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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