Sunday 21 July 2013

Credit - Every Silver Lining has its Cloud

"To penetrate and dissipate these clouds of darkness, the general mind must be strengthened by education." - Thomas Jefferson

Following up on our guest post from Rcube Global Macro Research, where our friends looked at the weakening global earnings momentum (except in Japan), we thought this week, we would take the contrarian approach given equities market seem oblivious to the gathering storm ahead, silver lining being the metaphor for optimism in the common English-language.

The origin of the phrase "Every Cloud has a Silver Lining is traced to John Milton's "Comus" (1634) with the lines:
"Was I deceiv'd, or did a sable cloud
Turn forth her silver lining on the night?"

Indeed, as John Milton's 1634 Comus, it has all to do with deception we think. 

We touched on the subject of cognitive bias in our "Dunning-Kruger effect" conversation. Like any cognitive behavioral therapist, we tend to watch the process rather than focus solely on the content, therefore, we would tend to agree with our friends Rcube latest call on global weakening earnings momemtum.

As humans we posited in our previous conversations that we tend to suffer from optimism bias as indicated by the work of Tali Sharot:
"Humans, however, exhibit a pervasive and surprising bias: when it comes to predicting what will happen to us tomorrow, next week, or fifty years from now, we overestimate the likelihood of positive events, and underestimate the likelihood of negative events." - Tali Sharot - The optimism bias - Current Biology, Volume 21, issues 23, R941-R945, 6th of December 2011.

Not only do we suffer, from optimism bias, but we suffer as well from "deception" and we also all play "deceit" to some extent. We are all "great pretenders", some way or another. In similar fashion to the 1955 hit by the Platters "The Great Pretender", while the song described a man who deals with his heartbreak by denying it, we seem to be dealing with the "broken economy" (more so in Europe) by "denying" its reality, but we ramble again. For those of you who enjoy human's ability in practicing deception, like ourselves, we recommend the site "" dealing with its various forms.

In this week conversation, we would like to look at the negative trend in Spanish nonperforming loans, indicating Spain is tilting towards the adverse scenario which was used by Oliver Wyman in their Spanish banking stress tests. We will also look at the divergence in Central banks approach and the consequences as well on credit from a "loan" perspective. But first a quick credit and markets overview.

The story last week has clearly been some normalization following the explosion of the "Daisy Cutter", namely bond volatility as displayed by the evolution of the Merrill Lynch MOVE  index, which has been falling  - graph source Bloomberg:
MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.
CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.

Therefore the receding volatility in the fixed income space has led to a significant rebound in High Yield as displayed by the price action in one of the most liquid and active ETFs in the High Yield space, namely HYG. Whereas its investment grade equivalent namely the LQD ETF has not rebounded significantly - graph source Bloomberg:
More interestingly the normalization in the credit space was accompanied by a significant tightening in Itraxx indices credit spreads, thanks to a more dovish tone from Ben Bernanke at the Fed. Therefore, not only credit investors have been enjoying some welcome respite for a fourth consecutive week, which has been the longest streak of gains since before the bond route drove yields to a nine months high in June according to Bloomberg, but, benefited from the re-opening of the new issue markets, with credit investors showing again their strong appetite. For instance Gazprom issued a benchmark bond with an initial price guidance of a 4% coupon 5 year (BBB rating) which attracted 5.5 billion worth of orders in the book from 450 different investors, leading to a lower revised guidance to a more reasonable 3.75% coupon at the launch.

Of course the dovish tones from both the Fed and the ECB have so far limited the surge of European Government Bonds yields as indicated in the below graph with German 10 year yields staying below the 1.60% level and French yields now around 2.16% - source Bloomberg:

As far as summer 2013, the on-going respite is indeed a different experience so far from the summer of 2011 and 2012, which saw a liquidity crisis for the first, followed the following year by a spike in peripheral bond spreads during the summer 2012 which was called-off by the "whatever it takes" stance which kept the "feral bond hogs" at bay for the rest of the year leading to 2012 being a spectacular year for credit returns, following closely the record "reflationary" year of 2009.

But, as we posited last week, and in accordance with this week's chosen title, every silver lining has its cloud, and as far as Europe is concerned, clouds are indeed gathering. Record basking temperatures might indeed lead us to some thundering storm ahead in Europe, looking at the unemployment issues particularly hindering the economic prospects for peripheral countries. One just has to glance at the Spanish "Misery" index to fathom the uphill struggle face by our European politicians - graph source Bloomberg:
The misery index is calculated by adding the 12-month percentage change in the consumer price index to the jobless rate. Arthur Okun, an adviser to Presidents John F. Kennedy and Lyndon Johnson, created the indicator in the 1960s.

As far as Spanish banks are concerned, the recent surge in non-performing loans (NPLs) is seriously raising questions again on the adequacy of their level of provisioning. Particularly if ones look at the continuous fall in Spain real estate prices - graph source Bloomberg:
From a starting point of a 100 in September 2007, Spanish prices are now down to 72.64, a fall of more than 28%.
Given that we are now in the middle period considered by the previous Oliver Wyman (OW) stress tests for Spanish banks one can indeed look at the trend for actual nonperforming loans (NPL) and the implication for Spanish banks loss absorption capacity. This exercise is exactly what Nomura has done in their recent note from the 19th of July entitled - "Spanish Banks - On the road for the adverse scenario?":
"Now that we are in the middle of the period considered by the Oliver Wyman (OW) stress tests, we compare actual non-performing loans (NPL) trends with the implied expected probability of default (PD). We estimate an adjusted NPL ratio in May 2013 of 19.5%, representing 55% of total expected 2014 PD in the adverse scenario of 35.2%. On a three-year horizon, the NPL trend is closer to the baseline scenario. However, without a relatively vigorous recovery in 2015, asset quality deterioration could continue beyond the timeframe of the stress test, which would make the current trend closer to the adverse scenario.

Non-recurring income to absorb continued deterioration of asset quality Capital gains from the debt portfolio and other asset disposals should allow the Spanish banks to absorb the continued asset quality deterioration and partially absorb the new provisions needed for restructured loans. We expect net interest income (NII) to reach the bottom this quarter in most cases, although we still see limited upside given the low interest rate environment and ongoing deleveraging.

Support from LatAm – not so much this quarter
Volatile FX and rising bond yields could add some additional headwinds to the earnings contribution from LatAm for BBVA and SAN this quarter (although more so for Brazil vs Mexico). We believe the revenue environment in Brazil remains weak, and given a deteriorating economic outlook, concerns about the outlook for asset quality could return. Although the economic outlook remains positive in Mexico, in our view, this quarter faces some pressure from rising NPLs (particularly from homebuilders).
Relative preferences
We remain negative on the Spanish banking sector. The expected continued asset quality deterioration, the potential impacts of removing mortgages floors, the additional provisions needed for restructured loans or the slowdown in some LatAm economies, are examples of the headwinds facing Spanish bank profitability. In relative terms, we prefer BBVA (Neutral) owing to our bullish medium-term outlook for Mexico and, among the domestic banks, CABK (Neutral) owing to its relative higher returns, and the recent measures announced regarding their international financial stakes, which will allow them to improve the capital position." - source Nomura

As far as nonperforming loans are concerned and in relation to Spain, clearly, the trend is not the Spanish banking friend as indicated by Nomura in their note:
"The OW stress test was made for a three-year period, starting at the end of 2011, so we are now in the middle of the period being considered. In Fig. 4, we compare the 2011 NPL ratio with the 2014 OW expected PD and the actual level of NPLs, adjusted and reported, at a sector level.
The reported ratio includes total sector NPL balances over total credit and loans, reaching 11.2% in May 2013. The adjusted NPL ratio also considers the sectors foreclosed assets, the assets transferred to the SAREB and other EUR 30bn of problematic assets, mainly restructured and substandard loans classified as performing, leaving the May adjusted NPL ratio at 19.5%.
The adjustment of EUR 30bn of problematic assets considers that around 50% of total sector restructured loans are NPLs instead of the 37% reported at the end of 2012. In our recent report, Better today than tomorrow, we showed how total sector restructured loans at the end of 2012 were EUR 208bn, representing 14% of private sector loans, of which EUR 43bn were classified as substandard, other EUR 88bn as performing loans and the remaining EUR 77bn were not performing. The Spanish banks are reviewing these portfolios in order to apply the new and more conservative classification criteria, which will increase the non-performing and substandard restructured loans balances. If we consider as problematic assets all restructured loans, the adjusted NPL ratio will increase from 19.5% to 25.5% for May 2013. Fig. 4 shows that the Spanish financial sector adjusted NPL of 19.5% in May represents 55% of expected 2014 PDs under the OW adverse scenario." - source Nomura

Nomura has also gone further in their report hand have looked at the trend in the on-going deterioration in asset quality:
"The OW stress test assumed a three-year period. However, we believe the economic outlook in 2015 is not clear and a further deterioration in asset quality is possible. In Fig. 6, we show the expected NPL ratios trends if the period was extended to four years instead of the three-year period considered in the OW exercise. In this case, the current adjusted NPL ratio of 19.5% is closer to the adverse scenario than the base one, which theoretically for a four-year period are 21.4% and 17.3%, respectively.
From a macroeconomic perspective, in Fig. 6, we compare the latest available forecasts for the Spanish economy with those considered in the OW stress tests. The IMF published its July World Economic Outlook update on 9 July, downgrading its 2014 GDP and unemployment forecasts for Spain. Its new forecasts now assume that the Spanish economy will not grow until 2015, and it expects a 2014 unemployment rate of 26.5%, which is 50bp above its previous estimate (although this is below the 28% forecast recently published by the OECD).
Although the IMF macroeconomic estimates are still below ours, the downgrades highlight the potential risks for the Spanish economy. We also consider as negative the ongoing political scandals about alleged corruption, which, considering what happened recently in Portugal, could also add more volatility and uncertainty to the country and the banking sector.
We remain negative on the Spanish banking sector. The expected continued asset quality deterioration, the potential impacts of removing mortgages floors, the additional provisions needed for restructured loans or the slowdown of LatAm economies in the case of the two large banks, are some examples of the challenging outlook for the Spanish banking sector and the potential additional negative impacts." - source Nomura

Of course we would have to agree with Nomura, in this case the trend is indeed not your friend and regardless of the "silver lining" of some credit returns, there are indeed some clouds gathering on the horizon. While the ECB has recently tweaked its collateral framework as additional policy support, as part of the intent towards re-launching the ABS market to improve SME funding conditions, we think it is too little, too late and that the credit transmission mechanism has been broken in Europe, leading to a surge in bankruptcies as well as unemployment.

As an illustration of this broken credit transmission mechanism, one can only look at the below graph from Nomura relating to loan growth in Italy to get a clear picture of the damages inflicted to the real economy:
Loan growth? What loan growth?

No wonder the story separating the US economy from the European economy is a credit story. For instance we have been looking on numerous occasions on the price action of the  US Leveraged Loans market versus the European Leveraged Loans market. Comparing market fundamentals between both regions from a credit perspective is paramount in order to gauge the potential growth outcome for the two regions we think. Morgan Stanley in their recent Global Leveraged Insights from the 19th of July and entitled "Game of Loans: US vs Europe" look at these differences:
"Comparing Market Fundamentals: European loans have lower average ratings, higher trailing default rates, and a more challenging loan maturity wall, relative to the US. However, given a much more ‘issuer-friendly’ environment in the US, cov-lite volumes are higher, LBO leverage is greater, and levering transactions are more prevalent.
Technical Strength, but for Different Reasons: The US has been a story of strong demand, thanks to substantial fund inflows and strong CLO issuance. In Europe, positive technicals have been much more a story of low net supply." - source Morgan Stanley

As we posited in May this year in our "Chart of the Day - Too many European banks and why the deleveraging has only just started", the impact of credit growth in Europe is seriously impaired by the on-going deleveraging leading to a vicious deflationary spiral in the European space. It is therefore not a surprise to learn from Morgan Stanley's report the importance in Europe for banks in the loan market:
"Differences in the Investor Base: Banks continue to account for a much larger share of the Europe loan buyer base. As we show in Exhibit 2, banks’ share of the primary market for loans has shrunk over the last decade in both the US and Europe. But banks still account for 50% of the European loan market compared to just 13% in the US." - source Morgan Stanley.

Of course there are as well some quality differences:
"Differences in Credit Quality: The average credit quality of the two markets also differs. Whereas the US loan market is split almost evenly between BBs and Bs, the European loan market is clearly skewed towards Bs (66%), with only 17% BBs. It is notable that this difference in credit quality is almost the exact opposite of what is seen in the US and EU High Yield bond markets, where Europe has a much higher average rating. Investors should keep this quality differential in mind when comparing headline spreads and yields." - source Morgan Stanley

The growth differentiation between the US and Europe is no doubt to us a question of supply in credit:
"Weak Supply Story in Europe, Stronger in the US: In 1H 2013, the US loan market absorbed $267bn in gross institutional issuance, nearly matching levels last seen in the 1st half of 2007. The mix of this issuance, however, is much different today. In 2007, LBOs accounted for 36% of issuance, compared to 10% in 1H13. The majority of gross issuance today is still for refinancing. Subtracting repayments, net issuance for the US loan market was a more manageable $92bn in 1H13, compared to $181bn in 1H07. While stronger 2H growth in the US could lead to more corporate activity, and in turn net issuance, our base case is that supply remains manageable in the US near term.
In Europe, supply has been more muted. From the second half of 2009 through the 1st quarter 2013, LTM leveraged loan net supply was negative, and has only turned positive (just under €1bn) in 2Q13. An important reason for low supply in Europe has been bond-to-loan refinancings. 1H13 EUR high yield bond issuance was €48bn, just slightly below the total for 2012 – the highest year on record. By our estimates, 27% of this issuance has been to refinance bank debt and unlike previous years, concentrated (60%) in single-Bs that tend to dominate the loan market. Naturally, this trend has led to lower issuance of loans and as a result, soft demand has been outpaced by even softer supply. There are, however, tentative signs of revival in the loan market, and we do expect net supply to remain positive in Europe." - source Morgan Stanley

But even for the US, every silver lining has its cloud given the fast pace of credit releveraging and surge in covenant quality trends as highlighted by Morgan Stanley in their note:
"New Issuance Trends – More Worrying in the US
However, not everything looks better in the US from a fundamental perspective. Covenant quality trends in the US have been particularly worrying. Year to date 51% of US loans have been cov-lite — a far higher share than the previous peak in 2007. Although the share of cov-lite issuance is high in Europe by historical standards, it is miles behind that of the US.
Across both markets, new issuance has primarily been used to refinance outstanding debt. US issuance has had a somewhat more shareholder friendly tone, with 15% of proceeds used to fund dividends or share buybacks compared to just 6 percent in Europe. New LBOs also make up a larger share in Europe, although this is predominantly a result of lower overall issuance levels." - source Morgan Stanley

For sure, the buy-back frenzy, has no doubt been more "equity" friendly and definitely more worrying from a credit investor's perspective, making the US market therefore more attractive as of late.

On a final note, "housing bubbles" thanks to cheap credit and hot inflows has no doubt been exported to Emerging Markets when one looks at the cost of housing in Columbia, so much for a post-bubble world... - gaph source Bloomberg:
"Anyone presuming financial markets are in “a post-bubble world” might have a different view after looking at the cost of housing in Colombia, according to Yale University Professor Robert J. Shiller.
The CHART OF THE DAY shows how a home-price index compiled by the South American country’s central bank compares with the Standard & Poor’s/Case-Shiller price gauge for 10 U.S. cities from seven years earlier. Colombia’s index focuses on Bogota, Cali and Medellin, the three largest cities. Both indicators
have been adjusting for inflation. 
“I was not expecting a bubble story when I visited Colombia last month,” Shiller wrote yesterday in a commentary posted on the Project Syndicate website. “People there told me about an ongoing real-estate bubble.” 
Home prices in Colombia have increased 69 percent in real terms since 2004, according to the posting. The gain recalled a 131 percent surge in the 10-city index from its 1997 low to its 2006 peak, he wrote.
Falling inflation and interest rates largely explain the Colombian market’s strength, Shiller wrote. Consumer prices rose in February at the slowest pace since 1955. The central bank cut the overnight lending rate seven times in the past year, and the current 3.25 percent rate is Latin America’s lowest.
Shiller also cited a diminished threat from a Marxist rebel group, the Revolutionary Armed Forces of Colombia, that has been active for half a century. The government has held peace talks with the guerrillas, known as FARC, since October. “That is a good enough story to drive a housing bubble,” the New Haven, Connecticut-based economist wrote." - source Bloomberg

"Every silver lining has a cloud." - Mary Kay Ash

Stay tuned!

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