Credit - The Donk bet

"There are three roads to ruin; women, gambling and technicians. The most pleasant is with women, the quickest is with gambling, but the surest is with technicians." - Georges Pompidou, former French president (1969-1974)

While watching the much anticipated LTROs refund on Friday, as well as the economic data during the week  with the rebound of the European PMI which we had anticipated (France being an outlier, but, our readers  know it doesn't come to us as a surprise), Spain's Economy Minister Luis de Guindos took center stage for us on Friday by declaring on Bloomberg TV: "Spain doesn't need any sort of bailout", adding that the target for the budget shortfall this year is "achievable" and concluding his remarks by "The perception of the Spanish economy has improved and will continue to do so over the next weeks and months". 

Given last week's title analogy referred to poker games in general and the art of bluffing in particular, we thought we had to use yet another poker game reference in our title namely the "Donk bet".

 The "Donk bet" being:

1. A bet made by a donk, i.e. one that is generally considered weak or to demonstrate inexperience or lack of understanding of strategy.
2. A bet made in early position by a player who didn't take initiative in the previous betting round. It was named because this move is often considered indicative of a weak player (since it is more often reasonable to expect a continuation bet). - source Wikipedia

It seems to us that Spain's Economy Minister has not fully demonstrated his understanding of the "Fabian Strategy" of Mario Draghi. Our "Generous Gambler" has been trying to "call the clock" (using another poker game reference) on Spain  namely trying to discourage them to take a long time to act.

We would therefore "agree to disagree" with Mr de Guindos given Spain pose the biggest threat to the survival of the Euro. In fact the Spanish Misery index has beaten Greece as the crisis bites and unemployment has reached 26.60% as indicated by Bloomberg:

The European Commission prediction for Spain’s budget shortfall last year is already wider than the EU’s goal of 6.3 % of gross domestic product. The target for 2013 is 4.5 %...

We quoted in our conversation "Agree to Disagree" Henry Queuille. Henri Queuille was the epitome for "professional politician": he served three times as Prime Minister and was 21 times minister in a French government under the IIIrd and IVth French Republic. He was the symbol of the inefficiency and the failure of the French IVth Republic:

"Politics is not the art of solving problems, but to silence those who ask." - Henri Queuille

It appears to us that Mr de Guindos is indeed a true disciple of Henri Queuille when we listened to his latest Bloomberg interview. As a matter of Spanish "quote" comparison, BBVA's Chief Operating Officer Angel Cano said in April 2010 that asset quality was probably going to be "stable from now on". Looking how "stable nonperforming loans have in been in Spain, one can wonder whether or not a Henri Queuille award should be set up in Europe for the best delusional political quote, but, we ramble again...

So in true poker fashion, one can posit "there's indeed plenty of action in this game". In this week's conversation we will therefore look at what lies ahead for the Spanish banking sector in general and Spain's real economy in particular in conjunction with the LTRO impact of the early refund. But first a quick credit overview.

US PMI versus Europe PMI - source Bloomberg

"Short term, we do expect a minor reduction in the divergence as reflected in credit prices such as the US leveraged loan cash price index versus its European peer." - Macronomics, The Fabian Strategy, 5th of January 2013

We explained the divergence in our conversation "Growth divergence between the USA and Europe" and we indicated early January that this divergence should persist in 2013. 

The uncanning similarity of the US leveraged loan cash price index versus its European peer with the above PMI graph - source Bloomberg:

"Loan prices have risen to 97.72 cents on the dollar, the highest since July 2007, from 59 cents in December 2008, as concern eases that the world’s largest economy will slide back into recession. Leveraged loans and high-yield, high-risk bonds are rated below Baa3 at Moody’s Investors Service and lower than BBB- at S&P." - source Bloomberg.

The current European bond picture with the continuing fall in Spanish and Italian yields with rising Core European yields - source Bloomberg:

In relation to our "Flight to quality" picture, Germany's 10 year Government bond yields have been recently rising above 1.60% and the 5 year CDS spread for Germany has been rising in tandem in the process - source Bloomberg:

2 year German bond yields versus 2 year Japanese yields, yet another "sucker punch" courtesy of the LTRO's refund anticipations. From 0% yield to 0.23% in January 2013 - source Bloomberg:

Credit and volatility wise, the Itraxx Crossover index (representing the credit risk gauge for 50 European high yield entities) have as well falling in tandem but with volatility (a subject we recently touched on) breaking through important levels similar to the regime of 2004-2007 - source Bloomberg.

Credit wise, what really caught our attention was not only the "new regime" in volatility (or should we say Central Banks' dictatorship via "financial repression"), but, the US High Yield space, where Tenet Healthcare has issued a 7 year bond with a single "B" rating with a coupon of 4.25%, which is an "all time low" level for a primary yield level on a single "B" credit on a 7 year bond.  

As we have discussed in our first credit conversation of the year "The Fabian Strategy", we don't believe the hype in credit and as we argued in our conversation "Hooke's law" previously the "credit mouse-trap" has been set by Central Banks. Well done...

We also recently reflexionate around the return of mega leveraged buyout transactions such as DELL inc  in our recent conversation "The return of LBOs - For whom the Dell tolls".  Record low borrowing costs in the market for junk bonds (high yield) where LBOs are financed is creating the ideal set up for a leverage buyout   buying spree: "There will be about $135 billion in LBO volume this year, compared with an average of $100 billion during the past two years, and below the $600 billion annual peak of 2006 and 2007, he said. Credit-default swaps typically surge on LBO speculation because the debt added to a company’s balance sheet to fund the takeover erodes its credit quality and leads to ratings downgrades. 
“As the recent experience with Dell illustrates, the risk of LBOs has a particularly large impact” on Markit’s investment-grade benchmark, pushing it a net 2 basis points wider, Bank of America’s Mikkelsen and Yuriy Shchuchinov wrote in a Jan. 23 note. Their model shows 14 percent of the index’s underlying credits are feasible LBO candidates. 
 Credit-default swaps on Quest Diagnostics have climbed 38.5 basis points to a mid-price of 123 basis points since Bloomberg News first reported Dell’s buyout discussions with private- equity firms, according to data provider CMA, which is owned by McGraw-Hill Cos. and compiles prices quoted by dealers in the privately negotiated market. 
Buying Protection:   
That was “precipitated by investors’ buying protection on names that have traditionally been considered LBO candidates,” following the Dell news, according to a note dated Jan. 23 from Barclays Plc analysts led by Shubhomoy Mukherjee. Credit-default swaps tied to Nabors surged 42 basis points to 191, the highest since July, and contracts on Avnet Inc.’s debt climbed as high as 254 basis points on Jan. 14 before falling to 178 basis points yesterday, CMA data show. Those on Falls Church, Virginia-based Computer Sciences Corp. added 40.5 basis points since Jan. 11 to 193 yesterday. Buyout firms announced a record $1.6 trillion of acquisitions from 2005 to 2007. The end of that era was “quite painful for many overleveraged deals and many PE firms and their investors have continued their long wait to reach that point where they can exit and take their gains,” CreditSights Inc. analysts Glenn Reynolds and Ping Zhao wrote in a note."  - source Bloomberg - Dell Lifts Default Risk on Next Buyout Targets: Credit Markets.

Could that be another indication of a "Donk bet" taking place in the credit space? We wonder...

As we have argued last week's Dell LBO conversation:
"One thing for sure with which we clearly agree on with CreditSights, is that the yield curve management policies of the Fed is clearly pushing investors into higher risk assets to reach for return in this "Yield Famine" induced environment of "Financial Repression" (probably out of their comfort zone too...)."

Moving on to the Spanish "Donk bet", no disrespect to Mr de Guindos and Mr Cano but we will have to agree with Citi's recent note on Spanish Banks - Iberoamerican Big Picture from the 21st of January:
"A change in the latest asset quality deterioration trend is needed for the sustainability of the banking system. If at a system level we maintain the loan contraction and the NPL growth during the next 5 quarters, the NPL ratio for the corporate segment would increase to 29.1% in 4Q13E from 16.6% in 3Q12. As expected the key drivers of the NPL growth will be the construction and the real estate sectors" - source Citi

"Just as an example, if we maintain the yoy loan contraction and the NPL growth during the next 5 quarters, the NPL ratio for the corporate segment would go from 16.6% in 3Q12 to 29.1% in 4Q13E. Just keeping the contraction deleverage pace stable pace with the stock of NPLs, the NPL ratio would increase to 18%." - source CITI

So much for "stability Mr Cano. So much for "improvement Mr de Guindos.

In last week's conversation "Cool Hand" we discussed the Bank of Spain's recent willingness in stemming the  war for deposits taking place in Spain:
"By trying to put an end to the deposit wars, the Bank of Spain ambitions to reduce the pressure on banks' earnings and profitability which would reduce the capital shortfall for some Spanish banks and the level of capital injunctions needed. It is once again a "Fabian strategy", buying time that is."

Citi's recent note on that matter is as follows:
"On 8 January 2012, the Spanish press reported that the Bank of Spain had “recommended” the largest banks in Spain to limit the yield of saving products. Other banks followed shortly. The measure apparently would also affect guaranteed funds and commercial paper products. The penalty for high yield deposits would consist of higher capital requirements, which would not affect foreign banks operating in the country (ie Banco Espirito Santo, ING). 

The press sources differ in the way the penalty is going to work, given the lack of official statements from Bank of Spain, the interpretation of the law can vary significantly. We expect a law to regulate this “recommendation” shortly. The Bank of Spain has taken this measure in order to reduce the cost of funding for the banks, which are expected to transfer part of this reduction to lower lending rates. We have to take into account that, according to the 3Q12 results, banks are already reducing the yield of loans after the repricing cycle during 2012. 

How do we understand the new recommendation? It will apply to the new savings production from banks — 85% of the new production of the banks won’t be able to exceed the yield limits set in the table below (Figure 4). The banks exceeding this limit will need to comply with higher core capital requirements, according to the press up to 125bps more from the current 9.0% requirement. The latest reports point out that the deposits above €10 million won’t be affected by the new requirement, supporting big corporate and public deposit accounts." - source CITI

The larger than expected EUR 137.2 billion initial repayment from the first three year LTRO (consensus was for 84 billion), we will have to wait until mid-march to get the geographical breakdown from National Central Banks in order to assess the complete picture for European countries.

But some Spanish banks such as Banco Sabadell indicated on the 11th of January, that the bank was planning to repay EUR 4.8 billion of LTRO funding (20% of the total requested) according to Citi's note.

As far as profitability for Spanish banks is concerned, as indicated by Citi's note:
"Given that the last LTRO was already announced in February 2012, it should be fully included in analysts’ estimates, reducing revenues expectations for 2015. Below we can find the revenue consensus estimates of our coverage universe. It is not only that revenues seem high, in our view, it is also that consensus seems to be missing the LTRO effect in 2015 revenue estimates, as they are expected to grow by 7% on average (ex Santander and BBVA)." - source Citi

An interesting analysis from Citi, while there are not missing out on the LTRO impact on earnings, we think they are lacking some essential points in relation to Spanish banks.

-First missing point - the issue of puttable bonds which we discussed in our conversation "When causation implies correlation":
"Banco Santander SA, Spain’s biggest lender, is placing its trust in bondholders by issuing 4.4 billion euros ($5.7 billion) of fixed-income securities that investors are able to redeem before maturity.
Bonds with put options make up 36 percent of Santander’s debt funding this year, compared with 9 percent in 2011, according to data compiled by Bloomberg. While the bonds have lower interest rates, they leave the bank vulnerable to a potential 7 percent increase in the 33.4 billion euros it must repay next year. Investors have already demanded early repayment on 1 billion euros of the notes." - source Bloomberg
Puttable bonds are indeed a typical instrument used by financial institutions under stress. For us, a big red flag." - source Macronomics, When causation implies correlation, 27th of October 2012

-Second missing point - the issue of the dwindling capacity in absorbing potential losses at the parent bank due to partial IPOs discussed in the same October conversation:
Another red flag we think for Santander, comes from its dwindling capacity in absorbing potential losses at the parent bank by its increasing policy of partial IPOs such as the one done in Mexico as indicated by CreditSights in their report Spanish Banks - The Value of Empires from the 22nd of October:
"In Santander's case especially, the capacity of equity in its foreign subsidiaries to absorb potential losses at the parent bank is being reduced by its policy of partial IPOs(the goal being to list all the most significant subsidiaries within five years – see Santander: Partial IPO in Mexico). The erosion of loss absorbing capacity that this implies at parent or group level is reflected in the Basel 3 reform that will ultimately prevent banks from including in consolidated CET1 capital any surplus equity contributed by minorities in excess of the subsidiaries' minimum regulatory requirements." - source CreditSights" 

-Third missing point being one of Macronomics's favourite namely the importance of "Goodwill" (see our conversation from November 2011 - "Goodwill Hunting Redux"):
"Large Goodwill Impairments increase the debt to equity ratio.
It is therefore paramount to track goodwill impairments in relation to future banks earnings."

Goodwill:
"Goodwill is an accounting convention that represents the amount paid for an acquisition over and above its book value. Under the accounting rules European banks use, the International Financial Reporting Standards, companies have to write down goodwill on their balance sheets if the underlying assets have permanently deteriorated in value."

In December 2010 ("Goodwill Hunting - The rise in Goodwill impairments on Banks Balance Sheet"), this is what we discussed as a reminder:

"When a bank acquires another one, goodwill as intangible asset goes on its balance sheet. When a medium bank acquires a smaller one, goodwill is created onto the balance sheet. But, when the medium bank is acquired by a larger one, there is a compounding effect given that the larger bank will also create some more goodwill of its own and therefore inflates its balance sheet.

As the process goes on and on, for banks on the acquisition war path, you find more and more goodwill making up the capital."

We also indicated at the time:

"Looking at non-cash intangible assets (i.e., goodwill) can be a good indicator and used as a proxy to determine the health of banks.

The significance of the write-downs on Goodwill is often presaged as rough waters ahead. These losses often take a real bite out of corporate earnings. It is therefore very important to track the level of these write-downs to gauge the risk in earnings reported for banks."

When one looks at European banks, Spanish bank Santander, Credit Agricole and Italian bank Intesa are carrying the most "Goodwill" as indicated in the table below from Bloomberg:

"A mere 5% of the 800 billion euros of outstanding goodwill was impaired in 2011, with about 19.2 billion (2.4%) relating to financial services, according to an analysis of 235 public European companies by the European Securities and Markets Authority. The top 24 European banks' combined goodwill fell to 173 billion euros at FY07, from a 2007 peak of 233 billion euros, with further impairments likely." - source Bloomberg.

In relation to the "real economy" in Spain and the on-going "Donk bet", Spanish recession has deepened in the last quarter of 2012 with GDP contracting 0.6% from the previous 6 months when it slipped 0.3%. So while Spanish Economy Minister Mr de Guindos is seeing an improvement in the perception of the Spanish economy, there is a difference between perception and reality. Even the European Commission on the 22nd of January indicated Spain would miss its 2012 deficit target. with a GDP contraction forecast of 1.4%, taking the deficit to 6% for 2013, not the "ambitious" 4.5% Mr de Guindos seems so sure of.

What matters is loan growth for economic growth to resume in Spain. We do not see it happening in 2013 for the "real economy" - graph below source Citi:

As indicated in the article from Charles Penty in Bloomberg from the 21st of January 2013 entitled - "Spain Banks selling debt still won't cut loan costs:
"The prospect of diminishing competition for retail deposits may boost lending margins. Reports that the Bank of Spain wants lenders to cap the yields they offer on deposits are positive for banks because it would provide relief for their funding costs and bolster margins, Sergio Gamez, an analyst at Bank of America Merrill Lynch, wrote in a Jan. 10 note to clients. Bank behavior may make it hard for Spain to rejuvenate an economy mired in a five-year slump and headed for a further contraction this year, said Tobias Blattner, an economist at Daiwa Capital Markets in London. Spain’s economy will shrink 1.5 percent this year after contracting 1.4 percent in 2012, according to the median forecast of 38 analysts surveyed by Bloomberg. “The interest rates that banks are charging to lend to companies aren’t going down and that’s a big worry,” Blattner said. “There are no signs yet of a pass-through by banks of their lower funding costs to the real economy.”" - source Bloomberg

We hate sounding like a broken record but, no credit, no loan growth, no loan growth, no economic growth and no reduction of aforementioned budget deficits:
"So austerity measures in conjunction with loan book contractions will lead unfortunately to a credit crunch in peripheral countries, seriously putting in jeopardy their economic growth plan and deficit reduction plans."- "Subordinated debt - Love me tender?" - Macronomics, October 2011

From the same Bloomberg article: 
“If they’re using wholesale debt that costs 3 to 4 percent to replace ECB funding that costs 0.75 percent, that means substantial pressure on margins,” Creelan-Sandford said. Banks are trying to wring more revenue from loan books as they seek to absorb the rising cost of a clean-up of 180 billion euros of real estate assets ordered by the government last year, he said. Banks in other nations have dropped their lending rates, ECB data show. German rates declined to 2.9 percent from 3.9 percent a year earlier, while French companies pay 2.2 percent, down from 3.2 percent. In Portugal, the cost of a loan for as much as 1 million euros fell to 6.7 percent from 7.6 percent, while Irish banks charge 4.6 percent, compared with 5.3 percent. Spanish companies are petitioning Prime Minister Mariano Rajoy, who says one of his priorities in government is to create conditions for credit to recover in Spain. The Spanish Confederation of Small and Medium-Sized Companies said in a Jan. 17 statement that it didn’t see “normal” financing conditions returning until 2016 at the earliest and that the lack of funding put firms in a “situation of extreme weakness.” - source Bloomberg

It is deflation in Europe and Spain is still mired in a deflationary spiral. 

On a final note the VIX volatility index passed the 5 year level as Bank CDS fall further as indicated in the Bloomberg chart from the 21st of January:

"The VIX Index, a widely-used measure of market risk often called the investor fear gauge, fell to its lowest level in more than five years as macroeconomic concerns, including those regarding the U.S. fiscal cliff, recede. Certain bank revenue streams remain correlated to volatility, with lower volatility increasing demand for risky assets, pressuring prices higher, and vice versa." - source Bloomberg

"There is no gambling like politics." -   Benjamin Disraeli, British statesman

Stay tuned!

Credit - The year of the empty hand

"Men occasionally stumble over the truth, but most of them pick themselves up and hurry off as if nothing had happened." - Winston Churchill

"This is the year of the empty hand 
Oh you hold on to what you can 
And charity is a coat you wear twice a year 

These are the days of the guilty man 
Your television takes a stand 
And you find that what was over there is over here"
George Michael - Praying For Time

"emp·ty-hand·ed (mpt-hndd) adj.
1. Bearing nothing.
2. Having received or gained nothing."
source the American Heritage Dictionary

While we recently looked into Spain's record surge in Nonperforming loans making a comparison with storm surges and Hurricane Sandy versus the 1991 "Perfect Storm", and looking at the epic performance in credit pointing towards a record year in similar fashion to 2009 (performance now close to 11% in Total Return), we thought this week we would be using part of the lyrics from George Michael's 1990's single hit "Praying for Time" for our title. James Hunter of Rolling Stone magazine described the song as "a distraught look at the world's astounding woundedness".We think our title is appropriate given the astounding woundedness caused by Balance Sheet Recessions (BSR). Looking back at the level of support provided in Europe to the financial system in conjunction with drastic austerity measures for some, the performance in the financial credit space has been epic while yielding no benefits to the real economy. The irony of our chosen title lies in the extraordinary returns for credit in 2012 with admittedly a very clear disconnect with valuations and fundamentals which we discussed last week and as indicated by the below graph from BNP Paribas:

Expensive credit markets you think? You bet!

But, given the on-going "Yield Famine" in the credit space, the theme in the cash market remains the same. Investors are underinvested and full of cash, and with the latest pause in issuance in the corporate space, there is technically no natural supply. As a market maker commented recently on this market context:

"So bonds remain bid and it is difficult to buy bonds even as corporate cash looks expensive. CDS remains quiet but generally feels a little weak in low beta."

In this week conversation, we will look at how to play credit in a deleveraging environment, as well as the upcoming pain for Spanish junior subordinated bondholders and we will finish with the future for credit returns after a record year for the asset class.

In a world facing "Yield Famine" and "River of No Returns" courtesy of a deleveraging environment, what is the investment recipe one should follow?

"All real-world investors face funding constraints such as leverage constraints and margin requirements, and these constraints influence investors’ required returns across securities and over time. Consistent with the idea that investors prefer unleveraged risky assets to leveraged safe assets, which goes back to Black (1972), we find empirically that portfolios of high-beta assets have lower alphas and Sharpe ratios than portfolios of low-beta assets. The security market line is not only flatter than predicted by the standard CAPM for U.S. equities (as reported by Black, Jensen, and Scholes (1972)), but we also find this relative flatness in 18 of 19 international equity markets, in Treasury markets, for corporate bonds sorted by maturity and by rating, and in futures markets." - source Betting Against Beta, Andrea Frazzini and Lasse H. Pedersen - October 9, 2011.

"These are the days of the beggars and the choosers" - George Michael - Praying For Time

The BAB factor (Betting Against Beta) explain the returns of some investors such as Warren Buffett:

"Leveraged buyout funds and Warren Buffett’s firm Berkshire Hathaway, both of whom have access to leverage, buy stocks with betas below 1 on average, another prediction of the model (BAB). Hence, these investors may be taking advantage of the BAB effect by applying leverage to safe assets and being compensated by investors facing borrowing constraints who take the other side. Buffett bets against beta as Fisher Black believed one should". - source Betting Against Beta, Andrea Frazzini and Lasse H. Pedersen - October 9, 2011.

The on-going forced deleveraging for large parts of the European financial system, which have been "begging" for liquidity and provided vast amounts of it, courtesy of our "Generous Gambler" aka Mario Draghi, is no doubt a golden opportunity for cash rich "choosers".

"And you find that what was over there is over here" - George Michael - Praying For Time

Europe is indeed finding out that the deleveraging (which has started earlier in the US) is accelerating over here in Europe hence the tremendous deflationary forces at play and the traumatic effect on the real economy with the EBA (European Banking Association) forcing banks to reach a target of 9% of Core Tier 1 capital in June 2012 in conjunction with austerity measures and unrealistic deficit targets but we ramble again...

As we reminded ourselves in our previous conversation Chadburn, on Full Ahead?:
"One of the most important indicator we think in relation to our Credit Chadburn and the growth divergence between the US and Europe is the evolution of the Loans-to-Deposit ratio progress."

The growing divergence between US and European PMI indexes - source Bloomberg:

US PMI versus Europe PMI from 2008 onwards.

Which as we pointed out recently, this growth difference can be seen in the credit prices between the USA and Europe. The divergence of growth between the US economy and the European economy is reflected in credit prices such as the US leveraged loan cash price index versus its European peer - source Bloomberg:

For Europe, the deflationary forces at play are tremendous. When looking at Spain, one can see the correlation of rising unemployment and rising nonperforming loans - source Bloomberg:

We could go even further by looking at the evolution of the Spanish misery index (inflation + unemployment) in conjunction with nonperforming loans- source Bloomberg:

As far as the Spanish hurricane is concerned, the amount of funding needed for 2013 is significant - source Bloomberg:

One could as well posit that our title could be a veiled reference to a game of high stake poker being played out in Europe. The beggars are indeed not the choosers when it comes to our chosen title and Europe. Pushing the analogy further, we would like to quote Dr Jochen Felsenheimer from his latest credit letter for November 2012 from credit asset management house "assénagon" :
"There are two games in particular whose mechanism is closed to that of capital market: Poker and chess. The development of recent years sadly suggest that the former has gained the upper hand. The central banks have shown their aces of spades, the European Union is using the Spanish Opening to fight for the center of the euro, investors are checking if they don't have anything in their hand after the flop, and the markets are using the Queen's gambit to bet on the same gameplay being repeated again and again. But there is also the possibility that it will be different this time. The financial markets are facing changes which might change the rules of the game for ever. Traditional investment approaches are about to be superseded and long decades of valid mechanisms will be influenced by new developments."

While the political game being played is a game of Chess (see our conversation "The Game of the Century"), we agree with Dr Jochen Felsenheimer's assertion relating to financial markets being currently a game of high stake poker:
"Having the ace and the king as your hole cards is somewhat disparingly know in Texas hold'em as an "Anna Kournikova" - "looks great but never wins". That describes the current situation in the markets extremely aptly. The markets' first reaction to the concerted action by the ECB (Draghi effect) in combination with the political developments (Spanish banks, ESM, etc.) was, of course, positive. The imminent breaking up has been averted for now, even if the fundamental problems are far from solved. The thin line between austerity and growth will continue to dominate the political discussions in Europe and regulatory measures are limited to a few segments and are seamlessly merging into the tradition of combating the symptoms, while the causes largely persist. The European monetary union's basic problem is due to nothing more than the heterogeneity of the member states. This is just what is causing the current problems - the necessity of transfer payments which are currently reflected in the massive TARGET2 balances. The close ties between the banking sector and governments are not solved by Basel III and a banking union - but only raised to another (European) level. And ultimately the economic environment will continue to represent the greatest challenge, as this makes the elegant escape of "growing out of the crisis" seem highly unlikely. Necessary structural reforms (which are known to take time) and the long-drawn-out reconstruction of the European architecture confirm us in our assumption that we are currently on the "Japanese path". And this is more similar to the Way of St. James than a walk in the park."

Indeed, European politicians have been praying for time, we think, and so is the Spanish financial  system!

The Spanish bad bank SAREB will have between 45 billion euros and 90 billion euros in assets. The estimated of assets to be transferred to SAREB taking into account Group 1 of banks (BFA-Bankia, Catalunya Banc, Novagalicia Banco and Banco de Valencia) is 45 billion euro. The average haircut for the transferred assets is between 46% and 63% based on Oliver Wyman's baseline scenario plus an additional discount. What amounts, we think, into wishful thinking from the Spanish government is that it ambitions to keep its stake in the structure below the 50% threshold so that SAREB stays private and Spain's public accounts are not affected and to avoid taking a hit on its public debt level. What caught our attention is that the Spanish government is already facing "mutiny" in the sense that BBVA has already balked at investing into the bad bank. Angelo Cano, BBVA's CEO has already voiced is concern and said last Wednesday he had no interest in investing in the bad bank in true Banker's algorithm fashion:
"When the system receives a request for resources, it runs the Banker's algorithm to determine if it is safe to grant the request. The algorithm is fairly straight forward once the distinction between safe and unsafe states is understood."
Request denied...from BBVA. "We have no real obligation"  - Angelo Cano, BBVA CEO.

Supposedly most of the funding for the SAREB is to come from private investors (8% equity) with an expected ROE of 14-15% (according to FROB). Three main sources of funding are envisaged:

-State-guaranteed senior debt

-Perpetual subordinated debt

-Common equity

Both the perpetual debt and the common equity will be subscribed in part by the restructuring Spanish fund FROB (Fund for the Orderly Restructuring of the Banking Sector) but with a majority subscribed supposedly by private investors.

Why has the request has been denied by BBVA, simply because of pending provisions to comply with the two RDLs (Royal Decrees relating to real-estate provisioning for banks) as displayed in the Exane BNP Paribas table below from their recent report on the Spanish Bad Bank SAREB from the 30th of October:

Only 31% of provisions have already been booked by BBVA, hence the rejection...

As far as losses are projected in relation to real estates exposure (all credit - performing or not - + foreclosed) - RD1 + RD2 versus Oliver Wyman's adverse scenario versus the Bad Bank Sareb and Deutsche Bank estimates versus NAMA, the below table from Deutsche Bank indicate the expected losses:

"Hanging on to hope when there is no hope to speak of" - George Michael - Praying For Time

Hanging on hope is exactly what Banco Popular Espanol junior subordinated boundholders are hanging onto. They are counting on being rescued by the Spanish lender's equity investors from avoiding being wiped out on 6.4 billion USD of junior debt as reported by Estaban Duarte from Bloomberg on the 1st of November in his article -  Popular Bond Wipe-Out in Shareholder Hands:
"The bank wants to raise as much as 2.5 billion euros ($3.2 billion) in shares to avoid seeking state aid that would trigger losses on subordinated bonds under European Union rules. Popular’s 5.702 percent junior notes due 2019 rose 15.8 percent in the past month to 7O cents on the euro, according to Bloomberg prices, compared with an average 1.93 percent increase for securities in the Bank of America Merrill Lynch Euro Financial Subordinated & Lower Tier-2 Index. Failure to raise funds through a share sale could mean Popular having to conduct a restructuring under the eyes of regulators, cap salaries and dispose of assets. The lender is a victim of Spain’s real estate collapse, failing the latest government stress tests which revealed the Madrid-based lender has a 3.22 billion-euro capital shortfall. “The share sale is the last hope for Popular subordinated bondholders since a failure would mean that the state would have to step in,” said Ignacio Victoriano, head of fixed-income at Renta 4 SGIIC, which manages 1.5 billion euros of assets including some Popular subordinated bonds. “We are confident that they will get the deal done.”" - source Bloomberg.

We " agree" to disagree", with the above statement from Ignacio Victoriano and we would rather side with the comment from Jean-Luc Lepreux, senior bank analyst at Societe Generale SA in Paris from the same Bloomberg article:
"Raising 2.5 billion euros when your market capitalization is 2.6 billion euros will be hard without running the extra mile,” Lepreux said in an interview. “Subordinated debt holders should be prepared to face high haircuts for banks needing public funds, up to 100 percent for fully nationalized institutions."

Banco Popular Espanol share price evolution since 1989- source Bloomberg:

"Popular wants its customers to buy 60 percent of the new shares being offered because Chief Financial Officer Jacobo Gonzalez-Robatto said Oct. 1 that “the bank has enormous goodwill of its customers.” The stock was at 1.20 euros today and has slumped 29 percent since the day before the share-sale announcement on Oct. 1, valuing the lender at 2.6 billion euros.
Bankia followed the same strategy in July last year when it tapped about 347,000 individual investors as it was seeking to boost capital. Bankia stock has fallen almost 70 percent since then.
Popular’s third-quarter profit fell to 75.6 million euros from 98.6 million euros in the same period a year earlier, the lender said Oct. 26. That surpassed the 42 million-euro median estimate in a Bloomberg survey of nine analysts." - source Popular Bond Wipe-Out in Shareholder Hands, Bloomberg.

As far as asset quality is concerned for Banco Popular in general, and Banco Popular's shareholders in particular, Banco Popular has still some significant provisions to book based on the two RDLs (4.9 billion euro) as reported by Nomura on their recent note on Banco Popular:

"Popular still has significant provisions to book based on the new legislation introduced this year of c.EUR 4.9bn. These provisions, plus additional ones highlighted by management, making a total of EUR 9.3bn will be booked following the upcoming rights issue." - source Nomura

This is exactly how our story is unfolding for junior subordinated bondholders:
"At some point, as we argued recently (Peripheral Banks, Kneecap Recap), losses will have to be taken."

We correctly foresaw this process for weaker peripheral banks.

"First bond tenders, then we will probably see debt to equity swaps for weaker peripheral banks with no access to term funding, leading to significant losses for subordinate bondholders as well as dilution for shareholders in the process." - Macronomics - 20th of November 2011.

"Oh, you hold on to what you can" - George Michael - Praying For Time

Moving on the subject of future returns for credit, it is indeed a question of holding on what you can.

Nomura in their recent Quantitative Strategies update from the 31st of October ask the following important question:
"Will future credit returns be a trick or a treat?"

Following up on the concept of "Betting on Beta" earlier in our conversation, one has to remember these fundamentals concepts when approaching credit as indicated by Nomura's note:
"Many investors understand that what they get from credit exposure depends on how high credit spreads are when they buy.
But relatively few grasp just how high credit spreads have to be to earn decent risk-adjusted returns. Only top-quartile spreads will do- "above-average" -is not good enough as shown below:

Spreads in 2009 were in the top decile, and credit has performed well since then. Spreads today are above-average but not top quartile. Adjusted for regulatory changes, they would probably be even lower.
The trick: average credit returns (stripping out funding and duration) are mediocre, as spreads barely cover the cost of fallen angels or defaults.
The treat: credit returns are semi-predictable, due to their links with trends in corporate fundamentals, rating actions, and business cycles. This makes credit a good fit for systematic long/short strategies.
Balancing carry, momentum and value investment styles to position long/short in credit indices outperforms, with a Sharpe ratio of 1.01." - source Nomura

Is buying and holding an issue in credit? Nomura indicates these empirical elements:
"Long-only credit returns have been poor over time 
In Figure 2 we show the cumulative duration-adjusted excess returns of US corporate bonds since 1997 and the bonds‘ average OAS":

"A long-only investor would have received very little additional return for the extra risk they were taking in this 15-year period. In our paper Making credit beta work for real we show how credit spreads tend not to compensate investors for the costs of fallen angels and defaults – investors sell bonds as they are removed from indices at a substantial loss to par. Even a small number of fallen angels or defaults can wipe out the positive carry from performing names. While there are periods where excess returns are positive, these tend to follow periods of spread widening."

Finally how does one generate future credit returns going forward? Combining long/short strategies makes credit perform as indicated by Nomura:

"A styles-based strategy combining carry, momentum and value to position in a basket of CDS Indices delivers solid returns since 2006. The index has a Sharpe of 1.01, Calmar of 0.92 and skew of 0.86 (vs. long-only Sharpe of 0.36, Calmar of 0.13 and skew of -0.7)." - source Nomura


"Nothing is enough for the man to whom enough is too little." - Epicurus 

Stay tuned!

Credit - The European iterated prisoners' dilemma

"The only possible Nash equilibrium is to always defect. The proof is inductive: one might as well defect on the last turn, since the opponent will not have a chance to punish the player. Therefore, both will defect on the last turn. Thus, the player might as well defect on the second-to-last turn, since the opponent will defect on the last no matter what is done, and so on. The same applies if the game length is unknown but has a known upper limit." - source Wikipedia

In continuation to game theory references, given we recently touched on the subject in our conversation "Agree to Disagree", we thought this time around we would make a reference to the prisoners' dilemna. After all, in Europe, it is all about game theory, given than many pundits are arguing whether Germany will cooperate or not in resolving the on-going European woes, pledging its balance sheet in the process.

In game theory and in relation to our European iterated prisoner's dilemma we have :

"If it is supposed here that each player is only concerned with lessening his time in jail, the game becomes a non-zero sum game where the two players may either assist or betray the other. In the game, the sole worry of the prisoners seems to be increasing his own reward. The interesting symmetry of this problem is that the logical decision leads each to betray the other, even though their individual ‘prize’ would be greater if they cooperated. In the regular version of this game, collaboration is dominated by betrayal, and as a result, the only possible outcome of the game is for both prisoners to betray the other. Regardless of what the other prisoner chooses, one will always gain a greater payoff by betraying the other. Because betrayal is always more beneficial than cooperation, all objective prisoners would seemingly betray the other.

In the extended form game, the game is played over and over, and consequently, both prisoners continuously have an opportunity to penalize the other for the previous decision. If the number of times the game will be played is known, the finite aspect of the game means that by backward induction, the two prisoners will betray each other repeatedly.

In casual usage, the label "prisoner's dilemma" may be applied to situations not strictly matching the formal criteria of the classic or iterative games, for instance, those in which two entities could gain important benefits from cooperating or suffer from the failure to do so, but find it merely difficult or expensive, not necessarily impossible, to coordinate their activities to achieve cooperation." - source Wikipedia.

For now every European politicians in Europe seem to "Agree to Disagree", it looks to us increasingly probable that the outcome could be different to what is expected from Germany. The outcome for the European project is going to be rather binary. It is either "Federalism" or break-up. In fact it is Germany who has always pushed for more integration, more "Federalism". In September 1994 both Karls Lamers and Wolfgang Schauble from the CDU presented their project of accelerated integration to France. It entailed a faster integration within the European Union for Germany, France, Belgium, Luxembourg and Holland. France at the time was under "Cohabitation", Socialist French President Mitterrand had as Prime Minister Edouard Balladur from the opposing party, having lost ruling majority in the parliamentary elections leading to a political stand-off which lasted for two years. The European game is therefore in the political French camp. President François Hollande having garnered a strong political support in the recent parliamentary elections, it will be interesting to watch if French politicians will indeed accept to lose their powers for the collective good, or, if they decide to cling on their individual mandates and powers and a "Federal Europe" will not happen. Will the French surrender again? We dare to ask, staying politically correct in our conversation ("Cheese-eating surrender monkeys", being a derogatory description of French people that was coined in 1995 by Ken Keeler, then-writer for the television series The Simpsons).

Looking at the "social-clientelism" mentality which has prevailed in French politics in the last 30 years, and given the trauma stemming from the European 2005 referendum, one has to posit the French willingness in moving towards a full lasting Federal European Union.

While many are comparing the need for Europe to evolve in a comparable way to the evolution of the United States towards a full Federal Union. We do not have to go that far to find a more relevant example to the current European plight. In fact as our good credit friend mentioned in one of our most recent conversation, he pointed rightfully towards...Switzerland! The Federal Constitution adopted in 1848 is the legal foundation of the modern Swiss federal state. It is among the oldest constitutions in the world.

There are three main governing bodies on the Swiss federal level: the bicameral parliament (legislative), the Federal Council (executive) and the Federal Court (judicial).

Europe already has all three.

"The Swiss Parliament consists of two houses: the Council of States which has 46 representatives (two from each canton and one from each half-canton) who are elected under a system determined by each canton, and the National Council, which consists of 200 members who are elected under a system of proportional representation, depending on the population of each canton. Members of both houses serve for 4 years. When both houses are in joint session, they are known collectively as the Federal Assembly. Through referendums, citizens may challenge any law passed by parliament and through initiatives, introduce amendments to the federal constitution, thus making Switzerland a direct democracy.

The Federal Council constitutes the federal government, directs the federal administration and serves as collective Head of State. It is a collegial body of seven members, elected for a four-year mandate by the Federal Assembly which also exercises oversight over the Council. The President of the Confederation is elected by the Assembly from among the seven members, traditionally in rotation and for a one-year term; the President chairs the government and assumes representative functions. However, the president is a primus inter pares with no additional powers, and remains the head of a department within the administration." - source Wikipedia.

The Swiss cantons also have a permanent constitutional status and, in comparison with the situation in other countries, a high degree of independence. Under the Federal Constitution, all 26 cantons are equal in status (pari-passu...). Each canton has its own constitution, and its own parliament, government and courts. Switzerland also boasts, in similar fashion to the US, a Federal Supreme Court.

So could it be France derailing the whole European project in the end rather than Germany? We wonder.
But we ramble again, erring on the political side. Time for our credit overview, revisiting our pet subject of bond tenders and the ongoing issues in the peripherals, particularly in Spain, given we recently received the results for the Spanish Bank Recapitalisation independent estimate and 62 billion is the number.

"The Gap is closed" we indicated on the 16th of June in relation to the European space. Now both the Eurostoxx and German 10 year Government yields seems to be moving in synch, lower that is while credit spreads for financials as indicated by Itraxx Financial Senior 5 year CDS index is moving wider following rating agencies multiple downgrades and on-going concerns on peripheral sovereign yield levels - Top Graph Eurostoxx 50 (SX5E), Itraxx Financial Senior 5 year CDS index, German Bund (10 year Government bond, GDBR10), bottom graph Eurostoxx 6 month Implied volatility. - source Bloomberg:

The current European bond picture with Spanish and Italian yields on the rise again - source Bloomberg:

Last week Spanish risk premium reached a new historical high breaching easily the 7% level, with renewed concerns on Spanish banks given the rise in Spanish bad loans. (reaching 8.72% in April from 8.37% in March).

As Societe Generale clearly indicated in their recent global research alert, the markets have indeed lost confidence in Spain:

The challenge European leaders face at the 28-29th June summit is to come out with a big plan as indicated in their recent note by Societe Generale: "Comprehensive restructuring of the economy/the banking sector is  required to restore market confidence....due to a rise in national and regional public debt...".

Indeed, Government debt to GDP could reach 90% of GDP in 2012:

"Spain’s budget deficit is expected to end 2012 at 5.3%, vs 8.9% in 2011, so government debt could reach 90% of GDP this year. On top of that, Spain holds a rising amount of regional debt (which has doubled since December 2008) and contingent liabilities, such as the FROB (Fund for Orderly Bank Restructuring). Taking into account these two elements and the current recession in Spain, debt could rapidly reach unsustainable levels." - source Societe Generale.

Unfortunately, Spanish property market and bank restructuring go hand in hand and as many pundits have indicated, Spanish property bubble and deleveraging has yet to start effectively as indicated by the below graph from Societe Generale:

"House prices could decline by a further 20-25% in an adverse scenario (see last week’s results of the independent evaluation of the Spanish banking sector)." - source Societe Generale.

The Spanish Test Assumptions:

The Stress Test Property Assumptions may not be aggressive enough - source Bloomberg:

"A 19.9% yoy drop in Spanish house prices for the adverse scenario could easily be exceeded if confidence is not restored by the recently announced bailout. At 1Q, yoy declines ranged between 7% and 12% depending on the source, while from 1Q08 highs, house price declines total 21%. Should this rate of deterioration continue, the 4.5% 2013 forecast decline may prove conservative." - source Bloomberg.

The results from the independent audit, the Spanish Assumptions at least looks credible for retail, for corporate less so, according to Bloomberg:

"A 6.8% contraction of lending supply for 2012 and 2013 looks reasonable for retail lending when compared with experience through the crisis. A 6.4% and 5.3% decline for corporate loan supply looks far less cautious when considering that January 2012 data showed a 6% yoy drop, before sovereign fears heightened." - source Bloomberg.

Another issue with the results from the Spanish Test Assumptions comes from the GDP worst case scenario retained no lower than 2009 experience as shown by Bloomberg:

"A decline of 4.1% in Spanish GDP for 2012, the adverse scenario used in the stress test, is less severe than the 4.4% yoy drop of 1H09. While this scenario is calculated from a lower absolute GDP base, it is key for bad-debt experience, unemployment and credit supply. Coordinated EU action is needed to drive long-term interest rate assumptions lower." - source Bloomberg.

We do not want to be seen as party spoilers, but as we posited in relation to the numerous EBA (European Banking Association) test for financial institutions, no test, no stress, no stress, no test...

No wonder Spanish Financial CDS has been on widening trend - source CMA:

Unless significant steps are taken in the next European summit, and we mean "shock and awe", given Spain and Italy have significant funding needs until 2014, the game might be coming to an end leading to the defect of some players in the process of our "European iterated prisoners":

- source Societe Generale.

From this similar Societe Generale note, higher loan delinquencies and low industrial production are the main risks:
"Risk 1: Spanish loan delinquencies, back to the 90s
-Spanish bank delinquent loans increased again to 8.72% in April, from 8.37% in March, thereby reaching an 18-year high. This trend is likely to
persist as unemployment and bankruptcies continue to rise.
-Acceleration in number of delinquent loans means Spanish banks are likely to suffer from increasingly larger losses in the future
-Report carried out by two consulting firms estimates Spanish banks' capital shortfall at up to 62bn euros.
Risk 2: European industry deteriorates
-Eurozone industrial production fell 2.3% compared to the same month last year, driven down by the southern Europe countries.
-If the Eurozone fails to undertake the necessary structural reforms, the northern European countries could get drawn into southern Europe’s downward spiral.
-In contrast, US industry has remained quite resilient since the beginning of the year, with total industrial production in May up 4.7 percent yoy."

We will not delve again into the difference between "Stocks and Flows" central to our thought process namely the United States and Europe growth differentiation as we already touched on this subject in our conversation "Growth divergence between US and Europe? It's the credit conditions stupid...".

Moving on to our pet subject of subordinated bond tenders, as at some point, as we argued recently (Peripheral Banks, Kneecap Recap), losses will have to be taken, it is all going Dutch, Dutch auction that is. While ailing Portuguese bank BCP (Banco Comercial Português) announced on the 20th of June a bond tender relating to mortgage backed securities, BBVA bought back some asset-backed bonds too on 26 senior and 25 mezzanine portions of bonds backed by consumer loans, mortgages and business loans, with prices ranging from 46 to 95%. All part of "liability" management exercises to raise some capital and strengthen the capital base, meaning more pain for bondholders in the process.
While the 62 billion being the estimated amount earmarked by independent consultants Oliver Wyman and Roland Berger, burden sharing is currently being considered with the European Union in respect to a 100 billion euro rescue package for the Spanish financial system.

"The government in Madrid is also considering giving more power to the national regulator to restrict sales of loss-absorbing securities such as preferred stock to individuals, said the person. De Guindos has said that preference shares shouldn’t have been sold to retail investors.

Supervisors “failed” over the sale of preference shares to retail investors, said De Guindos June 5 in the Senate.

Spanish lenders sold 22.4 billion euros ($28.2 billion) of preferred stock to individual investors through retail branches. Banks have offered clients holding most of that amount to swap the securities into common stock or other subordinated instruments, according to data compiled by CNMV, the financial markets supervisor." - source Bloomberg

We correctly foresaw this process for weaker peripheral banks.

"First bond tenders, then we will probably see debt to equity swaps for weaker peripheral banks with no access to term funding, leading to significant losses for subordinate bondholders as well as dilution for shareholders in the process." - Macronomics - 20th of November 2011.

We wrote in October 2011 relating to bond tenders and the move towards debt to equity swap:
"We expected others to follow suit and given the difficulty for the weaker players in the peripheral space to access capital at a reasonable rate, as well as needing to boost their core Tier 1 capital base, it was of no surprise to see Portuguese bank Banco Espirito Santo following French bank BPCE in tendering some of its subordinated debt on the 18th of October, but this time around, we have a debt to equity swap."

It is still a game of survival of the fittest, even for some Italian banks, given Monte dei Paschi di Siena (MPS), Italy’s third-biggest bank, according to December 2011 EBA exercise, had a capital shortfall of Euro 3.3 billion. The bank, which must also repay 1.9 billion euros of state aid provided in 2009... Monte Paschi may use the government’s aid program, the so-called Tremonti bond, as part of its plan to boost capital by end of June 2012 (9% Core Tier 1 Capital), Il Sole 24 Ore reported. Also, S and P put MPS’s ratings on Watch Negative citing pressure on the bank’s financial position from a combination of deteriorating asset quality metrics, weakened earnings, and low financial flexibility. Separately, the main shareholder of MPS, the Monte Paschi Foundation has reportedly reached an agreement with its creditor banks to restructure its debt. S and P placed its 'BBB/A-2' L-T and S-T counterparty credit ratings on Italy-based Banca Monte dei Paschi di Siena SpA (MPS) on CreditWatch with negative implications. Agency also put all of its ratings on MPS' subordinated, junior subordinated, and hybrid debt issues on CreditWatch negative. The rating action reflects S and P’s view as the convergence of various negative pressures on MPS' financial profile. Monte Paschi First-Quarter profit fell 61% on higher write downs and has a market value of around 2.8 billion euros. MPS is considering selling its 2.5% stake in the Bank of Italy to the central bank to reach the June 2012 threshold.

As indicated by Bloomberg, Italian corporate and household bad debt totaled 109 billion euros ($138 billion) in April, an increase of 15 percent from a year earlier, according to Bank of Italy data.

Non-performing loans rose to 5.4% in March, up from 3% in June 2008, according to Italian Banking Association data. Impairments, excluding writedowns, rose to 58 billion euros from 50 billion euros. CDS on UniCredit, (Italy's largest bank) rose to 532 basis points on June 19 from 292 on March 19, according to data compiled by Bloomberg.

With unemployment rate at 10.2% in April the highest in most than 12 years, Italian banks as well as their Spanish peers are facing economic deterioration facing but are not plagued by housing related issues and high household private debt levels.

If it could be of any solace to European Banking woes, the new capital regime for US Banks will as well trigger at some point some "liability" management exercises namely bond tenders as indicated by CreditSights in their note - US Banks - The New Capital Regime - Bonjour Basel - 24th of June 2012:

"US banking regulators released proposals for new capital rules for banks aimed at complying with Dodd-Frank Basel III. The new guidelines apply to all US banks with some variations/differences for banks over 50 billion USD in assets and were mostly in-line with expectations.

The new guideline call for higher levels of capital, which could make the financial system safer but also reduce returns and cause banks to reassess their balance sheets. They believe that new requirements fortify the banks’ ability to absorb losses and withstand a potential systemic shock, which is a positive for fixed income investors and both positive and negative for equity.

US banks will now have a new set of minimum capital requirements, incorporate additional capital buffers and limitations outlined in Basel III and phase-out trust preferred securities in accordance with the Dodd-Frank Act. When the new limits are fully phased-in, banks are required to maintain a common equity Tier 1 ratio of 7% and Tier 1 ratio of 8.5%, including a capital conservation buffer of 250 bps. The limitations and changes to risk weights could influence business decisions including lending and mortgage servicing.

Trust preferred securities are phased-out reflecting the requirements of the Dodd-Frank Act.

Non cumulative preferreds continue to receive Tier 1 capital treatment and could make up the majority of non-common equity Tier 1 capital. As a result, they expect issuers and investors to focus primarily on preferreds to address their non-common equity Tier 1 Capital and yield needs, respectively."

On a final note Money Markets wager ECB will cut deposit rate as indicated by a recent Bloomberg Chart of the day:

"The CHART OF THE DAY shows that the Eonia-OIS measure, which estimates interbank borrowing costs over the next three months, fell below the 25 basis points the ECB pays for deposits. The last two times this happened the central bank cut the rate within two weeks." - source Bloomberg

"There are few ironclad rules of diplomacy but to one there is no exception. When an official reports that talks were useful, it can safely be concluded that nothing was accomplished."

John Kenneth Galbraith

Stay Tuned!

Credit - Something Wicked This Way Comes

"Capital as such is not evil; it is its wrong use that is evil. Capital in some form or other will always be needed."
Mahatma Gandhi

Following the passing of great American writer Ray Bradbury today, we thought our credit rambling title had to be a reference to ones of Ray Bradbury's book as a form of tribute to one of our favorite writers. The 1962 novel by Ray Bradbury is about a nightmarish traveling carnival that comes to a Midwestern town one October. Looking at the ongoing nightmarish European carnival's, which has returned earlier this year, one has to wonder if indeed something wicked is coming our way. The carnival's leader in the book is the mysterious "Mr. Dark" who bears a tattoo for each person who, lured by the offer to live out his secret fantasies (markets rumors such as using ESM funding to recapitalized peripheral banks). Each person succumbing to these fairy tales has become bound in service to this (European) carnival of "Mr. Dark".

The book by Ray Bradbury "Something Wicked" has an emphasis on the more serious side of the transition from childhood to adulthood, a point we discussed precisely in our conversation "St Elmo's fire" in relation to our "European carnival" traveling from one member to another, like dominos falling, were we argued: "Looking at the attitude of our "European Brat Pack", one has to wonder if our European Politicians will ever adjust to their respective responsibilities and embrace somewhat adulthood which would in effect determine whether our Saint Elmo's fire evolves towards a positive outcome in Ludovico Ariosto's fashion, (leading to the rise of the Dioscuri), or to the negative association of Saint Elmo's fire, namely disaster and tragedy."

As our good credit friend put it:

"The capital markets have not paid enough attention to various pieces of the global puzzle falling into places, and the true picture is a cause of concern. The overall capital structure of the current financial system is at risk. Financial institutions are in dire need of capital and bailing them out will drag sovereigns (issue of circularity) with them unless policy makers decide to follow a path they have refused so far (following Lehman Brothers bankruptcy). The no-no policy (no loss for bondholders – no loss for shareholders) advocated by Paulson when he was in charge of the Treasury is not valid anymore. Investors will have to take losses if leaders want to save their populations from disaster (Greece is the canary in the coal mine). So shareholders and subordinated debt holders should be wiped out, and senior bonds holders could become the new shareholders if there is not enough capital. How long can leaders still expose their countries to such big risks is unknown, but debt to equity swaps should make the headlines again at some point."

Indeed, it has been a recurring theme of ours in our various conversations, namely that additional pain will have to be inflicted to both bondholders and shareholders. Given the EU proposals for restructuring and managing banks in crisis, something wicked indeed is coming this way, at least towards financial bondholders and shareholders. As ECB President Mario Draghi asked clearly today, the ESM (the permanent EU bailout fund) is not currently set up to be a shareholder in banks:

"Do we want an ESM that is a shareholder in banks?"

So, in this conversation we will review the need for capital which cannot be resolved by liquidity injections alone and the recent Bank Bail-ins proposal. At some point, as our good credit friend put it, losses will have to be taken.

But before we go through this important subject, it is time for a quick credit overview.

The Itraxx CDS indices picture on Friday - source Bloomberg:

Today had a positive "short covering" tone in the credit space with Itraxx Crossover 5 year CDS index (50 European High Yield entities - High Yield credit risk gauge) tightening significantly by 27 bps on the day. The SOVx index representing the CDS gauge risk for 15 Western European countries (Cyprus replaced Greece recently in the index) remains at elevated levels around 321 bps and so does the Itraxx Financial Senior Index while tighter by 13 bps on the day, a further indication of the existing correlation between financial and sovereign risk.

Itraxx SOVx index versus Itraxx Financial Senior 5 year CDS (senior unsecured financial risk gauge) - source Bloomberg:

We presented the issue of circularity indicated by Martin Sibileau in our conversation "The Daughters of Danaus":

"The circular reasoning therefore resides in that the recapitalization of banks by their sovereigns increases the sovereign deficits, lowering the value of their liabilities, generating further losses to the same banks, which would again need more capital."

We also argued at the time:
"As far as the Danaides punishment/Circularity issues goe, the Spanish banking woes threaten to cancel out austerity benefits meaning that we will not see meaningful reduction of deficits due to this vicious circle and deflation trap Spain is victim of."

Of course, most Spanish banks are in favor of seeking European funds given neither the banking system nor the government can afford to absorb the losses. As reported by Charles Penty in  Bloomberg in his article "Spain Bankers Backing EU Aid Highlight Doubts on State Finances", according to Santiago Lopez, an analyst at Exane BNP Paribas in a May 29 report:

"Spain’s financial system may still need 45 billion euros in taxpayer money, including 30 billion euros to clean up three previously nationalized banks and 15 billion euros for other lenders."

On top of that, from the same article:
"JPMorgan’s estimate that Spain may need a bailout costing as much as 350 billion euros."

Today's price action in the European Bond Space saw Spanish yields receding towards 6.28%, remaining elevated and a cause for concern in Spain's ability to access funding which it will attempt on the 7th of June for 2016 and 2022 bond auctions. France and Germany saw their yields widen respectively by 8 bps and 12 bps - source Bloomberg:

The "Flight to quality" picture as indicated by Germany's 10 year Government bond yields (well below 1.50% yield) with 5 years Germany Sovereign CDS slightly above 100 bps - source Bloomberg:

Moving on to the subject of capital raising needs, Spanish banks which have suffered rating downgrades (Bankia and Bankinter downgraded to junk by Standard and Poor's on the 25th of May) as well as rising funding costs face a 43 billion euro funding hole according to analysts, warning that they might not be able to roll over covered bonds (secured by pools of prime loans) that mature in the next 18 months according to Bloomberg in their article 'Spanish Banks Face Covered Bond Funding Squeeze" from the 1st of June:

"The seven largest Spanish banks -- Banco Santander SA, Banco Bilbao Vizcaya Argentaria SA, Banco De Sabadell SA, Bankinter SA, Banco Popular Espanol SA and Banco Espanol De Credito SA --with a total of 171.4 billion euros ($211.5 billion) in outstanding covered bond debt, have 43 billion euros maturing over the next 18 months, according to data compiled by Bloomberg.
No benchmark-sized public covered bond from a Spanish issuer has been sold for 10 weeks, and further issuance is unlikely in the near-term, according to analysts. Issuance in the first five
months of 2012 is at 36 percent of the total for 2011, according to figures from Leef Dierks, head of covered bond strategy at Morgan Stanley."

In relation to Spanish covered bonds, the secondary markets has been on the receiving end as far as Spanish banking woes are concerned as indicated by the same article:

"The issue-weighted average price of 348 Spanish covered bonds stood at 92.15 cents on the euro on May 30. Even the strongest issuers have seen their covered bonds fall in value. Banco Santander SA’s 4.5 percent covered bond maturing in July 2016 has declined to 98.37 cents on the euro from 101.65 in May. The asset-swap spread traded up to 350 basis points over mid- swaps on May 29, a near-one percentage point increase in the month and 47 basis points higher than its previous high on Dec. 2, 2011."

But it isn't only access to the most senior part of the bank capital structure which is proving difficult for Spanish banks. The access to the senior unsecured market is as well proving more and more elusive for Spanish banks:

Still below 2011 levels as indicated by Bloomberg, but another cause for concern:

"Since recovering to above par in March, the mid-yield on senior unsecured debt for Spain's two largest banks has risen steadily. Though still below November highs, sustained elevated yields will drive up the cost of refinancing. Bloomberg data show the two banks have 28.6 billions of euro-denominated senior unsecured debt maturing by 2014."

At the same time EU Banks withdrew 37 billion dollars of Interbank Support from Spanish banks according to Bloomberg:

"EU interbank exposure to Spain's banking system fell $37 billion dollars during 4Q11. Though liquidity fears were temporarily relieved by two ECB LTRO facilities, Bankia's troubles have driven unsecured funding costs higher. Should the withdrawal of interbank capacity continue faster than Spanish banks can deleverage, significant funding problems may return." - source Bloomberg.

Something Wicked indeed...as the title goes.

If it was only Spanish banks feeling the heat of Interbank lending drying in Q4 2011...

"Global cross-border claims fell $799 billion in 4Q11, 80% driven by a drop in interbank lending. Within this, euro zone cross-border claims fell $364 billion as institutions retrenched and shrank balance sheets. Absent further stimulus or a crisis solution, this draining of interbank support may become problematic as the ECB liquidity programs expire." - source Bloomberg

As the BIS put it in their Quarterly June 2012 report:

"Three features characterise the sharp decline in cross-border claims on banks in the fourth quarter. First and foremost, internationally active banks reduced their cross-border lending to banks in the euro area. Second, they also reduced cross-border interbank lending in several other developed countries, albeit by a lesser amount. Third, they cut interbank loans much more than other instruments.

Cross-border claims on banks located in the euro area fell by $364 billion (5.9%), which is equivalent to 57% of the decline in global cross-border interbank lending during the quarter. It was the largest contraction in crossborder claims on euro area banks, in both absolute and relative terms, since the fourth quarter of 2008. Cross-border lending to banks located on the euro area periphery continued to fall significantly. Lending to banks in Italy and Spain shrank, by $57 billion (9.8%) and $46 billion (8.7%), respectively, while claims on banks in Greece, Ireland and Portugal also contracted sharply.

Nonetheless, exposures to these five countries accounted for only 39% of the reduction in cross-border interbank lending to the euro area. BIS reporters also reduced their cross-border claims on banks in Germany ($104 billion or 8.7%) and France ($55 billion or 4.2%)."

In this elevated financial risk environment as indicated by the high level of Itraxx Financial Senior 5 year CDS, no wonder some European banks are on a quest of securing funding as indicated by Fabio Benedetti-Valentini in Bloomberg on the 25th of May "SocGen Search for Crisis Funding Takes Bank to German Car Buyers":

"Societe Generale SA’s quest for funding is prompting the bank, France’s second-largest, to mine
sources not tapped before: German car loans and Dim Sum debt. Seeking shelter from Europe’s resurgent sovereign debt crisis, Societe Generale and France’s three other large, listed banks -- BNP Paribas SA, Credit Agricole SA and Natixis SA --are seeking new ways of financing their balance sheets."

Lessons learned from 2011? Maybe. From the same article:

"Burned by last year’s liquidity crunch, Societe Generale, BNP Paribas and Credit Agricole are shrinking balance sheets in most overseas markets and cutting sovereign-debt holdings. The four Paris-based banks bolstered assets in France by 11 percent last year to 3.72 trillion euros ($4.67 trillion) while cutting commitments in other European countries by about 7 percent, according to the lenders’ data compiled by Bloomberg. BNP Paribas in 2011 cut assets even in Belgium and Italy, its largest retail-banking markets outside France, by 1.6 percent and 3.8 percent respectively, its annual report shows. Societe Generale boosted French assets by 15 percent and got most of its new debt placed with investors in northern Europe."

In relation to their respective funding needs:

"To protect against a refinancing drought, France’s three largest banks have completed about three quarters of their 2012 plans to issue at least 42 billion euros of debt with maturities over one year. Societe Generale went so far as to securitize 700 million euros of German car loans from a unit representing less than 0.5 percent of its balance sheet." - source Bloomberg.

So in effect, European banks while scaling back from dollar-funded businesses such as aircraft financing, are trying to find ways to diversify their sources of long-term funding such as private placements, Dim-Sum bonds (Societe Generale sold 500 million renminbi bonds to fund its Chinese operations), and securitizing German car loans (Societe Generale at its BDK unit, representing 8% of its medium and long term issuance between January and April 23rd).
funds as the region’s deepening debt crisis makes unsecured debt
sales scarcer and more expensive.

As far as the LTROs effects are concerned and investments funds strategy, as indicated in a recent note by CreditSights entitled "Eurozone Investment Funds Use LTROs to Exit Euro" from the 4th of June, they indicated the following in relation to banks' bonds take up:

"Eurozone investment funds increased their allocation to bonds by 69 billion euros in the first quarter; the largest net purchase of bonds since the third quarter 2010.

However the vast majority of that net allocation to bonds, 57 billion euro, was to emerging markets. Indeed the allocation was the largest by investment funds on record.

Investment funds also increased their allocation to banks’ bonds by the largest amount since the third quarter 2009. But that was entirely an allocation to two-year-and-shorter dated bank bonds. Funds reduced their holdings of longer-dated bank debt by 2 billion euro."

In relation to the subject of Banks Bail-in legislation, senior unsecured creditors will indeed be facing the music to cover costs from failing banks under the European plans unveiled today, meaning an end to the era of bank bailouts, in an attempt to move towards a more unified financial supervision. Under the plan, national governments would impose annual levies to set up enough cash for a resolution fund available to a failing financial institution. As of the 1st of January 2018, outstanding senior unsecured liabilities of European Banks will be "bail-in-able", excluding short-term debt (less than 1 month).
The "unintended consequences" of such a plan have been discussed in our conversation "From Hektemoroi to Seisachtheia laws?" as indicated by Nomura:

"the sooner a bank can increase its long-term debt issuance, raise its term deposit funding, or unwind its balance sheet before its competitors do the same, the cheaper its funding costs will be and the less pressure it will face to reduce its balance sheet. In this respect, the current effective subordination of unsecured creditors of eurozone banks due to the balance sheet encumbrance issue allied to a general aversion of creditors to increase exposure to banks is particularly worrisome as this impedes the ability of banks to obtain term-funding."

Yes, "Something Wicked This Way Comes" and as CreditSights put it in their note relating to the European Bank Bail-in - "D-Day for European Bank Bail-ins":

"Bail-in allows the authorities to write down some liabilities to allow the bank to remain in business. Our view is that normal insolvency proceedings are not an effective way of dealing with failing banks and preventing systemic crises, and that a resolution regime is therefore a sensible alternative. We also agree that if governments are determined that public funds should not be used to finance bank rescues, then either banks will have to have significantly higher equity and subordinated debt, or senior creditors will potentially have to be subject to write-down or conversion into equity.

However we think regulators and politicians are in denial about the consequences for banks'funding models. This will push banks towards deposits and covered bonds as principal funding instruments, which seems to alarm some regulators. Senior unsecured debt will be more expensive - some investors will inevitably view it as contingent capital - and the universe of investors will shrink. The Commission's own impact assessment reckons that the total funding cost of banks in the EU would increase on average by a range of 5 to 15 bp, reflecting an estimated average increase in yields on bail-in-able instruments of 87 bp. We suspect this significantly underestimates the likely costs and is one reason we recently revised our recommendations on European banks to Underweight."

So, thank you "Mr Dark" for the "Bail-in" invitation to your nightmarish European carnival. But, you won't be wearing another tattoo because we will not be lured in believing in yet another "secret fantasy". In our conversation "From Hektemoroi to Seisachtheia laws?" we once again voiced our concerns Mr Dark:
"We keep repeating this, but it is still very much a game of survival of the fittest....Cash is clearly king in the Basel III framework and, as Nomura put it, will therefore could lead to a war for deposits in Europe...The British stiff resistance to the latest regulatory proposals come from the fact that banks are very large in the UK relative to their GDP."

Deposit guarantee funds preference is more negative for bondholders. The resulting structural subordination means they will rank pari-passu (classes of bonds or shares having equal rights of payment or level of seniority) with unsecured claims and it could soon be a factor for UK banks if the government follows the ICB’s recommendations...

On a final note we leave you with a Bloomberg chart, showing that Indetex SA, owner of Zara clothing chain has overtaken Banco Santander SA as Spain's second-biggest company by market value as surging profit attracts investors growing wary of banks:

"The CHART OF THE DAY shows the market capitalization of Arteixo, northern Spain-based Inditex, and that of Santander. The world’s largest clothing retailer has almost trebled since the fourth quarter of 2008 to 42.1 billion euros ($53 billion), while Spain’s biggest bank has fallen more than 50 percent since 2010 to 41.6 billion euros. Telefonica SA, Spain’s biggest phone company, is the largest stock on the IBEX 35 index, with a value of 48.4 billion euros." - source Bloomberg, 21st of May.

“Really knowing is good. Not knowing, or refusing to know, is bad, or amoral, at least. You can't act if you don't know. Acting without knowing takes you right off the cliff.” 
  ― Ray Bradbury,  Something Wicked This Way Comes

Stay tuned!