Saturday, 30 March 2013

Credit - Gunfight at the O.K. Corralito

"Peace cannot be kept by force; it can only be achieved by understanding." - Albert Einstein 

Looking at the evolution in Cyprus, reminiscent of Argentina's 2001 "Corralito", which eventually led to its default, we thought this week it would be entertaining to use in our title, yet other multi-dimensional references as per last week conversation "The Doubt in the Shadow". 

Our first reference is of course the "Gunfight at the O.K. Corral" which took place on the 26th of October 1881 in Tombstone Arizona, and is generally regarded as the most famous gunfight in the history of the American Old West. Arguably our European Gunfight at the O.K. Corralito, will no doubt be regarded as the most infamous "deposit-levy" fight in "Old Europe's history". The O.K. Corral gunfight represented a time in American history where the frontier was open range for outlaws (tax havens) opposed by law enforcement that was spread thin over vast territories (Europe), leaving some areas unprotected (Cyprus). In similar fashion, the lack of a true European Banking Union from inception of the European project, means, that given the European banking sector's  leverage and thin equity buffers, the depositors can rightly feel unprotected. Yes, we know, on the 29th of June 2012, European leaders expressed their determination to "break the vicious circle between banks and sovereigns". The initial statement focused on the establishment of a "Single Supervisory Mechanism" (SSM) which would pave the way to direct recapitalization of banks by the ESM (European Stability Mechanism). This banking union would not just cover the Eurozone initially but would also be open to the soon to be 28 members of the EU (with Croatia being the next joiner), if they choose to join.

Our second reference is of course, Argentina's 2001 Corralito, which has been recently reenacted in October 2012, limiting ATM withdrawals for Argentinians. The Corralito was the informal name taken by Minister of Economy Domingo Cavallo's economic measures in order to stop bank runs in Argentina. It was not very successful...

Our third reference, is less so evident, but nonetheless, entertaining we think, given the famous Gunfight at O.K. Corral, also gave its name to a mathematical model - The Ok Corral and the Power of the Law (A Curious Poisson-Kernel Formula for a Parabolic Equation) by David Williams and Paul Mcilroy submitted in 1998:
"Two lines of gunmen face each other, there being initially m on one side,n on the other. Each person involved is a hopeless shot, but keeps firing at the enemy until either he himself is killed or there is no one left on the other side. Let Ī¼(mn) be the expected number of survivors. Clearly, we have boundary conditions:
FormulaWe also have the equationFormulaThis is because the probability that the first successful shot is made by the side with m gunmen is m/(m + n). On using the recurrence relation (1.2) together with the boundary condition (1.1), the computer produces Table 1 below, in whichFormula1991 Mathematics Subject Classification 60F05."

In similar fashion each European politician involved in our European Gunfight at the O.K. Corralito is as well a "hopeless shot" but keeps firing (or making blunders that is) until either he himself is killed (or his country's economy) or there is no one left on the other side (we have yet to see an Italian government...). Of course there is an elegant solution to this mathematical model - Solution to the OK Corral model via decoupling of Friedman's urn by J.F.C. Kingman and S.E. Volkov. Just for an illustration, the authors presented the probability that exactly 5 gunmen would survive provided there were initially 20 on both sides. 

We will let you mathematically work out in your own time how many  "hopeless shot European gunmen" will survive this "European O.K. Corralito gunfight" given than they will soon be 28 countries in the European Union, 14 on each side, but, as usual, we ramble again...

While in the last two credit posts we focused our attention on the lack of equity buffers (Dumb Buffers and The Doubt in the Shadow), in this week's conversation we would like to direct our attention to the "unintended consequences" of the Gunfight at the O.K. Corralito given that, in true "Zemblanity" fashion. (Zemblanity being defined as "The inexorable discovery of what we don't want to know"), there will indeed be casualties, and most likely in the peripheral banking space that is, with rising nonperforming loans due to lack of economic growth, thin equity buffers and high loan-to-deposit ratios and soon to happen deposit flights.

Although the intentions of the European Union has been to severe the link between financials and sovereigns with a move towards a European Banking Union, the ban on naked Sovereign CDS imposed on the 1st of November has effectively killed the Itraxx SOVx 5 year index market for good. This market had been trading closely to Itraxx Financial Senior 5 year index in the past (25 European banks and insurance single names CDS). Financial spreads have been as of late on the receiving end of the widening move in cash and CDS markets courtesy of discussions surroundings "bail-in" procedures  from one of the European gunmen (Jeroen Dijsselbloem). 

The EU Recovery and Resolution Directive proposes an orderly introduction of bondholder write-downs, with the bail-in tool set for implementation in 2018 but it looks like our lone gunman is trigger happy and ready to shoot early in the gunfight . Graph below SOVx versus Itraxx Financial Senior 5 year index since March 2011 -  source Bloomberg:
"27 February 2013 - The Markit iTraxx SovX Western Europe index will not roll into Series 9 in March 2013 due to low trading activity as recorded by the DTCC Section IV: Market Risk Transaction Activity data. Series 8 will remain on-the-run." - source Itraxx Markit

While Cyprus replaced Greece has a member of the SOVx index back in 2012, the only remaining series, will remain at 14 for the foreseeable future for lack of liquidity, or lack of market thereof:
Goodbye SOVx CDS market...

Financials have no doubt been the early casualties of the European Gunfight at O.K. Corralito, when one looks at the increasing divergence between the Itraxx Main Europe 5 year CDS (risk gauge for non-financial Investment Grade European Credit)  versus the Itraxx Financials 5 year CDS index - source Bloomberg:
In fact, CDS insuring against default on European financials have risen for 10 days in a row, the longest streak since August 2011, closing on the 28th of March towards the 205 bps, heading for its worst month since November 2011.

Of course in the financials space CDS wise, the Itraxx Financial Subordinated index (indicative of the risk gauge for subordinated debt, in the direct line of fire for bank recapitalization as per the SNS case...) took a pounding as well in this European Gunfight and widening towards 325 bps versus 205 bps for the Itraxx Financial Senior 5 year CDS index. - source Bloomberg:
Back in February in our conversation "House of pain and House of cards" we argued  the following in relation to the SNS case which saw subordinated debt totally wiped-out by the Dutch government:
"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."

We were glad to see Matt King from CITI joining our concerns in his note on the 15th of March entitled "Behold the new form of bail-in":
"The CDS trade has the additional advantage that not only are losses at senior level becoming more likely, but sub CDS protection is likely to be rendered worthless in cases where bonds are completely converted to equity or wiped out, because of a lack of deliverables. With sub/senior relationships still trading pretty much in line with their long-term averages, this does not seem yet to be priced in (chart below).
Perhaps the SNS auction next week (which is likely to confirm sub recoveries of zero) will be sufficient to give trading a jolt, a result which seems quite likely if there are eventually auctions on Laiki Bank or Bank of Cyprus CDS.5 Conceivably it may take longer: as with many factors in the current outlook, we fear the potential for discontinuities even as the market fails to react today — a sort of “ball in a bowl” phenomenon.6 But even if it takes a while, we think the bailin of bank bondholders on one small island today is ultimately likely to have significance far greater than its size suggests." - source CITI

The recent  "Dutch" case of SNS Reaal has indeed illustrated the shortcomings of the restructuring credit events in financial CDS.  Given the Dutch government expropriated all of the lender's subordinated debt in February before a CDS auction could be held, we wonder if the Subordinated market will indeed suffer a similar fate to the Sovereign CDS market and SOVx in particular. CDS notionals have remained on a downward trend since the market's peak of USD 58trn notional outstanding at the end of 2007, touching a new low of USD 27 trillion at the end on June 2012, according to the Bank for International Settlements. A dying market or simply yet another victim of our European Gunfight at the O.K. Corralito. We wonder...

Another "unintended consequence of the European Gunfight, has no doubt been the growing divergence between European volatility gauge V2X and its US equivalent VIX - source Bloomberg:
 The spread between both volatility risk gauges has been rising steadily since December, closing towards 8.60 but has yet reached its 2011 record of nearly 15.

Of course the obvious "unintended consequences" of the Gunfight at the O.K. Corralito, should be that depositors will think about spreading their wealth across banks to ensure they are below the 100,000 euros "implicit guaranteed" threshold - Euro deposits table, source Bloomberg:
"A key positive of the restructured solution for Cyprus is the underpinning of the 100,000 euro deposit insurance scheme, explicitly noted in the release. A consequence of the decision to use uninsured deposits along with equity and bond instruments to part-fund the recapitalization of Bank of Cyprus may be depositors spreading money across banks to ensure they don't exceed the threshold at any one lender." - source Bloomberg.

And, as we posited in "Winner-take-all", should a deposit flight occur in Europe, depositors will no doubt seek a German bank sanctuary.

In this European Gunfight at the O.K. Corralito, we wonder if Germany is really a "straight-shooter" when looking at the level of capitalization of some of its banks which have been deeply impacted by their venture into structured finance and shipping in particular fuelled by cheap credit.

We discussed in depth the issues plaguing Germany's second largest bank Commerzbank in our conversation Dumb Buffers: "Not only have overbuilding occurred due to cheap credit that fuelled an epic bubble in the Baltic Dry Index, but, the on-going decline on vessel prices, will no doubt exert additional pressure on recovery values for Commerzbank's loan book".

Another high profile German institution which had been on the receiving end of state aid has been HSH Nordbank:
"In December 2008 HSH was granted to issue up to EUR 30bn guaranteed notes under the German SoFFin program. One requirement that was imposed on HSH was to raise the capital ratio to at least 8%. On January 20, 2009 EUR 3bn 3 year guaranteed notes were issued. On February 24, 2009 HSH received new capital of EUR 3bn and credit guarantees of EUR 10bn by the two main shareholders, the states of Hamburg and Schleswig-Holstein. The other shareholders, JC Flowers and the savings bank association, did not participate in the capital infusion. Together with this increase of its core-capital, HSH announced further restructuring. It plans to spin off non-strategic activities and the Toxic asset portfolio into a—yet to be created—Bad Bank." - source Wikipedia

Could HSH subordinated bondholders suffer the same fate as Dutch bank SNS? Of course!
We agree with a recent note from Bank of America Merrill Lynch on this subject entitled "At the mercy of shipping":
"The most recent legislative proposals in the German banking sector do not appear to allow for direct bondholder expropriation by the German government / states, as happened with SNS REAAL. But if HSHN’s key sector exposure (ie, shipping) does not show signs of stabilization in the near term, negative outcomes for bondholders (ie, (very) low recoveries) could be achieved through transfer orders and/or recovery / resolution plans, we think. Also, when considering the relentless drive by the EU towards bailing in sub bondholders, we would not necessarily take the existing regulatory framework and – proposals in Germany as the last word on burden sharing by sub bondholders." - source Bank of America Merrill Lynch.

For, us, you probably know by now, why shipping is a leading credit indicator. For Dutch SNS it was commercial real estate, for HSH (and Commerzbank as well) it is shipping issues first:
"Shipping – plagued by overcapacity
At end-1H12, HSHN’s exposure to shipping was EUR32bn, of which about EUR12bn was housed in the restructuring unit. The bank finances ship owners, not ship yards. Due to the overcapacity in shipping and the low level of fleet utilisation (exacerbated by weaker economic growth and reduced global trade flows), the sector has been struggling for some time now, which has led to higher problem loans for most lenders in this field. Collateral values (ie, ship prices) have also come down.
Overcapacity in the shipping industry is unlikely to be resolved until 2014 at the earliest, due to the high number of new ships ordered over the past few years. A number of competitors are retrenching from shipping finance. On the one hand, this could result in financing problems for some shipping companies. On the other hand, it could improve the competitive position of the remaining players. As for HSHN, it has agreed with the EC to reduce its shipping exposure to about EUR15bn by end-2014 and to limit its share of new business in worldwide ship financing to 5% until end-2014." - source Bank of America Merrill Lynch

As far as HSH credit metrics are concerned, they are indeed very weak as indicated by Bank of America Merrill Lynch in their note:

"HSHN’s asset quality is weak. At end-1H12, its reported NPL ratio was 12.6% and this is expected to have increased significantly in 2H12. The bank’s reliance on wholesale funding remains high, with a loan/deposit ratio of 195% at end-3Q12. Its profitability has been very poor in recent years - it was loss-making in 2008, 2009 and 2011. It expects to be loss-making again in FY12 and in FY13. The bank will report FY12 results on 11 April." - source Bank of America Merrill Lynch.

And given structured finance and shipping loan books are very dependent on the evolution of the US Dollar, we expect trouble ahead in accordance with Bank of America Merrill Lynch's note:
"However, in 1H12, the bank’s RWAs jumped by 32%. This was due to ‘the renewed appreciation of the USD […] as well as the crisis in the shipping markets, which caused the risk parameters to deteriorate significantly.’ The negative impact of this RWA increase on the bank’s capital ratios was mitigated by:
- the EUR500mn capital injection by the federal states of Hamburg and Schleswig-Holstein in January 2012 (see below); and 
- the est. EUR260mn gain on the cash tender offer for LT2 bonds in February

But this was insufficient to offset the decrease in the bank’s capital ratios caused by the negative rating migration and USD appreciation in the shipping portfolio. This has meant that HSHN now needs the additional capital relief of lower RWAs. Therefore, in February 2013 the bank asked the two states to return the asset guarantee to its original size of EUR10bn." - source Bank of America Merrill Lynch.

So yes, we think, that looking at the shipping industry HSH subordinated bondholders could indeed face the SNS treatment at some point...and we also think that German banks will most likely welcome deposits from stricken peripheral countries. Michelle Wiese Bockmann in her Bloomberg on the 1st of March entitled - German Banks With Record Soured Ship Loans Forgo Seizing Vessels:

"Deutsche Bank AG and two other German lenders providing about 14 percent of credit to ship owners are forgoing seizing vessels even after soured loans to the industry rose to a record.
Europe’s biggest bank by assets, as well as HSH Nordbank AG, the largest in the market, and Norddeutsche Landesbank Girozentrale, which finances 1,500 ships, are restructuring loans and setting money aside instead of repossessing vessels, officials from the companies said. They have about $69 billion in loans to the industry out of $500 billion in total, according to data compiled by the banks and Petrofin Research SA, an Athens-based consultant" - source Bloomberg

It looks to us that the German gunslinger, is no doubt, a "fast-draw" artist in this European Gunfight at the O.K. Corralito.
Oh well...

The other "unintended consequences" for large depositors could as well benefit the buy-side, with large depositors seeking potentially the havens of managed funds rather than concentrating their deposits in banks as indicated in another note from Bank of America Merrill Lynch:

"Yet large depositors have clearly been put on notice that they should be careful where they invest. In our view, this could push larger sums out of the banking system into managed funds, e.g. money market funds or fixed income funds, and will likely spread deposits across a country’s banking sector at the insured level (which may be positive for risk assets)." - source Bank of America Merrill Lynch - A backward step - 26th of March 2013.

One thing for sure, in similar fashion to the O.K. Corral gunfight, this European O.K. Corralito, will not end up nicely for some in particular and for the euro in general.

On a final note, we were entertained by Bank of England's announcement that UK banks had a capital shortfall of 25 billion pounds (38 billion USD), to cover higher estimates for loan losses due to their exposure to commercial real estate as reported by Ben Moshinsky in Bloomberg in his article - BOE Says U.K. Banks Have Capital Shortfall of $38 Billion:

"The BOE said expected losses on loans could exceed provisions by 30 billion pounds, while future conduct costs could be 10 billion more than banks expect. It said lenders underestimated assets weighted for risk by 170 billion pounds, leading to a 12 billion-pound capital shortfall in that category. While the full impact of the three areas could deplete lenders’ capital by 52 billion pounds, some banks already have enough resources to cover them, leading to a total 25 billion-pound shortfall." - source Bloomberg.
"The Bank of England warned expected losses from high-risk loan portfolios, including U.K. commercial real estate and euro zone exposure, could exceed existing provisions at major banks by about 30 billion pounds ($45 billion) in the next three years. Lloyds noted at FY12 earnings that U.K. commercial real estate values fell in 2012, and were down 4.2% yoy, with non-London asset values struggling and only 5% higher than their 2009 trough." - source Bloomberg.

What was our previous comment in our last conversation "The Doubt in the Shadow" on Chancellor of the Exchequer George Osborne's latest 130 billion pound worth of mortgages guarantees?
"This is pure madness and will end up in tears"

"Insanity - a perfectly rational adjustment to an insane world."- R. D. Laing, Scottish psychologist.

Stay tuned!

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