Credit - Hungarian Borscht

"A great empire, like a great cake, is most easily diminished at the edges."
Benjamin Franklin

Given Hungary has been our pet subject in relation to the study of systemic risk diagnosis (Modicum of relief):

"A liquidity crisis happens when banks cannot access funding (LTRO helped a lot in preventing a collapse). A solvency crisis can still happen when the loans banks have made turn sour, which implies more capital injections to avoid default (hence the flurry of subordinated bond tenders we have seen). Rising non-performing loans is a cause for concern as well as rising loan-to-deposit ratios."

We thought it would be appropriate, to follow up on our "Hungarian Dances" post with some update on the situation relating to the ongoing stand-off between Hungary and the EU and IMF and, of course, credit conditions.

According to Unicredit and as reported by Bloomberg, Hungary may not obtain aid from the IMF and the European Union before the fourth quarter. It would only happen before that date under severe market drop.

Also reported by Agnes Lovasz, from Bloomberg: East European Deleveraging May Hurt Economic Growth, RBS Says:
"Western European lenders will continue to reduce their eastern exposure to meet stricter regulations, curtailing access to credit and economic growth, Royal Bank of Scotland Group Plc said.

“Distressed deleveraging will likely slow, but European banks are still likely to want to reduce balance sheets,” RBS emerging-markets analysts Timothy Ash and David Petitcolin wrote in an e-mailed note yesterday. “Loan books will continue to shrink in aggregate, which would suggest still a very weak credit growth channel across the region, which will continue to act as a broader drag on growth and recovery.”

Indeed, the ongoing restriction of access to credit is already putting Hungary's economic growth under serious strains as reported by Zoltan Simon in Bloomberg on the 26th of April:

"Hungary faces the rising risk of a credit crunch because of the withdrawal of external funds and the high ratio of non-performing loans, the central bank said.

Lenders replacing external funding with “risky” foreign-currency swaps may be another trigger for a credit crunch and the Magyar Nemzeti Bank will consider regulating such transactions, the rate-setting Monetary Council said in a statement today.

A loan agreement with the European Union and the International Monetary Fund, which Hungary requested in November, may help reduce the probability of a severe credit crunch as it may include the commitment of foreign banks to their Hungarian units, the central bank said. The European Commission authorized Hungary to start bailout talks on the 25th of April. “The risk of a severe credit crunch, mainly in the corporate segment, has increased recently, given the weakening in the banking sector’s lending capacity, in addition to its persistently low willingness to lend,” the Monetary Council said."

Of course the European Union and the IMF have started bailout talks, because, end of the day, the fall of the Hungarian financial system would undoubtedly wreak havoc on Austrian banks and European banks highly exposed to Eastern Europe (Erste Group Bank AG, Raiffeisen Bank International AG, UniCredit SpA, Bayerische Landesbank AG, KBC Groep NV, and Intesa Sanpaolo SpA).

As we have long argued in various conversations, it is after all a game of survival of the fittest. In fact in our conversation "Hungarian Dances", Deutsche Bank already had highlighted the five most vulnerable countries in EMEA in December 2011:
"EMEA dominates our list of the most vulnerable countries. Five countries (Hungary, Ukraine, Romania, Poland, and Egypt) show up as highly vulnerable, though for different reasons. Egypt’s underlying vulnerabilities, for example, are fiscal first and external second. Ukraine’s risks are mostly external. Hungary’s vulnerability reflects a combination of risks in all four areas."

Therefore it wasn't really a surprise to us to learn about the fall of the Romanian center-right government on the 30th of April as political turmoils sank the currency, the Leu. As reported by Irina Savu in Bloomberg:

"The turmoil triggered a sell-off in the country’s currency, which fell to an all-time low against the euro today and may force Romanian policy makers to shield the leu by keeping rates unchanged after lowering borrowing costs one percentage point to boost faltering economic growth."

From the same article:

“Given Romania’s heavy burden of foreign-exchange debt, the exchange rate is a critical factor in the National Bank’s decision process,” Neil Shearing, chief emerging-markets economist at Capital Economics in London, wrote in a note to clients on April 27."

We have heard this story before for Hungary about foreign-exchange debt weighting heavily on households, representing significant headwinds for banks, not only to provide much needed access to the real economy by providing credit, but also hindering in effect the deleveraging process and the healing process of households balance sheet in these countries.

The Romanian Leu depreciated to a record low of 4.4140 per euro in Bucharest, the biggest intraday slum since February 20. Romania secured a 5 billion euro precautionary loan from the IMF and the EU in 2011 to protect it from the debt crisis, triggered by foreign-exchange debt similar to what we have been seeing in Hungary.

We believe a credit crunch is unavoidable in both countries:
"The ratio of non-performing corporate loans reached 17 percent at the end of 2011, a 4 percentage point increase from a year earlier, the central bank said. Including restructured loans, about a quarter of corporate loans were impaired, the bank said. The ratio will probably rise through 2013, the central bank said.
The ratio of non-performing household loans rose to 13.1 percent in 2011 from 9.5 percent in 2010 and will probably peak this year, according to the report." - source Bloomberg, Zoltan Simon - 26th of April 2012.

Hungary Economic Sentiment - Erste Bank indicator - source Bloomberg:

Economic Sentiment indicator deteriorating in Hungary and standing at -19.30.

Rising Non-performing loans in Hungary now at 13.30% - source Bloomberg:

Troubles ahead for Hungarian banks given the rise of Non-performing loans is not accompanied by a rise in provisioning, on the contrary....down to 45% - source Bloomberg:

The ill-fated currency non-performing mortgages plaguing Hungarian households are still rising (in HUF millions) - source Bloomberg:

The impact of the start of the bailouts talks can be seen on both the Hungarian bond markets as well as on Hungary's sovereign CDS market - source Bloomberg.

As well as on EURHUF exchange rate - source Bloomberg:

As a reminder from our conversation "Modicum of Relief", Erste Hungary's lending capacity is deeply impaired by:
-loan-to-deposit ratio of 192%, the highest in the sector.
-the proportion of non-performing loans in the bank's portfolio rose to 20.5% in 2011 from 11.7% in 2010 (The rate in the retail portfolio increased to 16.3% from 11.4%, while the rate in the corporate portfolio climbed to 29% from 12.5%
We argued at the time:
"Rising non-performing loans is a cause for concern as well as rising loan-to-deposit ratios."

Erste Group AG published their results on the 30th of April, and not surprisingly, their results are affected by bad loans in both Hungary and Romania. Erste has therefore cut its outlook as reported by  Boris Groendahl in Bloomberg:
"Erste Group Bank AG said bad loans in Hungary and Romania will remain a drag on profit for longer than it predicted after they cast a pall over first-quarter results at eastern Europe’s second-biggest lender.
Bad debt charges will be about 2 billion euros ($2.7 billion), or about 10 percent more than it predicted Feb. 29, as asset quality continues to worsen in Hungary and Romania, the Vienna-based lender said in slides prepared for an analyst meeting in London today. That also means operating profit will be only stable this year, rather than rising “slightly” from 3.63 billion euros in 2011."

In both countries, about one in four loans on Erste’s Hungarian branch loan book is delinquent. Erste had its first loss since at least 1988 in 2011 because of write-downs in these two countries.

From the same Bloomberg article relating to Erste Bank's results:
"Risk provisions rose 26 percent to 580.6 million euros, more than the 22 percent rise analysts in the Bloomberg survey had estimated. The bank booked extra charges on corporate and real estate loans in Romania, and on Hungarian foreign-currency mortgages. Erste had predicted Feb. 29 that 2012 charges would decline to 1.8 billion euros from 2.27 billion euros last year."
Once again analysts are on the ball...Nice.

The IMF has recently cut Hungary's 2012 economic-growth forecast to zero from 0.3%, predicting a 1.8% growth in 2013. We don't see it happening with unemployment likely to reach 11.5% in 2012 from 11% in 2011. The budget deficit in Hungary may rise to 3.6% in 2013 from 3% in 2012 according to the European Commission, that compares to a target of 2.5% for 2012 and 2.2% in 2013. Was it again a case of "A Deficit Target Too Far"? One has to wonder...

As our good credit friend indicated back in March 2012:
"Credit dynamic is based on Growth! No growth or weak growth can lead to defaults and asset deflation."

In fact the Hungarian government is indeed in a bind and has been resorting to "Argentinian" tricks to bring in much needed revenue. On the 24th of November the Economy Minister Gyorgy Matolcsy nationalised private pensions, in a government drive to bring in 3 trillion forint (14.6 billion dollars), rolling back pension changes as indicated by Zoltan Simon in Bloomberg on the 25th of November:

"Hungary, the most indebted eastern member of the EU, is following the example of Argentina, which in 2001 confiscated about $3.2 billion of pension savings before the country stopped servicing its debt. The government in Buenos Aires nationalized the $24 billion industry two years ago to compensate for falling tax revenue after a 2005 debt restructuring."

Any similarities with actual events will of course be purely fortuitous, as the saying goes...

It is as well not a surprise to hear that recently the Hungarian government has been planning to levy a tax on phone and internet usage as reported by Zoltan Simon in Bloomberg:

"Hungary’s government plans to levy a tax after phone and internet usage, Origo news website reported, citing unidentified people at the Economy Ministry.

The government may raise as much as 50 billion forint ($222 million) from the new tax, which would be part of measures to plug budget holes next year, Origo reported."

Which, of course, led to a big sell-off in Magyar Telekom Nyrt. (MTEL) shares. Hungary’s former phone monopoly fell the most in more than three months after news website Origo reported that the government plans to tax phone and internet usage on the 20th of April.

On a final note, the ongoing delay for Hungary in securing a much needed bail-out funds linked to their ill-fated private sector woes plagued by currency mortgages issued by European banks is choking the economy - source Bloomberg:

"The CHART OF THE DAY shows Hungary’s monetary policy is the most restrictive since at least 2006, after holding the benchmark rate since December. The Monetary Conditions Index for Hungary, which assesses the effect of borrowing costs and currency strength on the economy, is 5.3 percent below its 10-year average, compared with 0.2 percent in the Czech Republic. A negative value shows a tendency toward contraction." - source Bloomberg.

"He who rejects restructuring is the architect of default." - Macronomics.

Stay tuned!

Markets update - Credit - The European Principle of Indifference

"Insanity: doing the same thing over and over again and expecting different results."
Albert Einstein

"In a macroscopic system, at least, it must be assumed that the physical laws which govern the system are not known well enough to predict the outcome. As observed some centuries ago by John Arbuthnot (in the preface of Of the Laws of Chance, 1692):

It is impossible for a Die, with such determin'd force and direction, not to fall on such determin'd side, only I don't know the force and direction which makes it fall on such determin'd side, and therefore I call it Chance, which is nothing but the want of art....
Given enough time and resources, there is no fundamental reason to suppose that suitably precise measurements could not be made, which would enable the prediction of the outcome of coins, dice, and cards with high accuracy: Persi Diaconis's work with coin-flipping machines is a practical example of this." - source Wikipedia

The "Principle of insufficient reason" was renamed the "Principle of Indifference" by the economist John Maynard Keynes (1921), who was careful to note that it applies only when there is no knowledge indicating unequal probabilities - source Wikipedia
Keynes was refuted by Frank Ramsey, but this is another story...

As a follow up to our Bayesian thoughts and following the recent Standard and Poor's downgrade of 9 European countries, our Principle of Indifference analogy relates to the European ongoing crisis. It seems our European politicians are applying the principle incorrectly, not only leading to nonsensical results, but as well as to nonsensical decisions (PSI on Greece, EFSF, and more). In this credit conversation, we will discuss collateral damage to our CPDO EFSF, again on Goodwill impairments ("Goodwill Hunting Redux") and more. But before, we go through the nitty-gritty; it is time for a quick Credit Market overview.

The Credit Indices Itraxx overview, slightly better in a quiet European session even after the downgrades - Source Bloomberg:

A fairly quiet day in the credit indices space with US being out. Overall credit indices were tighter while the Securities Markets Programme (courtesy of ECB) was in for the bid on the sovereign bond cash side.
The Itraxx Crossover 5 year index (50 High Yield companies) fell about 16 bps to close around 710 bps and Itraxx Main Europe 5 year index (125 European investment grade names) was tighter as well, around 167 bps, 5 bps tighter.

The liquidity picture in four charts. ECB Overnight Facility, Euro 3 months Libor OIS spread, Itraxx Financial Senior 5 year index, Euro-USD basis swaps level - source Bloomberg:

Still record holding at the ECB's overnight facility earning 0.25%, one more days until the start of a new reserve period on the 18th.

The current European bond picture with more respite for Italy and Spain courtesy of SMP intervention (ECB) - source Bloomberg:

No change on "Flight to quality", with tighter Germany 10 year Government bond still trending towards record lows - Source Bloomberg:

And our interesting disconnect between the 10 year German Bund and the Eurostoxx is still there, (we first noticed this disconnect in our post "Mind the Gap..." - source Bloomberg:

But the most significant movement we saw today was relating to Sovereign CDS, between Ireland and Portugal, a new record 510 bps between both countries - source Bloomberg:

Ireland 5 year CDS was at 800 bps on the 27th of September 2011 (see our post"Much ado about nothing").

As a follow up on our conversation "Long hope - Short faith", we were expecting Austria's sovereign CDS to trade wider than France at some point, courtesy of the Austrian banking sector Hungarian issues. Following the downgrade of both countries last Friday, we are getting closer to the point - source Bloomberg:

In relation to our CPDO/EFSF, following up on Friday's action, Standard and Poor's has effectively downgraded the leveraged structure from AAA to AA+.
Back in our "European Flutter" conversation we argued:
"The potential downgrade of both France and the EFSF, would render it useless or far more dangerous as we indicated in our post "Much ado about nothing and CPDO redux in European Style", namely that:
"In a CPDO/leveraged EFSF, when multiple downgrades happen, creating significant widening in spreads/higher interest rates, the loss in NAV can be significant."

This would basically mean, that the more downgrades you get, the more leverage you need in order to make up for the increased shortfall in quality collateral..."

How would a downgrade of a member country affect EFSF? - source EFSF
"There is a credit enhancement structure used under the Framework Agreement which constitutes the EFSF. Therefore a downgrade of a member country would not necessarily lead to a downgrade of EFSF securities."
Time to update the presentation...

Standard and Poor's stated:
"We consider that credit enhancements that would offset what we view as the now-reduced creditworthiness of the EFSF's guarantors and securities backing the EFSF's issues are currently not in place. We have therefore lowered to 'AA+' the issuer credit rating of the EFSF, as well as the issue ratings on its long-term debt securities."

What is the credit enhancement structure?
"In order to ensure the highest possible credit rating, various credit enhancements were put into place:
- an over-guarantee of 120 per cent on each issue.
- an up-front cash reserve which equals the net present value of the margin of the EFSF loan.
- a loan specific cash buffer
Together these credit enhancements ensure that all loans provided by EFSF are backed by guarantees of the highest quality and sufficient liquid resource buffers. The available liquidity is invested in securities of the best quality." - source EFSF

But given's Germany's Supreme Court recent reluctance on increasing the EFSF's firepower without a popular vote, we seriously doubt the credit enhancements expected by Standard and Poor's to reverse their negative outlook will materialise in the near future for the EFSF given:

"Unlike the EFSF, ESM.s structure will comprise paid-in capital, callable capital and guarantees. This therefore means that the ESM would not require the credit enhancements (over-guarantee, cash buffer and cash reserve) that the EFSF requires in order to secure a AAA rating." - source EFSF

We already discussed at length the frailty of the EFSF - "EFSF - If you are in trouble - double".

- source EFSF

Could EFSF be considered as a Collateralized Debt Obligation (CDO)? - source EFSF
"No, EFSF is not a CDO. The essential difference between EFSF and a CDO is that EFSF debt has no tranche structure. There is no seniority and all investors have exactly the same rights. Secondly, EFSF bonds are covered by the guarantees from the euro area countries. However, a triple-AAA rating from all three leading credit rating agencies is not assigned lightly. EFSF has put into place additional credit enhancements through the use of a cash reserve and loan specific cash buffer which are immediately deducted from the loan made to a borrowing country in order to provide additional reassurance to investors. Consequently, all claims on the EFSF are 100% covered by AAA guarantors and cash."

We would have to agree, the EFSF is not a CDO, it is worse. More akin to a CPDO, and given it has no tranche structure and no seniority, as we argued previously "the loss in NAV can be significant", suffices to say, it can just be binary.

Following up on BayernLB's goodwill impairments discussed in our "Bayesian Thoughts", we forgot to mention BBVA which took a Goodwill impairment charge of 1.5 billion euros, which according to CreditSights counter-intuitively helps improve its regulatory capital by generating an immediate tax credit:

"The 400 million Euros tax credit is offset against current taxation and relates to a gross goodwill impairment charge of about 1.5 billion euros rather than 1.1 billion euros, because of rounding differences. 400 million euros equates to an increase in retained earnings flowing into Core Tier One versus the retained earnings that would have been achieved without the goodwill impairment of the tax credit. This is because the gross impairment of 1.5 billion euros does not affect Core Tier 1, since all outstanding goodwill is already discounted in the regulatory number, even though in accounting terms, shareholders'equity will be negatively affected on the balance sheet. The benefit in ratio terms is 14-15 bps worth of Core Tier 1(which stood at euros 25,979 million at 30 September under the EBA Criteria).

Our understanding is that BBVA will be able to offset this against tax payable for the whole of 2011. Although a tax charge is accrued quarterly in the P&L, it is actually paid on an annual basis, so the lack of sufficient pre-tax earnings in the fourth quarter alone should not prevent the group from offsetting the 400 millions euros against the tax that will be payable on the full-year 2011 earnings."

So, no earnings mean no Goodwill impairment impact on earnings and a convenient tax credit in conjunction with an improved regulatory capital.

So yes, "Tracking goodwill impairments will indeed be a necessary exercise in 2012 as they can take a real chunk out of bank earnings in the process."
Indeed an interesting exercise in 2012.

Although Swedbank wasn't as lucky as BBVA, given, according to CreditSights:

"Swedbank: SEK 1.9 (215 millions euros) billion Latvian Goodwill Impairment in Q4 2011, a 49% impairment on the total goodwill of SEK 3,870 millions. The goodwill write-down will make a dent in Swedbank's FY11 profits when it reports on 14 February, but the size is manageable. Latvia remains a key market for Swedbank, but although economic growth revived in 2011, it is likely to show signs of slowdown in 2012."

On a final note, we leave you with Bloomberg Chart of the Day - "Collateral Damage’ to EFSF Fund":

Jan. 16 (Bloomberg) -- "Standard & Poor’s Jan. 13 downgrade of nine euro-area countries, including France and Italy, risks blunting trust in Europe’s main weapon against the debt crisis. The CHART OF THE DAY shows the zone’s average rating, calculated by Bloomberg from the three main evaluators’assessments, worsened to 3.56, implying three grades below the top level, from 3.27 on Dec. 31. The average is calculated by assigning each grading a number, with 1 as the top rating, and adjusting it for each country’s share in the bailout fund called the European Financial Stability Facility."

"In individuals, insanity is rare; but in groups, parties, nations and epochs, it is the rule."
Friedrich Nietzsche

Stay tuned!

Markets update - Credit - The Hungarian dances

"Learn from yesterday, live for today, hope for tomorrow. The important thing is not to stop questioning."
Albert Einstein

In a continuation of our previous analogy to the European flutter, as we enter 2012, the recent evolutions of the situation in Hungary which we discussed in our post "Mind the Gap...", warrant us this time around to ramble around how reminiscent the collapse of the Austro-Hungarian dual monarchy and empire (1867–1918) is with our European flutter. Could Hungary be the trigger in 2012? Before we enter yet another long credit conversation, for a change this time around, before our market overview, it is of importance to highlight the current situation in Hungary and contagion to Central Eastern Europe.

Back in October in our post "Long hope - Short faith" we discussed the worrisome Hungarian situation, which was also the main subject of our conversation "Leda and the (Greek) Swan and why Europe matters more for Emerging Markets".

We previously quoted an article by Geoffrey T. Smith from the Wall Street Journal on the subject and as we move into 2012, it will be paramount to monitor the risk of wholesale capital flight with the ongoing buildup of tensions in Hungary - "Austria Has a Déjà Vu Moment":

"the biggest threat to Austrian banks is still what it was in 2009—wholesale capital flight from emerging Europe."

On the 4th of January, Hungary's 5 year sovereign CDS widened by 65 bps, quoted 690-730 bps in the market, with limited liquidity and the CDS curve inverting in the process, meaning short dated protection is becoming more expensive than the 5 year point. We have seen this happening before with Greece, Portugal and others. The situation warrants caution as the Hungarian effect is spreading to other countries according to a market maker, spreading to Poland and Czech sovereign CDS, both trading wider in the process, Poland around 290 bps for the 5 year CDS and around 180 bps for Czech CDS 5 year.

As indicated by Simon Foxman in Business Insider article - Hungary's Currency Hits New Lows Amid More Signs Of Upheaval:
"The Hungarian forint weakened to its lowest value against the euro since last month—near its lowest level ever—at 319.4 amid worries that the political situation there is becoming untenable. Increasing attention is being paid to the small Eastern European country, at the center of Europe's other debt crisis.

The Hungarian government is running short on cash after it passed a law last week that could compromise the independence of its central bank. That law flaunted guidance from the European Union and the International Monetary Fund, who provided the troubled country with €20 billion ($26 billion) a bailout back in 2008. Hungary is paying through the nose to borrow even short-term funding, and the cost of insuring Hungarian debt via credit default swaps hit a new record, at 655 basis points according to Bloomberg. It paid yields of 7.67% to borrow for a three-month term and raise 45 billion forint ($190 million) yesterday.

Domestic turbulence is complicating matters, with protestors taking to the street to protest the government's new constitution (which includes that controversial central bank law). According to the BBC, protests are focusing on three major issues:

·A clause that defends the "intellectual and spiritual unity of the nation," which opponents argue could result in repression of intellectual freedoms

·Inclusion of social issues like the right of the unborn child and the definition of marriage as a union between a man and a woman

·Changes to the electoral system which could empower the leading Fidesz party at the expense of the opposition

Popular support for the Fidesz party hit 18% in a December opinion poll cited by the BBC, although it still leads other parties. If the Hungarian government were unable to pay its bills, it could wreck the Austrian banking system, which has an estimated $226 billion in exposure to Eastern Europe and €1.14 trillion ($1.6 trillion) of assets held in the region. 10-year yields on Austrian government bonds—and indicator of stress on the country—are moving sharply higher this morning. They rose to 3.20%, the highest level since before a central bank stilled their rise earlier in the year."

At the time of our November conversation "Mind the Gap...", we reminded the new legislation which passed by the Hungarian government in relation to the ill-fated currency mortgages which burden Hungarian households:
"Under the new legislation borrowers can repay their mortgage in a single installment at a HUF/CHF rate of 180 or a HUF/EUR rate of 250. Current FX rates are around 239 for HUF/CHF and HUF/EUR is around 297, a 25% and 16% discount according to CreditSights."
In November we commented:
HUF/EUR rate was 297 at the time, and is now much higher (315), meaning losses for European banks and in particular the likes of Austrian Erste Bank exposed to these mortgages will be significantly higher - source Bloomberg. Given HUF/EUR is reaching new highs, Austrian banks exposed to these mortgages face significant additional losses. So yes, contagion to EM, and in particular Central Eastern Europe, which was highlighted as a key risk for 2011, is indeed starting to materialise early in 2012.

But before we delve more into the Hungarian dances (as a reference to the 21 lively Hungarian dance tunes by Johannes Brahms), and discuss some of our previous call for concerns, it is time for a quick market overview.

The 36 months LTRO set up on the 21st of December by the ECB is far from having the expected results in relation to alleviating concerns that banks will use the cheap funding provided to generate generous positive carry by buying peripheral bonds. 455 billion euros are deposited at the ECB earning a paltry 0.50% of interest for now - The liquidity picture in four charts. ECB Overnight Facility, Euro 3 months Libor OIS spread, Itraxx Financial Senior 5 year index, Euro-USD basis swaps level - source Bloomberg:

The Credit Indices Itraxx overview - Source Bloomberg:

Most credit indices remain in the "concern" area, with Itraxx Financial Subordinate 5 year CDS index around 530 bps, still indicating the unsecured subordinated financial market is shut down, while Itraxx Financial Senior 5 year CDS index is rising again towards the 300 bps in a very thin market. As indicated by a market maker, so far both clients and dealers are on the sidelines. The Itraxx SOVx index tied to 15 European Government sovereign CDS is on the rise as well getting closer towards its 385 record set up on the 25th of November. Similar story to what we wrote in January 2010, "European problems not going away in 2011", and not going away in 2012.

The current European bond picture, a story of ongoing volatility, with Spain now rising as well with Italy following recent news of regional funding issues in Spain (Valencia) - source Bloomberg:

So what about our CPDO EFSF? It seems French yields are now rising faster as we start a new year, Investors demanded a yield of 3.29% on the 3.25% OAT due in October 2021, last auction on 1st of December was 3.18% - source Bloomberg:

German 10 year government yield falling (flight to quality) while German 5 years sovereign CDS rising - source Bloomberg:

In relation to the deflation story still playing out in Europe, here is an update on 30 year Swiss bond yields now below 1%, nearly 100 bps lower than Japan 30 year bond yields - source Bloomberg:

But back to our main story, namely the Hungarian situation and contagion to Emerging Markets (EMEA).

During various credit conversations, we argued that the name of the game is survival of the fittest in the race to raise much needed capital. It seems Deutsche Bank is sharing our views as indicated in their Emerging Markets special publications published on the 6th of December entitled amusingly "Survival of the fittest":
EMEA dominates our list of the most vulnerable countries. Five countries (Hungary, Ukraine, Romania, Poland, and Egypt) show up as highly vulnerable, though for different reasons. Egypt’s underlying vulnerabilities, for example, are fiscal first and external second. Ukraine’s risks are mostly external. Hungary’s vulnerability reflects a combination of risks in all four areas."

According to Deutsche Bank, for 2012, EMEA countries will be facing many difficulties and will need IMF support:

"Current account balances have improved in the last few years and central banks have been able to build bigger buffers of foreign reserves. But the large stock of external debt accumulated during the middle of the last decade still leaves the region with large external burden. Much of this borrowing took place in foreign currencies – Swiss franc mortgages in Hungary (20% of GDP) being just one example – the local currency burden of which is now being inflated as those currencies come under pressure. With these debts needing to be serviced on an ongoing basis, many countries still face large external financing needs even as their current account positions have improved. This is particularly true of Hungary and Ukraine, which have gross external financing needs of 30% of GDP or above in 2012 despite a moderate current account deficit in Ukraine and a small surplus in Hungary."

IMF support?

"Three of these countries (Hungary, Ukraine and Egypt) may well need to tap the IMF for financial support next year. Ukraine already has an IMF program (of which USD 12bn or 6.5% of GDP is potentially still available) but is currently looking first to Russia for cheaper gas prices to reduce its external financing needs. Hungary is seeking the reassurance of a precautionary IMF program although negotiation on the policy condition has not yet started and could well be difficult. Egypt had reached agreement in principle on a USD 3bn (1.2% of GDP) arrangement with the IMF but has yet to proceed with the deal for political reasons."

In our conversation "Leda and the (Greek) Swan and why Europe matters more for Emerging Markets", we already discussed at length the Western Europe banking deleveraging impact will have on Emerging Markets and in particular Central Eastern Europe. In their December note, Deutsche Bank also commented:

"The buildup of foreign currency debt was probably largely a reflection of relatively high and volatile inflation in some cases, leading to a large spread between domestic and foreign interest rates. But the availability of foreign currency loans was also facilitated by the rapid expansion of western European banks throughout much of the region. This has left many countries exposed to deleveraging by foreign banks as they seek to meet additional capital requirements imposed by the European Banking Authority. These requirements are largest for Greek, Italian, and Spanish banks, which may be a concern for Romania and Hungary (as well as Croatia, Serbia, and Bulgaria outside our sample) where Greek and Italian banks are most active. But other banks may also be reluctant to maintain their exposures in the region. Germany’s Commerzbank, for example, has indicated that it will temporarily suspend new lending outside of Germany and Poland. Austria’s central bank has also imposed limits on new lending in CEE by the subsidiaries of Austrian banks. And countries without strong parent-subsidiary ownership linkages are also unlikely to be immune. Turkish banks, for example, have substantially increased their short term external borrowing in the last couple of years (from foreign banks) and may face some difficulties in rolling these loans."

As indicated by Deutsche Bank, given Hungary exports to the euro area account for 40% of GDP, Hungary is arguably more exposed to a recession in Europe. The recent failed Hungarian auction and additional pressure on the Forint is definitely not helping.

And my good credit friend to comment on the 5th of January:

"The Hungarian Forint is under pressure again (EurHuf @ 321.50), and the country had problem raising 1 year T-Bills this morning (35 billion HUF instead of the 45 billion planned, the average yield rose to 9.96% versus 7.91% for the same kind of maturity on December 22nd). The cost of insuring Hungary’s debt through CDS reached an all-time high at 750 bps!

Basically, the country is now in a worst situation than Portugal, and without the IMF and EU assistance, the risk of a hard default is rising very quickly. Consequences for European banks exposed to this country are difficult to assess, but Erste Bank, Raiffeisen and some other players should suffer…"

And suffer they already have, not only with the legislation capping the exchange rate on currency mortgages provided to Hungarian households (putting them in a difficult situation) we mentioned above but, also in relation to Goodwill impairments (which we discussed in our conversation "Goodwill Hunting Redux").
As a reminder:

"Erste Bank in fact, wrote down the value of its Hungarian and Romanian units by a combined 939 million euros in October."

"UniCredit wrote down goodwill on assets in its home market, eastern Europe and former Soviet Union countries in its third-quarter earnings report in November (8.7 billion-euro impairment charge)".

It wasn't therefore a big surprise to us and our good credit friend to see a decline of 37% of UniCredit shares in three days following its 7.5 billion right issues priced with a 43% discount (selling shares for 1.943 euros each...).

Back in November in our Goodwill conversation we made the following warning:
"Tip for “banks’ friends”: First came dividends cuts, then bonds haircuts. Next, we will see some massive write-off (Goodwill ?). UniCredit started, others will follow. The path will be very painful for both shareholders and bondholders."


Given we already know that UniCredit made 60 billion USD worth of acquisition between 2005 and 2008, tracking goodwill impairments will indeed be a necessary exercise in 2012 as they can take a real chunk out of bank earnings in the process.

In relation to current bank exposure to Hungary, Deutsche Bank in their latest Hungarian sovereign risk review published on the 6th of December indicated the following:

"During the past days the Hungarian sovereign risk exposure has increased
significantly, taking the development of CDS prices as an indicator. Austrian banks have material exposure to Hungary, both via sovereign bonds and through loans. Erste Group has a total of EUR11bn in assets invested in Hungary (some EUR8bn in loans, some EUR3bn in sovereign exposure) while Raiffeisen Bank International has a total of EUR8bn in Hungarian assets (some EUR6bn in loans, some EUR2bn in sovereign exposure.
According to latest EBA data, as of 30 Sept 2011 the largest European banks have a total sovereign exposure of EUR31bn vis-a-vis Hungary. The data indicates the largest absolute exposures (combined net trading and banking book) are held by KBC with EUR6.9bn (of which EUR2.6bn was due within 3 months, so might have left the balance sheet by now), OTP with EUR4.2bn, Erste Group with EUR3.3bn, BayernLB with EUR2.2bn, Commerzbank with EUR2.0bn, Intesa with EUR1.7bn, ING with EUR1.7bn, RBI with EUR1.6bn. In some cases the maturity profile in the EBA spreadsheet was biased to short-term exposures, in some cases biased towards long-term exposures.
In relation to current market cap, high ratios result for KBC (c.220%), Erste Group (c.70%), RBI (c.40%) and Commerzbank (c.30%). A haircut on Hungarian sovereign exposure therefore would have meaningful implications for these institutions."

Continuing on the same Hungarian theme in Deutsche Bank EMEA Daily Compass published on the 6th of December, we have to agree with their assessment of the situation for Hungary:
"The failure of yesterday’s a12M bill auction has ignited fears that the situation in Hungary may spiral into a solvency crisis triggered by an inability to roll-over upcoming LOCAL debt maturities.
From a medium term perspective, a useful rule of thumb for assessing debt sustainability is to compare the marginal real yield required to roll-over the existing stock of debt and the real growth rate of the economy Over the past 10 years, real growth has averaged 2.4% y/y while yearly inflation stood on average at 5.9%, which suggests that at the current blended (local and external) marginal rate of refinancing (10.5%), a consistent fiscal primary surplus of 2.2% would be required to maintain current public debt levels stable. It is clear to us that such a theoretical outcome is not credible for the market, i.e. paradoxically yields have reached a level that is too high to motivate buyers to participate in the financing of an issuer that is running an unsustainable debt position."

Deutsche Bank to conclude their note making the following point:
"As a conclusion, we expect events to unfold rather quickly in Hungary. It may come down to a choice between a partial loss of sovereignty in economic management or of a debt restructuring, to be made at the highest political level."

And has clearly indicated by Bloomberg's Chart of the day of the 4th of January, we have seen this movie before...

"Hungary’s failure to secure an international bailout has pushed the cost of insuring its debt against default above that of Ireland for the first time since September 2010.
The CHART OF THE DAY shows that credit-default swaps on Hungary rose to 720 basis points in London on the 3rd of January, compared with 709 for Ireland, according to CMA, which is owned by CME Group Inc. and compiles prices quoted by dealers in the privately negotiated market.

Hungary’s default swaps surged to the highest on record on the third of January and the forint weakened to an all-time low versus the euro after Citigroup Inc. said an International Monetary Fund deal is unlikely in the next six months and European Commission spokesman Olivier Bailly said the European Union has no plans to resume aid talks."

"When there's uncertainty they always think there's another shoe to fall. There is no other shoe to fall."
Kenneth Lay - CEO and chairman of Enron from 1985 until his resignation on January 23, 2002.

Stay tuned!

Markets update - Credit - Long hope - Short faith, Hungary and Bank Recapitalization

“A good solution applied with vigor now is better than a perfect
solution applied ten minutes later.”
General George S. Patton

Call it a bear squeeze or a short squeeze, the action today in the credit space is clearly pointing to short covering with some players capitulating and forced to cover their short positions in both Corporate Single names CDS as well as in some credit indices.
Regardless of how you call it, given the short bias of the street, some got hurt pretty bad probably today, not helping their profit and loss trading account in the process.

So yes, another long post, looking slightly at the periphery with Hungarian mortgages and approaching the hot subject of Bank recapitalization and the somewhat apparent issue of raising equity.

Here is the market overview for Itraxx Credit indices in the European space - Source Bloomberg:

Itraxx Crossover CDS index 5 year of 50 High Yield names tighter by 23 bps on the day to around 746 bps.
Itraxx Main Europe CDS index 5 year (Investment Grade) tighter by 5.5 bps to around 173 bps.
Itraxx Financial Senior CDS index 5 year closed the day tighter by 8 bps to around 233 bps and the Itraxx Financial Subordinate Index declined 16 bps to around 468 bps.
Itraxx Main Europe 5 year CDS index (Investment Grade) versus Itraxx Crossover 5 year CDS index (High Yield):

Slightly better between both indices from the widest point.

Letting off the gas in the credit space, European Gas companies an example of the tightening move in the single name CDS space:

Source CMA

The Liquidity picture - Source Bloomberg:

Some improvement. Keep in mind the drop in the level of deposits at the ECB is due to the start of the new reserve period as of yesterday (September reserve period was shorter at 28 days). Also we learned today that the ECB had lent 1.4 billion USD to 6 European banks for three months at a fixed rate of 1.09%. One bank was also allotted 500 million dollars in its weekly operation, reason being and we know from our previous credit conversations as reminded by Bloomberg: "European banks need dollars to fund their own lending in the U.S. as well as to clients elsewhere doing business in the world’s leading reserve currency."

So all in all, we have, Itraxx Financial Senior 5 year index falling, Eurostoxx rising with German Bund 10 year bond yield above 2%, Volatility falling in the process - Source Bloomberg:

As you can see Eurostoxx and German Bund yield moving in lockstep, as there is a reduction in the flight to quality mode.

Germany Sovereign 5 year CDS level and German 10 year bond yield, from divergence to convergence - Source Bloomberg:

In the Emerging Markets Bond Yield space we also have a significant tightening wove. We discussed previously the sell-off in Emerging debt in the post "Markets update - Credit - Anterograde and Retrograde amnesia" - JP Morgan EMBI Global Diversified - Source Bloomberg:
The J.P.Morgan Emerging Markets Bond Index Global ("EMBI Global") tracks total returns for traded external debt instruments in the emerging markets:

And in relation to the SOVX Western Europe 5 year CDS index versus the SOVx CEEMA (Central Europe and Middle-East and Africa) we have complete convergence currently as both trade roughly at the same levels - Source Bloomberg:

But what I have been following more closely in the Sovereign CDS space for the last couple of months is the relationship between France Sovereign 5 year CDS and Austria 5 year Sovereign CDS:

Why did it catch my attention? Because I am expecting Austria's sovereign CDS to trade wider than France at some point, given the exposure of Austria's banking sector to Eastern Europe and in particular Hungary where a new law has been passed allowing foreign currency mortgages borrowers in Hungary to repay their loans at a fixed exchange rate with large discounts to current FX market rates, which will trigger losses to Austrian Banks.
According to an article from CreditSights from the 11th of October relating to Erste bank in particular and Hungary in general:
"With subsidiaries of foreign banks accounting to 80% of the banking system, the bulk of the losses will be suffered by western European banks. These include Erste Bank, Raiffeisen Bank International, Intesa, Unicredit, Bayerische Landesbank and KBC."
Under the new legislation borrowers can repay their mortgage in a single instalment at a HUF/CHF rate of 180 or a HUF/EUR rate of 250. Current FX rates are around 239 for HUF/CHF and HUF/EUR is around 297, a 25% and 16% discount according to CreditSights.

And the losses are significant, according to Boris Groendahl in Bloomberg on the 10th of October:
"Erste Group Bank AG, eastern Europe’s second-biggest lender, fell the most in more than two years in Vienna trading after saying that it expects to post a full-year loss of 800 million euros ($1.1 billion) this year.
Erste wrote down the value of its Hungarian and Romanian units by a combined 939 million euros, the Vienna-based bank said in a statement today. Erste won’t pay a dividend for 2011 and shelved for at least a year a plan to repay 1.2 billion euros of aid from the Austria government."
Ouch...

And Boris Groendahl in Bloomberg adding:
"Erste is writing off its remaining 312 million euros of goodwill in Hungary and made additional bad-debt provisions of 450 million euros. The lender will also inject 600 million euros of fresh capital into its business, Hungary’s fourth-biggest bank."

And about the mortgage relating problems in Hungary this is what CreditSights had to say in their report in relation to the size of the problem and the deleveraging needed:
"For several years now, the widespread practice in Hungary of mortgage borrowers taking out loans in foreign currencies, predominantly the Swiss franc, has seemed like an accident waiting to happen."
And we know it did...

CreditSights size up the problem:
"With foreign currency mortgages accounting for roughly 75% of total mortgage loans in Hungary on a system-wide basis (of which 80% are in Swiss francs), this will result in some losses for the banks."

And CreditSights to add:
"Based on the latest disclosure by Erste Bank, it appears that the proportion of mortgage lending in foreign currency is even higher for foreign banks than the 75% system average, reaching about 100% in the cases of Erste Bank and Raiffeisen International."
The two largest Austrian banks and CreditSights estimates the impact could be significant as the 10% to 30% of mortgage borrowers could take advantage of the new legislation covering mortgages issued before 2009.
CreditSights estimates under three scenarios (10%, 20% and 30%) pre-tax losses, as a percentage of the banks consolidated, annualised 1H11 pre-tax profit ranging from 6.6% for Erste Bank (10% scenario) to 19.7% (30% scenario) and 2% to 6% for Raiffeisen International.

And CreditSights to conclude:
"Although the specific damage from the FX mortgage legislation looks containable, the legislation casts wider doubt on contract enforceability in the system in the context of a difficult economy, which is likely to lead to other impairments."
So, when the economic situation change, the government can indeed, change the rules...

But another interesting item from the CreditSights article was relating to the CDS exposure for Erste:
"180 million euros P&L reclassification of CDS protection written by the bank, to account for it in the derivatives category, instead of classifying the CDS as financial guarantees. This followed a clarification from the IASB (International Accounting Standards Board), that, in order to use the guarantee classification and avoid marking contracts to market, a protection seller would have to suffer a loss on an underlying reference instrument. The CDS book largely relates to Western European sovereigns and amounts to between 2 billion euros and 2.5 billion euros. Some of this in periphery countries, but total sovereign exposure (including derivatives) to Greece, Portugal, Spain, Ireland and Italy is down to 0.6 billion at 3Q11, from 1.9 billion at FY10, within which the Greece/Portugal component has been reduced to just 10 million euros. Management pointed out that the CDS book was built up prior to the euro zone sovereign crisis as a risk diversification trade to compensate for Erste Bank's concentration in Central and Eastern Europe. The recognition of formerly unrealised losses accumulated from prior years in Available-for-Sale reserves in shareholders' equity leads to simultaneous adjustments of 310 million euros to regulatory capital, or 460 million euros to shareholders' equity in the balance sheet."
So to compensate for Eastern Europe exposure, Erste bank sold CDS protection on Western Europe countries prior to the European sovereign crisis. No comment.

And that leads me to the intense discussions on the subject of banks recapitalization in Europe as the EBA (European Banking Association) is discussing plans for banks to maintain a 9% Core Tier 1 Capital benchmark.
According to Bloomberg article from Ben Moshinsky and Aaron Kirchfeld:
"Nine percent of core capital based on EBA definitions may be roughly equivalent to the 7 percent of reserves that lenders will be obliged to hold from 2019 under measures agreed last year by the Basel Committee on Banking Supervision."
As a reminder, in July, the EBA stress test required Core Tier 1 threshold was put at 5%, 1% lower than the 2010 level of the EBA stress test at 6%.

So where the money is going to come from?

In relation to discussions surrounding Capital Regulation, contrary to many beliefs, Bank Equity is not expensive. It is a myth.
A study realised by Stanford University by Anat R. Admati is a must read and available here:
"Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Expensive"

Anat R. Admati is a professor of finance and economics at Stanford University and the co-author of “Fallacies, Irrelevant Facts and Myths in the Discussion of Capital Regulation: Why Bank Equity Is Not Expensive.”

and a summary of the presentation made to the Bank of England by the co-author is available here, a must read:
http://www.bankofengland.co.uk/publications/events/ccbs_workshop2011/presentation_admati.pdf

"Historical Facts About Bank Capital
• In 1840, equity funded over 50% of bank assets in US.
• Over the subsequent century equity ratios declined
consistently to single digits.
• There is evidence that steps to enhance “safety net”
contributed to this. In the US
– National Banking Act, 1863
– Creation of the Fed, 1914
– Creation of FDIC, 1933.
• Similar trends in UK, Germany. More trading business.
• Bank equity did not have limited liability everywhere
in the US until 1940s!"

Banks have fought bitterly against increasing equity buffers which is the cheapest and easiest way to recapitalize banks.

Why? because allowing high payouts to shareholders, namely bank employees in many cases, allows financial institutions to raise their leverage.

The author of the study Anat R. Admati voiced her opinion on the 25th of February in the following Bloomberg article:

"Fed Runs Scared With Boost to Bank Dividends: Anat R. Admati"

"In 1994, the Financial Accounting Standards Board wanted executive stock options to be expensed to reflect their actual cost. Industry opponents threatened that doing so would prevent entrepreneurial firms from obtaining financing, impede growth and reduce U.S. competitiveness.

Massive lobbying forced the board to back off. A decade later, after WorldCom Inc., Enron Corp. and other corporate scandals, the political atmosphere was different, and the FASB finally changed the rules. Since 2006, all companies must treat executive options as an expense. And the doom and gloom we were promised? There is no evidence that expensing options had any negative economic consequences."

and Anat Admati to comment:
"Like homeowners who took a mortgage with little down payments, when banks are highly leveraged, their equity can be easily wiped out by small declines in asset values. If 95 percent of a bank’s assets are funded with debt, even a 3 percent decline in the asset value raises concerns about solvency and can lead to disruption, the need to “deleverage” by liquidating inefficiently, and possible contagion through the interconnected system. As we have seen, this can have severe consequences for the economy."

Source - Anat Admati - http://www.bankofengland.co.uk/publications/events/ccbs_workshop2011/presentation_admati.pdf

"While equity is used extensively to fund productive business, bankers hate to use it. With more equity, banks have to “own” not only the upside but also more of the downside of the risks they take. They have to provide a cushion at their own expense to reduce the risk of default, rather than rely on insurers and eventually taxpayers to protect them and their creditors if things don’t work out.

Fixation with return on equity also contributes to bankers’ love of leverage because higher leverage mechanically increases ROE, whether or not true value is generated. This is because higher leverage increases the risk of equity, and thus its required return. Focus on ROE is also a reason bankers find hybrid securities, such as debt that converts to equity under some conditions, more attractive than equity."

Source - Anat Admati - http://www.bankofengland.co.uk/publications/events/ccbs_workshop2011/presentation_admati.pdf

“More equity… would restrict [banks’] ability to provide
loans to the rest of the economy. This reduces growth and
has negative effects for all.” Josef Ackermann, CEO of
Deutsche Bank (Nov. 20, 2009).
Wrong...

Anat Admati concluded her Bloomberg column by adding:
"The muddled debate on capital regulation has left us with only minor tweaks to flawed regulations, even after banks’ catastrophic failure in the crisis and the lasting consequences for the economy. The proposed solutions that regulators in the U.S. are focused on, such as resolution mechanisms, bail-ins, contingent capital and living wills, are based on false hopes. They can’t be relied on to prevent a crisis. Increasing equity funding is simpler and better than these pie-in-the-sky ideas."

And why do banks need more regulations and larger equity capital buffer?

The answer is given to us by Simon Jonhson, who served as chief economist at the International Monetary Fund in 2007 and 2008, and is now a Massachusetts Institute of Technology professor and a senior fellow at the Peterson Institute for International Economics in the following Bloomberg article - "Low Bank Capital Is Next Fiscal Crisis":
"Why was the financial crisis so devastating to the real economy? The answer is that, in large part, financial firms had become so highly leveraged, meaning they had very little real equity relative to their assets. This was a great way to boost profits during the economic boom, but when the markets turned, high leverage meant either that firms failed or had to be bailed out. Many financial firms in trouble at the same time means systemic crisis and a deep recession. In effect, a financial system with dangerously low capital levels creates a nontransparent contingent liability for the U.S. budget through the fall in GDP and loss of tax revenue."

Source - Anat Admati - http://www.bankofengland.co.uk/publications/events/ccbs_workshop2011/presentation_admati.pdf

For more on the subject:
"Procyclical bank risk-taking and the lender of last resort" - Mark Mink © voxEU.org

"Providing banks with liquidity support thus effectively allows them to use maturity transformation as a means to lower their borrowing costs, without worrying too much about the higher illiquidity risk.

Through reducing banks’ borrowing costs, the prospect of receiving liquidity support also stimulates forms of bank risk-taking other than maturity transformation. First, it provides banks with an incentive to increase their leverage, i.e. to use more debt and less equity to finance their activities. Doing so, however, comes at the risk of a small decline in asset value being sufficient to wipe out banks’ equity buffers and cause them to become insolvent."

"A leader is a dealer in hope."
Napoleon Bonaparte

So yes, markets are indeed long "false" hopes and most likely, short faith, or short leaders, or both.

Stay Tuned!