Tuesday, 9 September 2014

Credit - Sympathy for the Devil

"The greatest trick European central bankers ever pulled was to convince the world that default risk didn't exist" - Macronomics.

Looking with interest Spain issuing a 50 year bond with a 4% coupon, in conjunction with the latest raft of the decisions taken by our "Generous Gambler" aka Mario Draghi being a very crafty poker player no doubt in the steps of his July 2012 OMT bluff triggering a continuation in the weakness of the Euro versus the US dollar, we decided this week to venture towards a musical analogy in picking up our chosen title. Sympathy for the Devil is a song by The Rolling Stones which first appeared in 1968. 
In a 1995 interview with Rolling Stone, Jagger said: "I think that was taken from an old idea of Baudelaire's, I think, but I could be wrong. Sometimes when I look at my Baudelaire books, I can't see it in there. But it was an idea I got from French writing. And I just took a couple of lines and expanded on it. I wrote it as sort of like a Bob Dylan song." 

Mick Jagger wasn't wrong. As one knows, the "Devil is in the details" and if Mick Jagger had taken a closer look to his Baudelaire books he would have noticed that his inspiration indeed came from this great text from Charles Baudelaire called the "Generous Gambler" we have used in the past as a title for a post. This poem appears to be the 29th poem of Charles Baudelaire masterpiece Spleen de Paris from 1869 (an interesting anagram with 1968 we think):
"My dear brothers, never forget, when you hear the progress of enlightenment vaunted, that the devil's best trick is to persuade you that he doesn't exist!" - Charles Baudelaire - The Generous Gambler
We previously pointed out in our conversation "Complacency" back in November 2011 that this seminal work from Baudelaire also inspired the scenarists of the great 1995 movie Usual Suspects:
"The greatest trick the devil ever pulled was to convince the world he didn't exist" - Roger "Verbal" Kint- The Usual Suspects

Of course as our earlier quote goes, we could not resist using Baudelaire's work as an inspiration as well but we ramble again.

In this week's conversation we will look at why European banks deleveraging has much further to go (hence the much commented latest round of ECB decisions taken to support the banks in Europe in the process) as well as the credit clock and the on-going fast releveraging in the US corporate sector which we touch briefly in our previously published Chart of the Day and our fear in a US dollar rising too fast for some Emerging Markets (EM).

Whereas investors have indeed been mesmerized by Mario Draghi with his "Whatever it takes" and "Believe me it will be enough" moments, it is no surprise to us to see an acceleration in the continuation in yield compression, going negative for some, in the European government space. 

Investors have indeed Sympathy for the Devil we think, as they continue to pile up with much abandon and more and more getting "carried away" in their insatiable hunt for yield. In that sense Baudelaire's 1869 poem rings eerily familiar with the current investment situation in the sense that investors have been giving our "Generous Gambler" the benefit of the doubt (OMT - and now full blown QE) and shown their sympathy and their blind beliefs in "implicit" guarantees, rather than "explicit" (such as the German Constitution as we argued in various conversations):
"If it hadn't been for the fear of humiliating myself before such a grand assembly, I would willingly have fallen at the feet of this generous gambler, to thank him for his unheard of munificence. But little by little, after I left him, incurable mistrust returned to my breast. I no longer dared to believe in such prodigious good fortune, and, as I went to bed, saying my prayers out of the remnants of imbecilic habit, I said, half-asleep: "My God! Lord, my God! Please make the devil keep his word!" 

But as years have gone by in the European tragedy, we have become somewhat immunised from our great magician's spells. Many investors have indeed shown the greatest sympathy in respect to piling up on European Government Debt in the process, while banks have been shedding assets leading to outright credit contractions leading in the past two years European banks to cut their lending to businesses by about 8.5 per cent as reported by Matthew C Klein in FT Alphaville in his article "How to spend it: ECB bond-buying edition"  adding the following comment: "a remarkable development considering what has happened to credit spreads since Mario Draghi pledged to do “whatever it takes” to save the currency union"

For us, it isn't remarkable, as we have always stipulated in this blog that LTRO 1 and 2 in conjunction with the fateful EBA decision pushing banks to reach a Core Tier 1 ratio of 9% precipitated the recession and the credit crunch in peripheral countries more significantly. For us it amounted to "Money for Nothing" we argued at the time given the lack of transmission to the real economy. It looks to us the 8.5% credit contraction validates our take and the crowding out of the private sector we discussed in prior conversation "Tokyo Drift" being the latest:
Indeed, declining peripheral yields have not transferred to peripheral private sector funding due to "crowding out" which we discussed a year ago in our conversation "Fears for Tears":
One of main reason of the relative calm in the European government bond market has been the "crowding out" of the private sector.
"Although, the intention of European politicians has been to severe the link between banks and sovereigns, in fact what they have effectively done in relation to bank lending in Europe is "crowding out" the private sector. Peripheral banks have in effect become the "preferred lender" of peripheral governments
It is fairly simple, in effect while the deleveraging runs unabated for European banks, most European banks have been playing the carry trade and in effect boosting their sovereign holdings by 30% since 2011 to record"

We also commented at the time:
"Yes, we all know that Mario Draghi's OMT "nuclear deterrent" has yet to be tested. But what we are concerned about is, as we indicated in our conversation "Cloud Nine", is the lack of credit growth in peripheral countries which are most likely to be exacerbated by the upcoming AQR 
As a reminder: AQR = Asset Quality Review, planned for 1st Quarter 2014 as a prelude to the ECB becoming the Single Supervisor for large euro area banks in 2H 2014. The AQR's intent is to review banks challenged loan portfolios and the need for capital increase.
"Until the AQR is completed and capital shortfalls identified and remedied, you cannot expect a significant pick up in lending." 

The issue of course is that the deleveraging in the European banking space has a very long way to go as indicated by this Loan-to-deposit ratios chart coming from McKinsey's Working Paper on +Risk number 56 entitled "Risk in emerging markets" published in June 2014:
-source McKinsey

The scale in the deleveraging can be ascertained from the chart above with a reduction of 58% in the US and 31% in the United Kingdom. 

In regards to the capital structure, in comparison to Europe, the United States have increased much rapidly their capital levels than their European counterparts as displayed in the below chart from the same McKinsey report:
-source McKinsey

US banks have increased their capital basis by 57% since 2007 until 2012 while Western European banks by only 37% on the same period.
While investors boast sympathy for our "Generous Gambler", some German economists do not seem to show much sympathy given that at the end of July the German Constitutional court received yet another challenge, this time around the European Banking Union. It has not been reported as much by financial pundits but, a group of professors in Germany has filed a complaint claiming the European Banking Union has no legal basis in the EU treaties as reported by EurActiv on the 29th of July:
 "European banking union constitutes a violation of fundamental rights, said professor of finance and economic policy at the Technische Universität Berlin Markus C. Kerber, in a statement for the German newspaper "Welt am Sonntag".

The rules for the new single supervisory mechanism "represent the first step towards unprecedented German taxpayer liability for banks outside national banking supervision", Kerber said. According to the economic law expert, European banking supervision can only be introduced if changes are made to the EU treaties.

Kerber is not alone. He stands alongside numerous critics from the Europolis Group who are convinced that the German government and Bundestag have disregarded the responsibility for integration while dealing with Brussels' plans for a banking union.

The group has decided to lodge a complaint before Germany's constitutional court against the underlying legal regulation as well as the law ratifying the transfer of bank supervision to the European Central Bank (ECB).

Announcing the group's decision on Sunday (27 July) in Berlin, Kerber also accused German Finance Minister Wolfgang Schäuble of deceiving the public regarding the risks of banking union.

The complainants announced their intention to extend the constitutional complaint as soon as the regulation on the Single Resolution Mechanism (SRM) and its corresponding bank resolution fund take effect.

Starting in November, the new single supervisory mechanism will fall within the remit of the European Central Bank (ECB). It is a central component of banking union.

“We consider the banking union constitutional,” the German Finance Ministry explained, adding its legal basis was thoroughly assessed with the constitutional department.

The ministry said Germany did not feel the EU Treaty's internal market article [Article 127(6) TFEU], on its own, was sufficient for the union, as the Commission proposed. As a result, an additional agreement was made among the member states.

Kerber has been a strict opponent of EU bailout policy from the start. "The worst is yet to come", he warned in May 2012, predicting an imminent collapse of the eurozone. At the time, he called for the introduction of second currency in parallel to the euro called the "Guldenmark".

In March 2014, the German constitutional court finally gave the green light to the euro area bailout package, rejecting numerous complaints against the European Stability Mechanism (ESM). Kerber was among the official complainants at the time." - source EurActiv Germany

As we indicated in our conversation "Eastern promises" on the 9th of June 2012 we continue to think Germany could be the prime suspect in triggering a breakup:
"We think the breakup of the European Union could be triggered by Germany, in similar fashion to the demise of the 15 State-Ruble zone in 1994 which was triggered by Russia, its most powerful member which could lead to a smaller European zone. It has been our thoughts which we previously expressed."

Keep in mind that Angela Merkel while only appearing to be making material sacrifices has managed to keep Germany's liabilities unchanged so far.

Moving back to credit and the lack of private credit to the real economy which has been plaguing the much vaunted "recovery", disintermediation in Europe has accelerated in Europe where asset managers and private investors are picking up the direct lending baton from banks which in many instances have been in retreat due to lack of capital therefore balance sheet constrained. 

In last week Chart of the Day focusing on the difference between US High Yield and US we indicated the following:
"In Europe, the situation is different, where the explosion in growth in the High Yield market comes from substitution from corporate loans to bond issuance due to the disintermediation on the back of bank deleveraging (which by the way is way behind the US). Existing loans in Europe are getting refinanced therefore via new High Yield issuance in the bond market, which implies that there is no significant releveraging as seen in the US so far."

An illustration of the direct lending trend business in Europe can be ascertained by the increase in loans origination to mid-cap corporates and the hiring taking place in that space, with Paris based asset manager Tikehau hiring for its direct lending business veteran banker Nathalie Bleuven former deputy head of the mid-cap LBO and corporate acquisition from Societe Generale, While large corporates in Europe do not have issues with loan syndication or directly taping the market through the bond market, there has been a rise in the European markets of new entrants in terms of issuance to the bond market. European corporates depended to around 85% to the loan market in 2011, with bond issuance only representing 15%.  Europe has a very large banking sector relative to GDP. The aggregate balance sheet of euro area banks is around 270% of GDP, whereas in the US, where capital markets are deeper, it is only around 70% of GDP. A deleveraging banking sector implies lower credit supply, which is problematic and explains therefore the lack of recovery in the European economy. Of course the ECB is aware of the size of the problem as indicated by the speech given by  Yves Mersch, Member of the Executive Board of the ECB, in a keynote speech entitled "Finance in an environment of downsizing banks" given at the Shanghai Forum in May 2014:
"In terms of location, the cost of and access to finance in the euro area remains strongly based on national conditions. For example, the average cost of borrowing for non-financial firms in Portugal is more than 5% per year, whereas the equivalent for French firms is around 2% per year.

One would imagine in this situation that a Portuguese firm would seek out a French bank, but the euro area banking market does not facilitate such arbitrage. Direct cross-border loans to firms account for just 7.5% of total loans to firms. And local affiliates of foreign banks represent on average only around 20% of national markets, and much less in larger countries. Thus, firms depend heavily on the health of their domestic banks.

Moreover, while corporate bond issuance has partially substituted for bank lending, it is strongly concentrated in non-distressed countries where there has been no decrease in the net flow of bank loans. The net issuance of debt securities, quoted shares and bank loans in non-distressed countries was plus €66 billion in 2013, whereas it was minus €93 billion in distressed countries.

Of course, in principle firms from distressed countries can issue securities in non-distressed countries. In practice, however, it is legally complicated due to issues of different governing law, especially when securities are traded along a chain of financial intermediaries.

This analysis points to two missing pieces in the euro area financial market: lack of retail banking integration and lack of capital market integration.

The low level of retail banking integration reflects several factors, but diverging approaches to supervision and resolution are certainly among them. For one, the persistence of national borders in a European financial market has in the past created compliance costs and reduced the synergies of banking integration. A European Commission survey in 2005 found that opaque supervisory approval procedures were a major deterrent to cross-border banking M&As. [4]

Moreover, national considerations may have reinforced the fragmentation of retail markets during the crisis. For example, some commentators have argued that supervisors erected de facto “internal capital controls” within the euro area, which restricted the flow of funds between banks and within cross-border banks.

A similar pattern can be observed in how national authorities in the euro area have dealt with failing banks. In general, non-viable banks were merged with other national banks, rather than being wound down or broken up and sold off. Thus, what could have been an opportunity to increase foreign competition in domestic markets, and indeed to work through the crisis more quickly, in some cases ended up increasing national concentration. To give a comparison with the US, the FDIC has resolved around 500 banks since 2008, mainly by selling parts of banks to other banks, whereas the equivalent figure for the euro area is around 50.

All this suggests that the move towards a genuine Banking Union in the euro area could help create the conditions for deeper retail banking integration. A Single Supervisory Mechanism (SSM) should lead to harmonisation of rules and standards, and also remove distortions created by national borders. And a Single Resolution Mechanism (SRM) should ensure that banks are resolved from a European perspective and according to least-cost principles, which should in principle open the door for cross-border resolution strategies.

In this way, even though the banking sector on aggregate is downsizing, credit allocation across the euro area may become more efficient. Banking Union is key part in ensuring that location becomes a diminishing factor in access to bank finance.

While Europe is and will remain a bank-based economy, adding the second missing piece of the euro area financial market – deeper capital market integration – is key to ensure that firms in all jurisdictions can use capital markets as a “spare tyre” when banks are not lending – and not only those in larger countries with more developed bond markets. Within a single currency area, there is no reason in principle why firms should not be able to tap a European pool of savings. What prevents this in practice, however, is regulatory heterogeneity across the euro area." - source ECB

A recent example of a firm tapping a large European pool of savings has been the recent set up of Banque PSA Finance (the banking arm of French automobile constructor) in Belgium attracted by the very large pool of short term deposits of around €250 billion euros.

There is indeed in Europe a growing shadow-banking on the back of bank deleveraging as illustrated by asset managers like Tikehau and Banque PSA Finance growing implantations. This is also illustrated in Mr Mersch speech given in May 2014:
"The size of this “shadow banking” system – which in my view is a misleading term – has increased considerably in the euro area since the crisis, rising by almost 20% since 2008. It has also taken on a greater role in financing the real economy. At end-2013, outstanding amounts of loans from euro area non-bank financial intermediaries to euro area non-financial firms amounted to €1.2 trillion. But the key challenge from a policy perspective is to ensure that these funds make their way to the most credit-starved SMEs." - source ECB

Most credit-starved SMEs are relying more and more on non-traditional players such as asset managers in providing much needed financing.

At this juncture, we think it is very important to look back on how the "Global Credit Channel Clock" operates, as designed by our good friend Cyril Castelli from Rcube Global Asset Management:
Whereas Europe sits more closely towards the lower right quadrant, it is increasingly clear that the US is showing increasing leverage in the corporate space, indicating a move towards the higher quadrant on the left of the Global Credit Channel Clock we think. What we have been seeing is indeed a flattening yield curve in the US with re-leveraging courtesy of buy-backs financed by debt issuance which is the point we made in last week Chart of the Day.

The continuation in the stability in credit spreads particularly in the High Yield space depends in the continuation of low fundamental default risk. On that subject, leverage matters and as shown in CITI Research Credit Strategy report entitled "Wider or Tighter recently published, the evolution of the median leverage ratio in the US warrants close monitoring we think:
"We calculated leverage for two baskets of names — the overall IG universe updated quarterly since ’06, and for a basket comprised of credits that held an IG rating at any time since ‘06 (to capture falling angels). Either way, it doesn’t look good."
Who is Levering Up?
Pretty much everybody. We calculate leverage for the IG universe today and three years ago (leverage ratio on the Y axis, names on the X axis and ordered from most to least levered). In gross and net terms there has basically been a parallel shift upward.
In theory and all else equal, a company that buys its own shares will boost its EPS, but unfortunately its default risk is likely to rise as well. This may not be good for share price. But in practice this is not necessarily true, since factors such as QE can drive default risk as much as company-specific actions." - source CITI Research

What of course is still supportive in the US fixed income space is the total net supply which hasn't quenched the fierce appetite for yield as displayed by CITI in their note:
"Net supply in the overall bond market has been well below the longer-term average in recent years ($1.4 tn vs. $1.8 tn), a trend we expect to remain in place in the near-term." - source CITI Research

More interestingly CITI Research highlighted an important point when it comes to traditional investors reaching for yield outside their comfort zone:
"In credit we have seen two way capital flows in the wake of QE; for example, corporate treasuries have increased HG exposure at the expense of Treasuries, but HG has lost capital to HY as traditional HG investors added HY risk. In essence, non-traditional capital entered, traditional capital left. Perhaps market segments that haven’t experienced two-way flows may be most vulnerable."
- source CITI Research

In continuation to us voicing our concerns of a potential currency crisis thanks to dollar scarcity in our conversation "The European Catharsis" we remind ourselves the following:
"We expect a "regime change" in FX volatility as well. In fact we voiced our concern with the impact the end of tapering would have in terms of dollar liquidity in June 2013 in our conversation "Singin' in the Rain":
"If the Fed starts draining liquidity, some "big whales" might turn up belly up. Could it be Chinese banks defaulting? Emerging Markets countries defaulting as well due to lack of access to US dollars?

It is a possibility we fathom." - Macronomics, June 2013 

At risk in the LATAM region in the near term is Venezuela which saw its foreign currency reserves fall to an 11-year low of about $20 billion last month. Venezuela and its state-owned oil PDVSA has to make a $5.3 billion in bond payments in October. The country may find itself running out of cash to service debt as soon as next year as foreign reserves continue their downward trajectory to an 11-year low and oil prices continue to fall. When Chavez took over Venezuela oil giant PDVSA employed 51,000 people and produced 63 barrels per employee per day. 15 years later, PDVSA employs 140,000 people and the production per employee has fallen to 20 barrels per day per employee, meaning the country is envisaging importing oil from Algeria according to Reuters.

According to Bloomberg, the country earns about $70 billion a year from oil exports, with total debt service equal to about 25 percent of that amount.

Another candidate prime for "default risk monitoring" is in the High Yield corporate space in Brazil. Back in February 2013 in our conversation "The surge in the Brazilian real versus the US dollar marks the return of the "Double-Decker" funds" we indicated the following:
Brazilian companies have sold the most junk bond on record since May 2011 last Month according to Boris Korby from Bloomberg in his article - Junk Bond Frenzy Poised to Spill Into February: Brazil Credit from the 1st of February:
"Brazilian companies led by Banco do Brasil SA sold the most junk debt since May 2011 last month as unprecedented global demand for high-risk securities enabled the neediest borrowers to chop their financing costs. State-owned Banco do Brasil sold $2 billion of junior subordinated perpetual bonds rated BB by Standard &Poor’s in the nation’s second-largest high-yield sale on record, pacing $4.25 billion of speculative-grade offerings in January. Junk- bond issuance accounted for 81 percent of Brazil’s corporate debt sales, versus 34 percent globally and 18 percent in the country last year, data compiled by Bloomberg show." -source Bloomberg

The reason Brazil High Yield is at risk and US High Yield by contagion is as follows, as indicated by Fitch in their August 2013 note entitled "U.S. High Yield Sensitive to Emerging Market Defaults":
"EM dollar denominated issues total $116.5 billion, or close to 10% of U.S. high yield market volume. The EM total is up from just $65 billion at the end of 2010 with $43.3 billion issued since January 2012. 
The $116.5 billion includes some large issuers that are in distress, including Brazilian oil company OGX (Issuer Default Rating CCC, Negative Outlook, $3.6 billion in bonds).

The largest country concentration in this group is Brazil ($30 billion), followed by Mexico ($16.3 billion) and China ($14.4 billion). The industry makeup of these issues befits their EM source with infrastructure-related and financial bonds representing most outstanding volume. The top sectors include energy ($27.7 billion), banking and finance ($18.0 billion), telecommunication ($11.2 billion), real estate ($11.1 billion) and building and materials ($8.5 billion). The cyclical nature of the industry mix adds to their vulnerability if growth stalls.

The par weighted average recovery rate on the EM issues has been 36.9% of par to date. With the exception of one bond, the affected issues were all unsecured. Of the $116.5 billion in EM bonds currently outstanding, an estimated $95.2 billion is unsecured." - source FITCH

Given Brazilian growth is clearly stalling with Brazil's GDP shranking 0.6% in the second quarter from the previous three months, and first-quarter data was revised to a 0.2% contraction, according to the Brazilian Institute of Geography and Statistics with a growth forecast of 0.48% this year and 1.10% next year, we would indeed watch closely the LATAM space in the coming months.

On a final note given our concerns in relation to a rising US dollar for local EM "players" who have attracted the yield "tourists", we leave you with some Morgan Stanley graphs and comments from their recent FX pulse note entitled "Don't fight the ECB" showing that Low US bond yields have indeed been driven by capital inflows:
"As the Fed has reduced its monthly security purchases, falling US bond yields in an environment of rising local economic activity are the result of US capital inflows. Once US capital demand increases at a faster pace than the increase of global savings into the US, US bond yields should increase. This is when the USD rally should broaden out.
There are direct and indirect effects to observe. Rising USD funding costs will increase the cost of existing USD debt and via the higher USD push the valuation of USD debt higher in local currency terms. Where currencies are still pegged against the USD, the translation into local currency debt funding costs is one to one. But, even where currency pegs have weakened over recent years; USD rates are providing reference indications for local rates. Within pegged or quasi-pegged environments the cost-increasing effect on local debt from rising USD funding costs is most significant. Most Asian and other EM economies fall into this category.

This is simply a function of the external funding requirements of EM economies, which remain heavily skewed to USD denominated funding. 

Exhibit 11 shows current borrowing via tradable bonds issued by EM governments broken down by currency denomination; and shows that with exception of the CEE region, USD-denominated debt dominates. Borrowing by individuals and corporates broken down by FX denomination is also important in assessing FX sensitivity to rate market volatility – however, such data is not available for all currencies under our coverage. That said, we think government borrowing provides a good enough proxy.
- source Morgan Stanley

While we indeed have "Sympathy for the Devil" given the extent of European woes, when it comes to EM dollar sensitivity and a rising US dollar risk, we do indeed find the "Usual Suspects".

"You can fool all the people some of the time, and some of the people all the time, but you cannot fool all the people all the time." - Abraham Lincoln

Stay tuned!

1 comment:

  1. Excellent post. Right on the money!! I would agree that markets are not properly pricing risk. They are also not likely prepared for the Fed to raise rates.


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