Monday, 11 February 2013

Credit - Promissory Hope

"The man who promises everything is sure to fulfil nothing, and everyone who promises too much is in danger of using evil means in order to carry out his promises, and is already on the road to perdition." - Carl Jung

"A promissory note is a negotiable instrument, wherein one party (the maker or issuer) makes an unconditional promise in writing to pay a determinate sum of money to the other (the payee), either at a fixed or determinable future time or on demand of the payee, under specific terms." - source Wikipedia 

Promissory notes differ from IOUs in that they contain a specific promise to pay, rather than simply acknowledging that a debt exists.

While looking at the political success of Ireland in obtaining finally some debt-relief, which could be seen as an interesting step for European politicians in helping struggling European countries, we thought our chosen title should be "Promissory Hope" given S&P has just raised Ireland's outlook from negative to stable, in the footsteps of rating agency Fitch's revised outlook on the 14th of November. Our title also reflects that while the ECB agreement brings some relief, it doesn't reduce in no way the stock of debt and the impact on the Irish budget deficit will be limited to 0.6% in 2014 and 2015.

No doubt the liquidation of IBRC (the remnants of former Anglo Irish Bank and Irish Nationwide Building Society has put to rest the burden of 3.1 billion euros of annual repayments for the next 10 years.

But, our chosen title is also directed towards the negative spread reaction in subordinated CDS and Lower Tier 2 cash bonds (used as reference obligation in the CDS space) since the announcement of the SNS nationalization and expropriation. We discussed this touchy subject in our previous conversation "House of pain and House of cards":
"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.
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 nationalization, 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..."

Therefore in this conversation, we will focus on the implication for the Credit markets in general and the CDS market in particular.

While subordinated bondholders met their makers in the case of the nationalization process of SNS, at least Senior Unsecured bondholders got some welcome respite as indicated in the below Bloomberg graph on a specific SNS bond:
But given Germany, the Netherlands and Finland are looking at speeding up the European plans as soon as 2015 rather than 2018, to force losses on senior unsecured bondholders of failing European financial institutions, the bail-in push to protect European taxpayers looks to us that, rather that financial unsecured bonds are now more akin to "Promissory Notes" (or hope) rather than plain IOUs.

As indicated by Jim Brunsden and Rebecca Christie in their Bloomberg article from the 4th of February entitled "German Push to Accelerate Bank Bail-Ins Joined by Dutch, Finns":
"Senior bank bondholders so far have mostly avoided losses, while European governments and the International Monetary Fund have committed to 486 billion euros of aid since 2010. Under the EU plans, drawn up by the European Commission, regulators would be given the power to impose losses on holders of senior unsecured debt, as well as derivatives counterparties, once a lender’s capital and subordinated debt are wiped out. Regulators could also force debt to convert into common shares, so shoring up a struggling bank’s equity. 
Once the new rules take effect, national authorities would be expected to exhaust bail-in options before resorting to public money to stabilize the bank. 
 The nations are seeking a date as soon as 2015 because it would provide time to adjust to the measures while not putting individual countries at a competitive disadvantage if they apply bail-in rules ahead of 2018, one of the officials said."

Arguably this is what we have discussing in various conversations and is even more likely to happen sooner rather than later, we think as we posited in"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.

As usual the credit markets are only waking up to the rising risk and acceleration of what pains could be inflicted higher up in the capital structure. On that specific subject, we would have to agree with CreditSights note from the 10th of February entitled "Exploring the Sub-Conscious":
"The market is much more used to the idea of "burden-sharing" in hybrid debt, be it through non-calls, coupon deferrals, discounted tenders or principal write-downs. Even so, most of the latest crop of announcements does not help sentiment across the subordinated asset classes." - source CreditSights.

In similar fashion that the Greek CDS saga, followed up by the ban on naked Sovereign CDS last year questioned the existence of the Sovereign CDS market, the SNS episode is no doubt, raising serious questions on the value of subordinated protection as we argued in our previous credit conversation.

On this specific subject, CITI's note from the 11th of February entitled "What bail-in means for CDS" poses some serious questions:
"CDS protection in question – The consequences for CDS may be at least as far reaching as for bonds. Even if expropriation is deemed to be a trigger event, there is a real risk that no subordinated bonds will be left outstanding to be delivered into the contract. This would render subordinated protection practically worthless in the particular case of SNS (given that senior bonds are trading close to par)." - source CITI

In similar fashion to the sovereign CDS markets, it could no doubt, inflict some serious liquidity constraints to the credit markets as well as much needed reality check as per CITI's note:
"If any bank bondholders had not previously noticed that the rules were being rewritten on them, then the 80-point drop in SNS subordinated debt ought to have served as a wake-up call. Yet to our minds the implications for CDS may be almost as dramatic, and yet ironically may cause the market to rally rather than to sell off. 
Broadly speaking, the problem is that CDS contracts were designed prior to the invention of bail-in. Unless lawmakers are careful, they risk situations in which CDS protection turns out to be worth much less than protection buyers would have hoped and expected, either because it is not triggered at all, or because of problems with a lack of deliverable obligations. This would not only be very damaging for the CDS market; it would have very negative consequences for bank bond liquidity too." - source CITI

The Greek PSI in conjunction to the naked ban on naked Sovereign CDS have indeed somewhat "killed" the trading in the Itraxx Sovereign index SOVX as indicated by CITI:

We have as well to agree with CITI that, increased likelihood of bail-in is probably negative for cash bonds but how negative?

EDHEC-Risk Institute in their January 2012 note entitled "The Link between Eurozone Sovereign Debt and CDS Prices" provides us with some insight on the aforementioned impact:
"To examine the difference between these spread measures, we priced a 5-year bond with a 5% coupon in an environment where the default-free yield curve is assumed flat at 3% and the Libor risk-free curve is also assumed to be flat at 3.5%. We considered two cases - first an expected recovery rate of 40% and second an expected recovery of 0%. We then varied the 5-year survival probability assuming a flat term structure of default rates11 and calculated the implied bond price and spread measures. In all cases we assumed k = 1.

Figure 2 Comparison of the model-implied CDS, bond yield-spread and par asset swap spread measures as a function of 
the full price of a 5-year bond with a 6% coupon. We show this for an expected recovery of 40% (above) and 0% (below).":

"The results are presented in Figure 2. When the expected recovery rate is 40% we find that as the 
bond price falls (and it cannot fall below 40), the CDS spread grows and asymptotically tends to infinity while the yield-spread and asset swap spread tend to different large but finite numbers. However, if we set the expected recovery rate to zero then the yield-spread also tends to infinity and is very close in value to the CDS spread as the bond price falls to zero." - source EDHEC-Risk

Therefore, as we indicated in our previous conversation, if the recovery rate for SNS LT2 subordinated bonds is zero, the significance for the European subordinated CDS market is not neutral to say the least 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.

What are the implications and "unintended consequences" for the financial credit markets? CITI's note gives some additional insights:
"Likewise, lawmakers may feel that the decline in liquidity in sovereign CDS following the ban on naked shorting may not seem to have had an immediate effect. But here too we would argue that this is mostly because we happen to have been in a rallying market, and that the future consequences may stretch well beyond just CDS itself. If investors become forced sellers following downgrades to junk for Spain and Italy, as we think quite likely, the lack of liquidity in CDS would exacerbate the movement in bonds. While some liquidity remains in single-name sovereign CDS, the effect on the SovX index of the shorting ban has been quite dramatic (see graph above on Itraxx SOVX weekly trading). 

The potential problem in bank CDS is almost as large. Although net notional outstandings for single-name European bank CDS are only $68bn,7 DTCC data show that traded volumes are some $36bn/month. This compares with gross turnover in €-denominated bank bonds of only €15bn/month (on €600bn of outstandings). CDS plays an extremely important role in terms of index trading and price discovery, and is often actively used as a hedge for bond portfolios by investors because of its greater liquidity. 
These issues over triggers and deliverables could all too easily jeopardise the validity of the CDS market as a hedge. If it were accidentally “killed off”, the consequences for the bond market would be severe. Unlike in sovereigns, where the underlying cash market has normally been more liquid than CDS, in the corporate market liquidity is heavily fragmented. Without the signaling and hedging role of an active CDS market, bond transparency would fall, trading would become more lumpy, and ultimately the cost to bank issuers would increase, as an increased illiquidity premium became factored into spreads. This hardly seems a desirable outcome." - source CITI

On a final note, as far as Europe is concerned, whereas the US was all about the "fiscal cliff" recently, we think investors in Europe should be focusing on the potential "earnings cliff" given we think analysts are somewhat a little bit too optimistic in their expectations. As an illustration Dutch KPN fell 18% recently to its lowest level since September 2001, following a 4 billion euros right issues in conjunction with earnings well below expectations, leading S&P to downgrade the credit to BBB-, one notch above junk - source Bloomberg:

"Everyone's a millionaire where promises are concerned." - Ovid

Stay tuned!

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