Credit - The Night of The Yield Hunter

"Ah, little lad, you're staring at my fingers. Would you like me to tell you the little story of right-hand/left-hand? The story of good and evil? H-A-T-E! It was with this left hand that old brother Cain struck the blow that laid his brother low. L-O-V-E! You see these fingers, dear hearts? These fingers has veins that run straight to the soul of man. The right hand, friends, the hand of love. Now watch, and I'll show you the story of life. Those fingers, dear hearts, is always a-warring and a-tugging, one agin t'other. Now watch 'em! Old brother left hand, left hand he's a fighting, and it looks like love's a goner. But wait a minute! Hot dog, love's a winning! Yessirree! It's love that's won, and old left hand hate is down for the count!" - Reverend Harry Powell - The Night of the Hunter - 1955 American Thriller by Charles Laughton

While watching with interest gold hitting an intraday low of $1,493.35 per ounce, putting it 22.3% below September 2011's intraday peak of $1,921.41, with Cyprus selling its bullion in the process, we thought this week we had to use as a title analogy one of our favorite movies of all time being "The Night of the Hunter". 

In the movie Reverend Harry Powell, a serial killer and self-appointed preacher has tattooed across the knuckles of his right and left hands two words "LOVE" and "HATE" so that he can use them in a sermon about the eternal struggle between good and evil. As investors, we think you should have two words tattooed across your hands: "INFLATION" and "DEFLATION" so that you can use them in assessing the eternal struggle between inflation and deflation in this current environment.

The sell-off in gold, a clear "sucker punch" moment - chart source Bloomberg:

 But as indicated by David Goldman, the former global head of fixed income research for Bank of America,  in a previous article about Gold and Treasuries and bonds in general he wrote in August 2011:

"Why should gold and Treasury bonds go up together? Gold is an inflation signal and bonds are a deflation hedge. At first glance it seems very strange for both of them to rise together. Why should this be happening?

 The answer is simple: bonds are an option on the short-term interest rate, and gold is a perpetual put option on the dollar. Both rise with volatility.

 It’s like the old joke about the thermos bottle: “How does it know if it’s hot or cold?” If the policy compass is spinning and there’s no way to predict how governments will react, you don’t know whether to hedge for inflation or deflation, so you hedge for both. By put-call parity, if there is huge volatility in the policy responses of governments, the option-value of both gold and bonds goes up."

We also agree with David Goldman's previous comment on gold, namely that it is not an inflation hedge; it is a hedge against the end of the dollar’s status as a reserve currency, a deep out-of-the-money put against the US currency as a whole.

So after all, our call last week for higher gold prices in the second quarter might be premature and some people might see the right hand "LOVE" (inflation) as "a goner" in similar fashion to Reverend Harry Powell's sermon.

It appears to us that old left hand "HATE", namely deflation, to the great sorrow of our self-appointed "preachers" aka central bankers, is currently having the "upper hand". Therefore in this week conversation, we would like to review some of the key indicators we are seeing as evident signs of the deflationary forces at play in this eternal struggle between "LOVE" (inflation) and "HATE" (deflation). 

As we posited in "Zemblanity", being "The inexorable discovery of what we don't want to know", we have always found most interesting the "relationship" between US Velocity M2 index and US labor participation rate over the years. Back in July 1997, velocity peaked at 2.13 and so did the US labor participation rate at 67.3%. Now at 63.5% the US is back to 1981 and velocity is still falling (1.58), even lower than 1960's levels- source Bloomberg:

The great Irving Fisher told us in his book "The money illusion" and in his equation MV=PQ that what matters is the velocity of money which is the real sign that your real economy is alive and well. We do not see any sign of rebound in velocity.

We do agree with James G. Rickard's view of the situation, a partner at JAC Capital Advisors, which he made in a presentation at the recent Global Investment Risk Symposium which was summarized in an article entitled "The Fed is playing with a Nuclear Reactor" at the CFA Institute:

"To really understand what is going on, you have to start with the quantity theory of money, or MV = PQ. (Quick refresher: PQ = nominal GDP, Q = real GDP, P = inflation/deflation, M = money supply, and V = velocity of money.) The issue here is that the theory doesn’t hold up in the real world because velocity — the number of times money changes hands, or turns over — is not constant. ”Velocity is collapsing,” Rickards said. “You can think of monetary policy as a desperate race between increasing money supply and decreasing velocity, and the Fed is printing money to offset the decline in velocity. . . . So the Fed’s problem is best understood as one of trying to bend this velocity curve."

  

A similar disconcerting image is the growing disconnect between Oil prices, US Treasuries, which have seen their yield falling and the S&P500 - source Bloomberg:

We think there is currently an accumulation of worrying signs that the global economy is decelerating and that old left hand deflation has indeed a solid grip when one looks at China's shrinking electricity use, a bearish sign for a price index of industrial metals that, according to Bloomberg, has posted a first-quarter decline for the first time in 12 years - source Bloomberg:

"The CHART OF THE DAY shows that a gauge of six prices from the London Metal Exchange fell 5.6 percent in the three months ended March, the first drop for the period since 2001. China’s electricity demand in January and February gained 5.5 percent from a year earlier, compared with an increase of 6.7 percent in those months in 2012 and more than 12 percent in 2011.

China, the world’s biggest consumer of metals from aluminum to zinc, targets economic expansion of 7.5 percent in 2013. Factory production, which accounts for two-thirds of power use, increased 9.9 percent in the first two months of the year, the weakest start since 2009. Profit at industrial companies still rose for the fourth straight month, indicating higher corporate investment to fuel growth." - source Bloomberg

While our friend Cullen Roche from Pragmatic Capitalism tracks Rail Traffic as an economic activity indicator, we, at Macronomics, tend to track shipping and Air Cargo Traffic, because they are not only economic activity indicators but as well as credit/deflationary indicators as we pointed out in our conversation "Shipping is a leading credit indicator":

"For us the Baltic Dry Index is another indicator in the deterioration of credit as well as an indicator in deteriorating credit conditions leading to a surge in Non-performing loans on Banks' Balance Sheets."

For instance, Shanghai's containerized freight is 6% lower year on year as of the 22nd of March, 23% below its peak in May 2012 as indicated by Bloomberg:

"The Shanghai Export Containerized Freight Index (SCFI) fell 6% yoy in the week ending March 22, the fourth straight yoy decrease. The SCFI is 23% below its May 2012 peak, while the China Export Containerized Freight Index is 3.2% higher yoy and 17.1% below the May peak. Containerized traffic is driven by consumers, and changes in spending have a direct effect on global traffic volume." - source Bloomberg

In similar fashion the burst of the credit bubble had a dramatic impact on housing, shipping was as well not spared as cheap credit did indeed fuel a bubble of epic proportion - source Bloomberg:

"The Baltic Dry Index aggregates the costs of moving freight via 23 seaborne shipping routes. It covers the movement of dry-bulk commodities, such as iron ore, coal, grain, bauxite and alumina. During 1Q, the index typically increases from its seasonally weak period. In 2013, it has been no exception, as the index declined 30.2% sequentially in 1Q. The gain was driven by the tightening panamax market." - source Bloomberg

The Baltic Dry has yet to recover.

China's slowdown is the reason behind the difficulties encountered by shipbuilders such as STX Group as indicated by Kuynghee Park on the 4th of April in his Bloomberg article - China Turns Graveyard From Goldmine Hurting Ship Makers:

"For shipbuilders such as STX Group, China was once a goldmine. Now it’s a graveyard. China’s lower appetite for commodities undermined the group’s plan to sell its shipping line, wiping out a combined $435 million of investor wealth at the South Korea-based conglomerate’s three main companies this week. That also threatens the group’s ability to repay $1.2 billion of debt by the end of the year. STX’s crisis comes after last decade’s boom prompted the group to set up a shipbuilding and offshore complex in Dalian, northeastern China. With Asia’s biggest economy slowing down and the European crisis adding to a plunge in cargo rates, China Cosco Holdings Co., the nation’s biggest mover of bulk commodities and containers, last week reported a loss for 2012, a third straight annual loss."  - source Bloomberg

From the same Bloomberg article:
"Since the credit crisis, orders to build new ships have plunged. Contracts for new vessels halved to $84.7 billion last year, compared with $174.7 billion in 2008, according to Clarkson Plc, the world’s biggest shipbroker."  - source Bloomberg


For financial institutions such as Germany's second largest bank Commerzbank and impaired German bank HSH Nordbank, a large part of their recovery is linked to the fate of new ship deliveries given their shipping loan books have been seriously damaged by over-supply in the container ship markets as reported by Michelle Wiese Bockmann in Bloomberg on the 1st of March in her article - German Banks With Record Soured Ship Loans Forgo Seizing Vessels:

"Deutsche Bank AG and two other German lenders providing about 14 percent of credit to ship

owners are forgoing seizing vessels even after soured loans to the industry rose to a record. Europe’s biggest bank by assets, as well as HSH Nordbank AG, the largest in the market, and Norddeutsche Landesbank Girozentrale, which finances 1,500 ships, are restructuring loans and setting money aside instead of repossessing vessels, officials from the companies said. They have about $69 billion in loans to the industry out of $500 billion in total, according to data compiled by the banks and Petrofin Research SA, an

Athens-based consultant. Owners from Denmark to Indonesia defaulted in the past year, while U.S. tanker company Overseas Shipholding Group Inc. sought bankruptcy protection and ship earnings fell to a record last month. An unprecedented $80 billion out of $125 billion of German loans to the industry aren’t performing as they should, estimates Paul Slater, chairman of Naples, Florida-based ship-finance consultant First International Corp." - source Bloomberg.

HSH Nordbank has shipping loans of 29 billion euros covering about 2,800 vessels, but looking at weak trading conditions, as indicated in a recent note by JP Morgan on HSH Nordbank published on the 4th of April, some ship owners are pushing for new ship deliveries originally scheduled in 2013 to be delivered later in 2014, with additional deferrals expected:

But looking at the deflationary depressed level of Dry-Bulk Shipping rates which are down 9% YoY, but up 78% from 2012 lows - source Bloomberg:

In that context of depressed rates, it is currently driving ship owners to scrap vessels at a strong pace as indicated by Bloomberg:

"This year is expected to be the third straight year of strong scrapping of dry-bulk vessels, according to Eagle Bulk, with scrap rates at about $450 per lightweight ton. Eagle Bulk management forecast in its 4Q call that scrapping rates could equal 4% of the world fleet, or 30 million deadweight tons in 2013. Scrapping should be strongest for sub-panamax vessels, given that about 16% of this type are 20 years old or older." - source Bloomberg

Bulk vessels and Container ships have seen a steady number of ships being broken up due to weak rates and  tied up to the weakness in global economic activity - source Bloomberg:

"Excess capacity and depressed charter rates have increased the number of container ships sent to be scrapped by 503% since June 2005. This is creating a more efficient fleet as older ships are replaced by newer models. Triple-E ships consume about 35% less fuel per container and are able to carry 16% more containers, according to Maersk." - source Bloomberg

This deflationary environment, and "Schumpeter" like creative destruction is enabling innovation, in the container shipping space benefiting, the fittest to survive such as Danish Maersk currently busy upgrading massively its container fleet.

Whereas German HSH Nordbank's survival is depending on renewed global economic activity and its fate  is tied up to shipping and so is the fate of its subordinated bondholders who, at some point could indeed face the same "restructuring" music as Dutch SNS bondholders as indicated in JP Morgan's note:
"We remain negative on the T1 instruments, as we believe that the next catalyst for these bonds would provide negative pricing pressure due to our expectation that there will need to be a retroactive charge for the increased risk shield at HSH which will impact the cash flow expectations of the T1 instruments. We acknowledge the bonds are pricing in a significant number of deferrals already, however, we do not see a positive catalyst in the near term. For both the LT2 and T1 instruments we will be keeping a keen eye on the deliveries of ships and any delays into future years as this could potentially prolong the turn in the shipping cycle out into 2015. If this were to happen we would become much more concerned for the outlook of HSH and its debt securities." - source JP Morgan

Another economic activity and deflationary indicator we have been tracking has been Air Cargo. It is according to Nomura a leading indicator of chemical volume growth and economic activity:

"Over the past 13 years’ monthly data, there has been an 84% correlation between air cargo volume growth and global industrial production (IP) growth, with an air cargo lead of one to two months. In turn,
this has translated into a clear relationship between air cargo and chemical industry volume growth" - source Nomura:

"Our air cargo indicator of industrial activity came in at -3.8% (y-o-y) in March, following -7.8% in February and -8.3% in January. As a readily available barometer of global chemicals activity, air cargo volume growth is a useful indicator for chemicals volume growth."  - source Nomura.

Of course another sign of that old left hand "HATE", namely deflation, has been the absolute level of core European government yields, which have no doubt been supported by "Abenomics" like we indicated last week - source Bloomberg:

Government bond market yields across the euro zone dropped near 2-year low as the aggressive Japanese monetary action ripples through. Italy sold 7.2 billion euros of debt and French and Belgian government bond yields declined as well to record lows. The European bond picture, with Spanish 10 year yields  well below 5% at 4.71%, whereas Italian 10 year yields well  below 5% now around 4.35% and German government yields stable around 1.25% levels, but the most impressive move was on French OAT10 year bonds closing around 1.80%.

No doubt Kuroda's "whatever it take" moment has delivered a powerful right hand "LOVE" moment, inflating its Nikkei index in the process and surging past emerging markets equities surging now well above the MSCI EM index - source Bloomberg:

In relation to our title being "The Night of The Yield Hunter", it appears to us that Japan, is having a very strong effect on global yields, in similar fashion to a gigantic black hole or a powerful vacuum cleaner.  So on that premise although last week we indicated that France's economy was in trouble, selling OATs is "NO GO" at the moment for that specific "Japanese" reason. We would therefore be incline to go for duration and look for visible, stable sources of income.

This Night of The Yield Hunter is as well marking the return of the famous retail Uridashi funds also known as Double-Deckers which we discussed in February in our conversation "The surge in the Brazilian real versus the US dollar marks the return of the "Double-Decker" funds."
The Brazilian Real is one of the top "Double-Deckers" preferred currency play for its interesting carry:
"As we indicated in October 2011, in our conversation "Misery loves company", the reason behind the large depreciation of the Brazilian Real that specific year was because of the great unwind of the Japanese "Double-Decker" funds. These funds bundle high-return assets with high-yielding currencies. "Double Deckers" were insignificant at the end of 2008, but the Japanese being veterans of ultralow interest, have recently piled in again."

And as indicated by Boris Korby and Julia Leite on the 11th of April in their Bloomberg article - "Kuroda’s $75 Billion Lets Gerdau Win Lowest Yield", Brazilian corporate credit is benefiting from this Yield Hunt from yet another self-appointed preacher namely Kuroda:

"Fixed-income money managers are scouring emerging markets for higher returns after Bank of Japan Governor Haruhiko Kuroda said last week that he would double bond purchases to $75 billion a month to help revive growth in the world’s third-largest economy. As the yen fell to a four-year low and the nation’s government bond yields sank to a record, Japanese and investors following them may have bought about $13.5 billion of non-Japanese bonds since the announcement, 10 times more than the previous period, Societe Generale SA said." - source Bloomberg

In that global hunt for yield which has been further stigmatised by Kuroda's monetary policies, even the lowest rated Brazilian issuers are taking advantage of the on-going hunt as indicated in the same article:
"Brazil’s lowest-rated investment-grade issuers are taking advantage of the absence of Brazil’s largest and most creditworthy borrowers from the market to raise funding and reduce borrowing costs, according to Henrique Catarino, the head of international sales at Banco Votorantim SA in Sao Paulo.
Lenders Itau Unibanco Holding SA and Banco Bradesco SA as well as state-run oil company Petroleo Brasileiro SA and iron-ore producer Vale SA, which sold a combined $13 billion abroad in the first quarter of 2012, have refrained from issuing bonds this year, flush with cash and willing to delay issuance until borrowing costs retreat further, according to Catarino. All four companies are rated at least Baa2 by Moody’s and BBB by S&P, on par with Brazil’s government." - source Bloomberg

We made the following point in "Structural Instability":
"The great Hyman Minsky thesis was "stability leads to instability", we would argue that dwindling liquidity and excessive spread tightening in core quality credit spreads courtesy of zero interest rates policy in both the US and Europe is extremely concerning and are already indicative of a great build up in structural instability."
We also added our previous "Hooke's law" ending remarks:

"Given the "Yield Famine" we are witnessing, we believe our credit "spring-loaded bar mousetrap" has indeed been set and defaults will spike at some point, courtesy of zero interest rates."

When reading the following article from Lisa Abramowicz entitled "Hardest-to-Sell Junk Lures Buyers Hooked on Fed", no doubt the self-appointed preachers of this world, namely central bankers have set this credit mousetrap:
"Investors are favoring the riskiest, hardest-to-trade junk bonds by the most in 17 months as confidence mounts that central banks from Japan to the U.S. will prop up debt markets through year-end.
The extra yield investors demand to buy the least-traded bonds with the lowest speculative-grade ratings instead of more liquid securities narrowed to 1.2 percentage points on April 9, the smallest gap since November 2011, according to Barclays Plc data. Yields on the smallest and oldest CCC rated notes contracted by 1.9 percentage points this year, three times the drop on yields for more active notes with comparable grades. Bond buyers seeking to escape the financial repression brought on by near zero interest rates are venturing deeper into the market in search of returns. They are bidding up the debt of companies that would otherwise be the most vulnerable to bankruptcy had the Federal Reserve not injected more than $2.3 trillion into the financial system since 2008." - source Bloomberg

Moving back to our "The Night of the Hunter" analogy, we  think that Japan is a well a great illustration for assessing this LOVE / HATE relationship between inflation and deflation in this current environment. One just have to look at gold priced in yen and the weakening of the yen versus the dollar to get the point - source Bloomberg:

"The CHART OF THE DAY shows gold priced in yen jumped 2.9 percent in March as the currency slid 1.8 percent against the dollar. The metal rose another 4.3 percent this month through yesterday, and may reach 165,842 yen ($1,675) an ounce this year, the highest since February 1980, according to Bart Melek, TD’s head of commodity strategy. Bank of Japan Governor Haruhiko Kuroda said on April 4 that the central bank would boost its monthly bond purchases to 7.5trillion yen ($76 billion) in a bid to fight deflation and revive the economy. The bank suspended a cap on some bond holdings and dropped a limit on debt maturities as they set a two-year horizon for their goal of 2 percent inflation." - source Bloomberg.

We would like to make the following points in relation to the deflationary forces at play in Europe:

-Without private credit growth, how exactly do you get inflation in Europe? It would be the only big reason to sell core European governments bonds and French OATs, or another reason would be 'The Big One" (to use another analogy, this time an earthquake analogy), meaning the unwind of the European project.

-Unless European banks start lending to the private sector again – and this seems unlikely – how is this scenario not deflationary?

Consumer credit, which represents 12% of lending to households, decreased on average by 2.8% over 2011.

-Lower banking profits are a symptom of deflation as well, you are getting smaller ROE in the European banking space, well below double digits

The place to buy banks is where there is economic growth. Banks are the second derivative of an economy. For us, it is a leverage play. (Brazilian banks have double digits ROE in the region of 15% - 17% but that's another subject...).

 LOVE - HATE / DEFLATION - INFLATION:

 -Falling home prices in Europe are a symptom of deflation

 -Governments restructuring debt is a symptom of deflation.

 -A contraction in Europe of banks balance sheets is deflationary.

We believe Europe face the risk of a disinflationary aka deflation bust.
A great definition of a disinflationary bust was made by the Gavekal team:

"Disinflationary Bust: If credit conditions tighten too much then capitalism is strangled: companies pull back on investment, their customers put away their wallets, and economic growth slows. These conditions encourage the marginal equity investor (some of whom have bought with leverage) to exit the market. Investors then typically head for the safety of long-term bonds, as there is little sign of inflation and short rates are likely to fall in response to slowing growth and/or deflation fears." 

In similar fashion UBS in their March 2012 note entitled "The Ides of March" made an interesting point which could validate the on-going weakness in both commodities and Emerging Markets:

"The end of Federal Reserve and European Central Bank (ECB) stimuli will cause an acceleration of capital flows out of emerging markets, hitting commodity demand."  - source UBS

They published last year on that subject an interesting investment clock:

- source UBS.

UBS indicated at the time they were following the HY ETF HYG as a stress indicator:
"We follow the HYG US high yield bond ETF to signal the state of US credit conditions."

In the US, High Yield credit has remained in line with equities since the beginning of the year. The de-correlation between credit and equities is nearly exclusively coming from Investment Grade credit and we indicated the relationship between High Yield and Consumer Staples in our conversation "Equities, playing defense - Consumer staples, an embedded free "partial crash" put option" how defensive the rally in the S&P500 has been so far - source Bloomberg:

The risk of a deflationary bust, validates our negative stance towards commodities and emerging markets as indicated last week for the second quarter. Here comes that "HATE", that old left hand.

On a final note, the 30 year-year interest-rate swap spread is approaching zero again linked to the fact that Dodd-Frank is forcing swaps to become cleared which will be supportive for US Treasuries as indicated by Bloomberg:

"The CHART OF THE DAY shows the 30-year interest-rate swap spread approaching zero. The swap rate has held below the similar-maturity Treasury yield, causing the spread to be negative, for almost every day since November 2008. The spread fell below zero for the first time following the September 2008 collapse of Lehman Brothers Holdings Inc., which prompted dealers to shore up balance sheets.“Part of Dodd Frank is forcing derivatives to become exchange cleared and creating the need to post margin on swap trades,” said Michael Cloherty, head of U.S. interest-rate strategy at Royal Bank of Canada’s RBC Capital Markets unit in New York. “That has made it cheaper for investors to use Treasuries and Treasury futures, rather than swaps, to obtain the duration they need." - source Bloomberg.

As far as Europe is concerned one could argue in similar vein to Reverend Harry Powell that:

"Salvation is a last-minute business, boy."

Stay tuned!

Credit - Gunfight at the O.K. Corralito

"Peace cannot be kept by force; it can only be achieved by understanding." - Albert Einstein 

Looking at the evolution in Cyprus, reminiscent of Argentina's 2001 "Corralito", which eventually led to its default, we thought this week it would be entertaining to use in our title, yet other multi-dimensional references as per last week conversation "The Doubt in the Shadow". 

Our first reference is of course the "Gunfight at the O.K. Corral" which took place on the 26th of October 1881 in Tombstone Arizona, and is generally regarded as the most famous gunfight in the history of the American Old West. Arguably our European Gunfight at the O.K. Corralito, will no doubt be regarded as the most infamous "deposit-levy" fight in "Old Europe's history". The O.K. Corral gunfight represented a time in American history where the frontier was open range for outlaws (tax havens) opposed by law enforcement that was spread thin over vast territories (Europe), leaving some areas unprotected (Cyprus). In similar fashion, the lack of a true European Banking Union from inception of the European project, means, that given the European banking sector's  leverage and thin equity buffers, the depositors can rightly feel unprotected. Yes, we know, on the 29th of June 2012, European leaders expressed their determination to "break the vicious circle between banks and sovereigns". The initial statement focused on the establishment of a "Single Supervisory Mechanism" (SSM) which would pave the way to direct recapitalization of banks by the ESM (European Stability Mechanism). This banking union would not just cover the Eurozone initially but would also be open to the soon to be 28 members of the EU (with Croatia being the next joiner), if they choose to join.

Our second reference is of course, Argentina's 2001 Corralito, which has been recently reenacted in October 2012, limiting ATM withdrawals for Argentinians. The Corralito was the informal name taken by Minister of Economy Domingo Cavallo's economic measures in order to stop bank runs in Argentina. It was not very successful...

Our third reference, is less so evident, but nonetheless, entertaining we think, given the famous Gunfight at O.K. Corral, also gave its name to a mathematical model - The Ok Corral and the Power of the Law (A Curious Poisson-Kernel Formula for a Parabolic Equation) by David Williams and Paul Mcilroy submitted in 1998:

"Two lines of gunmen face each other, there being initially m on one side,n on the other. Each person involved is a hopeless shot, but keeps firing at the enemy until either he himself is killed or there is no one left on the other side. Let μ(m, n) be the expected number of survivors. Clearly, we have boundary conditions:

We also have the equationThis is because the probability that the first successful shot is made by the side with m gunmen is m/(m + n). On using the recurrence relation (1.2) together with the boundary condition (1.1), the computer produces Table 1 below, in which1991 Mathematics Subject Classification 60F05."

In similar fashion each European politician involved in our European Gunfight at the O.K. Corralito is as well a "hopeless shot" but keeps firing (or making blunders that is) until either he himself is killed (or his country's economy) or there is no one left on the other side (we have yet to see an Italian government...). Of course there is an elegant solution to this mathematical model - Solution to the OK Corral model via decoupling of Friedman's urn by J.F.C. Kingman and S.E. Volkov. Just for an illustration, the authors presented the probability that exactly 5 gunmen would survive provided there were initially 20 on both sides. 

We will let you mathematically work out in your own time how many  "hopeless shot European gunmen" will survive this "European O.K. Corralito gunfight" given than they will soon be 28 countries in the European Union, 14 on each side, but, as usual, we ramble again...

While in the last two credit posts we focused our attention on the lack of equity buffers (Dumb Buffers and The Doubt in the Shadow), in this week's conversation we would like to direct our attention to the "unintended consequences" of the Gunfight at the O.K. Corralito given that, in true "Zemblanity" fashion. (Zemblanity being defined as "The inexorable discovery of what we don't want to know"), there will indeed be casualties, and most likely in the peripheral banking space that is, with rising nonperforming loans due to lack of economic growth, thin equity buffers and high loan-to-deposit ratios and soon to happen deposit flights.

Although the intentions of the European Union has been to severe the link between financials and sovereigns with a move towards a European Banking Union, the ban on naked Sovereign CDS imposed on the 1st of November has effectively killed the Itraxx SOVx 5 year index market for good. This market had been trading closely to Itraxx Financial Senior 5 year index in the past (25 European banks and insurance single names CDS). Financial spreads have been as of late on the receiving end of the widening move in cash and CDS markets courtesy of discussions surroundings "bail-in" procedures  from one of the European gunmen (Jeroen Dijsselbloem). 

The EU Recovery and Resolution Directive proposes an orderly introduction of bondholder write-downs, with the bail-in tool set for implementation in 2018 but it looks like our lone gunman is trigger happy and ready to shoot early in the gunfight . Graph below SOVx versus Itraxx Financial Senior 5 year index since March 2011 -  source Bloomberg:

"27 February 2013 - The Markit iTraxx SovX Western Europe index will not roll into Series 9 in March 2013 due to low trading activity as recorded by the DTCC Section IV: Market Risk Transaction Activity data. Series 8 will remain on-the-run." - source Itraxx Markit

While Cyprus replaced Greece has a member of the SOVx index back in 2012, the only remaining series, will remain at 14 for the foreseeable future for lack of liquidity, or lack of market thereof:

Goodbye SOVx CDS market...

Financials have no doubt been the early casualties of the European Gunfight at O.K. Corralito, when one looks at the increasing divergence between the Itraxx Main Europe 5 year CDS (risk gauge for non-financial Investment Grade European Credit)  versus the Itraxx Financials 5 year CDS index - source Bloomberg:

In fact, CDS insuring against default on European financials have risen for 10 days in a row, the longest streak since August 2011, closing on the 28th of March towards the 205 bps, heading for its worst month since November 2011.

Of course in the financials space CDS wise, the Itraxx Financial Subordinated index (indicative of the risk gauge for subordinated debt, in the direct line of fire for bank recapitalization as per the SNS case...) took a pounding as well in this European Gunfight and widening towards 325 bps versus 205 bps for the Itraxx Financial Senior 5 year CDS index. - source Bloomberg:

Back in February in our conversation "House of pain and House of cards" we argued  the following in relation to the SNS case which saw subordinated debt totally wiped-out by the Dutch government:

"If the recovery rate for SNS LT2 subordinated bonds is zero, the significance for the European subordinated CDS market is not neutral given the assumed recovery rate factored in to calculate the value of the CDS spread is assumed to be 20% for single name subordinated CDS and 40% for senior financial CDS."

We were glad to see Matt King from CITI joining our concerns in his note on the 15th of March entitled "Behold the new form of bail-in":

"The CDS trade has the additional advantage that not only are losses at senior level becoming more likely, but sub CDS protection is likely to be rendered worthless in cases where bonds are completely converted to equity or wiped out, because of a lack of deliverables. With sub/senior relationships still trading pretty much in line with their long-term averages, this does not seem yet to be priced in (chart below).

Perhaps the SNS auction next week (which is likely to confirm sub recoveries of zero) will be sufficient to give trading a jolt, a result which seems quite likely if there are eventually auctions on Laiki Bank or Bank of Cyprus CDS.5 Conceivably it may take longer: as with many factors in the current outlook, we fear the potential for discontinuities even as the market fails to react today — a sort of “ball in a bowl” phenomenon.6 But even if it takes a while, we think the bailin of bank bondholders on one small island today is ultimately likely to have significance far greater than its size suggests." - source CITI

The recent  "Dutch" case of SNS Reaal has indeed illustrated the shortcomings of the restructuring credit events in financial CDS.  Given the Dutch government expropriated all of the lender's subordinated debt in February before a CDS auction could be held, we wonder if the Subordinated market will indeed suffer a similar fate to the Sovereign CDS market and SOVx in particular. CDS notionals have remained on a downward trend since the market's peak of USD 58trn notional outstanding at the end of 2007, touching a new low of USD 27 trillion at the end on June 2012, according to the Bank for International Settlements. A dying market or simply yet another victim of our European Gunfight at the O.K. Corralito. We wonder...

Another "unintended consequence of the European Gunfight, has no doubt been the growing divergence between European volatility gauge V2X and its US equivalent VIX - source Bloomberg:

 The spread between both volatility risk gauges has been rising steadily since December, closing towards 8.60 but has yet reached its 2011 record of nearly 15.

Of course the obvious "unintended consequences" of the Gunfight at the O.K. Corralito, should be that depositors will think about spreading their wealth across banks to ensure they are below the 100,000 euros "implicit guaranteed" threshold - Euro deposits table, source Bloomberg:

"A key positive of the restructured solution for Cyprus is the underpinning of the 100,000 euro deposit insurance scheme, explicitly noted in the release. A consequence of the decision to use uninsured deposits along with equity and bond instruments to part-fund the recapitalization of Bank of Cyprus may be depositors spreading money across banks to ensure they don't exceed the threshold at any one lender." - source Bloomberg.

And, as we posited in "Winner-take-all", should a deposit flight occur in Europe, depositors will no doubt seek a German bank sanctuary.

In this European Gunfight at the O.K. Corralito, we wonder if Germany is really a "straight-shooter" when looking at the level of capitalization of some of its banks which have been deeply impacted by their venture into structured finance and shipping in particular fuelled by cheap credit.

We discussed in depth the issues plaguing Germany's second largest bank Commerzbank in our conversation Dumb Buffers: "Not only have overbuilding occurred due to cheap credit that fuelled an epic bubble in the Baltic Dry Index, but, the on-going decline on vessel prices, will no doubt exert additional pressure on recovery values for Commerzbank's loan book".

Another high profile German institution which had been on the receiving end of state aid has been HSH Nordbank:
"In December 2008 HSH was granted to issue up to EUR 30bn guaranteed notes under the German SoFFin program. One requirement that was imposed on HSH was to raise the capital ratio to at least 8%. On January 20, 2009 EUR 3bn 3 year guaranteed notes were issued. On February 24, 2009 HSH received new capital of EUR 3bn and credit guarantees of EUR 10bn by the two main shareholders, the states of Hamburg and Schleswig-Holstein. The other shareholders, JC Flowers and the savings bank association, did not participate in the capital infusion. Together with this increase of its core-capital, HSH announced further restructuring. It plans to spin off non-strategic activities and the Toxic asset portfolio into a—yet to be created—Bad Bank." - source Wikipedia

Could HSH subordinated bondholders suffer the same fate as Dutch bank SNS? Of course!
We agree with a recent note from Bank of America Merrill Lynch on this subject entitled "At the mercy of shipping":
"The most recent legislative proposals in the German banking sector do not appear to allow for direct bondholder expropriation by the German government / states, as happened with SNS REAAL. But if HSHN’s key sector exposure (ie, shipping) does not show signs of stabilization in the near term, negative outcomes for bondholders (ie, (very) low recoveries) could be achieved through transfer orders and/or recovery / resolution plans, we think. Also, when considering the relentless drive by the EU towards bailing in sub bondholders, we would not necessarily take the existing regulatory framework and – proposals in Germany as the last word on burden sharing by sub bondholders." - source Bank of America Merrill Lynch.

For, us, you probably know by now, why shipping is a leading credit indicator. For Dutch SNS it was commercial real estate, for HSH (and Commerzbank as well) it is shipping issues first:
"Shipping – plagued by overcapacity
At end-1H12, HSHN’s exposure to shipping was EUR32bn, of which about EUR12bn was housed in the restructuring unit. The bank finances ship owners, not ship yards. Due to the overcapacity in shipping and the low level of fleet utilisation (exacerbated by weaker economic growth and reduced global trade flows), the sector has been struggling for some time now, which has led to higher problem loans for most lenders in this field. Collateral values (ie, ship prices) have also come down.
Overcapacity in the shipping industry is unlikely to be resolved until 2014 at the earliest, due to the high number of new ships ordered over the past few years. A number of competitors are retrenching from shipping finance. On the one hand, this could result in financing problems for some shipping companies. On the other hand, it could improve the competitive position of the remaining players. As for HSHN, it has agreed with the EC to reduce its shipping exposure to about EUR15bn by end-2014 and to limit its share of new business in worldwide ship financing to 5% until end-2014." - source Bank of America Merrill Lynch

As far as HSH credit metrics are concerned, they are indeed very weak as indicated by Bank of America Merrill Lynch in their note:

"HSHN’s asset quality is weak. At end-1H12, its reported NPL ratio was 12.6% and this is expected to have increased significantly in 2H12. The bank’s reliance on wholesale funding remains high, with a loan/deposit ratio of 195% at end-3Q12. Its profitability has been very poor in recent years - it was loss-making in 2008, 2009 and 2011. It expects to be loss-making again in FY12 and in FY13. The bank will report FY12 results on 11 April." - source Bank of America Merrill Lynch.

And given structured finance and shipping loan books are very dependent on the evolution of the US Dollar, we expect trouble ahead in accordance with Bank of America Merrill Lynch's note:
"However, in 1H12, the bank’s RWAs jumped by 32%. This was due to ‘the renewed appreciation of the USD […] as well as the crisis in the shipping markets, which caused the risk parameters to deteriorate significantly.’ The negative impact of this RWA increase on the bank’s capital ratios was mitigated by:
- the EUR500mn capital injection by the federal states of Hamburg and Schleswig-Holstein in January 2012 (see below); and 
- the est. EUR260mn gain on the cash tender offer for LT2 bonds in February
2012.

But this was insufficient to offset the decrease in the bank’s capital ratios caused by the negative rating migration and USD appreciation in the shipping portfolio. This has meant that HSHN now needs the additional capital relief of lower RWAs. Therefore, in February 2013 the bank asked the two states to return the asset guarantee to its original size of EUR10bn." - source Bank of America Merrill Lynch.

So yes, we think, that looking at the shipping industry HSH subordinated bondholders could indeed face the SNS treatment at some point...and we also think that German banks will most likely welcome deposits from stricken peripheral countries. Michelle Wiese Bockmann in her Bloomberg on the 1st of March entitled - German Banks With Record Soured Ship Loans Forgo Seizing Vessels:

"Deutsche Bank AG and two other German lenders providing about 14 percent of credit to ship owners are forgoing seizing vessels even after soured loans to the industry rose to a record.
Europe’s biggest bank by assets, as well as HSH Nordbank AG, the largest in the market, and Norddeutsche Landesbank Girozentrale, which finances 1,500 ships, are restructuring loans and setting money aside instead of repossessing vessels, officials from the companies said. They have about $69 billion in loans to the industry out of $500 billion in total, according to data compiled by the banks and Petrofin Research SA, an Athens-based consultant" - source Bloomberg

It looks to us that the German gunslinger, is no doubt, a "fast-draw" artist in this European Gunfight at the O.K. Corralito.
Oh well...

The other "unintended consequences" for large depositors could as well benefit the buy-side, with large depositors seeking potentially the havens of managed funds rather than concentrating their deposits in banks as indicated in another note from Bank of America Merrill Lynch:

"Yet large depositors have clearly been put on notice that they should be careful where they invest. In our view, this could push larger sums out of the banking system into managed funds, e.g. money market funds or fixed income funds, and will likely spread deposits across a country’s banking sector at the insured level (which may be positive for risk assets)." - source Bank of America Merrill Lynch - A backward step - 26th of March 2013.

One thing for sure, in similar fashion to the O.K. Corral gunfight, this European O.K. Corralito, will not end up nicely for some in particular and for the euro in general.

On a final note, we were entertained by Bank of England's announcement that UK banks had a capital shortfall of 25 billion pounds (38 billion USD), to cover higher estimates for loan losses due to their exposure to commercial real estate as reported by Ben Moshinsky in Bloomberg in his article - BOE Says U.K. Banks Have Capital Shortfall of $38 Billion:

"The BOE said expected losses on loans could exceed provisions by 30 billion pounds, while future conduct costs could be 10 billion more than banks expect. It said lenders underestimated assets weighted for risk by 170 billion pounds, leading to a 12 billion-pound capital shortfall in that category. While the full impact of the three areas could deplete lenders’ capital by 52 billion pounds, some banks already have enough resources to cover them, leading to a total 25 billion-pound shortfall." - source Bloomberg.

"The Bank of England warned expected losses from high-risk loan portfolios, including U.K. commercial real estate and euro zone exposure, could exceed existing provisions at major banks by about 30 billion pounds ($45 billion) in the next three years. Lloyds noted at FY12 earnings that U.K. commercial real estate values fell in 2012, and were down 4.2% yoy, with non-London asset values struggling and only 5% higher than their 2009 trough." - source Bloomberg.

What was our previous comment in our last conversation "The Doubt in the Shadow" on Chancellor of the Exchequer George Osborne's latest 130 billion pound worth of mortgages guarantees?
"This is pure madness and will end up in tears"

"Insanity - a perfectly rational adjustment to an insane world."- R. D. Laing, Scottish psychologist.

Stay tuned!

Credit - The Doubt in the Shadow‏

"Truth is beautiful, without doubt; but so are lies." - Ralph Waldo Emerson, American poet.

Looking at the deposit-levy fallout in Cyprus and the rising concerns about the sanctity of European deposits as whole, we thought this week that our title analogy should be on two levels.

Our title is first and foremost a veiled reference to the 1943 Alfred Hitchcock movie "Shadow of a Doubt".

Let us explain our "twisted" analogy. In the movie, Charlotte "Charlie" Newton always complained that nothing seemed to be happening in her life until her uncle Charlie Oakley paid her a visit (the European Troika). Charlie Oakley, in the movie is suspected of being a serial killer known as the "Merry Widow Murderer", who seduces, steals from, and murders wealthy widows. At first young Charlie refused to even consider the police's claims that her uncle is the man they are looking for. Her suspicion grows, and her uncle finally spilled the beans and admitted to her that he was the man the police were looking for aka the serial killer. He begged her for help and she resigned herself to keep the horrible scandal secret in order to avoid her family being destroyed (the European Union). Uncle Charlie is delighted in the movie to be off the hook, but, knowing that young Charlie knows all his secrets, he decided to get rid of her. In Hitchcock's movie, Uncle Charlie failed the assassination attempt on his niece and died. But, young Charlie ended up resolved to keep her uncle's crimes secret in the end.

Of course, the first level of our analogy with the deposit-levy and capital control imposed in Cyprus by the European Troika visit is purely fortuitous, but, the second level of this week's title analogy resides in the doubts we have in shadow banking in general, and banks' capital in particular, in continuation of last week's conversation "Dumb Buffers".

We have regularly indicated that, like any good behavioral therapist, we always prefer to focus on the process rather than the content. 

In relation to the Cyprus outrage on the deposit-levy, we think it is entirely "misdirected". What the outrage should be all about is that, as we posited last week, (and in agreement with Bloomberg editors views, Simon Johnson, the MIT professor and Stanford University professor Anat R. Admati), the lack of sufficient equity buffers in banks, means no doubt, that banks are indeed the "serial economic killers" of this world, or "Merry Widow Murderers". As indicated by Ben Moshinsky in his Bloomberg article "Big Banks had $269.2 Billion Basel III Shortfall in Mid-2012":

"The largest global banks would have needed an extra 208.2 billion euros ($269.2 billion) in their core reserves to meet so-called Basel III capital rules had the standards been enforced in June 2012, increasing capital levels by about 166 billion euros from the end of the previous year.

Global banks also had an average leverage ratio of 3.8 percent versus a target of 3 percent ratio for banks’ equity to debt, the Basel Committee on Banking Supervision said today in a statement on its website. The Basel measures are scheduled to be phased in by 2019.“The Committee appreciates the significant efforts

contributed by both banks and national supervisors to this ongoing data collection exercise,” the Basel group said.

Global regulators have clashed with lenders over the severity of the capital and liquidity rules, which were set out in 2010 as part of an overhaul of banking regulation in the wake of the financial crisis that followed the collapse of Lehman Brothers Holdings Inc. The Basel III measures will more than triple the core capital that lenders must hold to at least 7 percent of their assets, weighted for risk.

The biggest lenders in Europe would have needed a combined 112.4 billion euros to reach the core tier one capital target of 7 percent, the European Banking Authority said in a separate statement today.

Both the EU and the U.S. missed a January 2013 deadline to begin phasing in the standards, and have said they will seek to apply them from next year.

The lenders surveyed also needed a combined 2.4 trillion euros to meet another liquidity rule set by the Basel committee, which would force banks to back long-term lending with funds that are unlikely to dry up in a crisis.

Banks can address shortfalls in meeting capital requirements by either boosting their reserves or by reducing their assets weighed for risk. "

And, in similar fashion to Uncle Charlie in Hitchcock's movie, the Charlie Oakleys of this world, namely  banks, have indeed been let off the proverbial hook.

This week we will again focus our attention on the banking sector in particular. 

In October 2011, we argued that the markets were long hope and short faith, we also looked at bank recapitalization and in particular professor Anat R. Admati's work. 

On numerous occasions she voiced her opinion on the lack of equity buffer for banks. Specifically she wrote a column in Bloomberg on the 25th of February 2011 on that very subject entitled - "Fed Runs Scared With Boost to Bank Dividends: Anat R. Admati":

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

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

Truth is bank debt is indeed a much larger universe than equity, no question there in the capital structure in the banking space:

"However, bank shareholders’ equity represents typically just around 5% of total balance sheet and c. 25% of investable liabilities. Other main investable liabilities include Basel 3 compliant Alternative Tier 1 (eg, including some contingent convertibles (Cocos)), Basel 3 compliant Tier 2 (including some former hybrids), non-Basel 3-qualifying subordinated debt (some former hybrids that counted as Tier 1 or upper/lower Tier 2 (LT2) debt under Basel 2.5), senior unsecured debt and covered bonds. Future resolution legislation could lead to the creation of new classes of ‘bail-inable’ debt." - source Nomura, European Banks - Navigating the liabilities - 30th of November 2012.

Anat Admati concluded her Bloomberg column of 2011 by adding:

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

In addition to the delays in implementing much needed regulations, banks have been using CDS to lower their capital requirements, as indicated by Jim Brundsen in a Bloomberg article from the 22nd of March entitled - Banks' Use of CDS to Lower Capital Targeted by Basel Regulators:

"Global regulators are planning to crack down on banks that underestimate their capital requirements because of the way they use credit-default swaps and other instruments to lower the amount of risk on their books.

The Basel Committee on Banking Supervision said today that it would seek to stop banks from lowering capital charges by buying instruments such as CDS to insure themselves against losses, while failing to recognize the large liabilities they incur from what they pay for this protection, the group said in a statement on its website.

“The proposed changes are intended to ensure that the costs, and not just the benefits of purchased credit protection are appropriately recognized in regulatory capital,” the Basel, Switzerland-based group of international regulators said in a statement. There exists a “potential for capital arbitrage” as banks can book the benefits of these deals without also booking the associated costs, the group said.

The measure is one of many developed by global regulators to bolster banks’ solvency after the financial crisis. For banks, such credit-protection transactions offer a way to redeploy capital more profitably while meeting the stiffer requirements of the latest round of Basel rules.

Critics say the practice doesn’t make the lenders any safer and pushes the lending risk into the unregulated shadow-banking industry.

Blackstone Group LP, the world’s largest private-equity firm, last year insured Citigroup Inc. against any initial losses on a $1.2 billion pool of shipping loans. The regulatory capital trade, Blackstone’s first, let Citigroup cut how much it sets aside to cover defaults by as much as 96 percent, while keeping the loans on its balance sheet, according to two people with knowledge of the transaction." - source Bloomberg

On top of the use of CDS to massage "capital requirements", the 2012 losses from JP Morgan CIO office also shows the inefficiency of the enforcement of the 2010 Dodd-Frank Act derivatives rule given the lack of transparency and clarity of the information received by the CFTC (Commodity and Futures Trading Commission) from the repositories such as the DTCC (Depository Trust and Clearing Corp) as reported by Silla Brush on the 19th of March in Bloomberg - Dodd-Frank Swap Data Fails to Catch JPMorgan Whale, O’Malia Says:

"Swap-trade data the agency has been receiving since the end of last year from repositories including the Depository Trust and Clearing Corp. is inadequate to identify large positions and have overwhelmed government computer systems, O’Malia said in a speech prepared for a Securities Industry and Financial Markets Association conference in Phoenix.

The data “is not usable in its current form,” said O’Malia, 45, one of the agency’s five commissioners. “The problem is so bad that staff have indicated that they currently cannot find the London Whale in the current data files.” JP Morgan, regarded on Wall Street as one of the best- managed banks in the world, lost more than $6.2 billion last year in a derivatives bet on companies’ creditworthiness that reached a net notional value of $157 billion.

Dodd-Frank was enacted in part to give regulators better oversight of the $639 trillion global swaps market after largely unregulated trades help fuel the 2008 credit crisis. The CFTC and Securities and Exchange Commission were granted authority to write rules requiring trade information to be reported to so-called swap data repositories that function as central record keepers." - source Bloomberg

O'Malia also added in the same article:

"“It means that for each category of swap identified by the 70-plus reporting swap dealers, those swaps will be reported in 70-plus different data formats because each swap dealer has its own proprietary data format it uses in its internal systems,” he said. “The permutations of data language are staggering. Doesn’t that sound like a reporting nightmare?” The CFTC’s computer systems are failing to handle the incoming data. “None of our computer programs load this data without crashing,” O’Malia said."

Hence our "doubt in the shadow" reference in our title. Oh well...

One of our recurring themes in our numerous conversations has been around the "accounting tricks" which have been played by banks in relation to capital requirements. The June 2011 Basel 3 monitoring exercise by the EBA showed that large European banks were short of EUR 242 billion of capital to meet CET1 requirements including the G-SIB surcharge (The regulations require a further 1.5% of ‘Additional Tier 1’ plus a further 2.0% of Tier 2, for Global Systemically Important Banks).

Of course reaching the overly ambitious targets for June 2012 have meant credit contraction in peripheral countries such as Portugal where Portuguese banks are still on "IV" (Intravenous therapy) support from the ECB as reported by Anabela Reis in Bloomberg on March 20 - Portuguese Banks Stay Hooked on ECB Feeding Cash:

"ECB lending slipped to 49.51 billion euros ($64 billion) last month, down 0.4 percent from January, the Bank of Portugal said on March 12. While that was the least in a year, ECB money still accounts for a larger proportion of the financial industry’s assets in Portugal than Ireland, the epicenter of the euro region’s worst banking crisis to date. The ECB’s credit line to Portuguese banks in January was 49.7 billion euros, or 9 percent of their total assets, according to central bank data compiled by Bloomberg. Spain relies on the funding for 9.9 percent of its assets, with the figure 6.1 percent in Ireland."

The ECB provided 841 billion euros of emergency funding to periphery banks at the end of January, according to the latest central bank data available. That’s down from a peak of 977 billion euros in August as reported by Bloomberg.

The on-going deleveraging - source Morgan Stanley Research:

European banks are indeed trying to clean up their balance sheets, spreading, no doubt the cost across shareholders (debt-to-equity swaps, or right issues such as the recent one announced by the second largest German bank Commerzbank with its equity share tanking by 17% in the process), bondholders (bond tenders or junior subordinated debt wipe-outs such as SNS) and now even with depositors (Cyprus).

As a reminder, here are a few illustrations of some of these accounting tricks enabling either boosting capital requirements or boosting earnings which we have discussed in the past.

Liability management:

Banks may have an incentive to buy back non-compliant Basel 2.5 hybrids that do not qualify as regulatory capital under Basel 3. To the extent that such "liability management exercises" can result in debt being repurchased at a discount to par (well below a cash price of 100), banks are able to generate common equity Tier 1 (CET1) gains. On that subject see our October 2011 conversation "Subordinated debt-love me tender?".

Recently Spanish banking giant Santander has been trying to get junior bondholders to contribute to the balance sheet clean-up of its liability structure but not encountering the same level of success it had in 2012. We illustrated the game played by Santander in our August 2012 conversation "Banker's algorithm":

"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." - source Macronomics

While bond tenders for Santander were so "2012ish", it ain't so much in 2013 given that the acceptance level of the recent proposed "hair cut" on the main GBP/Eur part of the bond tender offer was only 7% in aggregate with sterling bond holders more eager to get the "shaving" treatment with 30% accepting the proposed terms according to CreditSights in their recent Euro Financial Movers report from the 17th of March 2013 - The Week Before Cyprus.

Goodwill write-downs and the beauty of tax credits:

Back in 2012 we indicated that BBVA took a Goodwill impairment charge of 1.5 billion euros in January 2012, which according to CreditSights counter-intuitively helps improved its regulatory capital by generating an immediate tax credit:

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

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

While it was a Spanish trick in 2012, in 2013 it is an interesting Italian trick. Unicredit in its 4Q12 earnings statement reported losses at -€553m vs. -€173m company's gathered consensus it could have been much worse:

"Goodwill tax redemption (DTAs) saves the day:

The results were marked by a very high credit loss charge at €4.6bn which was however partly offset by c. €2bn goodwill tax redemption. Lower yoy costs were a positive but management guided to a flattish 12-13 cost line. In 4Q12 revenues dropped a significant 6% yoy and qoq (NII >€200m lower qoq)" - source Bank of America Merrill Lynch - Alberto Cordara - The Cost of deleveraging - 18th of March 2013

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

"Losses at -€553m were worse than expectations but capital impact was contained with a B3 fully phased common equity at 9.2% (9.3% in 3Q12) while B2.5 core tier I was slightly higher. UCG was able to offset a high credit charge at -€4.6bn with DTA generated by the goodwill tax redemption (€2bn = €3.9bn – €1.9bn substitute tax).

Capital position:

Basel 2.5 core Tier 1 improved to 10.84% despite a negative earnings impact (-17bps) thanks to lower RWA (+24bps) and other actions at 10bps. The bank stated to be at 9.2% fully-phased Basle 3 lower than in 3Q12 (9.3%) probably on account of higher DTA deductions. " - source Bank of America Merrill Lynch - Alberto Cordara - The Cost of deleveraging - 18th of March 2013

For more on goodwill, see our post from November 2011 - Goodwill Hunting Redux.

Earnings boosting techniques - FAS 159:
In July 2010 we commented on the above: "Statement 159 - Debt Valuation Adjustments - Déjà Vu 2008"

"Statement 159, adopted by the Financial Accounting Standards Board in 2007 allows banks to book profits when the value of their bonds falls from par. This rule expanded the daily marking of banks’ trading assets to their liabilities, under the theory that a profit would be realized if the debt were bought back at a discount."

And  we wrote more on the subject in October 2011 - For whom the vol tolls and the return of FAS 159.

Bank Profits Depend on Debt-Writedown ‘Abomination’ in Forecast - Bloomberg July 2010:
"To the extent that the earnings power is less, the banks would not generate as much capital, so there’s less capital available to absorb future losses." - Credit Agricole Securities USA analyst Michael Mayo
Any similarities to today's situation are of course purely fortuitous. As a reminder from David Hendler, Senior Analyst from CreditSights did sum it up nicely in the same Bloomberg article around FAS 159:

"When the prevailing winds of credit spreads tighten, they make a lot of money, and when spreads widen, they can’t make as much." 

Of course the on-going discussions surrounding the most recent tool in liability management being deposits, the risk of letting the genie out of the bottle is raising fears of contagion across Portugal and Spain as indicated by Bloomberg:

"A controversial bank-deposit levy to raise 5.8 billion euros ($7.5 billion) of a 10 billion euro Cypriot rescue package raised fears of bank runs across Southern euro zone nations. While the proposed 6.75% levy on deposits of 100,000 euros or less may be amended to shift a greater burden to larger accounts, it could still prompt deposit runs in Portugal or Spain. That would drive CDS levels higher, raising funding costs for both sovereigns and banks." -source Bloomberg.

A total of 378 billion euros was pulled from banks in so-called peripheral countries -- Ireland, Spain, Portugal, Greece and Italy -- in the 13 months through August, according to data compiled by Bloomberg. 

But the Cyprus situation is not unique: 

"In 2011, Denmark became the first EU nation to bail-in bank depositors when it forced some Amagerbanken A/S savers and senior creditors to share losses. While the move affected only depositors holding more than the EU insurance limit, it left its mark on Danish banks by increasing borrowing costs.Outside the EU, Iceland decided to pay domestic depositors only after the country allowed its banks to fail, leaving out about $5 billion of deposits collected in the U.K. and the Netherlands. The British and Dutch governments made depositors in those countries whole and demanded payment from Iceland.

The almost blanket protection of depositors has been one reason withdrawals from banks in the periphery haven’t soared. Another is higher interest rates paid on deposits. Lenders in those countries and Cyprus are paying customers 3 percent to 5 percent interest on savings, compared with about 1 percent by German banks and 0.5 percent in Belgium, according to ECB data." - source Bloomberg - EU Getting Closer to Bank Union Fails to Help Cyprus Crisis.

Talking about regulations and banks, being "serial economic killers" in true Charlie Oakley fashion, although Denmark was the first EU nation to imposed bail-in, the lack of equity buffers in banks are indeed a serious threat even for Denmark given Danish borrowers are starting to struggle on their interest-only mortgages with a deepening property slump as reported by Frances Schwartzkopff on the 19th of March in Bloomberg - Denmark Races to Prevent Foreclosures as Home Prices Sink:

"The Association of Danish Mortgage Banks and the Mortgage Bankers’ Federation are due to start talks with Business Minister Annette Vilhelmsen to decide how to treat borrowers who won’t be able to afford the interest-only loans they took out a decade ago once amortization requirements kick in this year.

Borrowers are also struggling as a deepening property slump drives house prices down to 2005 levels.

“Eighty percent of homeowners under 35 years of age are under water. That’s a lot,” Curt Liliegreen, head of the Center for Housing Economics in Copenhagen, said yesterday in a telephone interview. “This is a problem that threatens the Danish economy.”

Denmark’s housing crisis, which started when the nation’s property bubble burst in 2008, is showing signs of deepening. Prices sank 2.8 percent last quarter from a year earlier, the two mortgage groups said yesterday. More than 100,000 households will need to have special terms negotiated if they are to meet their loan obligations, according to a February study by the University of Southern Denmark." - source Bloomberg.

We have argued in a 2011 conversation that the policy of achieving a high home ownership rate is the biggest threat to an economy:

"The issue with enticing a high home ownership rate is the level of household debt it generates. It can be argued that the most toxic of all bubbles is a housing/property bubble. They also always generate a financial crisis when they burst due to the leverage at play. How the risk can be mitigated? By forcing players to have more skin in the game.

Recently Sweden passed a law limitating the maximum Loan to Value (LTV) to 85%. In effect, Swedish people will need to put down a minimum of 15% of deposits to borrow 85% of the remainder."

More recently the prudent Swedish Central bank has entered into a direct confrontation with the Swedish bank regulators over macro-prudential supervision as indicated in a Bloomberg article on the 22nd - Swedish Banks Find Ally in FSA Warning Against Risk-Weight Race: 

"Sweden’s financial watchdog cautioned against a central bank proposal to consider raising risk weights from levels announced less than half a year ago.

Riksbank Governor Stefan Ingves said earlier this week Sweden should consider increasing risk weights on mortgage assets to more than the 15 percent proposed by the regulator in November. The Financial Supervisory Authority’s target, which is three times existing levels, is due to become effective later this year.“We don’t today see any reason to immediately touch these,” Martin Andersson, director-general at the FSA, said in an interview in Stockholm. “To make lots of changes and then make changes to the changes before anyone has had a chance to evaluate them and before we’ve even had time to implement these I think is to run a bit too fast.” The watchdog, which has argued against proposals to hand over macro-prudential supervision to the central bank, has defended stricter bank capital standards than those set elsewhere as Sweden tries to shield taxpayers from the risk of losses. The biggest Swedish banks, whose combined assets are four times the size of the economy, must set aside at least 12 percent core Tier 1 capital of their risk-weighted assets by 2015.

The FSA in 2010 reacted to signs of excessive credit growth by imposing an 85 percent cap on loan-to-value ratios. The regulator has also warned it is ready to do more should the need arise. Measures to date have started to work and credit growth slowed to 4.5 percent in January, compared with a peak of 13.2 percent in March 2006. " - source Bloomberg

In our 2011 conversation relating to housing we also said:

"One could argue, that home ownership should not be recklessly encouraged by politicians as it does appear to be a "Weapon of Economic Destruction" (WED). If people are struggling to raise large deposits required to secure a mortage, should the government encourage them to leverage too far in the first place? The recent credit bubble burst in the US and the subprime debacle, highlights the dangerous results in the incestual relationship between politicians and banks, and the promotion of the "American Dream" at all cost."

The housing bubble in Europe - source Nomura - EU Banks Macro Hedging, March 11th 2013

In relation to Sweden's housing market, and the previously quoted Bloomberg article:

"Though the real estate market has cooled in the past two  years, property prices have soared about 25 percent since 2006. That has fanned speculation the market may be overstretched, making households vulnerable to interest rate increases. Ingves signaled last month his bank may start raising rates next year. Swedish home prices could fall by as much as 10 percent in the next 18 to 24 months, Jens Hallen, director for financial institutions at Fitch Ratings, said last month.

Ingves has also discussed introducing other measures to cool the housing market, including requiring borrowers to amortize their mortgages. A March report by the FSA showed that the average Swedish household needs 140 years to pay down its home loan." - source Bloomberg

Lessons learned?

Quite frankly no, when one looks at the latest proposal from the United Kingdom Chancellor of the Exchequer George Osborne as reported by Bloomberg on the 21st of March - Cameron Unsettled by Housing in Austerity Offers Aid: Mortgages:

"Osborne yesterday pledged 3.5 billion pounds ($5.3 billion) to help buyers of new homes with loans of as much as 20 percent of the property’s value, broadening an existing program beyond first-time purchasers. He also announced a plan to guarantee as much as 130 billion pounds of new mortgages to fuel demand from purchasers with limited cash for a deposit."

From the same Bloomberg article:

"Osborne’s Help to Buy program will provide potential buyers equity loans for newly built homes worth up to 600,000 pounds starting in April. The program lasts three years. It also offers guarantees to support 130 billion pounds of mortgages for existing and newly built homes. Under the program, which starts in 2014 and runs for three years, lenders can buy a state guarantee that compensates part of their losses in the event of foreclosure, and the government will charge a fee for the assurance."

This is pure madness and will end up in tears. 

We completely agree with a recent Gavekal note on this subject from Anatole Kaletsky: 

"This is akin to creating a British equivalent to Fannie Mae mortgages to offer equivalent sub-prime loans. The government whose excessive prudence has discouraged banks from offering mortgages worth more than 75% of a home’s value, will now guarantee borrowers who have a 5% deposit the additional 20% loans they need to qualify. In doing this, the Treasury will expose itself to any falls in house prices beyond 5%—and this exposure will not be included in national debt statistics. In short, Britain will imitate the off-balance sheet financing of Fannie Mae that helped to trigger the 2008 crisis, and will use this mechanism to “support £130 billion of high loan-to-value mortgages over three years”that are much more leveraged than Fannie Mae’s “conforming” loans. (In relation to GDP, the US equivalent of £130bn would be roughly $1.5 trillion)." - source Gavekal.

On a final note and in relation to our recent computational analogy "Winner-take-all", should a deposit flight occur in Europe, depositors will no doubt seek a German bank sanctuary - source Bloomberg:

"German lenders could be the beneficiaries of renewed peripheral Europe depositor-outflow fears after the Cypriot bailout, as savers seek a haven in the euro zone's strongest economy. German banks have been awash with deposits since the onset of the sovereign debt crisis, with inflows from retail and corporate clients accelerating in the aftermath of the political gridlock following Greek elections in mid-2012." - source Bloomberg

"Doubt grows with knowledge." - Johann Wolfgang von Goethe 

Stay tuned!