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!

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