat improved financial conditions for French corporate treasurers, nevertheless conditions remain tough.

In order to comprehend the opinion of French corporate treasurers on the evolution of banks' margins, the AFTE calculates a difference between the average interest rate applied to new corporate loans and the 3 months Euribor rate. The series below stopped in November and indicated some stability in banks' margin on new corporate loans. New credits above a one year maturity provided  to French corporate treasurers remains at elevated levels:
"Problems are not stop signs, they are guidelines." - Robert H. Schuller, American clergyman 

Stay tuned!

Tuesday 29 January 2013

US share buy-backs and dividends increases in two charts

"If you ask a firm's management, they'll likely tell you that a buyback is the best use of capital at a particular time. After all, the goal of a firm's management is to maximize return for shareholders and a buyback generally increases shareholder value. The prototypical line in a buyback press release is "we don't see any better investment than in ourselves." Although this can sometimes be the case, this statement is not always true." - source 

- Source - Societe Generale US Credit Research.

Increasing buy-backs in conjunction with rising dividends:
- Source - Societe Generale US Credit Research.

"The Bottom Line: Are share buybacks good or bad? As is so often the case in finance, the question may not have a definitive answer. If a stock is undervalued and a buyback truly represents the best possible investment for a company, the buyback - and its effects - can be viewed as a positive sign for shareholders. Watch out, however, if a company is merely using buybacks to prop up ratios, provide short-term relief to an ailing stock price or to get out from under excessive dilution."  - source 

For us, buy-backs are credit negative if it means buying-back using leverage and more debt, particularly for banks given it reduces the equity buffer needed in case of trouble. 

Increasing debt to fund share buy-back is a trend we have seen lately. It might be more efficient from a tax point of view given interest on debt is deductible, but, remember, a debt has to be repaid at some point...

Share buy-backs do eat into FCF (Free Cash Flow). While we recently touched on the return of LBOs with the example of DELL inc ("The return of LBOs - For whom the Dell tolls"), from a credit perspective, in similar fashion to LBOs, the rising trend in share-buybacks using debt finance warrants close monitoring in this "Yield Famine" induced environment of "Financial Repression", where the "credit mouse-trap" has been set up by Central Banks.

"If you do not change direction, you may end up where you are heading." - Lao Tzu 

Stay tuned!

Sunday 27 January 2013

Credit - The Donk bet

"There are three roads to ruin; women, gambling and technicians. The most pleasant is with women, the quickest is with gambling, but the surest is with technicians." - Georges Pompidou, former French president (1969-1974)
While watching the much anticipated LTROs refund on Friday, as well as the economic data during the week  with the rebound of the European PMI which we had anticipated (France being an outlier, but, our readers  know it doesn't come to us as a surprise), Spain's Economy Minister Luis de Guindos took center stage for us on Friday by declaring on Bloomberg TV: "Spain doesn't need any sort of bailout", adding that the target for the budget shortfall this year is "achievable" and concluding his remarks by "The perception of the Spanish economy has improved and will continue to do so over the next weeks and months". 

Given last week's title analogy referred to poker games in general and the art of bluffing in particular, we thought we had to use yet another poker game reference in our title namely the "Donk bet".

 The "Donk bet" being:
  1. A bet made by a donk, i.e. one that is generally considered weak or to demonstrate inexperience or lack of understanding of strategy.
  2. A bet made in early position by a player who didn't take initiative in the previous betting round. It was named because this move is often considered indicative of a weak player (since it is more often reasonable to expect a continuation bet). - source Wikipedia

It seems to us that Spain's Economy Minister has not fully demonstrated his understanding of the "Fabian Strategy" of Mario Draghi. Our "Generous Gambler" has been trying to "call the clock" (using another poker game reference) on Spain  namely trying to discourage them to take a long time to act.

We would therefore "agree to disagree" with Mr de Guindos given Spain pose the biggest threat to the survival of the Euro. In fact the Spanish Misery index has beaten Greece as the crisis bites and unemployment has reached 26.60% as indicated by Bloomberg:
The European Commission prediction for Spain’s budget shortfall last year is already wider than the EU’s goal of 6.3 % of gross domestic product. The target for 2013 is 4.5 %...

We quoted in our conversation "Agree to Disagree" Henry Queuille. Henri Queuille was the epitome for "professional politician": he served three times as Prime Minister and was 21 times minister in a French government under the IIIrd and IVth French Republic. He was the symbol of the inefficiency and the failure of the French IVth Republic:
"Politics is not the art of solving problems, but to silence those who ask." - Henri Queuille

It appears to us that Mr de Guindos is indeed a true disciple of Henri Queuille when we listened to his latest Bloomberg interview. As a matter of Spanish "quote" comparison, BBVA's Chief Operating Officer Angel Cano said in April 2010 that asset quality was probably going to be "stable from now on". Looking how "stable nonperforming loans have in been in Spain, one can wonder whether or not a Henri Queuille award should be set up in Europe for the best delusional political quote, but, we ramble again...

So in true poker fashion, one can posit "there's indeed plenty of action in this game". In this week's conversation we will therefore look at what lies ahead for the Spanish banking sector in general and Spain's real economy in particular in conjunction with the LTRO impact of the early refund. But first a quick credit overview.

US PMI versus Europe PMI - source Bloomberg
"Short term, we do expect a minor reduction in the divergence as reflected in credit prices such as the US leveraged loan cash price index versus its European peer." - Macronomics, The Fabian Strategy, 5th of January 2013

We explained the divergence in our conversation "Growth divergence between the USA and Europe" and we indicated early January that this divergence should persist in 2013. 

The uncanning similarity of the US leveraged loan cash price index versus its European peer with the above PMI graph - source Bloomberg:
"Loan prices have risen to 97.72 cents on the dollar, the highest since July 2007, from 59 cents in December 2008, as concern eases that the world’s largest economy will slide back into recession. Leveraged loans and high-yield, high-risk bonds are rated below Baa3 at Moody’s Investors Service and lower than BBB- at S&P." - source Bloomberg.

The current European bond picture with the continuing fall in Spanish and Italian yields with rising Core European yields - source Bloomberg:

In relation to our "Flight to quality" picture, Germany's 10 year Government bond yields have been recently rising above 1.60% and the 5 year CDS spread for Germany has been rising in tandem in the process - source Bloomberg:

2 year German bond yields versus 2 year Japanese yields, yet another "sucker punch" courtesy of the LTRO's refund anticipations. From 0% yield to 0.23% in January 2013 - source Bloomberg:

Credit and volatility wise, the Itraxx Crossover index (representing the credit risk gauge for 50 European high yield entities) have as well falling in tandem but with volatility (a subject we recently touched on) breaking through important levels similar to the regime of 2004-2007 - source Bloomberg.
Credit wise, what really caught our attention was not only the "new regime" in volatility (or should we say Central Banks' dictatorship via "financial repression"), but, the US High Yield space, where Tenet Healthcare has issued a 7 year bond with a single "B" rating with a coupon of 4.25%, which is an "all time low" level for a primary yield level on a single "B" credit on a 7 year bond.  

As we have discussed in our first credit conversation of the year "The Fabian Strategy", we don't believe the hype in credit and as we argued in our conversation "Hooke's law" previously the "credit mouse-trap" has been set by Central Banks. Well done...

We also recently reflexionate around the return of mega leveraged buyout transactions such as DELL inc  in our recent conversation "The return of LBOs - For whom the Dell tolls".  Record low borrowing costs in the market for junk bonds (high yield) where LBOs are financed is creating the ideal set up for a leverage buyout   buying spree: "There will be about $135 billion in LBO volume this year, compared with an average of $100 billion during the past two years, and below the $600 billion annual peak of 2006 and 2007, he said. Credit-default swaps typically surge on LBO speculation because the debt added to a company’s balance sheet to fund the takeover erodes its credit quality and leads to ratings downgrades. 
“As the recent experience with Dell illustrates, the risk of LBOs has a particularly large impact” on Markit’s investment-grade benchmark, pushing it a net 2 basis points wider, Bank of America’s Mikkelsen and Yuriy Shchuchinov wrote in a Jan. 23 note. Their model shows 14 percent of the index’s underlying credits are feasible LBO candidates. 
 Credit-default swaps on Quest Diagnostics have climbed 38.5 basis points to a mid-price of 123 basis points since Bloomberg News first reported Dell’s buyout discussions with private- equity firms, according to data provider CMA, which is owned by McGraw-Hill Cos. and compiles prices quoted by dealers in the privately negotiated market. 
Buying Protection:   
That was “precipitated by investors’ buying protection on names that have traditionally been considered LBO candidates,” following the Dell news, according to a note dated Jan. 23 from Barclays Plc analysts led by Shubhomoy Mukherjee. Credit-default swaps tied to Nabors surged 42 basis points to 191, the highest since July, and contracts on Avnet Inc.’s debt climbed as high as 254 basis points on Jan. 14 before falling to 178 basis points yesterday, CMA data show. Those on Falls Church, Virginia-based Computer Sciences Corp. added 40.5 basis points since Jan. 11 to 193 yesterday. Buyout firms announced a record $1.6 trillion of acquisitions from 2005 to 2007. The end of that era was “quite painful for many overleveraged deals and many PE firms and their investors have continued their long wait to reach that point where they can exit and take their gains,” CreditSights Inc. analysts Glenn Reynolds and Ping Zhao wrote in a note."  - source Bloomberg - Dell Lifts Default Risk on Next Buyout Targets: Credit Markets.

Could that be another indication of a "Donk bet" taking place in the credit space? We wonder...

As we have argued last week's Dell LBO conversation:
"One thing for sure with which we clearly agree on with CreditSights, is that the yield curve management policies of the Fed is clearly pushing investors into higher risk assets to reach for return in this "Yield Famine" induced environment of "Financial Repression" (probably out of their comfort zone too...)."

Moving on to the Spanish "Donk bet", no disrespect to Mr de Guindos and Mr Cano but we will have to agree with Citi's recent note on Spanish Banks - Iberoamerican Big Picture from the 21st of January:
"A change in the latest asset quality deterioration trend is needed for the sustainability of the banking system. If at a system level we maintain the loan contraction and the NPL growth during the next 5 quarters, the NPL ratio for the corporate segment would increase to 29.1% in 4Q13E from 16.6% in 3Q12. As expected the key drivers of the NPL growth will be the construction and the real estate sectors" - source Citi
"Just as an example, if we maintain the yoy loan contraction and the NPL growth during the next 5 quarters, the NPL ratio for the corporate segment would go from 16.6% in 3Q12 to 29.1% in 4Q13E. Just keeping the contraction deleverage pace stable pace with the stock of NPLs, the NPL ratio would increase to 18%." - source CITI

So much for "stability Mr Cano. So much for "improvement Mr de Guindos.

In last week's conversation "Cool Hand" we discussed the Bank of Spain's recent willingness in stemming the  war for deposits taking place in Spain:
"By trying to put an end to the deposit wars, the Bank of Spain ambitions to reduce the pressure on banks' earnings and profitability which would reduce the capital shortfall for some Spanish banks and the level of capital injunctions needed. It is once again a "Fabian strategy", buying time that is."

Citi's recent note on that matter is as follows:
"On 8 January 2012, the Spanish press reported that the Bank of Spain had “recommended” the largest banks in Spain to limit the yield of saving products. Other banks followed shortly. The measure apparently would also affect guaranteed funds and commercial paper products. The penalty for high yield deposits would consist of higher capital requirements, which would not affect foreign banks operating in the country (ie Banco Espirito Santo, ING). 

The press sources differ in the way the penalty is going to work, given the lack of official statements from Bank of Spain, the interpretation of the law can vary significantly. We expect a law to regulate this “recommendation” shortly. The Bank of Spain has taken this measure in order to reduce the cost of funding for the banks, which are expected to transfer part of this reduction to lower lending rates. We have to take into account that, according to the 3Q12 results, banks are already reducing the yield of loans after the repricing cycle during 2012. 

How do we understand the new recommendation? It will apply to the new savings production from banks — 85% of the new production of the banks won’t be able to exceed the yield limits set in the table below (Figure 4). The banks exceeding this limit will need to comply with higher core capital requirements, according to the press up to 125bps more from the current 9.0% requirement. The latest reports point out that the deposits above €10 million won’t be affected by the new requirement, supporting big corporate and public deposit accounts." - source CITI

The larger than expected EUR 137.2 billion initial repayment from the first three year LTRO (consensus was for 84 billion), we will have to wait until mid-march to get the geographical breakdown from National Central Banks in order to assess the complete picture for European countries.

But some Spanish banks such as Banco Sabadell indicated on the 11th of January, that the bank was planning to repay EUR 4.8 billion of LTRO funding (20% of the total requested) according to Citi's note.

As far as profitability for Spanish banks is concerned, as indicated by Citi's note:
"Given that the last LTRO was already announced in February 2012, it should be fully included in analysts’ estimates, reducing revenues expectations for 2015. Below we can find the revenue consensus estimates of our coverage universe. It is not only that revenues seem high, in our view, it is also that consensus seems to be missing the LTRO effect in 2015 revenue estimates, as they are expected to grow by 7% on average (ex Santander and BBVA)." - source Citi

An interesting analysis from Citi, while there are not missing out on the LTRO impact on earnings, we think they are lacking some essential points in relation to Spanish banks.

-First missing point - the issue of puttable bonds which we discussed in our conversation "When causation implies correlation":
"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." - source Macronomics, When causation implies correlation, 27th of October 2012

-Second missing point - the issue of the dwindling capacity in absorbing potential losses at the parent bank due to partial IPOs discussed in the same October conversation:
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" 

-Third missing point being one of Macronomics's favourite namely the importance of "Goodwill" (see our conversation from November 2011 - "Goodwill Hunting Redux"):
"Large Goodwill Impairments increase the debt to equity ratio.
It is therefore paramount to track goodwill impairments in relation to future banks earnings."

"Goodwill is an accounting convention that represents the amount paid for an acquisition over and above its book value. Under the accounting rules European banks use, the International Financial Reporting Standards, companies have to write down goodwill on their balance sheets if the underlying assets have permanently deteriorated in value."

In December 2010 ("Goodwill Hunting - The rise in Goodwill impairments on Banks Balance Sheet"), this is what we discussed as a reminder:
"When a bank acquires another one, goodwill as intangible asset goes on its balance sheet. When a medium bank acquires a smaller one, goodwill is created onto the balance sheet. But, when the medium bank is acquired by a larger one, there is a compounding effect given that the larger bank will also create some more goodwill of its own and therefore inflates its balance sheet.

As the process goes on and on, for banks on the acquisition war path, you find more and more goodwill making up the capital."
We also indicated at the time:
"Looking at non-cash intangible assets (i.e., goodwill) can be a good indicator and used as a proxy to determine the health of banks.

The significance of the write-downs on Goodwill is often presaged as rough waters ahead. These losses often take a real bite out of corporate earnings. It is therefore very important to track the level of these write-downs to gauge the risk in earnings reported for banks."
When one looks at European banks, Spanish bank Santander, Credit Agricole and Italian bank Intesa are carrying the most "Goodwill" as indicated in the table below from Bloomberg:
"A mere 5% of the 800 billion euros of outstanding goodwill was impaired in 2011, with about 19.2 billion (2.4%) relating to financial services, according to an analysis of 235 public European companies by the European Securities and Markets Authority. The top 24 European banks' combined goodwill fell to 173 billion euros at FY07, from a 2007 peak of 233 billion euros, with further impairments likely." - source Bloomberg.

In relation to the "real economy" in Spain and the on-going "Donk bet", Spanish recession has deepened in the last quarter of 2012 with GDP contracting 0.6% from the previous 6 months when it slipped 0.3%. So while Spanish Economy Minister Mr de Guindos is seeing an improvement in the perception of the Spanish economy, there is a difference between perception and reality. Even the European Commission on the 22nd of January indicated Spain would miss its 2012 deficit target. with a GDP contraction forecast of 1.4%, taking the deficit to 6% for 2013, not the "ambitious" 4.5% Mr de Guindos seems so sure of.

What matters is loan growth for economic growth to resume in Spain. We do not see it happening in 2013 for the "real economy" - graph below source Citi:

As indicated in the article from Charles Penty in Bloomberg from the 21st of January 2013 entitled - "Spain Banks selling debt still won't cut loan costs:
"The prospect of diminishing competition for retail deposits may boost lending margins. Reports that the Bank of Spain wants lenders to cap the yields they offer on deposits are positive for banks because it would provide relief for their funding costs and bolster margins, Sergio Gamez, an analyst at Bank of America Merrill Lynch, wrote in a Jan. 10 note to clients. Bank behavior may make it hard for Spain to rejuvenate an economy mired in a five-year slump and headed for a further contraction this year, said Tobias Blattner, an economist at Daiwa Capital Markets in London. Spain’s economy will shrink 1.5 percent this year after contracting 1.4 percent in 2012, according to the median forecast of 38 analysts surveyed by Bloomberg. “The interest rates that banks are charging to lend to companies aren’t going down and that’s a big worry,” Blattner said. “There are no signs yet of a pass-through by banks of their lower funding costs to the real economy.”" - source Bloomberg

We hate sounding like a broken record but, no credit, no loan growth, no loan growth, no economic growth and no reduction of aforementioned budget deficits:
"So austerity measures in conjunction with loan book contractions will lead unfortunately to a credit crunch in peripheral countries, seriously putting in jeopardy their economic growth plan and deficit reduction plans."- "Subordinated debt - Love me tender?" - Macronomics, October 2011

From the same Bloomberg article: 
“If they’re using wholesale debt that costs 3 to 4 percent to replace ECB funding that costs 0.75 percent, that means substantial pressure on margins,” Creelan-Sandford said. Banks are trying to wring more revenue from loan books as they seek to absorb the rising cost of a clean-up of 180 billion euros of real estate assets ordered by the government last year, he said. Banks in other nations have dropped their lending rates, ECB data show. German rates declined to 2.9 percent from 3.9 percent a year earlier, while French companies pay 2.2 percent, down from 3.2 percent. In Portugal, the cost of a loan for as much as 1 million euros fell to 6.7 percent from 7.6 percent, while Irish banks charge 4.6 percent, compared with 5.3 percent. Spanish companies are petitioning Prime Minister Mariano Rajoy, who says one of his priorities in government is to create conditions for credit to recover in Spain. The Spanish Confederation of Small and Medium-Sized Companies said in a Jan. 17 statement that it didn’t see “normal” financing conditions returning until 2016 at the earliest and that the lack of funding put firms in a “situation of extreme weakness.” - source Bloomberg

It is deflation in Europe and Spain is still mired in a deflationary spiral. 

On a final note the VIX volatility index passed the 5 year level as Bank CDS fall further as indicated in the Bloomberg chart from the 21st of January:
"The VIX Index, a widely-used measure of market risk often called the investor fear gauge, fell to its lowest level in more than five years as macroeconomic concerns, including those regarding the U.S. fiscal cliff, recede. Certain bank revenue streams remain correlated to volatility, with lower volatility increasing demand for risky assets, pressuring prices higher, and vice versa." - source Bloomberg

"There is no gambling like politics." -   Benjamin Disraeli, British statesman

Stay tuned!

Tuesday 22 January 2013

Volatility Regime Change and Central Banks - a key driver

"If you do not change direction, you may end up where you are heading." -  Lao Tzu

While we recently asked ourselves about the possibility of a regime change in the volatility space in early January:
"Long dated volatilities a regime change?"

and touched as well on the change in volatility regime in both the US and Europe:
"The Change in volatility regime - a follow up"

A note from Goldman Sachs entitled "The Buzz - The Great Compression - VIX regimes over the last 23 years" from the 22nd of January seems to confirm the shift into a lower vol regime:
"Our VIX analysis back to 1990 shows that the VIX has been through seven “statistically” distinct volatility regimes over the past 23 years. The model currently assigns an 89% probability that the VIX has shifted into an even lower gear, and is currently transitioning into its 8th regime characterized by lower volatility levels."
- source Goldman Sachs.

More interestinggly has we have been discussing in our recent credit conversations, we have to agree with Goldman Sachs note, namely that when it comes to a lower volatility regime, Central Banks have been a key driver:
"Our statistical test allows us to track the probability of a regime shift over time. The probability of a new lower vol regime hit a low of 14% in mid-summer 2012, and then accelerated higher post ECB President Draghi’s comments in July to do “whatever it takes” to preserve the Euro. After the official launch of QE3 in the US and ECB monetary stimulus in September the probability moved from the low 30’s to where it stands now in the high 80’s, over 6x its mid-July level. Our simulations show that a replay of VIX levels over the last two months would push our regime shift probability to 95% and make the new VIX regime official from a statistical perspective." - source Goldman Sachs.

Following the footsteps of our recent conversation relating to the regime change in the volatility regime, Goldman Sachs in their note argue the following:
"While much has been written on the imbalances which led to the “Great Recession" and the unprecedented volatility levels reached, understanding the common post-crisis volatility patterns can have strong implications for volatility investors. The VIX averaged 17.8 in 2012, on par with 2007 levels, and has averaged 13.7 in the early stages of 2013, similar to the average level from January 2004 through mid-2007. The VIX transition from the Great Recession to the Great Compression has been a long, slow healing process, and the number one question we have gotten from investors in 2013 has been: “Is the VIX shifting into a lower vol regime?” The short answer: The statistics say YES."
- Source Goldman Sachs, Krag Gregory, Ph.D., Jose Gonzalo Rangel - 22nd of January 2013.

When it comes to measuring or not the probability of regime change, according to Goldman Sachs, the probability of a new VIX regime has increased six-fold since mid July 2012 and stands currently at 89%. The chart below from Goldman Sachs shows the probability of rejecting the hypothesis of "no regime change". Data as of January 18, 2013:
- Source Goldman Sachs, Krag Gregory, Ph.D., Jose Gonzalo Rangel - 22nd of January 2013.

Goldman Sachs makes the following points in their research note:
"-Supply/Demand: Trading behavior could also put pressure on the back-end of the volatility curve. In low vol environments investor behavior often changes. From a supply/demand perspective, in lower realized volatility environments investors become reluctant run pure long volatility strategies and often try to minimize carry. That is often done through calendar spread trades which sell the back to fund the front-end of the volatility curve. That flow would put downward pressure on the back-end of the VIX and S&P curves. 

-Investors continue to search for yield: In an environment where rates are exceptionally low, investors have had to look to other asset classes to generate income. Low vol regimes typically bring out the vol sellers. Investors often wait for persistently low levels of VIX and realized volatility to sell puts, straddles and strangles. This shift in trading behavior from long vol to short volatility risk premium generation strategies may also push vol lower. 

-Caveat: Shouldn’t the VIX curve be steeper now than in 2007 given VIX ETN’s? One issue which makes comparisons to 2007 and quantifying potential term structure shifts difficult is that VIX ETN’s and ETF’s did not exist in 2007. These products by their construction have a tendency to steepen the VIX curve. So we may not see the same flatness we saw in 2007 unless volumes on these products decline considerably." - source Goldman Sachs

More importantly, Goldman Sachs makes the following important points in regards to a sub-14 VIX level:
"What is a sub-14 
-VIX telling us?What is a sub-14 VIX telling us? The VIX landed at 12.5 last Friday, and has averaged 13.7 YTD. The VIX has traded at an average spread of 4.4 vol points above S&P 500 one-month realized volatility back to 1990. If taken literally, VIX levels below 14 in early 2013 suggest that the VIX is "forecasting" sub-10 realized market volatility, at least for the near term. S&P 500 realized volatility was 12.8 in calendar year 2012, one- and three-month realized are around 13, and ten-day has dropped below 6.
-Equity volatility and the business cycle: Our US Economics team is currently forecasting real GDP growth of 1.5% for 2012Q4, with an expectation for 1.5% in 2013Q1. The ISM manufacturing index has been hovering around the 50 mark over the past few months and our economists expect little change in 2013Q1. Over the last 50 years S&P 500 realized volatility has typically averaged about 14 in months when the ISM was between 50 and 55 and 14.8 in quarters when GDP growth rates were in the 0%-2.5% range.
-Our economic model for S&P 500 one-month realized volatility suggests that volatility should currently be trending around 14 based off of current levels of manufacturing, consumer spending, and labor data. So benchmarking relative to the ISM, GDP, or our own formal model, suggests realized volatility should be around 14.
-But benchmarking relative to the economics may be less relevant now. In our view changes in volatility are about changes in information content. So low but steady levels of ISM and GDP growth for prolonged periods may not be indicative of higher volatility levels. We have been in this macro environment for a while and we argue it is sharp changes in the macro and financial information sets that are volatility inducing. We are also in the unchartered territory of unprecedented global Central Bank liquidity which may make comparisons to typical volatility levels in past economic states more difficult. In short, no bad news equals good news for lower VIX levels, especially if we get through the debt ceiling and sequester debates unscathed." - source Goldman Sachs.

As we argued in March 2012, in our conversation "The two main drivers of equity volatility":
"The two main drivers of equity volatility are for us, credit availability (Merton model) and revisions of earnings forecasts estimates."

VIX since 2005 - Source Bloomberg:

One thing for sure, the on-going excessive search for yields could have a long-term impact (relative immunisation risk of credit versus equities).

"Consequences are unpitying." - George Eliot, British author.

Stay tuned!

Monday 21 January 2013

The return of LBOs - For whom the Dell tolls

"It was easier to live under a regime than fight it." - Ernest Hemingway, For Whom the Bell Tolls, Chapter 34.

"A leveraged buyout (LBO) is an acquisition (usually of a company but it can also be single assets like a real estate) where the purchase price is financed through a combination of equity and debt and in which the cash flows or assets of the target are used to secure and repay the debt. As the debt usually has a lower cost of capital than the equity, the returns on the equity increase with increasing debt. The debt thus effectively serves as a lever to increase returns which explains the origin of the term LBO." - source Wikipedia

In the run-up to the financial crisis of 2008, 2006 and 2007 where the years where "cheap credit" fuelled the housing bubble, but it was the years as well of the mega-buyouts. In 2006, private equity firms bought 654 US companies for 375 billion USD, 18 times the level of 2003 and raising 215.4 billion USD in investor commitments to 322 funds. 2007 saw yet another record with 302 billion USD of investor commitments to 415 funds. 

The paroxysm of the mega-buyout deals of the period was Energy Future, formerly known as TXU Corp which was taken private by KKR and Co. for a cool 43 billion USD in 2007. The deal did not evolve favorably for bond holders given Energy Future is now seeking an extension of maturity for the portion of Texas Competitive's revolving loan that matures in 2013 (2.1 billion million USD of revolving credit facility used in total).  
Energy Future Holdings is loaded with 37.4 billion USD worth of obligations whereas Texas Competitive is saddled with 32.2 billion USD in debt, 700 million USD of which is due in 2013, and with 2.7 billion USD in interest payment due in 2014 according to Bloomberg. 

KKR and Co., TPG Capital and Goldman Sachs Capital partners paid themselves 528.3 million USD in fees while TXU Corp is moving towards bankruptcy and restructuring according to Bloomberg article by Richard Bravo and Mark Chediak - TXU Teeters as Firms Reap $528 million fees
"Energy Future’s long-term debt has soared to $42 billion since the buyout and the company is poised for its seventh straight quarterly loss as it struggles with natural gas prices 73 percent below their 2008 peak. Moody’s Investors Service says the company may need to restructure next year and derivatives traders are pricing in a 95 percent chance of default within five years for its deregulated unit." - source Bloomberg.

The issue with TCEH was that their breakeven cash flows needed in 2011 was based on 6.40 USD/mcf sustainable gas prices to cover all interest expenses and 450 million USD of maintenance CAPEX according to CreditSights calculations in April 2011. Of course it went horribly wrong for natural gas in 2012 and the "assumptions".
- source

When too much leverage and when assumed breakeven on natural gas prices are so far out from reality, it does not end well for the TXU/TCEH bondholders and could get even uglier if natural gas price falls again towards the April 2012 lows...but that's another story and we ramble again...

Buyout firms went on a record-breaking shopping spree in 2006-07, saddling themselves with 1.5 trillion USD in assets that they intended to sell at a profit. For 2008, about one quarter of the 86 S&P-rated companies that defaulted on debt were private equity backed, according to the Private Equity Council.

While we already delved into the insidious returns of cov-lite financing in our September conversation "The World of Yesterday":
"This latest credit market "euphoria" has been marked by the significant return of Covenant lite issuance."

In May 2012, we specifically discussed this return in our conversation "The return of Cov-Lite loans and all that Jazz...":
"Unintended consequences" of low rates environment have led to a flurry of issuance of Cov-lite loans again in the market."

Back in February 2011, we also discussed the dangerous return of Cov-lite loans financing and we referred to what Bethany McLean, known for her work on the Enron scandal and the 2008 financial crisis, said in her article - Corporate Subprime - The default crisis that never happened:

"When most of us think about the credit bubble that burst in 2008, we think about the lax terms of mortgage loans. But many corporations, particularly those that were bought out by private equity firms, also got debt on lax terms. This debt was known as "covenant-lite," because the normal terms of corporate credit—such as a requirement that a company, say, maintain a certain level of profits—were waived by deal-hungry lenders.
After it all went pop, banks regretted the cov-lite loans almost as much as mortgage originators regretted their "no documentation" loans to home buyers. Cov-lite loans plunged in price. At his retirement dinner in May 2007, Anthony Bolton, Fidelity's investment guru, said, "Covenant-lite borrowing … will come back at some stage to haunt the banks." Indeed, Goldman Sachs and other big firms took massive losses when they sold or marked down the price of the bonds they were stuck holding. One person involved in negotiating these deals says his banking clients swore, "Never again."
But less than three years later, cov-lite loans are back. "With a vengeance," my friend David Pesikoff, a Texas-based hedge-fund manager, assures me. Has the world of finance gone insane? Not necessarily. The return of cov-lite loans makes a certain sense in the current financial environment. But I find myself wondering what that says about the current financial environment."

Old habits die hard:
"Cov-lite loans were used to finance some of the biggest, best-known deals of the era, like KKR's buyout of Alliance Boots and Thomas H. Lee and Bain Capital's buyout of Clear Channel. According to the credit rating agency Standard and Poor's, $32 billion in cov-lite loans were issued between 1997 and 2006."

The latest news surrounding the possibility for Dell to go private via the use of a LBO, have made us want to look into more details about the return of the LBOs, which was previously linked to the previous credit bubble. It was fuelled, in similar fashion by "cheap credit". 

Following a comment from Dave Merkel, writer of the Aleph Blog in relation to our post "Chart of the Day - S&P 500 pension equity allocation" ("Private equity is replacing public equity in many DB pensions. The "Chart of the Day" may not mean what you think."  - David Merkel), 

Here comes the time for us to go into the Dell case, and the unsurprising come-back of the mega-LBOs. So yes David, you are right, private equity and large LBOs are coming back with a vengeance.

During the run-up to the credit crisis of 2008, the impact of LBOs where not only a nightmare for investment grade credit portfolio managers given a LBO is by definition a negative credit event (more leverage with more debt on the balance sheet meaning an obvious fall in the rating spectrum), it was as well a nightmare for market makers in the credit space, natural sellers of CDS protection to their clients, given the "sucker punch" capacity and P&L pain infliction caused by widening CDS spread on LBO news such as the one relating to DELL. 

For instance, the latest news surrounding DELL have cause a serious "denting P&L" kind of spike in the CDS price - source Bloomberg:
This kind of "sucker LBO punch" significantly hurts your P&L if you have been a net seller of CDS protection on DELL in this tightening spread environment (+200 bps on 5 year...).

Sector wise, the result is similar, DELL has indeed widened significantly relative to some peers on the LBO news as displayed by the below graph of CMA, part of S&P Capital IQ:
The latest news surrounding DELL is that it has hired Evercore to seek higher bids should a buyout be formalised according to Bloomberg:
"Silver Lake and its partners are close to lining up about $15 billion in funds for a buyout of Dell, the third-biggest maker of personal computers, people familiar with the situation said last week. The deal would likely value Dell between $23 billion and $24 billion, said one of these people." - source Bloomberg.

A similar Texan company that went through a similar buyout than DELL, was Freescale Semiconductor Inc back in 2006 which was bought for 17.6 billion USD by Blackstone and loaded with 8.1 billion USD worth of debt.

Following the 2008 crisis, the ability for the DB pensions mentioned by David Merkel to monetise their investment was shut down because the IPO market went down by 70%. Endowments and pension funds which poured into private equity pools during the "credit" binge, did not receive the return they thought they would get on their investments.

So why DELL is looking at a LBO? It stock price fell 29% in 2012 due to increased competition from the likes of LENOVO.

DELL Share price 1 year evolution (18th of January 2012 to 17th of January 2013) - source Bloomberg:

DELL reported weak results in its Q3 with revenue below its prior guidance range (down 10.7% YoY) and EPS below expectations. DELL's is facing increasing headwinds in the PC space and has seen its business fall sharply in the third quarter in both consumer and commercial markets.

In this "deflationary environment" (falling prices) in the PC space, both DELL and HP have been losing market shares to Lenovo in both end-user segments. As we posited before, whether it is for the car industry, or the shipping industry, it is, end of the day, a game of survival of the fittest which entails serious strategic adaptations for some.

"Lenovo shipments gain 24% in industry beset by falling prices" - source Bloomberg
"PC shipments should increase while prices decline as value markets such as China and India grow to become larger portions of the market. Intel-branded Ultrabooks are spurring innovation in PC technology that appeals to mass-market buyers, and has been largely absent in recent years, apart from the laptop. Lenovo's shipments grew 24% in 2Q." - source Bloomberg

As reported by Bloomberg, Dell's "PC Competitiveness" is a much in focus as its financial metrics - DELL, HP and LENOVO, market shares evolution:
Although DELL has been losing PC Market Share, it has managed to increase its market share in the Global Server Market.

The Global Server Market Share was impacted by the macroeconomic weakness of 2012 which drove, according to Bloomberg a 4% YoY decline in 3Q server revenue. DELL was the only top five server vendor  to increase revenue, with 8% growth. HP saw its revenue in that space fall 12% while IBM declined 8% ahead of new products being introduced in the fourth quarter. Oracle fell 23% as it moves away from low-end servers - source Bloomberg:

While Dell's current 9 billion USD debt pile isn't insurmountable at 89% of total equity as of the end of 3Q, the serious threat posed by Lenovo warrants caution in relation to its future under a new owner via a LBO, because Lenovo has leapfrogged HP to become the top global notebook maker with 15.9% market share:
"The overall portable market fell 7%, led by declines at Hewlett-Packard (19%), Dell (18%) and Acer (7%). Apple grew 10% and Asustek 8%. Tablets and smartphones appear to be increasingly hurting portable sales." - source Bloomberg
"Dell's debt is 89% of total equity as of the end of 3Q, with a total of $9 billion on its balance sheet. With cash and equivalents of $11 billion and a trailing free cash flow of $3.1 billion during the last four quarters, this debt burden is not insurmountable, especially with low rates and an A- S&P credit quality rating." - source Bloomberg

From a pure deal point of view, we agree with Bloomberg in the sense that Dell's cash flow and valuation makes the private equity option looks rational - source Bloomberg:
"Dell's free cash flow generation of $3.1 billion, $2.2 billion net cash position and valuation metrics (7.6x ex-cash P/E and 6.9x price-to-free cash flow) may appeal to a buyer. Dell is discussing going private with TPG Capital and Silver Lake, Bloomberg News reported. An assumed 30% premium to Dell's Jan. 14 price would create the industry's first $28 billion deal, topping HP's $25 billion 2001 acquisition of Compaq." - source Bloomberg

But from a strategic point of view, it all depends on the strategic orientation DELL will embrace under its new ownership. The intensity in the competition for PC from the likes of Lenovo, makes it increasingly difficult for DELL to protect its own turf as PC have become more commoditised and are facing as well a change in consumer spending patterns with the increased developments of smartphones and tablets.

If DELL is to survive, even under a new "leveraged" ownership, it will have to adapt fast, given that across most of its product lines (storage, software, peripheral, mobility and desktop) have seen important declines as per their recent 3Q results (PC business declined 19% YoY with desktop down 8% YoY and mobility down 26% YoY).

For DELL, the only way is up, up the value chain that it is (entreprise solutions and services) for the LBO to increase its probability of success and to avoid being saddled by debt like its Texan neighbor Freescale Semiconductor Inc.

Moving back on the private equity deal flow and in relation to David Merkel astute comment, relating to pension funds allocation to private equity, a recent note by independent credit research house CreditSights entitled "LBO Risk Revisited for HG Bonds" from the 20th of January 2013 explains clearly the rationale behind private equity allocation:
"The correlation between strength in the high yield origination cycle and private equity deal volume is hardly a new one since the HY market exploded onto the scene in the 1980s. The problem with high yield origination booms is that they have had a habit of quite literally exploding as they did after the LBO binge of the mid-to-late 1980s and after the TMT cycle. In the LBO boom of 2005-2007, the end was also quite painful for many overleveraged deals and many PE firms and their investors have continued their long wait to reach that point where they can exit and take their gains. The reality is that a wide range of LBO deals are still in limbo from the 2006-2007 period and it will take more time to get those deals off the books via an IPO or strategic buyers. That does not prevent new funds from being set up by new investors or to see higher allocations from pension funds raising their commitments to private equity. These funds need to plan on meeting their return shortfalls in future years, and their allocations in high quality fixed income make for very difficult math." - source CreditSights

One thing for sure with which we clearly agree on with CreditSights, is that the yield curve management policies of the Fed is clearly pushing investors into higher risk assets to reach for return in this "Yield Famine" induced environment of "Financial Repression" (probably out of their comfort zone too...).

As we have discussed in our first credit conversation of the year "The Fabian Strategy", we don't believe the hype in credit and as we argued in our conversation "Hooke's law" previously the "credit mouse-trap" has been set by Central Banks:
"So, in relation to our title, in true Hooke's law fashion, given the "Yield Famine" we are witnessing, we believe our credit "spring-loaded bar mousetrap" has indeed been set and defaults will spike at some point, courtesy of zero interest rates. (The first spring-loaded mouse trap was invented by William C. Hooker of Abingdon Illinois, who received US patent 528671 for his design in 1894)."

For us, mega-LBOs, such as DELL, are another "smart way" in snaring in "yield starving investors" in the "credit mouse-trap".

"Any statistician will tell you, a good outcome for a bad risk doesn't mean the risk wasn't bad; it just means you happened to get lucky."

Stay tuned!

Sunday 20 January 2013

Credit - Cool Hand

"Sometimes nothing can be a real cool hand" - Paul Newman in 1967 Cool Hand Luke.

Looking at how credit risk has receded in 2012 and continue to recede, albeit at smaller pace in 2013, we thought we could refer to one of our movie favourite of all times, 1967 drama Cool Hand Luke in our title analogy, given Luke's character deservedly earned his nickname by winning a poker game on a bluff with a worthless hand. This is exactly what our "Generous Gambler" aka Mario Draghi has done.

So, one can wonder if our "Generous Gambler" should in fact be given a new nickname such as "Cool Hand Mario" when one looks at the Spanish CDS level which has receded below mid-2011 levels with auction costs declining in the process as indicated by Bloomberg:
"Spain's CDS spread fell below mid-2011 levels, when sovereign concerns increased aggressively and funding costs spiked. Beyond easing bank funding conditions, given high wholesale and deposit funding costs pressure margins, lower CDS also benefits the cost of sovereign auctions, as evidenced by January's 1.95 billion euro placing at below 4%, vs. 6.5% in mid-2012." - Source Bloomberg

Not only does our "Generous Gambler" deserve some praise in relation to the on-going Spanish situation but he also prevented a serious financial crisis liquidity induced meltdown courtesy of his two LTROs, given European cost of dollar funding is now at the lowest level in 18 months as displayed in the below Bloomberg graph:
"As CDS spreads on banks and sovereigns continue to narrow, the cost of accessing dollar funding for European financial institutions (euro-basis swap) has fallen to its lowest level in more than 18 months. Simultaneously, U.S. money-market funding to non-U.S. financials has risen 12% since the start of 2013, providing further confirmation of easing bank liquidity conditions." - source Bloomberg

As we posited in regular posts in 2012 these liquidity induced measures that were the LTROs amounted to "Money for Nothing" given the real economy did not benefit from the ECB's "Cool Hand". Weak monetary expansion and weak credit growth have meant weaker economic growth prospect for Europe as displayed in the Below Bloomberg table of Euro Area Monetary Aggregates:
"A shrinking ECB balance sheet, lower yields and CDS spreads coupled with capital inflows and lower redemptions were all cited by Mario Draghi as evidence of the gradual repair of euro zone fragmentation in a Jan. 10 address. These positive developments have as yet failed to reach the real economy, as reflected in weak monetary expansion and credit growth."  - source Bloomberg

In this week conversation we will focus on the possible outcome relating to the market's anticipation of the much awaited early repayment of the LTROs first tranches which are due at the end of the month for 523 banks, given analysts are divided between how much money will be repaid from the 1 trillion euros provided with estimates ranging from 10% to 20%. But first, a quick market overview.

The indicator we have been monitoring in relation to "Risk-On" and "Risk-Off" phases, has been the 120 days correlation between the German Bund and its American equivalent, namely the US 10 year Treasury notes - source Bloomberg:
Back in our conversation "River of No Returns" in June 2012, we indicated that in "Risk Off" periods we had noticed that the 120 days correlation has been close to 1 in 2010, 2011 and 2012, whereas in "Risk On" periods, the correlation is falling to significantly lower level. The correlation between both the German Bund and US 10 year note is falling towards 70%, indicative of a continuous "Risk-On" phase for now.

Nota Bene: ("Risk On" refers to a period of time in which investors are putting money into risky assets such as stocks, commodities, etc. "Risk Off" meaning the exact opposite with investors putting money into safe haven assets such as cash and treasuries or German Bund).

The "Fabian Strategy" at play - European bond picture, the fall was dramatic for peripheral bonds in the second half of 2012 thanks to Mario Draghi's intervention with Spanish 10 year yields falling towards 5.00%, whereas Italian 10 year yields are now well below 5% around 4.16% and German government yields rising towards 1.60% levels with other core European bonds yields rising as well in the process - source Bloomberg:
While all seem fine and dandy, for Spain and other peripherals, Spanish Minister Mariano Rajoy did manage by stealth to add to off-balance sheet debt in the closing hours of 2012 by adding more than 3 billion euros to the Spanish debt load according to Ben Sille and Esteban Duarte, as reported in their Bloomberg article - Rajoy Stealth Order Adds to Off-Balance Sheet Debt on the 8th of January:
"Spanish Prime Minister Mariano Rajoy added more than 3 billion euros ($3.9 billion) to his debt load in the closing hours of 2012 with a New Year’s Eve order removing a cap on utilities’ government-guaranteed losses. The decision, announced in the official gazette, added to the snowballing power-tariff debt, which isn’t included in the public accounts. The shortfall exceeded 20 billion euros at year end, according to government filings. Spain’s government-controlled electricity system has raised less revenue from consumers than it pays to power companies for most of the past decade. Officials have covered the difference selling bonds through the so-called FADE program, which is not reflected in public accounts." - source Bloomberg.

We would like to use again a reference to Bastiat in relation to Spain and this "off-balance" sheet issue (a quote we used in our conversation "The Unbearable Lightness of Credit"): "That Which is Seen, and That Which is Not Seen" as indicated in the same Bloomberg article:
"Behind the political spat over whether the electricity- system losses wind up on the government’s balance sheet lies the structural challenge of reining in the cost of powering the Spanish economy. The ECB’s intervention has enabled Spanish officials to push the liabilities down the road. Public debt jumped 17 percentage points to 85 percent of gross domestic product last year. Power Debt Without action, the power debt would reach about 50 billion euros by 2015, Soria said last year. The 2012 deficit equates to about 70 percent of the profits of Spain’s four biggest power companies. The burden poses a problem of the same order as the toxic real estate assets that forced Rajoy to request 39 billion euros of bank aid from Europe last year, according to Cesar Molinas, former head of European fixed income at Merrill Lynch now a partner at CRB Inverbio private-equity fund. “It’s on the scale of the bank rescue,” Molinas said in a telephone interview. “That’s what we are heading for.”" - source Bloomberg

Yes, no doubt that our "Cool Hand Mario" won 2012's poker game with the bond vigilantes on a bluff. But, as we posited above, in true Bastiat, fashion, problems in Europe in general and Spain in particular have not been resolved, they have just been postponed.

We do agree with Ben Sills and Angeline Benoit in their Bloomberg article published on the 14th of January entitled "Draghi's Bond Rally Masks Debt Loop Trapping Spain's Rajoy", as we believe Spain is in a deflationary trap:
"The bond rally that has sent Spanish borrowing costs to 10-month lows has distracted attention from the nation’s growing debt pile. Spain’s budget deficit probably exceeded 9 percent for a fourth year in 2012 as Europe’s highest unemployment rate, a third recession in four years and the cost of bailing out its banks offset almost all of the government’s 62 billion euros ($83 billion) of spending cuts and tax increases, according to economists at Societe Generale SA, Lombard Street Research and the Madrid-based Applied Economic Research Foundation. Total debt will reach 97 percent of gross domestic product this year, the International Monetary Fund forecasts. “This is a classic example of the doom loop,” Societe Generale’s London-based chief European economist, James Nixon, said in a Jan. 10 telephone interview. “They just aren’t making any progress.” The last time Spanish debt was trading at this level, with 10-year yields around 5 percent, was early March 2012 after European Central Bank President Mario Draghi flooded the banking system with more than a trillion euros. Spanish Prime Minister Mariano Rajoy shattered that calm when he surprised EU leaders March 2 by rejecting the country’s deficit target just hours after signing a treaty on budget discipline." - source Bloomberg.

From the same Bloomberg article:
“The market is ignoring unresolved macro issues,” Alberto Gallo, head of European macro credit research at Royal Bank of Scotland Group Plc in London, said in an interview last week.“Spain is not sustainable.”

On top of that you have Italy looking for at least 9 billion euros in additional budget measures in 2013 to meet its deficit targets as a worsening recession is no doubt hurting tax revenues and hindered by surging unemployment costs.

Credit wise, the Markit Itraxx Europe index of 125 companies with investment-grade ratings is now only 15 bps above the CDX IG, its US equivalent, representing the smallest gap in 19 months between both indices -  source Bloomberg:

At the same time European High Yield yields less than US High Yield, the first time since 2010 at 1.24% less on average than US speculative-grade securities according to Bloomberg, after being 3.90% more at the end  of 2011.

The relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge) - source Bloomberg:
Volatility in Europe as clearly reached lower levels courtesy of the "illusory" disappearance of systemic risk provided by Central Banks intervention.

So, as we indicated in our recent conversation "Fabian Strategy", short term, we do expect a minor reduction in the divergence between the PMI in Europe and the US PMI as reflected in credit prices such as the US leveraged loan cash price index versus its European peer which have shown a recent uptick in prices - source Bloomberg:
In next week's PMI releases in Europe, we therefore we think we could see a slight improvement in the data in Europe.

Moving on the on-going debate surrounding the implications of an early repayment of the first tranche of the LTRO at the end of January, the speculation has had its effect last Thursday, and delivered yet another proverbial intraday "sucker punch" as indicated in the rise in core European bonds such as the German five year bond yield - source Bloomberg:

The uncertainty surrounding the amount of repayments link to the first tranche of the LTRO is dividing a lot of analysts.

Gareth Gore from the IFR review in his article "Early LTRO repayments far from certain" on the 18th of January made the following important points on that subject:

"Analysts are divided over how much of the €1trn will be paid back, with estimates ranging from 10% to 20%. Banks in northern Europe, which generally have better access to capital markets and cheaper funding, are expected to pay back more than those in the south.
But with more than a third of the LTRO having gone to Spain and a quarter to Italy, the reluctance of peripheral banks to repay will weigh heavily. Morgan Stanley, which expects €116bn to be repaid in its base case, has said it expects repayments will be a “spectator sport” for many banks in the periphery.
So far, only Commerzbank and Banco Sabadell have confirmed they will repay early, with the Spanish bank signalling it will return 10% to 20% of what it took. Although that might deliver a quick public relations boost, bankers warn alternative funding is just too costly to justify switching. Sabadell sold a five-year €1bn covered bond earlier this month paying a coupon of 3.375%.
Extra debt?
Debt bankers say there is little evidence of banks issuing extra debt in recent months to repay the LTRO money, with almost all banks sticking to funding plans announced months ago. That indicates banks would have to either sell assets or draw down some of their deposits at central banks.
Banks currently have €223bn stored away in the ECB’s deposit facility, down from almost €800bn last summer. Such deposits earn nothing, meaning banks in effect lose money, but some argue that might be a price worth paying for a while longer.
“Banks have to be very careful,” said one senior capital markets banker. “Things can change very quickly in funding markets as we have seen over the last few years, and treasurers will be reluctant to draw down their liquidity buffers held at central banks because it gives them that extra bit of insurance.”
According to some banks that tapped ECB facilities, the LTRO also provides another form of protection, allowing banks to partially hedge against a possible break-up of the eurozone. Indeed, some larger banks tapped the LTRO via their subsidiaries in peripheral countries as a way to swap assets there into euros ahead of any possible redenomination into local currencies and subsequent devaluation." - source IFR.

As we argued back in our conversation "Zemblanity" in September last year in relation to the LTROs:
"The main concern of European authorities has been trying to break the close relationship between sovereign risk from financial risk. Many European politicians are expecting that the European Banking Union will finally break this relationship. But in fact, the ECB's two LTRO operations so far have not only increased the link but made it in effect more acute."

Gareth Gore from the IFR review in his article "Early LTRO repayments far from certain" confirmed that not only the link has not been severed but it has been increased. According to ECB data, Spanish banks increased their holdings of government debt from about €180bn before the LTRO to more than €260bn shortly afterwards.

We previously studied the demise of Monte Paschi di Siena, Italy's oldest bank which was brought up by its strategy of piling up in domestic sovereign bonds in our conversation "The Uneasiness in Easiness". As a reminder:
"But what in effect our "Generous Gambler" did previously with the two LTRO operations has been reinforcing in effect the link between weaker peripheral financial institutions with their sovereign country, causing some to pile up on their domestic sovereign bonds and in effect precipitating their demise for some. Italian oldest bank Monte dei Paschi di Siena SpA, was encouraged to "gamble" by committing too much money to Italian bond holdings, (in similar fashion Greek banks were over exposed to Greek Sovereign debt and we know how well it ended...) as indicated by Bloomberg:
"The CHART OF THE DAY shows Italian government bond holdings of the nation’s biggest banks by percentage of tangible capital and average maturity. Monte Paschi, founded in 1472 and rescued
twice in the last three years, made a treasury bet that was four times bigger than one by UniCredit SpA, the nation’s largest lender, and lasts three times longer than Banco Popolare SC’s.
The bank’s exposure to a single asset class cost it a capital shortfall of 3.3 billion euros ($4.2 billion), according to the second round of stress tests completed last year by the European Banking Authority. The world’s oldest bank is borrowing an additional 1.5 billion euros by selling bonds to the state after it asked for 1.9 billion euros in 2009." - source Bloomberg.

So thank you ECB, the LTRO gamble, courtesy of our "Generous Gambler", was indeed an offer too good to refuse but too toxic to defuse, for some:
"Italian banks doubled their treasury holdings in the last three years even as Europe’s debt crisis eroded their country’s credit quality. That strained regulatory capital that was already stretched by a round of banking mergers. Monte Paschi Chairman Alessandro Profumo, hired this year to clean up the bank, said it was government debt and not a 9 billion euro purchase of Banca Antonveneta SpA that damaged his company." - source Bloomberg.

The LTROs have had so far a debilitating effect on the strength of weaker peripheral financial institutions we think contrary to many beliefs."

The LTROs were never a long term solution but an integral part of the "Fabian Strategy" against the "bond vigilantes".

When it comes to banking woes and specific Spanish banking woes, as we posited on numerous occasions, in this deflationary environment, the game of survival of the fittest has led to a war for deposits in many European countries and in Spain in particular finally leading to the Bank of Spain stepping in to rein in the hostilities and revisiting the introduction of caps to time deposit rates as indicated by Bloomberg:
"The Bank of Spain may be revisiting the introduction of caps to time deposit rates in Spain, in an effort to stem the continued deposit war and increase in deposit costs, news reports suggest. This recalls 2011, when speculation that a similar rule would be implemented failed to materialize. Should a limit be successfully enforced and deposit costs fall, net interest income gains could be significant." - source Bloomberg

By trying to put an end to the deposit wars, the Bank of Spain ambitions to reduce the pressure on banks' earnings and profitability which would reduce the capital shortfall for some Spanish banks and the level of capital injunctions needed. It is once again a "Fabian strategy", buying time that is.

In our May 2012 conversation "From Hektemoroi to Seisachtheia laws?", we put forward Nomura's take on  the cheap funding provided by the LTROs from their note Eurozone and Basel III - Fears for Tiers, from the 4th of May:
"Subordination is a recurring aspect of the eurozone debt crisis. This has taken the form of private sector investors in government debt being junior to not just the IMF into a debt restructuring, but also to the ECB and its SMP. It also takes the form of unsecured bank creditors being effectively subordinated by the growing reliance of banks on secured funding, as assets are pledged as collateral and balance sheets grow increasingly encumbered. The ECB's 3yr LTRO collateralised loan facility has accelerated balance sheet encumbrance and exacerbated a shortage of collateral in Europe. Unsurprisingly, eurozone monetary data confirm that banks are still struggling to raise term-funding.
The challenge that many banks face in raising term-funding is particularly problematic as over the coming years the eurozone banking sector will need to implement the Basel III liquidity framework. This forces institutions to increase the maturity of their funding profile. (The EBA estimate the Basel III funding shortfall at EUR1.9trn, which is around 75% of the size of the European senior debt market, and we use simplifying assumptions to calculate the demand for term-funding from the eurozone banks at around EUR4.9trn.) Early adopters of Basel III (most notably banks in Australia and New Zealand) have shown that this process leads to sharply rising bank funding costs, wider lending rate spreads to the policy rate, and as a consequence a lower "neutral" central bank policy rate. This latter point in turn has notable consequences for the conduct of monetary policy and the behaviour of yield curves, which tend to flatten and shed curvature at lower yield levels.
We already expected Basel III to spur these changes over the coming years, but the impact will be magnified if the unsecured financing markets do not recover. This will increase the extent to which Europe experiences a war for deposits among banks, the extent to which lending rates rise and the extent to which balance sheets shrink."

A war for deposits has indeed happen in Spain regardless of the cheap funding provided by the two LTROs!

European banks have still less equity relative to assets than their US peers and will continue to have to shrink or boost capital as regulators demand reduced leverage as reported by John Glover in his article from the 17th of January "European Banks to Shrink as U.S. Peers Set Pace":
"During the past six months, the average cost of insuring against default by the largest U.S. lenders for five years was71 basis points less than for European banks, according to prices in the credit-default swap market.
Banks in the Americas raised $536 billion of new capital in the 12 months starting in the fourth quarter of 2008, almost 40 percent more than their European peers, data compiled by Bloomberg show." - source Bloomberg

Finally, as far as the reimbursement of the 1st tranche of the LTRO is concerned at the end of January, what really matters is the fact that banks have been able to boost liquidity measures with illiquid assets as indicated by Bloomberg's Chart of the Day:
"Regulators are allowing banks to boost liquidity with assets that proved tough to sell when markets froze in the 2008 credit crunch. The CHART OF THE DAY shows how relative yields on the lowest-rated investment-grade corporate bonds, now accepted by regulators as liquid assets, blew out to as much as 7.3 percentage points during the crisis when investors shunned the notes, according to Bank of America Merrill Lynch index data. Higher-rated AA securities, previously the minimum accepted, held tighter than 1 percentage point over benchmarks. The Basel Committee on Banking Supervision eased rules on the amount and range of easy-to-sell assets lenders must have available to cover a 30-day run on deposits or other short-term disruptions to funding. Corporate debt, which previously had to be graded in the top four ratings categories to be considered liquid, now can be graded as low as BBB-, one step above junk. “I just don’t think corporate bonds are liquid enough to be included, especially if you need to sell in any size,” said Chris Bowie, head of credit portfolio management at Ignis Asset Management in London, which oversees about $110 billion of assets. “Banks will struggle to sell in a crisis, or if wholesale markets close like they did in 2008.” The Basel Committee delayed full implementation of the rules until 2019, rather than 2015 as originally proposed. Lenders will be permitted to use lower-rated securities to cover as much as 15 percent of their liquidity requirements and the value of the corporate bonds used will be discounted by 50 percent." - source Bloomberg.

By allowing lenders to use lower-rated securities to cover the liquidity requirements, with still very thin equity buffers in the European banking space, the regulators are no doubt taking a serious "Cool Hand", we think.

"The hardest tumble a man can make is to fall over his own bluff." -  Ambrose Bierce, American journalist.

Stay tuned!

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