Credit - House of pain and House of cards

"Criticism may not be agreeable, but it is necessary. It fulfills the same function as pain in the human body. It calls attention to an unhealthy state of things." -   Winston Churchill

While looking at the action this week in the credit space in general and, in the banking space in particular, we initially thought about "House of pain" as the main title for our post, given the goodwill writedowns we witnessed and expected in the banking space (for example 2.7 billion EUR for Crédit Agricole) as well as the nationalisation of Dutch bank SNS in conjunction with the total wipe-out of subordinated bondholders. 

Goodwill writedowns and subordinated bondholders' pending punishments have long been a "pet subject" of ours in various conversations such as "Subordinated debt - Love me tender?" and "Goodwill Hunting Redux"):

"First bond tenders, then we will probably see debt to equity swaps for weaker peripheral banks with no access to term funding, leading to significant losses for subordinate bondholders as well as dilution for shareholders in the process." - Macronomics - 20th of November 2011.

After all, in the banking space, and in this deflationary environment, it is has been all about the "survival of the unfittest".

In a "Central Banks" world dominated by the "Sorcerer's apprentice" aka Dr Ben Bernanke and our "Generous Gambler" aka Mario Draghi, the "creative destruction" in a Schumpeter way has been prevented by "all means". It has in effect maintained various "zombie" financial institutions standing up until they finally paid the piper such as SNS bank.

In relation to the added "House of cards" part of our title, when one looks at the record-low yield touched of 5.61% touched by the US High-Yield index on the 24th of January and that Barclays's index for lower junk-rated companies dropped to a record 7.87% for issues with ratings about Caa from Moody's Investors Services and CCC from Standard & Poor's being the lowest since London-based Barclays began the indexes in 1983 as reported by Bloomberg, we thought we had to extend our aforementioned title.

As reported by Bill Rochelle from Bloomberg in his article "Junk, Nortel, Madoff, Hostess, A123, ResCap" published on the 30th of January, credit investors have to keep dancing until the music stops, and rest assured, at some point it will.

We therefore have to agree with David Tawil, co-founder of Maglan Capital LP which was interviewed by Bloomberg:

"Some of the refinancing deals getting done now are starting to get laughable, in the sense of the credit quality of the borrower and the low interest rates,” Tawil said in an interview. “The government has incentivized lenders to lend to unworthy borrowers,” and even for credit-worthy companies, “rates are unjustifiably low,” he said. HD Supply Inc., the wholesale-supply business once owned by Home Depot Inc., is an example of a low-rated company benefiting from rock-bottom rates. Yesterday, Atlanta-based HD was selling $1.28 billion in senior unsecured notes in a private placement rated CCC+ by Standard &Poor’s. The new debt was expected to yield about 7.375 percent. Proceeds will be used to refinance existing debt. While companies gain, “the government has left the unemployed out in the cold during this free-money fest,” Tawil said." - source Bloomberg

On one hand we have the "House of pain" in the banking space and on the other hand, the credit space is increasingly looking wobbly hence the "House of cards" reference.

In our usual credit overview we will look at the "House of Pain" in the credit and banking space and the "unintended consequences" for remaining subordinated bondholders with the latest SNS case and the "House of cards" in the credit space.

The indicator we have been tracking 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 and this week it did change course which warrants caution, we think - 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 has risen this week above 74%, indicative of a potential "regime change" from "Risk-On" to "Risk-Off".

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).

Another indicator we have been following in various credit conversations has been the spread between 10 year Swedish government yields and German 10 year government yields. It looks like this relationship is now broken with Swedish yields rising - source Bloomberg:

Sweden is one of only 7 remaining AAA rating countries with stable outlook. As we posited on the 3rd of January, Sweden has indicated it's done with the "easing policy" hence the normalisation of Swedish government bond yields versus their German counterpart. Riksbank, Sweden's central bank has clearly decided to hold the line in 2013.

In relation to credit indexes, the Itraxx Crossover index (European High Yield risk gauge for 50 European entities) versus the Itraxx Main index (Investment Grade risk gauge in Europe for 125 entities) is indeed very tight, indicative of the spread compression we have seen in recent months - source Bloomberg:

Core European Investment Grade credit is definitely in the "expensive territory" area.

While the difference between the US PMI and the European PMI is a "credit" story, the divergence between both PMI's will remain in 2013 - source Bloomberg:

 The ISM in the US rose to 53.1 in January from 50.2 a month earlier whereas in Europe Markit's PMI gauge rose to 47.9 from 46.1 in December indicative of manufacturing contraction, albeit recession.

Not a surprise as the US leveraged loan cash price index versus its European peer picture has an uncanning resemblance with the evolution of the PMI index - source Bloomberg:

The weakness in the credit space this week in Europe saw the widening by 25 bps of the Itraxx Financial Subordinate index (high beta financials) in conjunction with a weakness seen in cash with the IBoxx Euro Corporate index (commonly used as a benchmark for credit funds) giving away 6 bps, marking somewhat a pause in the continuous rally in credit in Europe we have seen in Europe since last summer.

Unsurprisingly, the continued weakness in PMI in Europe has led to a reversal in the risk gauge in Europe in investment grade credit indices seeing the Itraxx Main Europe underperforming versus its US equivalent CDX IG, indicative of the weaker tone in the European space, now 23 bps apart and climbing - source Bloomberg:

As far as investment grade is concerned, as indicated by Bank of America Merrill Lynch recent note entitled "Dude, where's my return?" from the 23rd of January, investment grade credit has indeed been in the "House of pain": "What if you have been used to fat returns for years, but one day wake up after the party and can’t find returns? For nearly three months – since the end of October last year – stocks are up more than 6% and high yield corporate credit in excess of 4% (Figure 7). However, the total return on high grade corporate bonds over the same period is zero (and that was before Friday’s big move higher in interest rates). Such a positive environment for risk assets with higher interest rates highlights our outlook for mediocre total returns in high grade this year – at best. We now consider it most likely that total returns will fall short of our low 1.6% target, as the risk of the rotation out of bonds, into equities starting in 2013 has increased enough to become our base case." - source BAML.

- source BofA Merrill Lynch Global Research

Bank of America Merrill Lynch also added in their note:
"A disorderly rotation out of bonds, into equities – where interest rates increase significantly, leading to massive outflows from high grade bond funds and much wider credit spreads – is the biggest risk to investment grade this year and the one we are getting increasingly concerned about. Thus high grade credit spreads and 10-year swap spreads share the property that significant increases in interest rates can lead to spread widening." - source BAML

Given that about half of HG (High Grade) investors consider themselves total return investors according to BAML, rising interest rates could cause a selling stampede following the rise of the retail investor through mutual funds and ETFs, a move from the "House of pain" to the "House of cards" that is, but we digress.

The European bond picture, with Spanish 10 year yields rising towards 5.17%, whereas Italian 10 year yields below 5% hovering around 4.25% and German government yields rising towards 1.70% levels, hurting investment grade bond investors in the process with other core European bonds yields rising as well - source Bloomberg:

Moving on to the subject of the "House of pain" in the banking sector this week, as we pointed out last week in our conversation "The Donk bet":
"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."

For instance Deutsche Bank reported a larger than expected 4Q12 losses of 2.6 billion Euros including 1.9 billion euros in goodwill impairments. It was a similar story for Crédit Agricole which reported 2.68 billion euros of goodwill write-downs in the fourth quarter. We indicated last week that the bank had 16.9 billion euros worth of goodwill on its balance sheet as of the end of September:

"The European Securities and Markets Authority called on Jan. 21 for improvements in disclosures after reviewing 800 billion euros of goodwill assets at 235 companies in 23 countries across Europe. Goodwill is an accounting convention that represents the amount paid for an acquisition over and above the fair value of its net assets. While writing down goodwill doesn’t deplete capital, it reduces profit and signals a company overpaid for acquisitions. Deutsche Bank AG, Germany’s largest bank, yesterday took 1.9 billion euros of write-downs on goodwill and other intangible assets. ArcelorMittal, the world’s largest steelmaker, said in December it will write down the goodwill in its European businesses by about $4." - source Bloomberg, Credit Agricole to Book EU2.68 Billion in Goodwill Writedowns.

So how do goodwill impairments affects credit you might rightly ask?

A previous article from Standard &Poor's written in March 2012 dealt with this precise point - Why U.S. And European Banks’ Goodwill Assets Are Under Pressure:

"How Impairments Affect Credit:

While companies may downplay impairment charges as noncash, nonrecurring accounting charges, they often have implications for an issuer's credit quality. An impairment charge often signals that a business unit to which the intangible asset relates is suffering some level of stress; as a result, management's view of future operating performance (e.g., revenue and earnings projections) of the unit and perhaps the organization as a whole needs to be reevaluated. An impairment charge can also be a reflection on management, which may need further examination in our analysis. It could mean management at the time of the acquisition misjudged the extent of some synergies during an acquisition, or executed poorly on some plans that seemed to justify a higher-than-market purchase price. A management change may also sometimes precede an impairment charge, because the charge allows certain balance-sheet metrics to be reset (e.g., removing goodwill may improve the quality of assets on the balance sheet). Such an event could affect future M&A activity. 

Headline and reputation risk from impairment write-downs is another factor that could have consequences, particularly when the impairment charges are unusually large or unexpected. For example, a bank's ability to tap the equity or debt markets may be constrained if the capital markets react poorly to its recognition of a significant impairment charge. Such an issue could spill over and adversely affect operating performance. An impairment charge, especially when significant, could affect a company's existing and future dividend policy. In addition, while we believe most debt covenants exclude charges related to noncash impairment charges, some covenants could be affected. Lastly, in rare circumstances, outsized impairments and resulting losses may have a direct or indirect impact on the servicing of hybrid capital instruments, a risk that may affect our ratings on these instruments." - source Standard & Poor's

"House of Pain" - Potential goodwill impairments impact, a few examples as per S&P's article as of December 2011:

- source Standard & Poor's

To bring some solace to banks, the world's biggest mining and steel companies have already wiped out50 billion dollars off project valuations in 2012 according to Bloomberg's article "Writedowns Near $50 Billion as M&A Haunts Mine CEOs" from Thomas Biesheuvel and Jesse Riseborough on the 30th of January:

"The world’s biggest mining and steel companies have wiped about $50 billion off project valuations in the past year and the purge is poised to continue this earnings season as managers reassess expensive takeovers. Anglo American Plc, Vale SA and Rio Tinto Group led the writedowns as declining metal prices, rising project costs and slowing demand forced reviews. Glencore International Plc may write down some nickel and copper assets acquired through its takeover of Xstrata Plc, Liberum Capital Ltd. has said. BHP Billiton Ltd. may trim aluminum operation valuations, according to Goldman Sachs Group Inc. and Sanford C. Bernstein Ltd. Executives and shareholders are paying the price for a $1.1 trillion M&A binge over a decade. Failed deals in aluminum and coal caused $14 billion in writedowns at Rio and cost Chief Executive Officer Tom Albanese his job this month. Cost overruns contributed to Cynthia Carroll’s departure as CEO of Anglo American, which slashed $4 billion off the value of its Minas- Rio iron-ore project in Brazil yesterday. She leaves in April." - source Bloomberg

The SNS case this week has had some major significant risks to the "House of pain" in the European banking sector that warrants additional close attention for the remaining subordinated bondholders.

On Friday the Minister of Finance in the Netherlands has issued a Decree by which the state expropriates "the securities and capital components of SNS Reaal NV and SNS Bank NV in connection with the stability of the financial system, and to take immediate measures with regards to SNS Reaal NV".

Meaning Tier 1 bonds and LT2s losses equates to 100% as indicated by BNP Paribas's European credit note published on the 1st of February - Nationalisation and Expropriation in the EU: The SNS Case.

"We understand that, as of 8.30am today, the property of SNS Reaal NV and SNS Bank NV have

been transferred to the Dutch State. So, effectively, subordinated bondholders are currently suffering a100% loss on their investment. The paper from the Finance Ministry stipulates in Article 50 that the

expropriation makes it possible for the sub debt to be exchanged into equity in order to improve the solvency of the entity, but this would be equity owned by the Dutch state." - source BNP Paribas

As we discussed in our conversation "Kneecap Recap" in May 2012, the liability management exercises of bond tenders were opportunities for the subordinated bondholders to "get to the exit while they can" and take their losses...

Why is the SNS case significant? From the same BNP Paribas note:

"-The SNS intervention clearly pushes the envelope on how far national authorities are willing (and able) to go in the resolution of a failing financial institution.

-This action is the harshest we have seen since Amagerbanken in Denmark and certainly the harshest treatment to bondholders (including LT2) for any large European bank

- Northern Rock had nationalised some preference shares in the past (which had no recovery so far), but the other hybrids were not nationalised and in fact offered a generous LME later on." - source BNP Paribas

The budget deficit of the Netherlands will widen by 0.6% in 2013 as a result of the SNS intervention and the previous forecast was for a budget deficit of 3.3% of GDP in 2013.

The broad picture for European subordinated bondholders from the BNP Paribas note:

"We believe the SNS precedent, while very important, has limited read across to other European jurisdictions. That said it does change the realm of what is possible. To put it in mathematical terms, prior to this precedent the downside recovery for LT2 (using the Irish precedent) was generally assumed to be 20%. This should now be 0%. Also, given the SNS precedent one could argue the probability of this outcome in the distressed situations has gone up. Therefore investors are justified to demand higher yield, which will put pressure on the prices of subordinated debt securities for special situations such as Bankia and other distressed Cajas, Monte dei Paschi and HSH Nordbank. But we still believe every situation is different and needs to be analysed in the context of the country, circumstances of the bailout and perhaps even holders of the bonds. For instance we have seen a very different attitude to bondholder burden-sharing in Spain where due to large retail ownership of the preferred shares the government has tried to minimize the losses for these investors (although retail investors are also invested in some SNS subordinated bonds). Last but not least, the SNS precedent reinforces our view that EU policy makers are in no mood to impose senior burden-sharing at this point in time" - source BNP Paribas

Why the change in recovery rate from 20% to 0% matters in the CDS space?

As we pointed out in "European Derecho", implied recovery rates matter enormously in relation to the determination of the payout for subordinated CDS referencing LT2 debt:

"Fixing the recovery of subordinated debt and taking the spreads on senior and sub debt observed in the market, it becomes possible to solve for a recovery rate on senior." - source Morgan Stanley

In relation to LT2, as a reminder from our September 2011 credit conversation "Credit - Crash Test for Dummies":
"Typically, in subordinated CDS single names, the bond reference is a Lower Tier 2 bond (LT2), and not Tier 1 (T1) bonds or Upper Tier 2 bonds (UT2), as coupon payments can be deferred in these structures. For Tier 1 bonds and UT2, missing a coupon does not constitute a credit event, therefore they cannot be used as a reference for a single name financial subordinate CDS, so no CDS on these bonds."

If the recovery rate for SNS LT2 subordinated bonds is zero, the significance for the European subordinated CDS market is not neutral given the assumed recovery rate factored in to calculate the value of the CDS spread is assumed to be 20% for single name subordinated CDS and 40% for senior financial CDS.

On top of that, a nationalisation, such as SNS case, is not by itself a credit event trigger. Appointing an insolvency official is.

As far as delivery of LT2 underlying subordinated bonds referenced in any CDS contract referencing SNS, you would have to ask the Dutch state for delivery (if the subordinated bonds are not simply cancelled or converted into equity...).

So what's the value of your subordinated single name CDS on SNS? Could it mean single name subordinated CDS are a "House of cards"? We wonder. Oh well...

On a final note, while goodwill impairments are bad news for European banks, as indicated by Bloomberg's recent Chart of the Day, goodwill may as well be bad news for US asset values:

"Paying too much for takeovers represents a risk to the value of U.S. companies, according to Erin Lyons, a Citigroup Inc. credit strategist. The CHART OF THE DAY tracks goodwill, or the amount by which purchase prices exceeded asset values, for companies in the Standard &Poor’s 500 Index during the past decade. Lyons had a similar chart in a report two days ago. Goodwill more than doubled to $245.9 billion, and climbed to 7.8 percent of assets from 5.2 percent in the 10-year period, according to quarterly S&P 500 data compiled by Bloomberg. The chart displays dollar amounts and percentages. “In some cases, companies are realizing that paying a high premium for acquisitions may not have been worth it,” Lyons, based in New York, wrote in the report. Cliffs Natural Resources Inc., the biggest U.S. iron-ore producer, said last week that it will write down $1 billion of goodwill from a deal completed in 2011. Caterpillar Inc., the world’s largest maker of construction and mining equipment, disclosed a $580 million writedown earlier in January on a Chinese unit acquired last year. Three S&P 500 companies -- Frontier Communications Corp., Nasdaq OMX Group Inc. and L-3 Communications Holdings Inc. -- have more goodwill than market value, based on Bloomberg’s data. They were among 44 companies listed on U.S. exchanges that Lyons named as potential candidates for writedowns."  - source Bloomberg

"The worst pain a man can suffer: to have insight into much and power over nothing." - Herodotus

Stay tuned!