Credit - When causation implies correlation

"All human actions have one or more of these seven causes: chance, nature, compulsions, habit, reason, passion, desire." - Aristotle 

Looking at the dismal economic figures coming out of Europe as of late (PMI, consumer confidence, unemployment in Spain, IFO, etc.), we could not resist using in our title a veil reference to the phrase used in science and statistics "Correlation does not imply causation". Admittedly, a correlation between two variables does not necessary imply that one causes the other, but when it comes to European woes, not only did the ECB's LTROs amounted to "Money for Nothing" given the lack of transmission to the real economy as we posited in February this year, but looking back at the overzealous deficit targets set up by the European Commission which we discussed in our conversation "A Deficit Target Too Far", we are not surprised to see that the economic causation does indeed implies correlation to current European economic woes unsurprisingly due to poor loan growth as displayed by the below Bloomberg graph displaying loan growth in in the Euro Zone with the Euro Zone Money Multiplier at multi-year low:

"Third quarter bank results will shed further light on the outlook and appetite for euro zone bank lending. The money multiplier remains at multi-year lows and recent regulatory steps to soften or defer the implementation of new liquidity and capital rules underscore the pressing need for banks' loan supply to improve, release cash to the economy and support growth" - source Bloomberg.

Yes, some will counter us, by saying that the opposite assumption which we used in our title, that correlation proves causation is a questionable cause of logical fallacy also called "cum hoc ergo propter hoc" ("with this, therefore because of this"). Well, truth is, the economic contraction in Europe is a consequence of the first event sometimes describe in latin as "post hoc ergo propter hoc" (after this, therefore because of this) namely rapid credit contraction due to accelerated bank deleveraging courtesy of the EBA (European Banking Association) objective for most European banks to reach a Core Tier 1 capital of 9% by June 2012.
So dear readers, no, we do not think it is a logical fallacy, "post hoc" supposedly being a "tempting error" because the temporal sequence in Europe appears to be integral to causality namely credit contraction:
A occurred, then B occurred
Therefore, A caused B

Of course as of late, our "Generous Gambler" aka Mario Draghi, ECB's president, has defended is latest OMT (Outright Monetary Transactions) bond buying plan on the 24th of October in front of the German parliament with a warning about deflation risks:
"In our assessment, the greater risk to price stability is currently falling prices in some euro-area countries"
and added:
"In this sense, OMTs are not in contradiction to our mandate: in fact, they are essential for ensuring we can continue to achieve it."

Arguably our dexterous "Generous Gambler" has indeed been highly successful in propelling Spanish bonds gains above Germany as indicated by Bloomberg:

"Investors who held onto Spanish bonds this year as the price of the securities whipsawed amid the euro-area debt crisis stand to earn more than those who sought refuge in German bunds. The CHART OF THE DAY shows Spanish debt has handed investors a 4.2 percent return since Jan. 3, rebounding from an 8.7 percent loss in the period through July, according to data compiled by Bloomberg and the European Federation of Financial Analysts Societies. German bunds, perceived as Europe’s safest sovereign debt, have earned 2.7 percent this year. The Iberian nation’s securities have surged since the European Central Bank said it will buy bonds." - source Bloomberg

Making us reminding ourselves part of the great poem from Charles Baudelaire which we have used in numerous conversations:
"If it hadn't been for the fear of humiliating myself before such a grand assembly, I would willingly have fallen at the feet of this generous gambler, to thank him for his unheard of munificence. But little by little, after I left him, incurable mistrust returned to my breast. I no longer dared to believe in such prodigious good fortune, and, as I went to bed, saying my prayers out of the remnants of imbecilic habit, I said, half-asleep: "My God! Lord, my God! Please make the devil keep his word!"
Charles Baudelaire, French poet, "Le Joueur généreux," pub. February 7, 1864

The most recent table of monthly purchases of sovereign debt is a clear indicator of the faith many investors have put in our "Generous Gambler" - source Bloomberg:

"Euro zone banks purchased an aggregate 33.3 billion euros of sovereign debt in September, following sales of 24.9 billion euros in the preceding two months as yields fell and gains were taken. The ECB commitment to do "whatever it takes" drove the Spanish 10-year yield down to 5.5% from August highs above 7%, and recent bank purchases reflect this new-found confidence." - source Bloomberg

"The greatest trick the devil ever pulled was to convince the world he didn't exist"
Roger "Verbal" Kint- The Usual Suspects

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

Our generous gambler also argued the following: 
"OMTs will not lead to disguised financing of governments. All this is fully consistent with the Treaty’s prohibition on monetary financing. Moreover, they will focus on shorter maturities and leave room for market discipline."

But he also said the following:
"The ECB intervenes only in countries where the economy and public finances are on a sustainable path."

Our "Generous Gambler" is indeed kept on a tight leash for now, a German one that is, courtesy of the Banker's Algorithm.

Our "Banker's Algorithm" comes into play when you think about on-going Spanish deflationary vicious spiral given our computational reference which we touched again last week:

"The algorithm avoids deadlock by denying or postponing the request if it determines that accepting the request could put the system in an unsafe state."
So of course, our Banker's algorithm has avoided the deadlock in Europe because of Spain. Clearly by denying or postponing the request, it has determined the Spanish request could put the European system in a clear unsafe state!
For Spain, it is "request denied" courtesy of the Bankers' algorithm."

Question being now, can Europe survive in the current form (number of countries) without making material sacrifices? One has to wonder...

By managing to keep Germany’s liabilities unchanged German Chancellor Angela Merkel has been in fact the clear "winner" of the last European summit in June (number 19...) we argued in our conversation "Europe - The Game of the Century". On the 18th of October, Chancellor Merkel in her address to the German lower-house has indeed craftily defended again Germany's liabilities by declaring:
"Financial aid without conditions attached has in some cases frustrated the drive to streamline economies, and therefore joint liability is the wrong answer"

Given the IMF has cut its euro-region growth forecast for 2013 from 0.7% to 0.2% with the European economy potentially shrinking by 0.4% in 2012 instead of the "projected" 0.1% by the ECB, in this week's conversation we will look at correlations and causation on our European ship given the increasing risks of "Mutiny on the Euro Bounty" in 2013 which we have been highlighting since April this year:
"As well as Fletcher Christian and part of the crew, our European "sailors" (politicians) were attracted to the "idyllic" initial cheap funding environment provided by a single currency umbrella. The recent austerity "harsh treatments" measures imposed by the captain of the ship (European Commission) which we reviewed in our recent conversation ("The Charge of the Light Euro Brigade") seems to be clearly pushing some of the members of the crew towards mutiny. This explains somewhat, why the European ship is attempting to change tack, moving towards growth."

"Prosperity makes friends, adversity tries them." - Publilius Syrus

Unemployment figures in Germany which will be published next week and will be key. So will be economic data from Germany. In September 2011, in our conversation "Much ado about nothing" we argued:
"And given Merkel's big u-turn relating to the Japanese nuclear disaster in 2011, and that next general election in Germany are to be held in September 2013, and we know that Merkel is already committed to a third term, we would really follow closely the German economy in general and the German labour market in particular. "

There is indeed a growing rift between France and Germany in relation to the course that needs to be taken in relation to Europe due to a growing divergence in the political agenda for both France and Germany. We agree with the latest report from Nicolas Doisy - Politoscope number 10  from Cheuvreux which validates our recent analysis Merkel and our Banker's algorithm:
"Delaying the euro federal Big Bang again: the Franco-German “phoney war” (redux):
-While it should be starting, Europe's federal Big Bang is stalling again due to diverging political agendas in Germany and France with regard to the euro institutions. The disagreement is partly real (i.e. of substance) and partly fake (i.e. purely motivated by domestic politics) and likely to drag on for months… if not years.
 -Merkel has timed her agenda in 2013 with a view to the full monty (re-election and a euro to her liking) and thus intends to frame the debate to her advantage. To keep her options open, Merkel wants to have the final say on any decision regarding Spain and the euro: this is why she uses the federal agenda as a red herring.
-To secure her chances for re-election, Merkel needs to keep the Eurozone quiet during the coming year: this is why she has agreed to the ECB's OMT for Spain. For as long as she is leading the electoral polls, she is sure to keep both France and the SPD in check: this is why she is skilfully nurturing German anti-euro feelings.
-Hollande's options are limited, as he can only bank on the SPD or market pressure to break the deadlock: he thus also uses this debate to keep his own left in check. His only potential ace is to use next year's recession in the Eurozone to table his "growth" agenda again, so as to get a more lenient fiscal treatment by Germany. 
-All in all, this Franco-German divide over institutional options looks very likely to lead to a two-speed Eurozone as the periphery will continue entering its debt-deflation." - source Cheuvreux.

Moving on to France and the subject of when causation implies correlation, we noted from the same interesting note from Cheuvreux the following interesting correlation. Namely that Hollande's popularity is 100% correlated with the rise in unemployment since he has taken office: 5,000 more unemployed = 1% less popularity for Hollande, so that (theoretically), according to Cheuvreux's analysis, he should be ousted when unemployment reaches 3.2 million:

"Hollande's first option out of this diplomatic deadlock could be for the social democrats to win next year's election or the leadership of another Grand Coalition. However, after supporting France's stance very vocally on several occasions in the winter of 2011, the SPD has gone mute on the issue of Eurobonds in particular. This clearly is a sign that Merkel has so far won the battle of public opinion on the euro issue." - source Nicolas Doisy - Cheuvreux.

Following up on François Hollande's political strategy of hoping for the social democrats to win next year's election, we could not resist, (given our post title) but refer to "Mierscheid law"!
The Mierscheid law was a satirical forecast published in German magazine Vorwärts on 14 July 1983 which forecasted that the Social Democratic Party of Germany (SPD)'s share of popular based on the size of steel production in Western Germany: "The Vote share of the SPD equals the Index of the crude steel production in the western federal states - measured in millions of tonnes - in the year of the federal election".

"The last corroboration of the law was in the 2002 election, where the West German crude steel production was 38.6 million tonnes, and the vote share of the SPD 38.5%. For the early election in 2005 the vote share was 38.4%, with a mean crude steel value of 40.0 million tonnes. Over the last ten elections, the two values were within two units nine times, and within one unit seven times." - source Wikipedia

- source - the full Wiki.

With German confidence falling to the lowest level in more than two and half years and Europe's composite PMI falling to 45.8 from 46.1 in September, the IFO institute's business climate index unexpectedly dropped to 100.0 from 101.4 in September, indeed accelerated deleveraging and generalized austerity is increasing the causation of economic woes and the correlation with worsening economic outlook. We feel comfortable with our recent call of growing divergence between the growth differential between USA and Europe as indicated by the recent PMI.

We also believe that as economic woes weight on both Germany and France in 2013, so will increasing political rifts arise in the process. We do agree with Nicolas Doisy's take from Cheuvreux, namely that there is indeed a new "phoney war" evolving between both countries:
"This (peaceful) remake of the Franco-German phoney war obeys a purely political logic and forces the Eurozone to continue walking along the abyss for another year. Unfortunately, it can only add to the uncertainty surrounding the fate of the Eurozone by leaving deflationary Spain very much on the hook: there is no clear prospect of Eurobonds any time soon, be it to recapitalise Spanish banks or help Spain's government. Beyond, this phoney war could well turn into another "battle of Stalingrad" when the actual size of the Spanish problem is fully revealed, right after the German election (if not before). It is thus to be hoped that another Grand Coalition wins in Germany, as seems to be the preference of the German electorate. Such an outcome would have the advantage of creating the conditions of a de facto national unity government in Germany. In any event, this Franco-German great divide over institutional options looks very much apt at leading to a two-speed Eurozone of sorts in the not-so-distant future. Indeed, it appears clearly from this debate that the core issue is what to make of the periphery. This amounts to raising the question: (where and how) does the periphery belong in the Eurozone? While still implicit, this theme will surely rise to the front in near future." - source Cheuvreux - Nicolas Doisy

Indeed, what to make of the periphery in general and Spain in particular given the recent Spanish banks earnings which clearly indicate that Oliver Wyman's nightmare scenario could as well play out which therefore clearly justify the retention in the allocation process of our European Banker's algorithm?
Caixabank, the third biggest bank saw its profit fall 42% as it accelerated loss recognition tied up to real estate with 4.41 billion euros of provisions in the first nine months to fully cover the required 2.44 billion euros from the first RDL (Royal Decree Law) and 600 million of the 2.1 billion euros in charges needed from RDL2 passed in May. Bad loans jumped to 8.42% in September from 5.58% in June and 4.9% in December 2011.
It was a similar story for Spanish giant Santander, with third quarter profit felling 94% due to the necessary purge in real estate exposure needed with net income falling to 100 millions euros from 1.8 billion euro a year earlier. Bad loans as a proportion of total lending rose to 4.33% from 4.11% in June. The bad-loan ratio across the Spanish business climbed to 6.38% from 5.98% in June and 5.15% a year earlier.

The rise in bad loans are all a reflection of the rise from bad loans in the construction sector as reported by Bloomberg:

"September's Spanish stress test projected aggregate losses of 270 billion euros for the banks under its adverse scenario, with a 43% loss on real estate developers, identical to Santander's 3Q real estate non-performing loan ratio. Spain's construction and real estate bad debt topped 100 billion euros at 1H and may rise faster and further than stress estimates." - source Bloomberg

No wonder the Banker's algorithm is reluctant in allocating "resources". In that context, the bad bank SAREB which need to be in place by December, will have as much as 90 billion euros of asset based on their transfer price, initially comprising land, developer loans and residential units that went bad according to Bloomberg article "Spain Bad Bank Seen Too Big to Work With $117 Billion: Mortgages" by Sharon Smyth from the 25th of October.
"The Bank of Spain has yet to fix transfer valuations for the assets based on the stress tests of Spanish lenders carried out by management consultants Oliver Wyman and published on Sept. 28. The 90 billion euro number is based on transfer prices, so the original value of the assets is likely to be higher.
In comparison, Ireland’s National Asset Management Agency, set up in 2009, spent 32 billion euros on mortgages with a face value of 74 billion euros to cleanse its banking system.
Lenders that take state aid will have to transfer to the bad bank foreclosed property of more than 100,000 euros, real estate and builder loans of more than 250,000 euros and controlling stakes in property firms, according to the Economy Ministry official. A decree to regulate the entity should be passed on Nov. 16. It may be amplified in the future to include loans to consumers, small and medium enterprises and retail mortgages." - source Bloomberg.

In relation to Bankia, we argued in May 2012 in our conversation "The Tempest the following" with our good credit friend:
"A better solution would be to force a conversion of debt to equity (In a debt-for-equity swap, a company's creditors generally agree to cancel some or all of the debt in exchange for equity in the company). Doing so will not require 7 to 10 billion funds, but would of course dilute shareholders and destroy bond holders (haircut)."

The ECB is now pushing for inflicting losses on junior debtholders as reported by Emma Ross-Thomas, Esteban Duarte and Ben Sills from Bloomberg on October 25 - ECB is Said to Push Bankia Losses as Spain Purges Assets:
"The European Central Bank and European Commission want investors including preference shareholders to swap their securities for new shares to reduce the cost to the taxpayer, according to two people who asked not to be named because the discussions are private. Profit at Banco Santander SA, Spain’s biggest lender, slumped in the first nine months as it took a 14.5 billion-euro charge on real estate losses.
Confronting the toxic legacy of Spain’s 10-year building boom is imposing political costs on Prime Minister Mariano Rajoy as he faces a separatist challenge in Catalonia, protests on the streets of Madrid and a battle to avoid a full bailout." - source Bloomberg.

Back in our May conversation we indicated:
"Transparency in asset valuations would finally help in discovering the extent of the problems plaguing the Spanish Financial sector. The set-up of a "Bad Bank" in similar fashion to Ireland's NAMA, would indeed force price discovery and true valuations provided a third party assessor is drafted."

and we added:
"Without credit growth resuming, the ambitious target deficits will not be met in Spain. The conditions for growth needs credit growth to resume, as shown by the recent credit growth in the US (see our conversation - "Growth divergence between US and Europe? It's the credit conditions stupid..."). Spain has to go through resolving the Spanish banking encumbered balance sheets."

When causation implies correlation...

Credit wise, for Spanish banks, the rise in the issuance for "Puttable bonds" is a cause for concern we think. Puttable bonds are fixed-income securities which investors are able to redeem before maturity. It is a very dangerous option given the funding shock it could create should investors decide in concert to exercise their option. As reported by Bloomberg by Esteban Duarte and John Glover on the 25th of October in their article "Santander Seeks Salvation in Puttable Bonds":
"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.

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

On a final note, looking at the our "Flight to quality" picture as indicated by Germany's 10 year Government bond yields (well below 2% yield), falling again towards 1.55% versus 5 year Germany Sovereign CDS which has cratered below 25 bps, by avoiding increasing so far Germany's liabilities, Chancellor Merkel has in effect alleviated concerns on Germany's exposure to European woes we think - source Bloomberg:

It's deflation (デフレ) in Europe.

"Correlation is not causation but it is sure a hint" - Edward Tufte - professor emeritus of political science, statistics and computer science at Yale University.

 Stay tuned!

Credit - Banker's algorithm

"An algorithm must be seen to be believed." - Donald Knuth, Professor Emeritus at Stanford University.

"The Banker's algorithm is a resource allocation and deadlock avoidance algorithm developed by Edsger Dijkstra that tests for safety by simulating the allocation of predetermined maximum possible amounts of all resources, and then makes a "s-state" check to test for possible deadlock conditions for all other pending activities, before deciding whether allocation should be allowed to continue" - source Wikipedia

"The Banker's algorithm is run by the operating system whenever a process requests resources. The algorithm avoids deadlock by denying or postponing the request if it determines that accepting the request could put the system in an unsafe state (one where deadlock could occur). When a new process enters a system, it must declare the maximum number of instances of each resource type that may not exceed the total number of resources in the system. Also, when a process gets all its requested resources it must return them in a finite amount of time" - source Wikipedia

Given the on-going discussions relating to Greece negotiating with its creditors and trying to buy some additional time, as well as the much anticipated Spanish official rescue request, with the ECB waiting on the fateful 12th of September German Constitutional court ruling, we thought this time around we would venture towards computational analogies in our title. In similar fashion to our "Banker's algorithm" analogy, it remains to be seen if our European algorithm will avoid deadlock by denying or postponing the Spanish request if it determines that accepting the request could put the European system in an unsafe state.

In similar fashion to our banker's algorithm analogy, the coming months will indeed be decision time given Europe will have to decide at some point whether "allocation" should be allowed to continue.

In reference to Spain, the recent decision by the Spanish State to "allocate" an urgent transfer of 6 billion euros to its bank rescue fund FROB, which controls stakes in Spanish lenders such as Bankia group, will indeed appear in central government budget data once the payment is made:
"Spain is about to boost the capital of the rescue fund after writing down investments in lenders including Bankia group, according to the fund’s annual report dated July 26. The fund posted a net loss of 10.56 billion euros in 2011, sparking a negative equity of 1.86 billion euros." - source Bloomberg, Angeline Benoit and Estaban Duarte, 24th of August 2012 -

We think our analogy this week is once again appropriate. In our computational reference, namely the Banker's algorithm, in similar fashion to the upcoming Spanish rescue request, in our Banker's algorithm:
"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.
1. Can the request be granted? If not, the request is impossible and must either be denied or put on a waiting list
2. Assume that the request is granted
3. Is the new state safe?
-If so grant the request
-If not, either deny the request or put it on a waiting list.

Whether the system denies or postpones an impossible or unsafe request is a decision specific to the operating system."

On the 31st of August, the Spanish government will detail the rules for the Spanish lenders to access funds from the European bailout of as much as 100 billion euros earmarked in June to support the Spanish financial system. Spain must create a "bad bank" as a condition for accessing the loan from the 16 other European countries. The European Commission has asked Spain to delay by another week the plans to create this very "bad bank" so that its experts in Brussels can review the project. We might be speculating again but maybe the European Commission is as well using the "Banker's algorithm".

The Spanish government is introducing new rules to restructure and, if needed, dismantle non-viable financial institutions according to Bloomberg. One can therefore posit that Spanish FROB could indeed use as well the Banker's algorithm in its allocation process...but here is the catch:

 "Like other algorithms, the Banker's algorithm has some limitations when implemented. Specifically, it needs to know how much of each resource a process could possibly request. In most systems, this information is unavailable, making it impossible to implement the Banker's algorithm." - source Wikipedia
Oh well...

CreditSights in their note from the 9th of August entitled - Spanish Government - We Need to Talk about Cutting made the following points:
"The Spanish government has negotiated with Eurozone partners a budget-deficit target for 2012 of 6.3% of GDP. The plan is then to reduce the deficit to below the 3% Maastricht Criterion by 2014. But this year’s target has already been revised up twice from the original 4.4% illustrating how difficult cutting government spending and raising taxes is when the economy is deep in recession.
Following Spain’s 1990s recession, the budget deficit exceeded the 3% Maastricht Criterion in all but two quarters in the eight years between 1991 and 1998. Since the 2007 recession, budget deficits have been larger, but have so far only exceeded the 3% Maastricht Criterion for three-and-a-half years.
Yet, the problems facing the Spanish economy are this time around much larger than they were in the early 1990s. The private-sector debt position at the start of the 2007 recession was equivalent to 215% of GDP. At the start of the 1992 recession, household and business debt was 65% of GDP.
And in the 1990s, Spain’s exit from the ERM allowed the currency to depreciate and the current account to move into surplus. In this recession, Spain’s membership of euro means there is no ability to recover competitiveness via currency depreciation;
The result is that the Spanish government will need to run budget deficits that are far larger than the targets it has negotiated with its Eurozone partners. But it is impossible to see the market continuing to buy the bonds to fund such deficits, Spain is all but certain to need a full government funding programme from the EFSF/ESM."
The process whereby lenders to Spain are paid back thanks to an implicit loan from the Eurosystem to the Spanish government won’t be allowed to persist indefinitely. And when it stops, the money to repay those Spanish government bonds won’t be available.
Absent the Spanish people tolerating a wrenching reduction in their incomes within an unrealistically short timeframe in, they believe a government request for EFSF / ESM funding is all but inevitable."

We would have to agree to the above key points from CreditSights, both Italy and Spain pose the biggest threat to the survival of the Euro. In fact the Spanish Misery index beats Greece as crisis bites as indicated by Bloomberg:

"Record unemployment is cementing Spain’s position as Europe’s most miserable nation, widening the gap over twice-bailed-out Greece, as the debt crisis deepens.
The CHART OF THE DAY shows a composite gauge of Spanish jobless and inflation rates, known as the misery index, is rising quicker than those of other European economies, and as Greece’s retreats from a 2012 high. Globally, only South Africa is faring worse, according to data compiled by Bloomberg News. Spain’s misery index is 26.83 percent, comprising a jobless rate of 24.63 percent and inflation at 2.2 percent. Greece’s score is 23.9 percent and that of the euro region is 13.6
percent. South Africa, which has an inflation rate of 5.5 percent and 23.2 percent unemployment, has a misery reading of 28.7 percent, according to data compiled by Bloomberg News.
The misery index is calculated by adding the 12-month percentage change in the consumer price index to the jobless rate. Arthur Okun, an adviser to Presidents John F. Kennedy and Lyndon Johnson, created the indicator in the 1960s." - source Bloomberg.

In our credit conversation we would like to focus on the changing corporate bond environment and focus once again on the structural change in market liquidity as well as default risk, in the credit space. But first our credit overview!

The Itraxx CDS indices picture, ending the week on a weaker note in the credit derivatives space - source Bloomberg:

Credit indices were overall wider on Friday, ahead of the long week-end in the United Kingdom. Overall quality cash credit from investment grade core issuers has been the clear outperformer during the summer. While last week Itraxx Crossover 5 year index (High Yield risk gauge based on 50 European entities) came closer last week to its lowest level since March, it widened back by the end of the week towards 600 bps, on the back of weaker economic data (European PMI).

Both the Eurostoxx and German 10 year Government yields seems to be moving are still moving in synch. It seems the short burst of "Risk-On" is marking a pause, with fast falling German Bund yields towards 1.30% yield level and a slightly weaker Eurostoxx 50 at the end of the week  - 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:

In relation to the European bond picture, Spanish 10 year yields remain elevated at 6.43, slightly below 7% whereas Italian 10 year yields are below 6% around 5.76% and German government yields fell towards 1.33% - source Bloomberg:

Severing the Sovereign risk / Financial risk link has been the main concern of European authorities as indicated by the difference in spreads between the Itraxx SOVx 5 year CDS index and the Itraxx Financial Senior 5 year index. The recent rise of Itraxx Financial Senior CDS 5 year above the Itraxx SOVx Western Europe 5 year index is only indicative of the respite provided to Sovereign CDS spreads for Italy and Spain provided by the recent discussions surrounding ECB intervention. - source Bloomberg:

 

The widening of Italy and Spain in the sovereign CDS markets has been increasing by the end of the week (Spain back above 500 bps and Italy at 461 bps on 5 year markets) during which both also touched their lowest level since April 2012 - source Bloomberg:

The spread difference since March between both countries has been relatively stable as indicated in the lower graph.

Our "Flight to quality" picture marking a pause in "Risk-On" with Germany's 10 year Government bond yields falling again towards 1.30% and the 5 year CDS spread for Germany rising above 60 bps after having touched a low point as well during the week - source Bloomberg:

Credit wise, while in our last conversation "Desperado" on the 21st of August  we touched on Santander 2 year senior unsecured 2 billion euro new issue, which had been the first Spanish bank to issue since mid-march, we were taken aback by the latest "liability management" exercise which Santander followed immediately after its new issuer with. Banco Santander and Santander Financial Exchanges (each an Offeror and jointly the Offerors) inviting holders of certain Tier 1, Upper Tier 2 and Lower Tier 2 securities to tender such securities for purchase for cash at prices to be determined pursuant to an Unmodified Dutch Auction Procedure (as such term is defined in this Tender Offer Memorandum). The maximum aggregate principal amount of Securities that the Offerors intend to accept for purchase jointly pursuant to the Offers, will be an amount equivalent to €2,000,000,000. The impact of the announcement triggered a rally in some of the securities being proposed for the "liability management" exercise:

As we argued recently (Peripheral Banks, Kneecap Recap), "losses will have to be taken, it is all going Dutch, Dutch auction that is". The moment for losses to be taken has arrived at least for preference shares holders given Spain will impose losses of as much as 80% on owners of preference shares of banks that have received state aid and may be liquidated courtesy of an operation "Banker's algorithm" but we ramble again...In relation to Bankia, being clearly in the crosshair of such "exercise", back in June (Agree to Disagree - 16th of June 2012) we indicated:
"Spain has yet to apply the full extent of the Irish recipe which we discussed in "The road to hell is paved with good intentions":"Given the recent outrage by individuals investors relating to the performance of Bankia's share price following its IPO in 2011, it will be interesting to watch the subordinated bond space when looking at the difference in ownership between Ireland and Spain. One has to wonder if Spanish retail investors will be inflicted additional pain..."
The pain is definitely about to be inflicted.

This latest move reminded us of some of the comments our good credit friend had relating to Spanish banking woes back in April in our conversation "Mutiny on the Euro Bounty":
"Main Spanish banks have so far refused the government suggestion to create a bad bank which would carry all property toxic assets, arguing that they could manage their assets on their own. The dire reality is that the creation of such bad bank will bring transparency to asset prices, which is not what Spanish bankers want! The murkier the market, the better it is to extend and pretend..."

In it is not the first time we have been surprised by Santander, back in April we also indicated:
Moving on to the subject of the Spanish banking sector, quite frankly we have been baffled by Santander CEO Alfredo Saenz deriding Spain defaults surge: "“Mortgages get paid in good times and in bad”. He also added: "“Anyone raising this problem as one of the issues for the Spanish financial system is saying something stupid. (We discussed Spanish issues at length in our conversation "Spanish Denial")."

When it comes to Spanish woes and the difficulties in tackling Spain's economic woes, one might wonder how it can be achieved given when Rajoy came to power he split the finance ministry and decided not to give the title of deputy premier for economy to either Montoro or De Guindos, which is creating additional headaches for wary investors as indicated by Ben Sills in his Bloomberg article from the 23rd of March - Montoro Outburst Highlights Rajoy Paralysis as Cabinet Splits:
"The divisions at the heart of Rajoy’s government have hobbled Spain’s ability to operate on a European level. While De Guindos, who represents the government at European meetings, inspires confidence in the bloc’s other finance ministers, they question his ability to deliver on his promises
because he is often contradicted by Montoro, according to an official who takes part in finance ministers’ meetings. In January, De Guindos’s efforts to persuade investors and officials that Spain was fixed on its budget targets was undermined by Montoro’s calls for more flexibility on the pace of deficit reduction."

Moving on to the subject of the changing corporate bond environment and the structural change in market liquidity, we wanted to tackle again this issue of dwindling liquidity and its implication on the credit markets (which we discussed in our conversation "Yield Famine") given yields on corporate bonds worldwide fell to a record low on the 23rd of August as indicated by Bloomberg in their article -
Global Corporate Bond Yields Decline to Record After Fed Minutes:
"Borrowing costs for the most creditworthy to the riskiest companies fell to an unprecedented 3.76 percent yesterday, from 3.8 percent on Aug. 21, according to Bank of America Merrill Lynch index data. Yields on global investment-grade debt dropped to a record 2.97 percent. The extra yield investors demand to own global corporate bonds of all ratings rather than government debt narrowed to 261 basis points Aug. 21, the lowest level since August 2011, Bank of America Merrill Lynch index data show. The gauge widened 1basis point to 2.62 percentage points on the 23rd of August."

Liquidity risk is a concern we share with Thames River Credit fund which indicated the following in their July 2012 letter:
"A structural decline in liquidity has been taking place in the corporate bond market, which has serious repercussions for credit investors. The term liquidity may sound like an obscure, even technical, word but it reflects the ease with which a security can be bought and sold. The most efficient markets are those that benefit from deep pools of willing buyers and sellers, facilitating the transfer of risk. Unlike the equity market, the majority of trading in the corporate bond market is not transacted through centralised securities (also known as market-making).
One of the reasons why corporate securities have traded off-exchange is their greater complexity compared to asset classes such as equity. Features such as duration, maturity, credit risk and subordination can differ even amongst the debt of a single issuer making credit a highly heterogeneous asset class. The trade-off for the greater customisation of corporate securities is diminished liquidity. Of the US$ 8 trillion US corporate bond market only a small proportion of issues will trade with relative frequency. This highlights the important role banks have played in the corporate bond market. A changed regulatory environment, however, is putting increased strain on banks’ ability to make markets in corporate securities."

Thames River conclude their July letter with the following important point in relation to the issue of liquidity for benchmarked credit funds:
"Regulation and bank deleveraging is forcing change on credit markets. This is most notable in the area of liquidity. Without the lubrication of market-making activity, long-only corporate bond mutual funds stand exposed to the risk of a significant sell-off in credit markets. When combined with weakness in the rates market,such an outcome could create a perfect storm for benchmarked corporate bond funds. This is why the decline in corporate bond liquidity matters."

We could not agree more, the risk is real. We used a reference to Bastiat in relation to liquidity and Credit Markets in our conversation "The Unbearable Lightness of Credit":
"That Which is Seen, and That Which is Not Seen"

The Bond Bubble:
"In 5 out of the past 7 years, inflows to bond funds have exceeded 5% of AUM. Inflows to bond funds are running at an annualized $259bn (versus prior 2010 alltime high of $183bn). Inflows to Investment Grade & High Yield bonds funds thus far in 2012 account for a staggering 63% of total fund flows to all equity, bond & commodities." source Bank of America Merrill Lynch:

"Investor preference for Bonds over other classes is clear to see. Since 2007 there has been $650 billion into Fixed Income. Over the same period, Equities including ETFs saw outflows of $52bn." - source BofA Merrill Lynch.

When it comes to our final subject of default risk, in the credit space, CreditSights in their High Yield Market Trends published on the 20th of August indicated the following:
"The current relationship with HY (High Yield) and HG (High Grade) is more in line with what is seen in high default rate periods in the US such as 2002 and 2009. That still holds true today in both the US and Europe. The 127% quarter-to-date average (113% in 1H12) comes against the current default rate of 3.3% and is dramatically above the 76% long term average. The current HY incremental yield % versus HG is more in line with 2H02 levels of 127% when the trailing default rate declined from 10% to 8%. During the 1H2009 crisis, the 129% average came against a backdrop of 11.5% default rates. In 4Q07, when default rates ran at 1.7% the premium was 50%. Obviously that did not price in a jump in the default rates to over 14% by the end of 2009. There certainly has been a legitimate discussion that the HY market remain cheap by any of these comparisons unless you see a massive spike in defaults ahead.
With respect to the European data, they would add a caveat that the relative lack of depth in the crossover and middle tiers of the corporate universe and the relative absence of industry breadth (i.e. beyond TMT) in the “early years” of the European HY market impairs the usefulness of these metrics in Europe. In terms of framing the very low default rate levels in Europe today with what we saw in late 2007 in HY markets globally, there is an eerie similarity in that systemic is what drove the spike after the subprime mortgage crisis took out Lehman Brothers and the structured finance market while sending banks into a counterparty-driven interbank meltdown. The mere discussion of such risks in the Eurozone could make the risk of a bank system liquidity event more of a threat to the Euro HY market than the US HY market. While all HY markets (and equities) would sell off dramatically in such an event, the fact that actual default rates would more likely spike in Europe (and for a protracted period) would increase the risk of forced realization of such losses. That in theory would be when the price gap between US HY index and Euro HY index would widen more notably and losses would be “crystallized”. While that is a fat tail, they often highlight that still could end more just as a tall tale. The reaction of the HY and equity markets in Europe are voting “tall tail” at this point.
At the end of the analytical process used to frame the relative value of HY assets, it is defaults that matter most, and a material differential in actual defaults will be required to generate a more notable decoupling of returns in the rolling returns over longer time horizons across the US and Euro HY markets. As they look out towards mid-2013, it will take a systemic crisis and more than economic contraction to drive that in their view. To this point the roll-up of individuals credits still shows very manageable defaults in both the US and Euro HY markets."

On a final note, in relation to liquidity and volumes, as far as our equities friends are concerned, Christmas came early volume wise, it came in August as indicated by Bloomberg Chart of the day:

"The CHART OF THE DAY tracks the number of shares changing hands on the benchmark Stoxx Europe 600 Index since 2002, based on weekly data. About 9.34 billion shares were transacted last
week, according to data compiled by Bloomberg. That’s the fewest since 2002 except for during the traditionally slow periods at the end of the year, when business across the continent all but grinds to a halt.
Investors are staying on the sidelines as European politicians and central bankers wrestle with the region’s debt crisis, which has spread to Italy and Spain as it enters its third year, said Graham Bishop, a strategist at Exane BNP Paribas in London. European Central Bank President Mario Draghi said Aug. 2 that the lender would consider buying distressed countries’ bonds to help lower borrowing costs. “Christmas has come early,” said Exane’s Bishop. “We are now in sight of replicating Christmas in August with investors in wait-and-see mode until the ECB does what they said they will do. There’s a combination of policy uncertainty and the normal summer lull.” - source Bloomberg.

"Complacency is a state of mind that exists only in retrospective: it has to be shattered before being ascertained." - Vladimir Nabokov

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!

Credit - The Daughters of Danaus

"In Greek mythology, the Daughters of Danaus or Danaids (also Danaides or Danaïdes) were the fifty daughters of Danaus. They were to marry the fifty sons of Danaus's twin brother Aegyptus, a mythical king of Egypt. In the most common version of the myth, all but one of them kill their husbands on their wedding night, and are condemned to spend eternity carrying water in a sieve or perforated device. In the classical tradition, they come to represent the futility of a repetitive task that can never be completed (see also Sisyphus)." - source Wikipedia

Moving back to the theme of Greek Mythology, given rising uncertainties on the upcoming Greek election, we thought this time around we would use this classical analogy. As in the classical tradition, the futility of the repetitive task of the ECB in injecting liquidity into the system to maintain afloat peripheral banks saddled with non-performing assets, (which by the way does not translate into meaningful credit growth in peripheral economies) we wonder how long Europe's muddle through situation will go on. The punishment of the Danaides was that they were forced to carry a jug to fill a bathtub (pithos) without a bottom (or with a leak) to wash their sins off. Because the water was always leaking they would forever try to fill the tub (or deficits in relation to Europe). As we indicated in our conversation relating to the growth divergence between the United States and Europe ("Growth divergence between US and Europe? It's the credit conditions stupid...", it is all about Stocks versus Flows. Yes, we ramble again with our Danaids analogy and their never ending task of filling the tub because we posited the following in various conversations:

"We mentioned the problem of stocks and flows and the difference between the ECB and the Fed in our conversation "The European issue of circularity", given that while the Fed has been financing "stocks" (mortgages), while the ECB is financing "flows" (deficits). We do not know when European deficits will end, until a clear reduction of the deficits is seen, therefore the ECB liabilities will have to depreciate."

Until we see a clear reduction in deficits, (which we might never see in true Danaides punishment or fashion), the ECB liabilities will indeed depreciate. Of course everyone is now awaiting the fateful Greek elections in June, to see if some of our European Danaides are ready to "expedite the divorce" or to whether our European Danaides will listen to their marriage counselors (the United States and the IMF) and go for "Shared Marriage Property". In the Greek legend, Hypermnestra (Germany) was the only Danaid to refuse to follow the orders of her father Danaus (European Commission) to execute her husband Lynceus (alter the ECB mandate) given that he had respected her on their wedding night. While the Danaides were punished in the underworld by being forced to carry water through a jug with holes, or a sieve, so the water always leaked out, Hypermnestra, however, went straight to Elysium.

Back in November, in a conversation with Cullen Roche on Pragmatic Capitalism - "The Impossible Refinancing Burden...", we argued:

"To put it simply there is no way Italy can refinance without the ECB acting as lender of last resort. The EFSF has not enough firepower to support both peripherals and the bank recapitalization process. It is either one or the other. Given the issue of circularity and the need for economic growth to break debt dynamics, I do not see the solvency issue resolved without the ECB stepping in. The big question is, would Germany allow the ECB to alter its DNA given it would contravene the Lisbon treaty, if it starts intervening massively? I have some doubt about it, and it is a scary prospect. So far the Bundestag and German Constitutional court have stepped in to rein in the expansion of the EFSF, because they do not want to betray German people. Either they know it is not the solution and are buying some time to allow for more integration within Europe and using it as a bargaining tool to force Greece and others to concede their independence somewhat in exchange of stronger support, or, the game is for Germany to buy some time and leave and join force with Austria, Finland, the Netherlands, and leave peripherals on their own."

Could Germany be like Hypermnestra and decide to go her own way as the Danaides story goes? But once again we divagate in our thoughts.

It is time for a credit overview, focusing again on Spain and its financial woes as well as credit contraction in Europe, but before we do, we thought it would be appropriate to move back to the issue of circularity namely the Danaides punishment which we discussed in October last year. The issue of circularity we mentioned last year could not be clearer than the graph realised by Martin Sibileau in his post - "The EU must not recapitalize banks":

And as indicated by Martin Sibileau:

"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."

Of course this circular reasoning can be applied to the ongoing debates of Spanish banks recapitalization in general and Bankia in particular. Only 5.3 billion euro is outstanding in the recapitalization fund FROB, the 19 billion needed for the exercise are not currently available.

To make matters worse, not only are deposits flights a cause for concern, as we argued in our conversation - "St Elmo's fire": "Deposits flows are indeed key factors in determining the stability of any financial system in peripheral countries", but, Bankia's assumptions for mortgages defaults, heighten concerns for the Spanish Mortgage Sector as indicated by Bloomberg:

"Bankia increased its range for mortgage defaults to 8% to 10% as part of updated assumptions underpinning its 19 billion euro bailout. Spanish mortgage data show that at FY11, 18.3 billion euros of 644 billion of total mortgages were in default. Each 1% increase toward the 8% level would require 1.9 billion of provisions, assuming 30% coverage." - source Bloomberg.

As far as the Danaides punishment/Circularity issues goes, 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:

"With sell-side estimates of the cost of addressing Spain's 184 billion euros of problematic real-estate loans exceeding 70 billion, the positive impact of Spain's 37 billion of targeted austerity cuts are rapidly being offset by deepening bank troubles. Spanish stress test results in late June will prove key to confidence in the announced measures." - source Bloomberg.

As far as the correlation between Sovereigns and Financials is when it comes to a widening trend - source Bloomberg.:

"Spain's beleaguered taxpayers may be forced to underwrite a direct capital injection of up to 19 billion euros after the ECB rejected a capital plan that involved injecting sovereign bonds into the parent, and using ECB facilities to convert these to cash. Citing the risk of monetary financing, the ECB's rejection may drive Spanish CDS to new highs." - source Bloomberg

Spanish and Italian Financials 5 year CDS drifting wider - source Bloomberg.

Back in October we agreed with Martin Sibileau's view:

"What would be a solution for the EU? We have repeatedly said it: Either full fiscal union or monetization of the sovereign debts. Anything in between is an intellectual exercise of dubious utility."

The Itraxx CDS indices picture, a tale of ongoing volatility - source Bloomberg:

 Itraxx Crossover 5 year CDS index (50 European High Yield entities - High Yield credit risk gauge), moving back to Friday's wide levels, drifting by 17 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 and so does the Itraxx Financial Senior Index, a further indication of the existing correlation between financial and sovereign risk.

Meanwhile the price action in the European Bond Space has been worsening with Spain reaching new alarming levels rising 24 basis points on the day to 6.74 percent (closing on the fateful 7% level which triggered the rescue of both Ireland and Portugal), with Italy surging as well following a disappointing auction - source Bloomberg:

The "Flight to quality" picture as indicated by Germany's 10 year Government bond yields (well below 1.50% yield) touching a new record low, with 5 years Germany Sovereign CDS falling below 100 bps - source Bloomberg:

Survival of the fittest, a question of preservation of capital rather than capital appreciation. We are getting closer to our initial target of 1.25% yield for German Bund we discussed in our conversation "Interval of Distrust".

The 2 year German notes touching a record low of 0.002% against the 10 Year German bund - source Bloomberg:

That Japanese European feeling - 2 year German Notes evolution versus 2 making new lows versus 2 year Japanese Notes - source Bloomberg:

Moving back to Spanish banking woes it is similar to Ireland, given the cost of "Zombie Developers' Loans plaguing the balance sheets as indicated by Bloomberg - "Spain Fails to Count Cost of Zombie Developers’ Loans":

"Spanish banks are masking their full exposure to soured property loans while they continue to prop up zombie developers, leading to credit-rating downgrades and plummeting share prices.

Spain is working to clean up its banks, requiring lenders set aside more for possible losses on loans deemed performing to developers like Metrovacesa SA, which hasn’t completed a project in more than a year and has none under way. While that represents about 30 billion euros ($38 billion) of increased provisions, it’s not enough because many loans said to be performing aren’t being repaid, according to Mikel Echavarren, chairman of Irea, a Madrid-based finance company specializing in real estate."

The game of extend and pretend is alive and well in the Spanish banking sector as indicated by the same article:

"Many Spanish banks are avoiding property sales so they don’t have to make mark to market valuations, which reflect current prices. Instead, they’re giving developers new loans to pay debt coming due to prevent defaults, said Ruben Manso, an economist at Mansolivar & IAX and a former Bank of Spain inspector."
“The larger banks have been selling bits and pieces and can absorb the losses,” Manso said. “Smaller savings banks are acting in bad faith in their refusal to allow transactions and saying they can’t mark to market because there isn’t one.”

The example of Metrovacesca, the fall from grace, has it was once Spain's largest developer:

" The Madrid-based company, which once owned HSBC Holdings Plc’s London headquarters and had about a 50 billion-euro market value, was taken over by creditors in 2009 after its largest shareholder struggled to service billions of euros of debt.
 Santander, BBVA, Banco Espanola de Credito SA, Banco Popular SA, Banco Sabadell SA and Bankia, canceled 2.2 billion euros of debts owed by the Sanahuja family in return for about 55 percent of Metrovacesa and purchased a further 10.8 percent of the stock in a deal that valued the company at 57 euros a share. The banks now own about 96 percent of Metrovacesa.
Santander and its Banesto unit, which now own about 35 percent of Metrovacesa, value the stake at 772 million euros, or 2.24 euros a share, according to a spokesman for Santander, who declined to be identified citing company policy. In 2009 and 2011, they made provisions of 269 million euros and 100 million euros against their holding, according to a 2011 report by Santander’s auditor." - source Bloomberg - "Spain Fails to Count Cost of Zombie Developers’ Loans".

"Zombie" Metrovacesa:

"Metrovacesa has racked up 1.8 billion euros of losses since 2008. It has debt of 5.1 billion euros and property assets valued at 3.9 billion euros."

source Bloomberg - "Spain Fails to Count Cost of Zombie Developers’ Loans".
Metrovacesa trades at 39 cents a share from an original valuation of 57 euros...

Keeping the "Zombie" alive:
"In August, its lenders renegotiated the terms of 3.6 billion euros of its debt, extending maturities on 2.47 billion euros of obligations and granting a five-year grace period for interest payments on 1.12 billion euros of loans."
source Bloomberg - "Spain Fails to Count Cost of Zombie Developers’ Loans".
Applying the Irish "Zombie" treatment:

"Before Ireland’s real-estate crash, banks including Anglo Irish avoided getting appraisals to avoid bringing them before audit committees, according to four people familiar with the matter, who declined to be identified because the information is private.

Anglo Irish gave developers capital to finish projects in 2008 using personal loans. That way, the bank’s primary loan would continue to appear as performing, Irish developer Simon Kelly, who together with his family owes banks 800 million euros, said in a phone interview." - source Bloomberg - "Spain Fails to Count Cost of Zombie Developers’ Loans".

The Bank of Spain allows loans that are refinanced before turning delinquent and interest-only loans to be considered “normal” or “performing” on banks’ books. The extend and pretend game.

As we argued in our conversation - "Peripheral Banks, Kneecap Recap"
"We believe debt to equity swaps will likely happen for weaker banks as well as full nationalization for some."
As our good credit friend said in November 2011:
"The path will be very painful for both shareholders and bondholders."

As far as Spanish banks are concerned we agree with our good credit friend:

"The headlines for the last few days came from Spain with Bankia being about to nationalized. But where the money will come from? The FROB has almost no money left, so the talks in the street are about the Spanish government injecting about Euro 20 billion in the bank.

Let's get serious for a moment. Should the Spanish government injects these funds, it will have to go to the markets to raise them, and considering the actual yield of the 10 years government bond, there is a good possibility for the yield to jump to 7% or above, a level which may push the State to ask for a bail-out. The country will be downgraded, funding access will be definitely closed. A story we have already seen with smaller countries (Portugal and Ireland). The effect will be devastating for growth which will contract further.

The only solution might be to "wipe-out" the current shareholders and to ask bondholders to fork the bill (subordinated debt bought back at big discount or converted to equities). If it is not enough, senior bondholders should be asked to participate. We could see in the process some class actions from shareholders and bondholders against Bankia, and even Deloitte which certified last year results (they have been restated from a small profit to euro 3.3 billion loss).

According to the Spanish newspaper “Expansion”, two other banks(NGB and CatalunyaBanc) are asking for Euro 30 billion capital injection. If confirmed, the bill to bail out the banking system will rise dramatically to Euro 50 billion! And there may be other banks asking for capital (we are convinced there will be)."

In relation to credit conditions, they have not been improving but in fact deteriorating. According to The Economist's credit-crunch index, credit is now tighter in the euro area than it was at the height of the financial crisis (five days moving average of six normalised indices on bank lending, Euribor-OIS spread, Euo-USD swap spread and five-year CDS for financial, industrial and sovereign sectors):

"This is having a detrimental effect on the real economy, as demonstrated in the following three charts. When the index was last at a similar level during 2008-09, economic output tanked, unemployment shot up and stockmarkets plummeted. Unless policymakers find a lasting and credible solution soon, it seems likely that the same will happen again."  - The Economist.

Nomura in today's Euro area April money and credit data survey indicated overall disappointing and worrying data for the ECB:

"This morning‟s money and credit data for April continue to point to even more subdued growth in the monetary aggregates. The headline numbers show a worrying trend, with the M3 annual growth rate declining to 2.5% from 3.1% in March and the annual growth in loans to the private sector (adjusted for sales and securitisation) declining to 0.8% from 1.1% in March.

The main drag on private sector lending, however, was within the OFC sector: loans declined by €30bn in April following the €8bn drop in March, with the annual growth rate turning negative at -1.5% from 2.3% in March. So it appears that the OFC sector has used part of their overnight deposits to pay down bank loans and possibly shifted part of the overnight deposits into non-euro area assets. A similar pattern was observed in Q4 2011.

In sum, today's money and credit data were disappointing and likely reflect both the continued deleveraging forces weighing on the bank's balance sheets and the heightened financial market uncertainty affecting especially portfolio decisions of the OFI (Other Financial Institutional)  sector. The ECB will certainly be scrutinising today's numbers for signs that the LTRO funds are finding their way into the wider economy. It is hard to argue that the credit outlook has improved in recent months. But whether today's money and credit numbers are sufficiently poor to prompt an ECB policy response as early as next week is the critical question. Given today's deterioration in financial market sentiment, the calls for immediate ECB action are clearly getting louder. For now, we stick with our call of no change in policy rates this month, followed by a 50bp rate cut in July but we now see a 30% probability of a 25bp rate cut already at next Wednesday's ECB meeting."

On a final note as far as Dr Copper is concern, it still spelling the D word, D for Deflation and Deleveraging:

"The CHART OF THE DAY shows that copper, sometimes referred to as the metal with a Ph.D in economics, tumbled to a four-month low on May 23 and is down 9.6 percent for the month, heading for the biggest slump since September. Since May 16, inflation expectations have gained 6.2 percent, based on the spread between five-year fixed-rate bonds and Treasury Inflation Protected Securities.
Copper, used to make wires and pipes, has dropped along with other raw materials as the risk of faltering global growth eroded the outlook for demand. Expecting prices to rise is “irrational” given ebbing economic expansion, suggesting expectations will fall in coming months, said Nariman Behravesh, the chief economist at IHS Inc. and a former Federal Reserve official." - source Bloomberg.

"It's the irrational things that interest me."
Harrison Birtwistle

Stay tuned!