Markets update - Credit - The European Overdiagnosis

"Analysis does not set out to make pathological reactions impossible, but to give the patient's ego freedom to decide one way or another."
Sigmund Freud

Following on our meditations on Bayesian outcomes, and the "European Principle of Indifference", it appeared to us appropriate this time around to focus on the unintended consequences of applying nonsensical decisions to nonsensical results, hence, we have decided this time around to use the analogy of overdiagnosis relating to our European issues:

"Overdiagnosis is the diagnosis of "disease" that will never cause symptoms or death during a patient's lifetime. Overdiagnosis is the least familiar side effect of testing for early forms of disease – and, arguably, the most important. It is a problem because it turns people into patients unnecessarily and because it leads to treatments that can only cause harm." - source Wikipedia

Indeed, this analogy seems to us particularly right relating to the current European and American "Balance Sheet Recession" which has been a recurring theme from Richard Koo, chief economist at Nomura Research Institute, as pointed out by Cullen Roche on Pragmatic Capitalism - "DEFICITS ARE GOOD DURING A BALANCE SHEET RECESSION":

"This (austerity) is akin to a doctor telling a patient suffering from pneumonia to go on a diet and get more exercise. While exercise is important, it assumes a healthy patient. If the patient is sick, he must build up his strength until he is physically capable of exercising again."

So, in a longer credit conversation than usual, we will first have a credit overview given recent significant price action (tightening spreads and much better tone in the credit space), before dealing more directly with the current" European Overdiagnosis" and unintended consequences courtesy of my global macro friends at Rcube Global Macro Research, quantifying "The likelihood of a Euro Breakup" in their latest paper, which follows on their previous analysis of Eurozone's core issue, namely Unit Labor Cost Divergence, which we discussed in our "European Flutter".

The Credit Indices Itraxx overview - Source Bloomberg:

"The Markit iTraxx Financial Index of credit-default swaps linked to the senior debt of 25 European banks and insurers now costs a record 120.5 basis points less than the Markit iTraxx SovX Western Europe Index of swaps on 15 governments. That compares with a 28 basis-point gap at the end of November and a previous high of 118 in July. Historically, it costs more to insure banks than governments." - source Bloomberg news - Abigail Moses and John Glover.

The Year of the Dragon should be rebranded the Year of the European Central Bank, given the significant tightening in credit indices which we have witnessed in Europe since the beginning of the year as indicated by Bank of America Merrill Lynch research - The ECB trade - 17th of January:

"The ECB funding “put”
Away from S&P’s downgrade distraction, we think funding stresses in the credit market have improved significantly over the last month. Three themes paint a better picture. Firstly, ECB 3yr LTROs have had big take-up, and more is to come.
Secondly, fixed-rate senior unsecured bank issuance has reached €15bn YTD, half of the entire 2H supply last year. And finally, as our banks colleagues highlight, government guarantee schemes can be a powerful solution to a bank funding crisis. With the ECB helping to transform funding pressures in credit, we think short-dated spreads can keep rallying."

As indicated above the fall in the Itraxx Financial Senior 5 year index has been significant versus the SOVx 5 year index (relating to 15 European sovereign CDS) courtesy of the breakdown in the correlation between Sovereign and credit spreads, as indicated by Bank of America Merrill Lynch in their report:

"Sovereign and credit spreads - the correlation is finally breaking
Thanks to ECB intervention, credit spreads have been much less correlated to sovereign spreads over the last month (although still positive). In fact, our work shows that the correlation between bank and sovereign spreads has fallen from 90% in mid December last year, to 40% currently. This isn’t far from the lowest correlation between the two since the start of 2010. How long this lasts will ultimately be a function of the outlook for peripheral sovereign debt, given banks’big exposure to the periphery."

In fact as my good macro friend pointed out early January, it is interesting to track the relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge):

Volatility has been falling faster than the Itraxx Crossover index and the index is clearly trying to catch up at the moment.

In relation to the liquidity picture, it has somewhat  improved as indicated in our four charts, ECB Overnight Facility, Euro 3 months Libor OIS spread, Itraxx Financial Senior 5 year index, Euro-USD basis swaps level - source Bloomberg:

New reserve period for deposits started on the 18th. It will be significantly important to track upcoming peripheral government bonds auctions, given that, while the ECB's intervention is clearly supportive for banks, volatility will depend on the Greek PSI outcome, upcoming downgrades for banks and corporate rating downgrades (following up on sovereign downgrades and which have already started).

As Bank America Merrill Lynch put it in a note published on the 16th of January - "Perhaps it's not so bad after all":
"Banks better placed than sovereigns?
It is certainly the case that European banks have a lender of last resort who is dealing very flexibly with their needs – something the ECB has so far proved reluctant to do with sovereign debt."

But, there is a catch and Bank of America Merrill Lynch report from the 17th is on target:
"It isn't all about European banks' sovereign exposure - its also about private sector lending, not just sovereign bond holdings."

"How long the low correlation between bank and sovereign spreads lasts will ultimately be a function of the outlook for peripheral sovereign debt, and Standard and Poor’s sovereign downgrades don’t help. Despite the ECB’s welcome funding, European banks’ exposure to sovereigns remains vast, as chart 7 shows. Note European banks’ large private sector lending to peripheral countries." - source Bank of America Merrill Lynch.

And Bank of America Merrill Lynch to conclude their note with the following advice in relation to credit in 2012: "a more trading, "macro-driven" credit market."

Truth is, while everyone is anxious about the results relating to the Greek PSI, Sovereign CDS wise, Portugal looks to be the ideal candidate for some additional haircuts as we indicated in our last post "The European Principle of Indifference".
Sovereign CDS, between Ireland and Portugal, a new record between both countries with a spread difference of 604 bps - source Bloomberg:

Portugal 5 year Sovereign CDS is now at 1245 bps, which according to CDS data provider CMA equates to a cumulated probability of default of 65.67% within 5 years.

Meanwhile, the disconnect between the 10 year German Bund and the Eurostoxx is still noticeable but today we saw some widening courtesy of German Bund 10 year spread climbing 9 bps and closing on the 2% level, (we noticed this disconnect first time around in November in our post "Mind the Gap...") - source Bloomberg:

In relation to our previous conversations relating to bond tenders and other steps taken by banks to shore up capital requrements (BBVA benefiting from a tax credit courtesy of a goodwill impairment as discussed recently), it was interesting to see the Wall Street Journal catching up with us in relation to the unusual steps taken by some European banks to raise capital in order to reach the 9% Core Tier 1 Capital threshold set up for June 2012 -
"Banks Seeking Capital Ideas - European Lenders Are Taking Unusual Steps to Meet Their Cash Requirements". But what also caught our attention was seeing Bank of America entering as well the raising capital game of bond tenders, offering to buy back 1.5 billion dollars worth of subordinated bonds on the 19th of January. As reported by Zeke Faux in Bloomberg:
"Bank of America is reducing long-term debt as Chief Executive Officer Brian T. Moynihan, 52, seeks to cut holdings, expenses and staff while raising capital to meet demands from regulators for a larger cushion against losses."
So European bankers, please take solace, you are not alone.
"The bank is offering about 95 cents for those securities, it said in the statement", according to Bloomberg, on 6.22% Subordinated bonds due in September 2026, which amounts to a smaller haircut than what we have witnessed in Europe recently on some subordinated bond tenders last couple of months.

But back to our main story, namely European politicians' "Overdiagnosis". What could happen if austerity bites too much, could it lead to Euro Breakup? This is what my friends at Rcube Global Macro Reasearch have recently worked on:

The Likelihood of a Euro Breakup

Since late November, the 2 year yields of both too-big-to-fail PIIGS have crashed (by 350bp for Italy and 320bp for Spain). This indicates that the latest initiatives to save the Euro – most notably the LTRO – have succeeded in lowering the perceived short-term risk of a Euro breakup. This is undeniably a bullish signal for risky assets in the short term. On the other hand, 10 year yields remain stubbornly high, especially in the case of Italy (which is still trading at around 6.5%). This shows that the market believes (as do we) that the question of the Euro’s long-term viability remains unresolved. In order to quantify the likelihood of a Euro exit for each endangered country, we have built a simple model based on CDS spreads and excess unit labor costs. Before showing the model itself, let’s explain why we don’t believe that solving the PIIGS’ government debt problems (through ECB initiatives and fiscal austerity) will be sufficient to prevent a Euro breakup.

In our recent paper about unit labor cost divergence (Macro Analytics 19/12/2011), we suggested that the Euro’s issues went beyond the current debt crisis. The Euro created competitiveness imbalances between Eurozone countries by preventing currency adjustments, which were prevalent in the period between the end of the Bretton Woods system (in 1971) and 1999:

We see some occasional swings, but the dominant pattern is a rather regular fall of most currencies – at different speeds - against the Deutsche Mark, the only exceptions being the Austrian schilling and the Dutch guilder. Unsurprisingly, countries whose currency deteriorated the most during this 28 year period were the PIIGS (the Greek Drachma led the trend with an impressive 95% devaluation against the DEM). When we look at unit labor costs compared to Germany between 1995 and 2012, we notice that countries’ rankings are close to being the opposite of their former currencies’ strength:

If we more thoroughly analyze the relationship between the devaluation rhythm of former currencies’ (+: depreciation, - : appreciation) during the 1971-1995 period and unit labor cost increases between 1995 and 2012, we find a Pearson correlation coefficient of 0.70, and a Spearman correlation coefficient of 0.87. This indicates a strong (albeit non-linear) relationship between those two data items.

Despite the stories about the Mileuristas in Spain, the Milleuristi in Italy and the 700€ Generation in Greece, wage-earners in the PIIGS faired relatively well on a productivity-adjusted basis during the 1995-2008 period, as if they were still being paid in a weak currency that justified regular wage increases. As an illustration of this, we recently learned that Italians now have the highest net worth amongst G8 countries, despite the dismal performance of Italy’s economy over the last decade (this is also a byproduct of Italy’s housing bubble).

Had the Euro never existed, it is fair to assume that PIIGS’ currencies would have naturally adjusted to compensate for their high relative unit labor costs. As countries renounced their ability to devaluate, their competitiveness suffered considerably. Even in the case of France, which is not (yet) considered as one of the PIIGS, its balance of trade went from +3.2% of GDP in 1997 to –3.0% in 2011.

By eliminating currency crises, which were common until the mid-1990s (and at the same time preventing evil “speculators” from making billions on them), the Euro built an economic crisis of far larger proportions. Once again, economics provides a good illustration of the old proverb “the road to hell is paved with good intentions”.  

It is an understatement to say that finding a politically acceptable solution to restore labor cost balance within the Euro framework will be difficult. In addition to the deep cuts that are currently being imposed on government budgets, real wages will have to fall across the board (and not only minimum wages). As people tend to think about money in nominal terms (Keynes’ money illusion), it might end up being easier to find a smart (i.e. non chaos-inducing) way to return to a system of floating currencies, rather than to impose years of internal devaluations.

This is the main reason why we believe that the question of the Euro’s long-term survival goes beyond knowing whether the ECB will finally use its proverbial bazooka during the next 12 months. Even if Greece’s government debt was reduced to zero (which could end up being the case someday), it would not change anything regarding its current lack of competiveness (exports: 7% of GDP, imports 21%). As an anecdote, we recently read that Greece had to import olive oil from … Germany.

A simple model to assess market-implied Euro exit probabilities:

We believe that a large part of Eurozone countries’ CDS spreads reflect their long-term probabilities of exiting the Euro, rather than their default risk within the Eurozone. Indeed, even though we’re not sovereign debt experts, it seems evident to us that if a country was to exit the Eurozone and switch to a new currency, it would have to convert its government debts to the new currency. This would most likely constitute a default in legal terms for most countries[1], but we cannot imagine a country keeping a huge debt denominated in a foreign currency. This would create a Weimar-type vicious circle and would inevitably crush the new currency into oblivion.  Additionally, defaulting without exiting the Euro would not solve the competitiveness issue of many European economies (we’ll soon be able to check this theory with Greece).

If we assume that new currencies would have to devaluate to readjust their unit labor costs to their 1995 level, we can work out theoretical recovery values after redenomination (from which we take a haircut of 20% to take into account overshooting). We then calculate 1-year and 5-year Euro implied exit probabilities by using a simple formula for default probability (Default Probability = Spread / ( 1 – Recovery Rate) ]. This gives us the following implied exit probabilities for the main EZ countries[2] that have a 5 year CDS spread higher than 100:

Despite the rather simplistic assumptions we made in our calculations, these levels appear to be close to what we would have expected: in the short-term (1 year or less), exit probabilities are rather low for most countries, with the exception of Ireland and Portugal. Too much political capital has been invested in the Euro by the last two generations of politicians. Additionally, it would be a mistake to believe that the system is out of ammunition. In a fiat money world, the ECB cannot run out of Euros.  Everything ultimately depends on politicians’ (especially Merkel’s) willingness to “save the Euro”. On its own, the ultimate kick in the can (massive debt monetization) would certainly extend the Euro’s life for quite a few years.  

Consequentely, we believe that the Euro will muddle through for a while, in a climate of painful fiscal tightening for most European countries…

However, if as we fear will be the case, austerity plans do little to address the underlying competitiveness problems faced by many countries, their growth rates will remain anemic. Instead of the rosy “J curve” that would have been promised to justify deep cuts in government expenses, weak EZ countries will experience the dreaded “L”. Rather than going through another purge, some countries will then make the choice to exit the Euro. In this context, the 5 year implied exit probabilities do not appear to be exaggerated to us. 

---

[1] Under ISDA rules, G7 countries (Germany, France and Italy) could decide to redenominate their debt without provoking a credit event.

[2] Outside from Greece whose default/exit probability is already 100%

"The physician must give heed to the region in which the patient lives, that is to say, to its type and peculiarities."
Paracelsus

Stay Tuned!

Markets update - Credit - Goodwill Hunting Redux

"Errors of opinion may be tolerated where reason is left free to combat it."
Thomas Jefferson

Dwindling liquidity has been leading to significant market volatility, in most asset classes. Credit hasn't been spared and while CDS single names and indices are still experiencing important intraday spread movements, Cash bonds in the European markets are not spared either. Thursday and Friday were very interesting, namely because we saw an important acceleration of bond tenders in the financial space (triggered by the Santander bond tender we mentioned in our "Mind the Gap" on the 15th), something we have been expecting to happen from our many previous conversations("Subordinated debt - Love me tender", "Crash Test for Dummies"). In fact in a more recent conversation ("Complacency") we argued:

"Something has gotta give" - subordinated bondholders or shareholders, or both.

Well, it looks like subordinated bondholders are the first in line, and are going to give some back, to help European banks shore up their Core Tier 1 capital as they rebuild/shrink their balance sheet in order to meet the June 2012 European Banking Association threshold of a core Tier 1 of 9%.

In today's long credit conversation, as we go through the latest price action and bond tenders, we will revisit Goodwill impairment, which is definitely back on the agenda, a subject which we already approached in December 2010 ("Goodwill Hunting - The rise in Goodwill impairments on Banks Balance Sheet").

But first it is time for a market overview:

The Credit Indices Itraxx overview - Source Bloomberg:

So, three weeks after a supposedly historic agreement on the 26th of October,  we are still near records levels CDS indices wise (Financial indices, and SOVx - European CDS sovereign risk gauge). Itraxx Crossover 5 year CDS index (High Yield gauge) is at around 760 bps, while Investment Grade Europe represented by Itraxx Europe Main 5 year CDS index is around 188 bps.

Itraxx credit indices for Financial Senior 5 year CDS and Financial Subordinate 5 year CDS, remain stubbornly high (300 bps and 538 bps respectively, close to September records level) - source Bloomberg:

Some respite in the Sovereign European CDS Space - source CMA:


In relation to the bond picture, contagion has been spreading to core Europe last week with some respite as well for France and Austria, as well as a pause in the flight to quality with German 10 year yield increasing, but for how long?- source Bloomberg:

In relation to our CPDO/EFSF relationship with French 10 year Government bond and German 10 year bund yields, while French OAT yields have receded, EFSF bonds yields are still rising towards 4%, currently at 3.87% - source Bloomberg:

Another indicator worth tracking is the relationship between 10 year Swedish Government yields and German 10 year Government yields, which, so far have been moving in lockstep, but recently spread between both are moving towards their highest level of 25 bps (contagion to Germany? Not yet) - source Bloomberg:

As far as the liquidity picture is concern, it is clearly deteriorating. The new reserve period for deposits at the ECB which started on the 9th of November will last this time around 35 days:

In relation to the liquidity update, please find an additional point made by Goldman Sachs Sales/Trading teams on EUR FRA/OIS Basis:

"FRA/OIS Basis shows the difference between the overnight and the 3 month interbank borrowing rate and shows the confidence of banks to lend to each other. Current levels show that the confidence is very low as the premium to borrow long term is very high despite recent unlimited LTRO (long term refinancing operation) by the ECB."

In our last conversation on the 15th, we discussed the latest bond tender by Santander in Europe, which in fact triggered a flurry of bond tenders in the market according to Bloomberg article by Esteban Duarte on the 18th of November:

"Societe Generale SA and Banco Santander SA are among banks offering to buy back or exchange part of about $30 billion of junior debt issuance to boost capital and raise money as borrowing costs rise.
The bond tenders that started in Europe this week allow the banks to repurchase subordinated notes at a discount, booking a capital gain, or swap the securities to raise senior debt. Others pursuing the strategy include BNP Paribas SA, France’s biggest bank, and Northern Rock Asset Management Plc, the so- called bad bank spun off from the lender being purchased by Richard Branson’s Virgin Money Holdings U.K."

And the article to detail the flurry of bonds tenders we have been expecting for a while:

"SocGen offered to repurchase as much as 900 million euros of a total $8.2 billion of Tier 1 notes today, at prices starting at 56 percent of face value. Banco Santander, the biggest Spanish lender, asked holders of 6.8 billion euros of subordinated bonds to swap their securities for new senior notes on Nov. 15.
BNP Paribas, France’s largest bank, offered to exchange or repurchase part of about $10 billion of subordinated bond issuance yesterday for as little as 72.5 cents on the dollar, according to a series of statements. SNS Bank BV of the Netherlands announced a tender of Lower Tier 2 notes yesterday, while nationalized U.K. bank Bradford and Bingley Plc is also tendering for debt."

Love me tender?

We already know the liquidity is poor and we discussed previously how issuance under current market conditions is difficult to say the least, it isn't really a surprise to read in the same article:

"“Banks are currently taking advantage of poor liquidity in the market to buy back, or more often exchange, redundant capital instruments on very attractive terms for the issuer,” said Mark Harmer, an analyst at ING Groep NV in Amsterdam.
“It’s definitely a growing trend, especially where traditional access to senior funding channels is limited.”

Given we already know 2012 is going to be a significant year for term issuance for banks ("Mind the Gap..."), you can expect more of the same. 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.

It was interesting to see as well Deustche Bank increasing the size of a previous 2 year Senior Unsecured FRN (Floating Rate Note) issue by 250 million euros (previous issue size was 1.75 billion Euros, maturity October 2013), at 3month Euribor +75bps.

So yes there is worrying liquidity and funding stress in the European financial system, and according to Bloomberg Liz Capo and Gavin Finch in their article - "Bank Stress Gauges Show Pain Lasting Through ’11: Credit Markets":

"Spanish banks borrowings from the ECB rose 10 percent to 76 billion euros in October, the highest level in more than a year, while Italian firms reliance increased 6 percent to 111.3 billion euros."

And added:

"Italian banks may be forced to increase their reliance on emergency funding from the ECB as their liquidity levels have fallen to levels not seen since January 2009 after the value of the government securities they held tumbled, the central bank wrote in its Financial Stability Report published on Nov. 3.
The ECB announced in October it would reintroduce year-long loans for the regions’ banks as the sovereign debt crisis threatens to lock local money markets. It had previously coordinated with the Federal Reserve to provide euro-area banks with dollars. The central bank offered 12-month loans last month and will off a 13-month loan in December."

According to Radi Khasawneh in the article published on the 18th of November - Italian Banks May Need $8.2 Billion as Government Bonds Slump:

"Italy’s five biggest banks, including Intesa Sanpaolo SpA, may need to raise a combined 6.1 billion euros ($8.2 billion) of additional capital as the Italian government bonds they own deteriorate in value.
Two-year Italian debt, which the banks valued at 97 cents on the euro or better on Sept. 30, trades at about 92.7 cents.
That suggests Intesa, UniCredit SpA, Unione di Banche Italiani
SCPA, Banco Popolare and Monte Dei Paschi di Siena SpA need more capital, today’s Bloomberg Risk newsletter reports."

Given the issue of circularity discussed in our previous post, the more pressure we get on Italian sovereign spreads, the more capital, they will need to raise.

All of the above lead us to revisit a subject we approached already in December 2010 as indicated above, and my good credit friend to comment:

"In term of credit market, following Santander, SNS bank and BNP…Here comes SocGen announcing a tender offer on $1.2 billion of subordinated debt! Hooray! The haircut is 44 %, the tender price is 56%…. I guess the bank will do better next time, if there is a “next time” and will offer tender prices below 50 %.

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

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."

Indeed, it will be painful. According to Liam Vaughan and Charles Penty, "EU Banks Face $270 Billion Goodwill Hangover for Past Purchases":

"European banks may have to write down some of the $270 billion of goodwill from their purchases in the run up to the financial crisis before they can sell assets, or new stock, to bolster capital.
UniCredit SpA, Italy’s biggest lender, this week opted to take an 8.7 billion-euro ($10 billion) impairment charge following a series of acquisitions at home and in eastern Europe. Other European banks are yet to follow, analysts said.
Credit Agricole SA, Banco Santander SA and Intesa Sanpaolo SA are among European banks with the most goodwill remaining on their balance sheets, according to data compiled by Bloomberg.
“Banks that paid a premium for businesses when the outlook was better will need to reassess the goodwill on their balance sheets,” said Andrew Spooner, an accounting partner at Deloitte LLP in London. “Previous acquisitions which are exposed to peripheral Europe are most vulnerable to impairments.”

We already discussed Austria's exposure to Eastern Europe ("Long hope - Short faith"). Erste Bank in fact, wrote down the value of its Hungarian and Romanian units by a combined 939 million euros in October.

Liam Vaughan and Charles Penty also commented in their article:

"UniCredit wrote down goodwill on assets in its home market, eastern Europe and former Soviet Union countries in its third-quarter earnings report this week, though it didn’t tie the charge to any specific deals among the $60 billion of acquisitions it made from 2005 to 2008."

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."

On June 29, 2001, The Financial Accounting Standards Board (FASB) unanimously voted in favor of Statement 142, Goodwill and Other Intangible Assets. Prior to this statement, goodwill was amortized over its useful life not to exceed forty years. Under FASB 142, goodwill will still be recognized as an asset, however, amortization of goodwill will no longer be permitted. Instead, goodwill and other intangibles will be subjected to an annual test for impairment of value. This will not only affect goodwill arising from acquisitions completed after the effective date, but will also affect any unamortized balance of goodwill."

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."

And we concluded back then:

"Large Goodwill Impairments increase the debt to equity ratio.
It is therefore paramount to track goodwill impairments in relation to future banks earnings."

For more on the subject, Bloomberg Columnist Jonathan Weil had an interesting column relating to Goodwill impairments - "UniCredit Bombshell Shouldn’t Be the Last One".

Time has come once again to become "Goodwill hunters" in relation to bank earnings!

On a final note I leave you with Bloomberg Chart of the Day from the 18th of November relating to debt collection in Spain (the hunt for bad loans...):

"The CHART OF THE DAY shows the proportion of staff in Bankia SA, Banco Popular Espanol SA and the Spanish unit of Banco Bilbao Vizcaya Argentaria SA working in the banks’ collections teams. The second panel shows the amount of bad loans being chased by each of the collection units’ employees. “I’d say it’s more crucial than ever for the Spanish banks to show they’re trying as hard as they can to recover bad loans,” John Raymond, a southern European banking analyst at CreditSights Inc. in London, said in a phone interview.
As the country’s property crash and a stalling economy drive up defaults, the bad-loans ratio of Spanish banks rose to 7.16 percent in September, the highest level since November 1994, according to Bank of Spain data."

"I believe that banking institutions are more dangerous to our liberties than standing armies."
Thomas Jefferson

Stay tuned!

Markets update - Credit - Long faith - Short hope and more on revamped EFSF

"To withdraw is not to run away, and to stay is no wise action, when there's more reason to fear than to hope."
Miguel De Cervantes

Epic capitulation in the Credit space CDS wised. Both dealers and clients were short credit via CDS and basically everyone ran for the hills and the short squeeze was massive. Most of the action was in the CDS space, from single names, to credit indices, to sovereign CDS. In this long post, we will first review today's price action as well as revisiting EFSF revamped and risk it entails.

This was the picture today for sovereign CDS - source CMA:


The core countries of the euro area - source CMA:


In the banking CDS space, the rally was significant, as well in equities - source CMA:


The squeeze was massive in Itraxx credit indices, 23 bps in Itraxx Main Europe 5 year CDS (investment grade credit index) which closed at 150 bps and 72 bps on Itraxx 5 year Crossover CDS index (High Yield credit index) which closed around 630 bps. It was a complete short capitulation and CDS curves steepened massively in the process in the front end of CDS curves - Source Bloomberg:

In the financial space Itraxx Financial Senior 5 year CDS index and Financial Subordinate 5 year CDS index tightened significantly and the spread between both CDS compressed as well - source Bloomberg:

But the most significant compression we have seen between indices has been between the Itraxx Financial 5 year CDS index and Itraxx Main Europe 5 year CDS, meaning financial spreads are converging towards corporate non financial spreads (investment grade)- source Bloomberg:

In terms of flight to quality, we had a widening in 10 year German Government bond yields and convergence again with German 5 year sovereign CDS spread - source Bloomberg:

In relation to EFSF 10 year bonds versus 10 year French government bond yields and German 10 year government bond yields, correlation is still alive and well - source Bloomberg:

The interesting point following last night agreement relating to Sovereign CDS is the fact that the 50% haircut will not constitute according to ISDA, a credit event. So what is the value of a sovereign CDS exposure?

As my good credit friend put it today:
"ISDA may find that 50% haircut is not a credit event…as the decision is “voluntary”.

So banks who bought CDS to protect their Greek bond holdings could endure more losses: 50 % on the bond, and a worthless CDS. To draw a parallel, it would be like finding after a car accident that the insurance you bought to protect the car does not cover you for anything ! Nice !!!"

In relation to last night's agreement relating to the ongoing European debt crisis, like most, I do not see this as the bazooka which will fix once and for all the European issues, hence the title of the post, this time it isn't "Long hope - Short faith" but, I rather see this as market participants desperately wanting to believe in lasting solution to the crisis and welcoming the respite. Call it "battle fatigue", or CSR (Combat stress reaction) in relation to the short squeeze. The only solution for Europe goes through more integration and ECB stepping in as lender of last resort, in the process changing its DNA and becoming more like a FED in effect, backed by a central treasury.

As research analyst David Watts from CreditSights put it in their latest sovereign analysis report - Eurozone Leaders Produce Belgian Waffle:
"It is possible that the measures taken will actually resolve the issues plaguing Eurozone governments. But there are very real risks that this will prove to be just another divet in the road that the "can" is currently being punted down. For the moment stock markets are up and credit markets are rallying. Given that this is at root a crisis of confidence over some Eurozone governments ability to repay their bonds at maturity, a change in sentiment for the better might be sufficient. If enough investors think that Italy (or at least the EFSF / ECB / IMF) will definitely pay them their money back when the bonds mature, they will buy the bonds and the financing become self-fulfilling.

But the markets are in no mood for "possible and "might". And the reality is that the institutions that the Eurozone policy makers have decided to create to underpin confidence in government's financing needs are themselves open to crises of confidence. Unless the backstop is cast iron, in other words, there can be no question over its ability to source and provide liquidity, there is always a risk that the market will lose faith and the house of cards will fall. That is why, we sincerely hope that this convoluted leveraging of the EFSF will prove sufficiently, we suspect that unless the ECB throws its weight behind government's, their liquidity position will always be open to question."

So yes, long faith but short hope.

We already discussed the EFSF structure in depth. In relation to the proposal of the EFSF proposing to write protection on the first loss tranche, effectively transferring first-loss risk from Italian bondholders to EFSF bondholders, we know by now that our CPDO/EFSF is not risk-free from the post "Much ado about nothing":
"when losses are incurred in our CPDO, the SPV must increase leverage in order to make up the increased shortfall in NAV (Net Asset Value), and by the way principal is not protected."
and we also know:
"In a CPDO/leveraged EFSF, when multiple downgrades happen, creating significant widening in spreads/higher interest rates, the loss in NAV can be significant."

EFSF fails if Spain or Italy require assistance or if France loses its AAA rating in the coming months. As a reminder, we have upcoming elections in France in May 2012.

And CreditSights commented on their latest note:

"The problem with proposal that first loss insurance is provided to Italian or Spanish bondholders by the EFSF is that it doesn't actually tell investors whether they are truly protected from losses."

We know they are not protected and my good credit friend to comment:
"A boost of the EFSF firepower to euro 1 trillion: This is less than what the market was initially expected, but expectation has been driven lower over the last days. It remains to be seen if the SPV will find some investors (I have strong doubts following Brazil, Russia and India refusals…Of course, everybody is expecting China to fill the gap, like a hero coming to the rescue. It is possible but, I tend to think that the PBOC will not put so much money to work. Also, the first loss guarantee on new primary issues is raising a lot of technical issues, and may not be implemented as it will create a “2 speed” markets (the new issues will be partially guaranteed while the old ones will not), and there will be a lot of conditions to be met by the country issuing to get the first loss absorption insurance…"

The first loss approach has been compared to the monolines which wrote protection on RMBS (Residential Mortgage Back Securities). It did not end up too well for many of them (AMBAC, and others...). But, as CreditSights put it, there is a VERY big difference in the revamped EFSF:

"The monolines wrote protection on the last loss tranche, i.e. the last part of the capital structure to experience losses. The EFSF is proposing to offer to write protection on the first loss tranche, the part certain to take losses in any write-down."

And given the Greek CDS credit event comedy, who gets to determine the recovery? European politicians...

The issue of circularity we previously discussed means that perception of debt sustainability is depending on economic growth. You cannot have growth expansion with fiscal consolidation and too much austerity.

The question now is: Will China buy the equity tranche of the gigantic European CDO and assume first loss? I doubt.

"Faith: not wanting to know what is true."
Friedrich Nietzsche

Stay tuned!

Markets update - Credit - Surf's up ! Much ado about nothing and CPDO redux in European Style

"No one loves the messenger who brings bad news".
Sophocles in Antigone

So what?

We have an epic rally in the equity space because of some news of a possible plan to leverage up the EFSF, CDO-SIV style? What has materially change today? Not much.
And my good credit friend to comment:
"Another volatile day in the equity market …. On rumors, rumors and more rumors of EFSF, ESM, EIB, ECB …. And overall leveraging of the existing system …. It may make the trick for a while, but I tend to think it will not be long before Mr Market rejects that “too complicated to work” puzzle."

The plan so far is sketchy at least and fraught with danger.

Why? Because it eerily reminds me of the halcyon days of the structured credit space, namely CPDO structures. A CPDO (Constant Proportion Debt Obligations) structure was a fixed income instrument with cashflows that had a high and rated likelihood of payment, in theory. At least that was the plan, when ABN AMRO launched its 1 billion euro CPDO called SURF in January 2007. Trouble was that the widening wave got too big to surf and SURF 100 got wiped out.

Its death came in October 2008:

"Requiem for the CPDO" - FT Alphaville - Sam Jones

October 13, 2008 (Bloomberg):
"ABN Amro Holding NV had the ratings on three constant proportion debt obligation funds totaling $305 million cut to D by Standard & Poor’s as the transactions were forced to unwind."
So much for the "Deal of the Year" awarded in February 2007 by Risk Magazine...

Sam Jones commented at the time:
"The CPDOs, funds that use credit-default swaps to bet on company creditworthiness, were downgraded because of “spread widening and increasing volatility” in the credit derivatives market."

"CPDOs, a structured finance post-mortem" - FT Alphaville - Tracy Alloway - Februrary 5 2010:

"Remember that these things, which basically used credit-default swaps (CDS) to bet on company creditworthiness, began popping up in the summer of 2006. ABN Amro’s Surf was the first to be issued, with an AAA rating."

Why did I chose to dicuss the CPDO example in relation to the proposal of the leverage EFSF proposal and not a Credit CPPI note?

Here is why:

The Credit CPPI note is an investment whose principal is protected by a low-risk portfolio (zero-coupon bonds or cash deposits) where the return is increased by leveraging the exposure to a risky portfolio of CDS names, when losses are incurred in the CPPI, the SPV (Special Purpose Vehicle) must decrease leverage to protect the principal.
But, when losses are incurred in our CPDO, the SPV must increase leverage in order to make up the increased shortfall in NAV (Net Asset Value), and by the way principal is not protected.

So, in the CPPI you have limited downside and unlimited upside, in the CPDO, you have limited upside and unlimited downside, kind of.
So in our levereraged EFSF play, the lower volatility in interest rates, the lower likelihood of default. But in a CPDO/Leveraged EFSF, there is a risk of failure of repayment of full principal at maturity.

Could it be the explaination for the apparent reluctance of our German friends to leverage/increase the EFSF given their first hand experience with structured credit?

In a CPDO/leveraged EFSF, when multiple dowgrades happen, creating significant widening in spreads/higher interest rates, the loss in NAV can be significant.

But back to our market overview:

The liquidity picture:

Bank deposits at the ECB still climbing. EUR 3 months Libor, a little bit better.

Italy Sovereign CDS 5 year versus Spain, same story as before, spread between both countries widening:

And Spanish Central bank to take on three more savings banks in distress. The Fund for Orderly Bank Restructuring controlled by Bank of Spain (FROB), will inject 5 billion euros in Catalunya Caixa (90% stake), Unnim and Nova Caixa Galicia according to WSJ.

Portugal 5 year Sovereign CDS versus Ireland 5 year Soveeign CDS:

The luck of the Irish.

10 year German Government bond versus 5 year German CDS:

Some welcome respite in the flight to quality with German 10 year yield moving back towards the 2% level.

In relation to European bank funding, it is not getting better. For the last three months, we know by now that banks have been unable to sell debt at affordable prices, apart from covered bonds, costly for some, backed by pools of prime loans. This quarter, only 34 billion dollars of senior unsecured debt has been issued in Europe by financial institutions, which will probably be by month end "the smallest of any quarter in more than a decade" according to Dealogic.

In relation to the ongoing European debt crisis and the Bundestag vote of the 29th of September, the whole game rest on Germany. Exane BNP Paribas in its latest report Strategy calls published on the 27th of September, goes through interesting points relating to German politics - frequently asked questions:

• "Merkel is safe (for now)

Despite some regional election defeats Angela Merkel remains popular (near 50% approval rating), as does her party (32% in recent polls). Her junior coalition partner(FDP, liberal) has suffered heavy losses while Merkel’s CDU has held an uninterrupted lead in polls since the last general election. Länder election losses are no direct threat through at least mid 2012."

• Germans like Europe (for now)

Despite euro-sceptic gains in Finland, Germans remain unwavering in their support of Europe and 64% are in favour of further integration. Sentiment towards Europe has not changed with the euro crisis. Reflecting this mood, opposition parties are more pro-Europe than Merkel and even support Eurobonds. In the recent Berlin election, voters rejected euro-sceptic election tactics by the FDP."

• It’s the economy, stupid

German voters’ opinions and Merkel's position could quickly change in a recession. Polls suggest Germans are happy to support the periphery as long as they are doing well themselves, i.e. their jobs are safe. When GDP growth turns negative the German economy begins shedding jobs, changing the dynamics within Germany. Merkel’s sudden about-face on nuclear power shows that she can quickly reverse long-held positions if the situation demands it."

And Exane BNP Paribas to add:

• "Will EFSF reform pass the Bundestag?

When it comes to Europe, all parties have a clear commitment to Germany being actively involved in the European Union, to keep the euro currency and support closer European fiscal integration.
More specifically, EFSF reform is generally supported by the government,but some CSU and FDP politicians in particular (but also some CDU MPs) have called for an open debate on an orderly default procedure instead of an open-ended transfer union.

• What about Eurobonds?

Eurobonds are a more contentious topic. The current coalition government is opposed to the principle of Eurobonds, particularly the smaller coalition partner (FDP). Within Merkel’s CDU, however, opposition to Eurobonds has begun to crumble with some MPs arguing for an open debate on the topic. The two largest opposition parties (SPD and Greens) in principle support the idea of Eurobonds as a key part of the solution to the sovereign debt crisis.
Taking a step back from the day-to-day political debate, Eurobonds seem to have much greater political support in Germany than is often assumed. Also note that in recent polls, 64% of Germans were in favour of closer fiscal integration in Europe, an important pre-condition to Eurobonds."

So far so good, but as Exane BNP Paribas add in the report:
"The main obstacle to Eurobonds perhaps comes from a recent ruling of the German constitutional court. The court in principle approved EFSF as a temporary measure, but at the same time said parliament must not introduce a permanent mechanism; Eurobonds would be."

So yes, right now, the German constitution is a serious obstacle to Eurobonds gathering momentum.

But Germans are still for more integration - Source Exane BNP Paribas:

And according to this report from Exane BNP Paribas, what is saving so far Merkel is the economy and the labour market, which is key in relation to "electoral fortunes". And Exane BNP Paribas to comment:
"As long as Germans feel their jobs are safe and the euro crisis does not hurt them directly, sentiments towards the European Union and European integration stays supportive. But with its export-driven economy Germany would be highly sensitive to any slowdown in global growth. And if unemployment rises, the willingness of German voters and thus German politicians to support their southern European neighbors could quickly dwindle. Our economist estimate that the German economy begins shedding jobs when GDP growth falls below 0%."

And given Merkel's big u-turn relating to the Japanese nuclear disaster this year, 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, I would really follow closely the German economy in general and the German labour market in particular.

And I as previously posted as a final quote in my previous post - "Markets update - the EM contagion":

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

German unemployment rate - January 2007 to September 2011:

German GDP growth rate from January 2007 to September 2011:

Stay tuned!