The Change in the Volatility Regime - a follow up

"If you change the way you look at things, the things you look at change." - Wayne Dyer, American psychologist   

While yesterday we touched on implications relating to regime changes in the volatility space, the phenomenon witnessed in the US is similar in Europe where European equity volatility trading has been trading marginally below the VIX as displayed in the below graph from Cheuvreux's recent Cross Asset Research paper from the 7th of January - The Tactical Message:

"The VStoxx index of implied volatility has followed the American example by falling to a cycle-low. The increase in America's political-fiscal risk premium since September has allowed indices of European equity volatility to trade marginally below the VIX." - source Cheuvreux Cross Asset Research, 7th of January 2013.

Cheuvreux makes the argument that the decline in financial volatility is a general phenomenon, with the lead coming from debt markets. They argue that there is more to it than financial repression:

- source Cheuvreux/Bloomberg

MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.

CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.

Back in March 2012 our good cross-asset friend indicated in relation to the relationship between Treasuries vs Equities and Forex volatility at the time:

"If the bond market’s move truly is the start of a long rates repricing for “good” reasons (namely finally validating the huge risky assets run-up of these last 4 months on better macro data) then it makes sense to see a risk transfer from the equities/forex sphere to the bond market’s sphere. As a matter of fact, we noticed this kind of discrepancy during a rather similar period : in Q4 of 2010, following the QE2 announcement, where we saw 10 year yield move up 100 bps, SPX and most risky assets rallyed hard with the same type of cross-asset vols opposite moves.

However these kind of disconnections in cross-asset vol markets generally do not last long. A correction in risky assets or a larger bond market rout would effectively probably see SPX and forex short volatilities move up rather quickly. We’re talking short-term volatility here so obviously timing is key to put on recorrelation trades as you need to be right pretty fast..."

At the time, of the bond market correction of March 2012, there was a similar disconnect, as indicated by Cheuvreux's graph between the CVIX and MOVE index, were Treasuries volatilities were up quite strongly and risky assets volatilities (equities and Forex volatilities remained at the low end of their recent range.

We can see a similar pattern in early 2013.

"Always remember that the future comes one day at a time." - Dean Acheson, American statesman

Stay tuned!

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!

Markets - Credit - The Tempest

"Worm or beetle - drought or tempest - on a farmer's land may fall, Each is loaded full o' ruin, but a mortgage beats 'em all."
Will Carleton - American poet.

Back in March we wondered if in our Credit Space it would be "Plain sailing until a White Squall", and by the end of the month in our conversation relating to Spain "Spanish Denial", we started asking ourselves: "One has to ask oneself if the time has not come to start taking a few chips off the table."

Looking at the recent price action in Europe, with the unnerving news flow following the recent Greek elections in conjunction with troubling news from the Spanish banking giant Bankia (third largest Spanish banking group), our analogy this time around refers to one of Shakespeare's last play "The Tempest", but we ramble again.

Given the acceleration in the news flow from the Spanish banking sector, following a quick credit overview we will focus on the recent Bankia headline and the continuous decline of weaker peripheral banks and the potential outcome. It still very much a game of survival of the fittest (we recently discussed the subject of bank recapitalisations in our conversation "Kneecap Recap").

The Credit Indices Itraxx overview - Source Bloomberg:

Mind the gap...while London markets were closed on Monday, and credit markets fairly muted on Monday, Tuesday was a different story altogether. Itraxx Crossover CDS 5 year index (50 High Yield entities, HY risk gauge) was wider by 22 bps and overall credit indices were wider across the board, Financials Indices taking as well a leading positioning in the widening move with Itraxx Financial Senior 5 year index wider by around 12 bps and Itraxx Financial Subordinate 5 year index wider by 14 bps.

No surprise there given the bad news flow coming from Bankia. As one Index Market Maker commented:

 "In my opinion, the way out for the Spanish bank system is to hurt bond holders further down the capital structure (i.e subordinated bond holders) and the bail-in proposal is supportive of senior bondholders but not for subordinated bond holders."

We have to concur. Of course it the way out! It support our long standing views expressed in our post "Peripheral Banks, Kneecap Recap, Kneecap Recap":

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

It is particularly bound to happen as we wrote it last year given we read on Bloomberg today the following:

"Prime Minister Mariano Rajoy said most Spanish regions, the nation’s “whole financial sector” and most big companies can’t finance themselves on debt markets.

“Today the Treasury is practically the only one that finances itself on the markets,” he said in the Senate today.

“That’s why we have to send the message that we will meet the deficit target.” Rajoy declined to answer a question from reporters as he left the Senate on how much public money may be used to overhaul Bankia."

So dear equity friends, "Mind the Gap" - There is a disconnect between the 10 year German Bund, touching new record lows and the Eurostoxx, it appears the divergence between both does not look correct, and warrant caution - source Bloomberg:

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.

The "Flight to quality" picture as indicated by Germany's 10 year Government bond yields (well below 2% yield), new record low dipping below 1.55% versus 5 year Germany Sovereign CDS stable at 85 bps. It's deflation (デフレ) and "Risk-Off". - source Bloomberg:

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

Moving on to the subject of Spain in general and Bankia in particular: "We do expect to see more debt to equity swaps for some weak peripheral banks".
 While discussing the implications of upcoming Moody's downgrade for 114 European banks and Basel III impacts for the European financial sector ("From Hektemoroi to Seisachtheia laws?") we implied: "We think upcoming downgrades means more collateral posting and more haircuts on collateral that can be pledged for funding at the ECB and dwindling "quality assets" therefore even lower German Bund Yields..." and as our Rcube friend mentioned in the same conversation:
"This year, it appears that Spain and/or Italy are going to be the culprits of a third summer of Eurozone distress."

The latest news on Bankia was that the government has forced the removal of Bankia's management and replaced its CEO with an experienced banker (formerly with BBVA). As indicated by Barclays in their Euro area economics morning comment, it is indeed an important move:
"It is also important because Bankia is by far the largest among the problem institutions. The size of its credit portfolio is nearly EUR200bn, of which 22% is to construction and developers (the bank has a net provisioning ratio of c 43% of problem loans in this sector). The Spanish media has also indicated that the government intends to inject public funds into the institution. Some newspapers have indicated that it could be done through the use of CoCos and with the injection of (public) FROB funds for about EUR7-10bn.
In our view the key to a resolution of Bankia (and to the rest of the problem banks) is a comprehensive, prudent and transparent valuation of their assets, including the legacy real estate assets. This asset evaluation process ideally should involve an independent third party. And it should be followed by a public recapitalization plan (with burden sharing by junior bond holders). If this process is managed swiftly and transparently it could help to restore market confidence."

Bankia Stock price evolution - source Bloomberg:

Bankia was formed on December 3, 2010 as a result of the union of seven Spanish financial institutions, with major presence in their areas of influence. The merger of the seven savings banks, known as 'cold fusion', took only four months, with the integration contract being signed on July 30, 2010.

The 3.3 billion euro IPO for Bankia was done in July 2011 with 824.57 millions shares offered at 3.75 euros a piece, now worth less than 2.25 euros, down 37.39% year to date ((Bankia market cap = E4.4bn). Bankia’s auditor, Deloitte, has not signed off on its 2011 accounts, fuelling further doubts about its asset quality.

According to Spanish newspaper "El Confidencial", the government is planning a capital injection of 7 billion euro. Two government sources also said the injection of public money into Bankia would likely take place through convertible shares, also known as Contingent Convertible bonds (or CoCos), but that other options were also being looked at.
As our good credit friend put it:
"According to recent news, the Spanish government intends to nationalize Bankia and to subscribe to Cocos (Contingent Capital) issued by the bank. To my view, this is definitely not the cheapest solution as the government will have to inject money that it is having already issues raising. Politically, this is not a good play while imposing harsh austerity measures with soaring unemployment. 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 FROB (Fondo de Reestructuracion Ordenada Bancaria - Spanish Restructuring Fund) had already dealt last year with a few ailing institutions but so far not in the size of Spanish giant Bankia. The state-funded bailout vehicle FROB has injected nearly €15bn into the banks. It injected last year 2.465 billion euro in NovaCaixa's capital with a discount of around 75 to 85% price to book. Also, CaixaBank's 1Q12 results were hit hard by real estate provisions and the bank was forced to merge with ailing Banca Cívica in 2011.

So far, the Spanish government solution has been consolidation (Savings banks reduced from 45 to 17). The set-up of a bad bank would imply price discovery and coming clean on true asset valuations. This exactly what our good credit friend mentioned in our conversation "Mutiny on the Euro Bounty" in relation to Spanish bank issues and valuations:
"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..."

and we replied at the time in relation to bond tenders in the Spanish RMBS space:
"Interestingly enough, while consolidation is being underway and encouraged by Spanish authorities, this week two bond tenders caught our attention, this time in the Spanish RMBS space, from Banco de Sabadell for an aggregate principal outstanding post amortisation amount of around 1,270 million euro and Banco CAM for 5,693 million euro. The decline in prices for these securities would have been steeper if not for the tender offers..."

Of course the decline would have been steeper! 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 to help in the  set up process as indicated above in Barclays comments.

As indicated by Deutsche Bank in their latest note on Spanish Financials - A new Royal Decree in the making:

"As soon as this coming Friday (surprisingly early), the government could approve a new Royal Decree (RD2) affecting the Spanish financial system. As a reminder, in early February another RD (RD1) was approved, requiring banks to double (by year-end 2012) the provisions for existing real estate risks (E25bn), while moving forward on loss recognition (via a new generic provision requirement for performing RE loans).

When quantifying how much is “enough” is impossible

While we argued in our latest sector piece that RD1 requirements looked

largely sufficient to cover existing real estate (RE) risks, the market seems to lack the patience and the visibility to wait and see whether the new provisioning levels will be sufficient (considering the NPA formation will accelerate); thus, overhang risk (in the form of underlying RE losses) persists in terms of banks’ solvency/P and L. The potential creation of a bad bank could be a positive step to calm down markets. However, at this point, we are skeptical that this may be the silver bullet for which the market is looking; the challenge is the lack of a consensus view when quantifying the size and form of this silver bullet (e.g., what is the “adequate” level of impairments? Will concerns stop at RE or will they extend to SME/mortgage lending?).

What to expect when you are expecting: provisions and bad bank (BB)

On a hypothetical announcement regarding more provisions (PM Mr. Rajoy said in an interview that the “RD2 will go and value RE assets again”), if the government does not want to contradict itself too much in relation to the RD1, the only area where it has some leeway is in the generic provision requirement for still-performing RE loans. We regarded this cushion as useful (though we are not sure whether it is sufficient) to tackle concerns around whether banks were providing an accurate picture of still-performing RE loans (i.e., restructured loans to non-viable clients). With the RD1, the generic provision was equivalent to 7% of still-performing RE loans (E10bn of incremental provisions). The NPA of the RE sector stands at c.50%; we estimate this will move to 70% by 2013. On the BB, there are numerous questions, the most relevant being: (1) the transfer price of the assets (we believe that requiring banks to transfer the assets below the RD1’s markdown levels will mean a low rate of participation by the institutions and a second round of equity raising –

even if some equity is freed up after the transfer – which the system is not in a position to take, except the larger names); and (2) who finances the BB. It could be the financial system (we believe this would not break the negative circular reference seen by the market), the government(probably a good solution depending on the transfer price, though any freeing up of funding will be dependent on whether the BB issues debt, which is exclusively subscribed by the banks), or Europe/IMF (unlikely due to the likely heavy conditionality accompanying the aid)."

As a reminder, BBVA and Santander need to provide around 2.3 billion euro each in 2012 under the RDL, and neither charged a meaningful portion of this in the first quarter (zero for Santander, and €174 mln for BBVA) so far in 2012. Caixabank has already met its 2012 RDL requirement of 2.4 billion euro in the first quarter.

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.

This is clearly indicated in a recent note by Cheuvreux - Spain, too much already but still not enough:
"Banks still have a lot of bad assets to deal with, in part thanks to regulatory forbearance. The official stance of the new government in this respect is very straightforward. Its aim is to clean up some of the excessive leverage through new impairments. Supposedly, the cleaner balance sheets and lower leverage following this action would allow loans to flow to where there is demand. A clear strategy does not necessarily make it a good one. And some banks are even vocal about what's next (both Santander and CaixaBank have publicly stated that private loans will have to fall by around EUR300bn-400bn over the next few years).
We believe the private sector deleveraging poses significant challenges for the Spanish economy going forward. Going back to the surplus/deficit per sector, a private deleveraging process would need to be countered by higher public spending to compensate for the fall in GDP. This was the case in Japan in the early 90s but it is not plausible for Spain within the current EU configuration, where fiscal austerity is king. In this regard, note that the Spanish government has undertaken to reduce the budget deficit from around 8.2% in 2011 to 5.3% and 3% in 2012 and 2013, respectively (gaps of around EUR40bn and EUR55bn, respectively).
More importantly, it is unclear whether corporates are willing to borrow given:
1) high levels of debt and B/S deterioration as the price of assets fall; and 2) many companies, particularly in the property sector, are unable not only to borrow more but to even pay back their existing debt. Consequently, a number of corporates are moving into debt reduction mode as opposed to maximising profitability. This is not helped by the ongoing credit crunch, as shown by higher lending spreads. See charts below."
Spain: Spreads in New Loans (%) - source Cheuvreux - Bank of Japan:

Spain: Lending Growth - source Cheuvreux:

LTRO was good news but will not promote lending growth - Cheuvreux (hence our "Money for Nothing" argument...):
"In a perfect world, the availability of an affordable (1% cost) source of medium-term (three years) funding would certainly promote lending to the private sector. There is sufficient empirical evidence to suggest, however, that neither low rates nor QE programmes foster lending to the private sector in highly leveraged economies. This has certainly been the case in Japan, the US and the UK where an enlarged monetary base did not lead to an increase in lending demand."

While the restructuring of the banking sector is a pre-condition in resuming enough credit growth to sustain economic growth, Cheuvreux estimates that the banking sector restructuring will take out 50 billion euro from taxed earnings and has clearly negative views for growth in Spain in 2011, forecasting a -2.4% print and -0.9% in 2013:

"True realism consists in revealing the surprising things which habit keeps covered and prevents us from seeing."
Jean Cocteau

Stay tuned!