Credit - It's a Wonderful Life

"It is best to avoid the beginnings of evil."- Henry David Thoreau 

Watching with interest Moody's savage six notch down-grade of the Cooperative Bank (from A3 to Ba3) on late Friday 12th of May made us wander again this week towards are much beloved cinematographic analogies for our chosen title. The Co-Op banking story sounds a lot like a replay of 1946 great Frank Capra movie called "It's a Wonderful Life" starring James Stewart. In the movie George Bailey after giving up on his childhood dreams, decided to run the Building and Loan community bank founded by his father and faced early in his banking role a collapse. Earlier in his banking life, Georges Bailey witnessed a bank run on his establishment and to avoid the fateful rout of the financial institution used the money for his honeymoon trip to avoid the demise of his local bank. Later in his life as a local banker, Georges faced another liquidation moment when the Building and Loan's cash funds are snatched, and the bank is only saved by the flood of townspeople donations to save George (facing prison) and the Building and Loan institution. Of course, any resemblance between the analogies used in this blog post and real events are purely coincidental...

In these days and ages it seems that, after all, sub-investment grade ratings at European banks, are no doubt, becoming more the norm rather than the exception, given Italian Bank Monte dei Paschi di Siena founded in 1472, the world's oldest bank, was given as well the multiple downgrade treatment by Moody's, falling three notches in the process (from Ba2 to B2). They have just lost 100.7 million euros in the first quarter compared to a profit of 89 million euros in 2012 and have lost 7.9 billion euros in the past two years with an outstanding market cap of 2.48 billion euros.

This multiple downgrades from a trigger happy rating agency is definitely one of the first results of the Cyprus effect, namely the "unintended consequences" of the recent talks surrounding an earlier implementation date for senior debt bail-in.

In its Co-Op decision, Moody's highlighted the "risk of write-downs on junior debt instruments and, potentially, the need for external support to maintain regulatory capital levels".

In its Monte dei Paschi di Siena (MPS), Moody's declared it "is concerned that the risk of burden sharing with creditors in order to ensure its adequate capitalisation has risen and would be significant under an adverse scenario".

We have been warning for a long time and on numerous occasions the risk of total wipe-out for subordinated bond holders, leading in many instances to debt-to equity swaps for some (Portuguese bank Banco Espirito Santo in October 2011), and numerous capital increases for others (Commerzbank in the market this week for its fifth capital increase in four years, this time around for 2.5 billion euros and probably not the last one...). 

While the case for the Co-Op could eventually lead to the first test of a bail-in of subordinated creditors in the UK, the SNS case and the acceleration of the implementation of "bail-in" are as well putting significant pressure on the ISDA to come up with new "credit event" definitions to save not only the Sovereign CDS market, which has been impacted by the Greek saga, but to conjure the potential demise of the subordinated CDS market if it doesn't take into account the "expropriation" trick from the SNS case as a "credit event" given the lack of deliverable subordinated obligations thanks to the total wipe-out. 

Therefore, in this week's conversation, we will look at the complacency in the subordinated market in this "Wonderful Life" of credit, where spreads are tightening at lightning speed, and credit risk is so much a "thing of the past", but, there we go, rather than rambling, you find us grumbling. Oh well...

But first our quick market overview.

Credit wise Itraxx Main Europe 5 year CDS index (Investment Grade credit risk gauge based on 125 entities) and Itraxx Crossover 5 year index (European High Yield risk gauge based on 50 European entities)   have marked a pause this week with Itraxx Crossover rising 5 bps to 387 bps and cash credit was also flat following four consecutive weeks of uninterrupted tightening  - source Bloomberg:

While credit has moved significantly tighter in 2013, following "whatever it takes 2" courtesy of "Abenomics", we have yet to touch the lowest spread of 255 bps between both indices from 2011.

At the same time European Credit has marked a pause in their rally, European government yields have moved back from their lows with German 10 year Government yields moving towards 1.30%  - source Bloomberg:

Equities wise, the Eurostoxx which has lagged the continuous rally seen in the S&P 500 has catch up is now moving in synch with the US index, whereas Italian government bonds, indicated in the same graph have been trading below the 4% level - source Bloomberg:

Whereas are Japanese friends are still recording significant increases, in their successful art of deceit, enticing even more investors in the rally game while creating significant headaches to local Asian countries in the process - source Bloomberg:

What is increasingly stirring our interest, when it comes to Japan is, as we indicated last week, has been the disconnect between credit spreads and volatility, which has been rising in the case of Japan as of late - source Bloomberg:

As indicated in last week's credit conversation, the shorter 3 months Implied volatility has been telling a different story since the beginning of the year and has been rising significantly. We are wondering now if Credit Risk which has been significantly tempered by Abenomics as displayed by the significant rally in the CDS Itraxx Japan 5 year index is not going to reverse its trend and start surging again.

For us Japanese equities and Japanese credits are indicating that investors are no doubt buying purely on hope. Yes, the three Japanese megabanks have reported an aggregate 11% rise in net profits for FY12 (+30% adjusted for prior year exceptionals) to a multi-year high of 2.2 trillion yen (22 billion USD). As reported by CreditSights in their 15th of May note entitled "Buying On Hope", the ROE ranged from 14% for SMFG to 10% for Mizuho and 8% for MUFG: "Profits were indeed helped in the last quarter by the lower yen which boosted overseas income and much reduced stock impairment losses as the stock market recovered; lower tax charges have also helped." - source CreditSights

Given that for these Japanese banks profits are tied up to substantial trading and "unrealised" investment bond gains from abroad and looking at the recent rise of JGB yields since the arrival of Mr Kuroda at the Bank of Japan, and knowing the very large size of JGB portfolios for these Japanese banks, in the absence of investment bond gains (which would mean selling some European government bond holdings...yikes!), unrealised losses on their JGB portfolios will not doubt put pressure, not only on their shareholder's equity and regulatory capital, but on their CDS spreads as well and their earnings. The CDS for these Japanese banks is trading closer to the more highly rated Australian banks but also Korean counterparts such as Kookmin according to CreditSights. Therefore, should "Abenomics" disappoint, there is indeed some room for these Japanese banks CDS to widen "significantly" at some point...(sorry we are not paper fortune tellers).

In terms of the recent poor macro data, and the continuous rally in risky assets with a fairly muted VIX (around 13), the recent move in the MOVE and CVIX indices warrant caution we think.

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.

Graph - source Bloomberg:

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 rallied hard with the same type of cross-asset vols opposite moves.

Looking at the recent disappointing batch of macro data and the huge rally in risky assets in similar to the move we have seen in early 2012, either, we are in for a repricing of bond risk as in 2010, or we are at risk of repricing in the equities space.

As we argued last week, Investment Grade is therefore a more volatility sensitive asset to interest rate changes, whereas High Yield is a more default sensitive asset. The correlation between the US, High Yield and equities (S&P 500) since the beginning of the year has weakened recently. Investment Grade as indicated by the price action in the most liquid US investment grade ETF LQD is more sensitive to interest rate risk  - source Bloomberg:

Moving on to our subject of complacency in the "Wonderful Life" of the subordinated credit space, the Cooperative Bank's capital gap is according to the FT at around 1 billion GBP, truth is their is 1.3 billion GBP in outstanding subordinated bonds, so as the saying goes "mind the gap", because the capital gap, is going to be filled and most likely in the first place by subordinated bondholders rather than  by a flood of townspeople donations like in the 1946 movie. On the complacency in the "Wonderful Life" of subordinated bond holders, we would have to agree with Bank of America Merrill Lynch takes on the subject from their 13th of May note entitled "It's all at the Co-op - now:

"A still complacent market – what next?

The precipitate decline of the Co-op’s bond prices highlights that bondholder haircuts are not in the price, even though the market ‘knows’ about bail-in. In spite of the recent chilling lesson from Cyprus, sub yields touch new bottoms and prices reach new highs. We believe there is no room for error in either. Our Credit Investor Survey last week saw more money going to subordinated financials, not less. We thought complacency reached its apogee last month when we saw Unicredit, a bank with 20% NPLs in its core Italian business, place sub bonds in the USD market. Capital is king in a bail-in world." - source Bank of America Merrill Lynch.

Back in January 2012 in our conversation "Bayesian thoughts" we quoted Dr. Constantin Gurdgiev, from his post entitled "Great Moderation or Great Delusion":
"when investors "infer the persistence of low volatility from empirical evidence" (in other words when knowledge is imperfect and there is a probabilistic scenario under which the moderation can be permanent, then "Bayesian learning can deliver a strong rise in asset prices by up to 80%. Moreover, the end of the low volatility period leads to a strong and sudden crash in prices."

As far as the Co-op's sub debt bonds are concerned, get ready for some "Bayesian learning", dear subordinated bondholders:

- source Bank of America Merrill Lynch.

Can you smell bond tenders or debt-to-equity? Because we can and so does Bank of America Merrill Lynch in their note:

"Liability management
Ironically, the precipitate fall in the bonds of the Co-op has increased its optionality with respect to using its subordinated bonds to bridge its capital gap. We estimate that the current gap between the face value of the Group’s tradeable subordinated bonds and their market value as of Friday close is £416m (there are other bonds which are much less liquid too in addition to this number). The monetization of this could be a key part of the solution, assuming that the bonds don’t jump in value next week as bottom fishers may come in.

That would be risky, we think, because all forms of liability management are potentially on the table, in our view, both coercive and voluntary. We can even see the possibility (though admittedly unlikely) of a debt-for-equity swap – the bank is a PLC after all, so it does have shares. The Group would resist this, we would expect, as it would hardly want to share ownership of the bank with sub bondholders, but it depends on how truly desperate the situation is and how the UK authorities decide to address it." - source Bank of America Merrill Lynch.

Of course the "unintended consequences" of Cyprus and "Abenomics" make us believe that in the "Wonderful Life" of the financial credit universe, no one is really prepared to "face the music" when the music, will stop, because at some point, with the implementation of "bail-in" it will!

It looks like Bank of America Merrill Lynch is facing our rather "sanguine" views as well on that matter:
"Is it priced in?
In our view the price action of Co-op bonds on Friday shows that the market is ill-prepared for bail-in of bank bonds, which rather undermines the idea that the concept is so well-known and talked about that it is ‘in the price’. It is not in the price in our view.
Our investment case for European bank bonds became much more cautious post-Cyprus. In summary, we think that the positive investment case for European bank bonds has faltered as a result of Cyprus. However we believe that has not been reflected in spreads or positioning. In fact, our recent investor survey shows that investors have been consistently increasing their allocations to subordinated debt and moving away from senior debt. Whilst we understand the concept that you don’t get paid for bail-in in senior debt, we have to underline that you don’t get paid for bail-in in subordinated debt either." - source Bank of America Merrill Lynch.

So, sorry to spoil the 'credit party mood', because current subordinated bond prices do not reflect the fundamentals and the underlying credit risk we think and we are not the only ones:
"We maintain our view that a more cautious stance is warranted, especially in the periphery where European bank asset quality problems are concentrated. We saw the recent USD 6.375% subordinated bond of Unicredit as the apogee of complacency in the market. This bond is currently trading well above 102 (a yield of nearly 5.9%). We can see the attraction of the yield but it is not normal for a bank to have NPLs of 20.1% in its domestic business. On a consolidated basis, a 14.1% NPL ratio (up from 13.6% at year end) with 44% coverage should not be considered normal either. It represents a significant risk to bondholders, in our view." - source Bank of America Merrill Lynch.

On a final note, given a few days back we pointed out that Air Traffic is pointing to additional economic activity weakness, we would like to add there is indeed a high correlation between passenger air traffic and GDP growth - graph source Bloomberg:

"Passenger air traffic correlates with GDP growth at a 1x multiple in developed countries and about a 1.5x to 2x multiple in developing markets. Consensus GDP forecasts provide insight to the trend for air traffic growth in the coming years." - source Bloomberg.


"It's not what you look at that matters, it's what you see." - Henry David Thoreau


Stay tuned!

Credit - Pain & Gain

"The aim of the wise is not to secure pleasure, but to avoid pain." - Aristotle 

Looking at the continued rally in the credit space, with the Iboxx Euro Corporate benchmark tightening to the tune of 5 to 6 bps every week in the last three week in the cash market, in conjunction with the massive compression of spreads in the Itraxx Credit indices space, we thought this week, we would use a reference to 1999, New Times three-part series of articles called "Pain & Gain" by writer Pete Collins which inspired 2013 American film directed by Michael Bay.  The story revolved around a gang of local bodybuilders with a penchant for steroids (liquidity from central bankers?), strippers, and quick cash. They later became known as Miami's Sun Gym gang and quickly developed a taste for blood and money.

Gain: 

We closed the week on almost 15 bps on Itraxx Main Europe to 92, the lowest since May 2010, which is the risk gauge for Investment Grade credit, and 50 bps in Itraxx Crossover to a low of 378 bps. 

Pain: 

As one credit index trader put it in his closing comments (which are reminiscent of the early days of 2007):

"With street put short yesterday by the massive short cutting, dealers are finding it hard to recycle positions and were having more and more pain as client kept selling index today as well. With shallow volumes, every enquiry drove the market lower. The incredibly strong payrolls drove us through 90 and this was the point when people were starting to have discussions of whether these tights are the new fair trading range or whether they should put those shorts."

 

There you go, the penchant for steroids induced rallies in the credit space is starting to inflict some serious pain to market makers as they are having to bid for credit indices and getting hit in a severe tightening market, not only inflicting P&L pain, given they are having trouble recycling their positions with less players in the market place than in 2007 (gone are the prop traders, fewer credit hedge funds and fewer market making banks) but, they are also facing negative carry on the trades they have had to absorb and did not recycle. Oh well...

So this week, we will focus our attention to the credit space, the releveraging taking place in the US and Mario Draghi's ambition of reviving the Euro Zone Corporate lending . But first, a quick market overview.

The absolute level of core European government yields has continued to fall even after the 25 bps rate cut this week - source Bloomberg:

2 year Italian yields dropped to 1.068% the lowest since Bloomberg started tracking the data in 1993 and Italian 10 year yields fell 7 bps to 3.84% the lowest since October 2010. Spanish yields also receded with the 10 year falling to 3.97% below 4%, the least since October 2010 and 2 year below 1.60%, the lowest since April 2010.

Credit wise Europe is indeed turning Japanese. It's D,  D for deflation. German 2 year notes versus Japan 2 year notes going negative again and indicative of the deflationary forces at play we have been discussing over and over again - source Bloomberg:

Credit wise the rally in 2012 has been epic courtesy of "whatever it takes 1" (Mario Draghi) and "whatever it takes 2" (Abenomics). Itraxx Main Europe 5 year CDS index (Investment Grade credit risk gauge based on 125 entities) and Itraxx Crossover 5 year index (European High Yield risk gauge based on 50 European entities) - source Bloomberg:

The absolute spread between both credit indices is closing to the level of March 2011 (255 bps apart) before the liquidity crisis of summer 2011 which was tempered by a good dose of "steroids" (LTRO 1 and 2).

The relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge) - source Bloomberg:

We are back to early 2008 levels for both the Itraxx Crossover index and Eurostoxx volatility.

While the Eurostoxx seems struggling to break the 2800 level, the German 10 year Government yields have touching record low levels this week towards the 1.16% yield level  and the Itraxx Financial Senior 5 year CDS index (indicative of credit risk for financials in Europe) have been dramatically falling towards 140 in the last couple of weeks while volatility remains muted at 18 for the V2X index - Top Graph Eurostoxx 50 (SX5E), Itraxx Financial Senior 5 year CDS index, German Bund (10 year Government bond, GDBR10), bottom graph Eurostoxx 6 month Implied volatility. - source Bloomberg:

We already indicated that divergence between the US PMI and European PMI divergence which we explained in our conversation "Growth divergence between the USA and Europe", was here to stay in 2013. This divergence can be seen as well in the difference in credit spreads risk gauges such as the Itraxx Main Europe CDS index and its US CDX counterpart - source Bloomberg:

What has been interesting has been the strong correlation between the US, High Yield and equities (S&P 500) since the beginning of the year. We have also noticed the strong rebound in Investment Grade as indicated by the price action in the most liquid US investment grade ETF LQD - source Bloomberg:

Talking about Pain and Gain, whereas March was brutal for investment grade, the rebound in April has indeed been very significant. As one can see the correlation between High Yield and equities seems to be stronger than ever as both the S&P 500 and the ETF HYG seems to be perfectly moving in synch.

But, if we focus our attention this week on credit, we would have to say that the unintended consequences of "steroids" induced policies from Central Banks is pushing investors more and more up the risk spectrum as everyone is seeking higher returns as indicated by Fitch recent European High Yield Chart book:

"As yields continue to compress in high yield, the risk-reward proposition for the investor becomes increasingly difficult to justify, shifting the dynamics in favour of issuers. European non-financial BBs now trade equal to equivalent US BBs, despite materially weaker growth, greater policy volatility and uncertain liquidity. European Bs continue to offer premia, though these too are tightening. Global monetary stimulus from quantitative easing in the US, the UK, and Japan together with an expected ECB rate leaves little choice for investors other than to move out along the maturity curve and go down the credit spectrum to seek diversification as they satisfy return objectives.
Deteriorating credit quality poses a risk to the market, but this is largely expected to translate into a migration of ratings to lower levels rather than any substantial increase in the default rate. The legacy loan market is at greater risk of rising defaults due to the concentration of riskier borrowers from 2006 and 2007 who were able to access tighter spreads and higher levels of leverage than the high-yield market could accommodate at the time.
However, further spread compression may entice riskier lower B‟ or CCC rated issuers from the leveraged loan market to issue high-yield bonds. Such developments tend to signal the end of cycle in European high yield and a period of yield and spread widening together with subdued new issuance. To date in 2013, the market is accepting lower quality instruments from higher quality borrowers, such as Sunrise Communications Holdings SA (BB−/Stable) recent PIK note (B− instrument rating). When the market tests low-quality instruments from low-quality borrowers the cycle will be set to return." - source Fitch

The European and US High Yield Market, new issuance and yields - source Fitch:

Using again our "Pain & Gain" title analogy, we would like to further delve into our analysis of the "Japonification" of credit in Europe and the difference with the US where we are seeing re-leveraging at play in the credit space.

For instance, many pundits are wondering how come peripheral EMU bond yields and peripheral bonds have been performing so strongly when indices such as the FTSE Italian bank index is still flat at 10,000.

For us, it is very simple, deleveraging is generally bad for equities and in particular financial stocks, but good for credit assets. We discussed this very subject back in April 2012 in our conversation "Deleveraging - Bad for equities but good for credit assets":
"When companies turn conservative and start reducing debt, credit holders benefit and equity holders lose out."

Why would we have had a rally in Italian banks? It doesn't make sense. For us a bank is a leverage play on the economy, it is the second derivative of a sovereign. No credit, no loan growth, no loan growth, no economic growth and no reduction of aforementioned budget deficits and no earnings for banks. Banks in peripheral countries had no choice but to shrink their loan books, reducing therefore their profitability and ROE.

European Banks ROE by countries from 2005 to 2011 - source Bloomberg - Macronomics:

Nota Bene: 2011 data for Germany not available. McKinsey & Co. said in its bank sector annual report. European bank average returns on equity were 15% to 17% in 2005-07, vs. 7% to 9% currently. With the revenue outlook poor, further cost cuts remain a key profitability lever. Median ROE in 2011 in the European Union was 2.2%.

As a reminder, 50% of banks earnings for average commercial banks come from the loan book: no funding, no loan; no loan, no growth; and; no growth means no earnings.

Credit dynamic is based on Growth. No growth or weak growth can lead to defaults and asset deflation which is what we are seeing in Europe and what a 1.2% inflation rate is telling you hence the ECB rate cut this week. But, once again ECB is behind the curve courtesy of the stupid European Banking Association decision of imposing a 9% Core Tier 1 threshold to European banks to be reached by June 2012, which precipitated a credit crunch in peripheral countries, leading to a surge in unemployment, bankruptcies and rapid rise in nonperforming loans.

A liquidity crisis happens when banks cannot access funding (LTRO helped a lot in preventing a collapse in 2011). A solvency crisis can still happen when the loans banks have made turn sour, which implies more capital injections to avoid default (hence the flurry of subordinated bond tenders we have seen in the European banking space and other accounting tricks...). Rising non-performing loans is a cause for concern as well as rising loan-to-deposit ratios in peripheral countries.

Therefore in Europe, you have been much better off buying senior financial corporate bonds as part of the reflation "whatever it takes" trade in this deflationary environment than peripheral financial stocks. As seen in Japan in the past, credit outperforms equities in a deflationary environment.

Peripheral banks equities = Pain

Peripheral banks senior financial bonds = Gain

At this juncture, we think it is very important to look back on how the "Global Credit Channel Clock" operates, as designed by our good friend Cyril Castelli from Rcube Global Macro Research which we introduced in our conversation "The Night of the Yield Hunter":

Whereas credit wise, European peripheral financials are deleveraging, hence the performance of their bonds ("Gain" - Love) rather than their equities ("Pain"- Hate), what we are starting to see in the US is leverage rising as indicated by Fitch, in their recent US High Yield Default insight from March 2013:

"Credit Gains Hit Speed Bump:
In the March 2013 edition of the “Fitch Ratings/Fixed Income Forum Senior Investor Survey,” a majority of investors saw U.S. corporate leverage moving higher over the coming year and expected some credit deterioration across both high grade and high yield. Fitch’s recurring analysis of the aggregate financial performance of a large sample group of speculative grade companies shows that leverage began to turn up in 2012 — a product of higher debt balances and sluggish EBITDA growth (see Debt / EBITDA chart below).

In the second half of the year, in fact, the number of companies in Fitch’s sample reporting year-over-year increases in EBITDA (approximately 55%) had fallen to the lowest level in three years and was on par with the share reporting year over year increases in total debt (also 55%) (see Companies Reporting Increases in Debt and EBITDA chart below). 

Rating trends further confirm this pattern, offering a more complete picture of the direction of credit quality. Fitch recorded more U.S. corporate downgrades than upgrades in 2012. In the first quarter of this year rating activity was roughly even for speculative grade borrowers, and so it appears that the negative rating drift has stabilized, but trends remain lackluster, especially compared with 2010 and 2011 activity when credit quality was more firmly on the upswing. Also notable, the volume of bonds rated ‘CCC’ or lower is now $237.5 billion, up from $226.5 billion at the end of 2012 and $196.8 billion at the end of 2011. Even absent aggressive precrisis transactions, there is still plenty of organic sensitivity to the subpar domestic and global economic environment. An offset to this is funding. Thanks to the Fed’s commitment to low interest rates and the demand it has created for yield product, companies have been able to successfully push out bond and loan maturities. This provides a meaningful support for keeping default rates low in the near term."

In terms of flattening yield curve, indicative of the credit cycle, we think as credit investors you should start monitoring the flattening of CDS curves. As a market maker commented recently:
"1 year and 2 year CDS curves are flattening, only a matter of time before 3 year versus 5 year curves does the same and flatten."

We have of course seen this movie before in the credit space in the heyday of the credit bubble build up in 2006 and 2007.

So as credit investors, yes we are indeed still dancing as the music is playing, but, given the liquidity levels closer to 2002 than 2007, we'd rather be dancing close to the exit door. As Aristotle put it, our aim, being wise we think, is not to secure pleasure, but to avoid pain, which will no doubt materialise at some point.

On a finale note, Mario Draghi ambitions to revive the real economy and corporate lending that is. The LTROs after all amounted to "Money for Nothing":

"Although LTRO provides cheap funding to European banks, rising unemployment levels and deteriorating credit conditions should consequently lead to a significant rise in Non Performing Loans (NPLs) on banks balance sheet."

Meaning plenty of liquidity impact (steroids) for banks (our European Sun Gym gang which have a taste for blood and money) but confirming our 2011 fears of credit contraction for corporates and households (Italy and Spain) - source Bloomberg:

"Corporate loans across the euro zone fell more than 350 billion euros ($460 billion) to March's total of 4.5 trillion euros from January 2009 highs. ECB President Mario Draghi's lowering of the marginal lending rate and hint at reviving European Asset-backed Securities mark early steps toward enlisting banks to lend-again. An ABS market would enable banks to package new lending into an ABS structure and post with the ECB to access further funding." - source Bloomberg.

As far as we are concerned, the deflationary forces at play and the unemployment levels in Europe cannot be addressed by ZIRP for the following "creative destruction reasons" as indicated by CreditSights in their recent Sovereign Analysis from the 1st of May entitled -If the ECB doesn't mind Spain deficit, nor do we":

"Spanish non-financial corporates alone saved the equivalent of 3.3% of GDP last year. That difference between corporates' revenues and expenses was used to pay down debt. Spanish, non-financial corporates have net debts equivalent to 129% of GDP. But it comes at the expense of Spanish households'. In the process of using revenues to pay down debt, corporates are ensuring that they aren't spending it and in the vast majority of cases won't not generate incomes for households. Those cut backs in investment spending are contributing to the decline in wages and rise in unemployment.

Unemployment has now reached 27.2% as of the first quarter. And wages have fallen by 1% over the past year. The decline in incomes mean that household savings have fallen from 6% of GDP in 2009 to 1% of GDP in 2012 as they have been forced to fall back on savings to be able to maintain spending. While households added €22 bn in financial assets in 2011 they reduced their holding of financial assets by €15 bn in 2012. That swing from saving €22 bn to dis-saving €15 bn contributed €37 bn to household spending and meant that year on year it rose by 0.2% in nominal terms rather than falling by more than 5.5%." - source CreditSights

 

Since 2008, you have seen creative destruction at play, meaning companies have preserved their margins by doing more with less people. Some job will just not return. What is the benefit of QE and ZIRP on structural unemployment? Zero so far:

ZIRP isn't only a European problem in this credit "japonifiaction" process at play. It is also the case in the US.

In fact productivity in the US has been rising as companies have been indeed preserving their margins by managing very tightly their labor costs and adapting to the low growth environment they face as reported by Shobhana Chandra in her Bloomberg article from the 2nd of May - Productivity in U.S. Rises as Companies Try to Cut Labor Costs:

"The productivity of U.S. workers rose in the first quarter as companies focused on containing labor expenses.
The measure of employee output per hour increased at a 0.7 percent annual rate, after dropping 1.7 percent in the prior three months, a Labor Department report showed today in Washington. The median forecast in a Bloomberg survey of economists called for a 1 percent advance. Expenses per worker increased at a 0.5 percent rate after jumping 4.4 percent.
Employers tried to control expenses by making do with their existing staff as demand grew in the January to March period. The emphasis on wringing efficiency gains may mean hiring will take time to accelerate, particularly as across-the board federal budget cutbacks and higher payroll taxes restrain the world’s largest economy." - source Bloomberg.

By keeping interest low to promote investment, like the Fed is also currently doing, full employment would therefore be "attainable" in the pure Keynesian tradition. For Keynes, the velocity of money should move together with the level of economic activity (and the interest rate). Well guess what. It isn't.

Why?

Credit growth is a stock variable and domestic demand is a flow variable.

Does the end (lowering unemployment levels) justify the means (increasing M) or do the means justify the end (deflationary bust)?

The only country in Europe we can think of which tackles efficiently structural unemployment by retraining the labor force is Sweden.

Why would the US labor participation rate in the US increase?

If the cost of capital is not priced but set by central banks, how can capital be efficiently deployed to innovation and not "mis-allocated"?

 

MV = PQ. (Quick refresher: PQ = nominal GDP, Q = real GDP, P = inflation/deflation, M = money supply, and V = velocity of money.).

Monetary policy at the moment is a desperate race. They are increasing money supply but velocity keeps falling. So the Fed’s problem is best understood as one of trying to bend this velocity curve.

Alan Greenspan made mistakes after mistakes, bubbles after bubbles, central bankers do not understand that negative real rates always lead to a collapse in velocity and a structural decline in Q, namely economic growth rate.

Pain in employment levels - Gain in financial markets.

"Prefer a loss to a dishonest gain; the one brings pain at the moment, the other for all time." - Chilon


Stay tuned!

LBO? No problemo!

"No problemo" is a slang expression used in North American English to indicate that a given situation does not pose a problem. It has roughly the same meaning as the expression "no problem," but is rarely heard as a response to "I'm sorry." - source Wikipedia

While looking at the quick succession in LBOs (Dell, Heinz), a subject we have tackled with Dell recently in our conversation "The return of LBOs - For whom the Dell tolls", as a credit investor, the "sucker punch" capacity of inflicting serious pain to the investment grade bondholder is reminiscent of the hay days leading to the burst of the credit bubble in 2007.

In similar fashion to the Dell transaction, the Heinz effect was rather more sanguine than ketchup, and probably as spicy as tabasco when it comes to spicing things up a bit in the CDS space - source Bloomberg:

From 50 bps to 200 bps, given Buffett's new found love for the ketchup is transforming H.J. Heinz into the most leveraged food maker in America as reported by Mary Childs in her Bloomberg article on the 21st of February - Buffett’s Ketchup Fancy Plies Heinz With Junk:
"Buffett’s Berkshire Hathaway Inc. and 3G Capital Inc.’s $23 billion acquisition of Heinz may double the company’s total debt to five times earnings before interest, taxes, depreciation and amortization, according to Fitch Ratings, the highest of any comparable food company. The cost to protect Heinz’s debt from losses soared to a record after the announcement. While Buffett has used takeovers to build Berkshire into a $249 billion company and burnish his reputation as the world’s most successful investor, financing the deal with $14.1 billion in debt threatens to strip Heinz of the investment-grade rating that it’s had for four decades. Fitch cut Heinz to junk on Feb. 15 and credit-default swaps imply a Ba1 rating, according to Moody’s Corp.’s capital markets research group. That’s two steps lower than its Baa2 rating from Moody’s Investors Service and three below its BBB+ grade from Standard & Poor’s. The trading “underscores the hazards of high-grade bonds in an active M&A environment,” said Martin Fridson, chief executive officer of research firm FridsonVision LLC. Investors should be aware of the “inherent danger now that leveraged buyouts as well as strategic acquisitions are once again prominent in the financial landscape,” he said." - source Bloomberg.

The cheap credit environment is indeed sufficiently friendly for shareholders in this on-going releveraging process and arguably very unfriendly and painful, to say the least, for the investment grade portfolio manager, given that the LBO story is clearly more favorable to equity investors than credit investors facing multiple downgrades and Profit and Loss hits.

In a recent note by CITI entitled "Ever Been a Better Time for a LBO?" published on the 22nd of February 2013, they argue that the current cheap credit environment makes the pursuit of shareholder-friendly activity quite compelling relative to historical norms:
"Question: If you could buy the exact same company for $75 today (sale price) or for $100 tomorrow (full price), which would you chose?

Answer: Depends. Paying full price may very well be better than paying the sale price if borrowing costs for the two are different. Price is one part of the “package.”

When considering re-leveraging activity, our sense is that many market participants tend to overlook the “package effect,” and as a result under-appreciate the extent to which corporate managers could favor shareholders. In fact, in a sum-of-the-parts context the argument for LBOs may look as compelling as it ever has." - source CITI

As we have also argued in our conversation "Bold Banking", when one looks at the return of Cov-lite loans to the fore front, no doubt to us we are entering, once again bubble territory in the credit space. In May 2012, we specifically discussed this return in our conversation "The return of Cov-Lite loans and all that Jazz...":

"Unintended consequences" of low rates environment have led to a flurry of issuance of Cov-lite loans again in the market."

"Low borrowing costs: Current borrowing costs are hovering near all-time lows. For example, a typical LBOed company is likely to carry a single-B rating, and Figure 2 (previous page) shows that the yield for the average single-B issuer is almost 4% below the historical norm (5.9% vs. 9.8%). Also noteworthy is that moving from single-A — the typical rating of an “un- LBOed” company — to single-B (likely post-LBO rating) is fairly cheap as well. Figure 3 (previous page) shows that the yield difference between the two is now only 3.4%, vs. the long-term average of 4.7%. And there are other lending features in the current environment that in practice cheapen borrowing costs as well, such as the relative lack of covenants (Figure 4). It really doesn’t seem to cost that much to move down the quality now." - source CITI

The "unintended" consequences of ZIRP courtesy of the Fed is favoring releveraging of corporates' balance sheets:

"Reasonable valuations: So an LBOed company in the current environment can be expected to provide a high income stream due to low interest expense, and equity stakeholders may now have an above average chance of collecting this income stream. But in addition, one also doesn’t have to pay all that much for these advantages; the PE ratio for the typical IG name is currently 12.8 (based on our sample universe as explained below), compared to the historical norm of 16.4 (Figure 6)." - source CITI

CITI goes further in their note displaying a real world example for the sake of the demonstration:

"Based on our sample universe, the typical “un-LBOed” company currently has $3.8 bn in total debt outstanding, current market cap of $13.8 bn, and earnings before interest of $1.8 bn (Figure 7). Given our assumptions, after an LBO this company’s equity value will decline by $9.6 bn and total debt will increase by the same amount." - source CITI

"Impact of low borrowing costs: If we consider an LBO scenario in a historical context borrowing cost rises from 5.1% (long-term average yield of the typical single-A issuer) to 9.8% (average single-B). Higher borrowing cost means that net income would fall from $1.58 bn to $0.45 bn for the typical name (albeit divided among fewer shareholders, of course; Figure 8). But currently all-in yields are low and the yield difference between the average single-A and single-B is only 3.4%, which means that interest expense rises by a fairly small amount (Figure 8, previous page). As a result, net income is not pressured by higher borrowing costs anywhere close to normal, and post-LBO net income is far higher than usual ($0.98 bn)." - source CITI

Given the pressure on CEOs to increase ROEs, the LBO can indeed justify the recourse in leveraging the balance sheet as indicated by the below table from CITI's note indicative of the potential increase of ROE that can be achieved via a typical LBO for an investment grade company:

"Pay less for more! One could normally expect the ROE for a typical company to be more or less flat post LBO (Figure 10). This is not all that surprising, as sponsors get paid to shift through the details. The multiple one has to pay for flat performance is normally 16.4x. But now the increase in ROE is over 11% in a post-LBO scenario (from 12.2% to 23.4%). And to get the relatively high ROE the multiple one must pay is lower than normal, not higher (12.8x vs. 16.4x)." - source CITI

As a reminder, in 2008, about one quarter of the 86 S&P-rated companies that defaulted on debt were private equity backed, but , as CreditSights put it in in their 29th of July 2008 report entitled LBO Analysis - It is more than Just Financial Metrics:

"Creating value by adding leverage is, in essence, an arbitrage strategy. And, like any arbitrage return, it will ultimately be arbitraged away as participants increase. 

Despite the favorable lending terms during 2005-2006 credit bubble, it stands that there is even less ability to create value simply from leverage.

LBO management can enhance value by exploiting knowledge of a competitor's play book when on the offense and by taking more financially productive responses when on defense." - source CreditSights

We could not agree more.

"What counts is what you do with your money, not where it came from" - Merton Miller 

Stay tuned!

Credit - The Donk bet

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

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

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

 The "Donk bet" being:

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

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

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

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

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

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

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

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

US PMI versus Europe PMI - source Bloomberg

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

We also indicated at the time:

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

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

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

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

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

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

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

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

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

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

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

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

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

Stay tuned!