Markets update - Credit - The European Overdiagnosis

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

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

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

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

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

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

The Credit Indices Itraxx overview - Source Bloomberg:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Likelihood of a Euro Breakup

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Stay Tuned!

Markets update - Credit - The European Principle of Indifference

"Insanity: doing the same thing over and over again and expecting different results."
Albert Einstein

"In a macroscopic system, at least, it must be assumed that the physical laws which govern the system are not known well enough to predict the outcome. As observed some centuries ago by John Arbuthnot (in the preface of Of the Laws of Chance, 1692):

It is impossible for a Die, with such determin'd force and direction, not to fall on such determin'd side, only I don't know the force and direction which makes it fall on such determin'd side, and therefore I call it Chance, which is nothing but the want of art....
Given enough time and resources, there is no fundamental reason to suppose that suitably precise measurements could not be made, which would enable the prediction of the outcome of coins, dice, and cards with high accuracy: Persi Diaconis's work with coin-flipping machines is a practical example of this." - source Wikipedia

The "Principle of insufficient reason" was renamed the "Principle of Indifference" by the economist John Maynard Keynes (1921), who was careful to note that it applies only when there is no knowledge indicating unequal probabilities - source Wikipedia
Keynes was refuted by Frank Ramsey, but this is another story...

As a follow up to our Bayesian thoughts and following the recent Standard and Poor's downgrade of 9 European countries, our Principle of Indifference analogy relates to the European ongoing crisis. It seems our European politicians are applying the principle incorrectly, not only leading to nonsensical results, but as well as to nonsensical decisions (PSI on Greece, EFSF, and more). In this credit conversation, we will discuss collateral damage to our CPDO EFSF, again on Goodwill impairments ("Goodwill Hunting Redux") and more. But before, we go through the nitty-gritty; it is time for a quick Credit Market overview.

The Credit Indices Itraxx overview, slightly better in a quiet European session even after the downgrades - Source Bloomberg:

A fairly quiet day in the credit indices space with US being out. Overall credit indices were tighter while the Securities Markets Programme (courtesy of ECB) was in for the bid on the sovereign bond cash side.
The Itraxx Crossover 5 year index (50 High Yield companies) fell about 16 bps to close around 710 bps and Itraxx Main Europe 5 year index (125 European investment grade names) was tighter as well, around 167 bps, 5 bps tighter.

The liquidity picture in four charts. ECB Overnight Facility, Euro 3 months Libor OIS spread, Itraxx Financial Senior 5 year index, Euro-USD basis swaps level - source Bloomberg:

Still record holding at the ECB's overnight facility earning 0.25%, one more days until the start of a new reserve period on the 18th.

The current European bond picture with more respite for Italy and Spain courtesy of SMP intervention (ECB) - source Bloomberg:

No change on "Flight to quality", with tighter Germany 10 year Government bond still trending towards record lows - Source Bloomberg:

And our interesting disconnect between the 10 year German Bund and the Eurostoxx is still there, (we first noticed this disconnect in our post "Mind the Gap..." - source Bloomberg:

But the most significant movement we saw today was relating to Sovereign CDS, between Ireland and Portugal, a new record 510 bps between both countries - source Bloomberg:

Ireland 5 year CDS was at 800 bps on the 27th of September 2011 (see our post"Much ado about nothing").

As a follow up on our conversation "Long hope - Short faith", we were expecting Austria's sovereign CDS to trade wider than France at some point, courtesy of the Austrian banking sector Hungarian issues. Following the downgrade of both countries last Friday, we are getting closer to the point - source Bloomberg:

In relation to our CPDO/EFSF, following up on Friday's action, Standard and Poor's has effectively downgraded the leveraged structure from AAA to AA+.
Back in our "European Flutter" conversation we argued:
"The potential downgrade of both France and the EFSF, would render it useless or far more dangerous as we indicated in our post "Much ado about nothing and CPDO redux in European Style", namely that:
"In a CPDO/leveraged EFSF, when multiple downgrades happen, creating significant widening in spreads/higher interest rates, the loss in NAV can be significant."

This would basically mean, that the more downgrades you get, the more leverage you need in order to make up for the increased shortfall in quality collateral..."

How would a downgrade of a member country affect EFSF? - source EFSF
"There is a credit enhancement structure used under the Framework Agreement which constitutes the EFSF. Therefore a downgrade of a member country would not necessarily lead to a downgrade of EFSF securities."
Time to update the presentation...

Standard and Poor's stated:
"We consider that credit enhancements that would offset what we view as the now-reduced creditworthiness of the EFSF's guarantors and securities backing the EFSF's issues are currently not in place. We have therefore lowered to 'AA+' the issuer credit rating of the EFSF, as well as the issue ratings on its long-term debt securities."

What is the credit enhancement structure?
"In order to ensure the highest possible credit rating, various credit enhancements were put into place:
- an over-guarantee of 120 per cent on each issue.
- an up-front cash reserve which equals the net present value of the margin of the EFSF loan.
- a loan specific cash buffer
Together these credit enhancements ensure that all loans provided by EFSF are backed by guarantees of the highest quality and sufficient liquid resource buffers. The available liquidity is invested in securities of the best quality." - source EFSF

But given's Germany's Supreme Court recent reluctance on increasing the EFSF's firepower without a popular vote, we seriously doubt the credit enhancements expected by Standard and Poor's to reverse their negative outlook will materialise in the near future for the EFSF given:

"Unlike the EFSF, ESM.s structure will comprise paid-in capital, callable capital and guarantees. This therefore means that the ESM would not require the credit enhancements (over-guarantee, cash buffer and cash reserve) that the EFSF requires in order to secure a AAA rating." - source EFSF

We already discussed at length the frailty of the EFSF - "EFSF - If you are in trouble - double".

- source EFSF

Could EFSF be considered as a Collateralized Debt Obligation (CDO)? - source EFSF
"No, EFSF is not a CDO. The essential difference between EFSF and a CDO is that EFSF debt has no tranche structure. There is no seniority and all investors have exactly the same rights. Secondly, EFSF bonds are covered by the guarantees from the euro area countries. However, a triple-AAA rating from all three leading credit rating agencies is not assigned lightly. EFSF has put into place additional credit enhancements through the use of a cash reserve and loan specific cash buffer which are immediately deducted from the loan made to a borrowing country in order to provide additional reassurance to investors. Consequently, all claims on the EFSF are 100% covered by AAA guarantors and cash."

We would have to agree, the EFSF is not a CDO, it is worse. More akin to a CPDO, and given it has no tranche structure and no seniority, as we argued previously "the loss in NAV can be significant", suffices to say, it can just be binary.

Following up on BayernLB's goodwill impairments discussed in our "Bayesian Thoughts", we forgot to mention BBVA which took a Goodwill impairment charge of 1.5 billion euros, which according to CreditSights counter-intuitively helps improve 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."

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

So yes, "Tracking goodwill impairments will indeed be a necessary exercise in 2012 as they can take a real chunk out of bank earnings in the process."
Indeed an interesting exercise in 2012.

Although Swedbank wasn't as lucky as BBVA, given, according to CreditSights:

"Swedbank: SEK 1.9 (215 millions euros) billion Latvian Goodwill Impairment in Q4 2011, a 49% impairment on the total goodwill of SEK 3,870 millions. The goodwill write-down will make a dent in Swedbank's FY11 profits when it reports on 14 February, but the size is manageable. Latvia remains a key market for Swedbank, but although economic growth revived in 2011, it is likely to show signs of slowdown in 2012."

On a final note, we leave you with Bloomberg Chart of the Day - "Collateral Damage’ to EFSF Fund":

Jan. 16 (Bloomberg) -- "Standard & Poor’s Jan. 13 downgrade of nine euro-area countries, including France and Italy, risks blunting trust in Europe’s main weapon against the debt crisis. The CHART OF THE DAY shows the zone’s average rating, calculated by Bloomberg from the three main evaluators’assessments, worsened to 3.56, implying three grades below the top level, from 3.27 on Dec. 31. The average is calculated by assigning each grading a number, with 1 as the top rating, and adjusting it for each country’s share in the bailout fund called the European Financial Stability Facility."

"In individuals, insanity is rare; but in groups, parties, nations and epochs, it is the rule."
Friedrich Nietzsche

Stay tuned!

Markets update - Credit - The Hungarian dances

"Learn from yesterday, live for today, hope for tomorrow. The important thing is not to stop questioning."
Albert Einstein

In a continuation of our previous analogy to the European flutter, as we enter 2012, the recent evolutions of the situation in Hungary which we discussed in our post "Mind the Gap...", warrant us this time around to ramble around how reminiscent the collapse of the Austro-Hungarian dual monarchy and empire (1867–1918) is with our European flutter. Could Hungary be the trigger in 2012? Before we enter yet another long credit conversation, for a change this time around, before our market overview, it is of importance to highlight the current situation in Hungary and contagion to Central Eastern Europe.

Back in October in our post "Long hope - Short faith" we discussed the worrisome Hungarian situation, which was also the main subject of our conversation "Leda and the (Greek) Swan and why Europe matters more for Emerging Markets".

We previously quoted an article by Geoffrey T. Smith from the Wall Street Journal on the subject and as we move into 2012, it will be paramount to monitor the risk of wholesale capital flight with the ongoing buildup of tensions in Hungary - "Austria Has a Déjà Vu Moment":

"the biggest threat to Austrian banks is still what it was in 2009—wholesale capital flight from emerging Europe."

On the 4th of January, Hungary's 5 year sovereign CDS widened by 65 bps, quoted 690-730 bps in the market, with limited liquidity and the CDS curve inverting in the process, meaning short dated protection is becoming more expensive than the 5 year point. We have seen this happening before with Greece, Portugal and others. The situation warrants caution as the Hungarian effect is spreading to other countries according to a market maker, spreading to Poland and Czech sovereign CDS, both trading wider in the process, Poland around 290 bps for the 5 year CDS and around 180 bps for Czech CDS 5 year.

As indicated by Simon Foxman in Business Insider article - Hungary's Currency Hits New Lows Amid More Signs Of Upheaval:
"The Hungarian forint weakened to its lowest value against the euro since last month—near its lowest level ever—at 319.4 amid worries that the political situation there is becoming untenable. Increasing attention is being paid to the small Eastern European country, at the center of Europe's other debt crisis.

The Hungarian government is running short on cash after it passed a law last week that could compromise the independence of its central bank. That law flaunted guidance from the European Union and the International Monetary Fund, who provided the troubled country with €20 billion ($26 billion) a bailout back in 2008. Hungary is paying through the nose to borrow even short-term funding, and the cost of insuring Hungarian debt via credit default swaps hit a new record, at 655 basis points according to Bloomberg. It paid yields of 7.67% to borrow for a three-month term and raise 45 billion forint ($190 million) yesterday.

Domestic turbulence is complicating matters, with protestors taking to the street to protest the government's new constitution (which includes that controversial central bank law). According to the BBC, protests are focusing on three major issues:

·A clause that defends the "intellectual and spiritual unity of the nation," which opponents argue could result in repression of intellectual freedoms

·Inclusion of social issues like the right of the unborn child and the definition of marriage as a union between a man and a woman

·Changes to the electoral system which could empower the leading Fidesz party at the expense of the opposition

Popular support for the Fidesz party hit 18% in a December opinion poll cited by the BBC, although it still leads other parties. If the Hungarian government were unable to pay its bills, it could wreck the Austrian banking system, which has an estimated $226 billion in exposure to Eastern Europe and €1.14 trillion ($1.6 trillion) of assets held in the region. 10-year yields on Austrian government bonds—and indicator of stress on the country—are moving sharply higher this morning. They rose to 3.20%, the highest level since before a central bank stilled their rise earlier in the year."

At the time of our November conversation "Mind the Gap...", we reminded the new legislation which passed by the Hungarian government in relation to the ill-fated currency mortgages which burden Hungarian households:
"Under the new legislation borrowers can repay their mortgage in a single installment at a HUF/CHF rate of 180 or a HUF/EUR rate of 250. Current FX rates are around 239 for HUF/CHF and HUF/EUR is around 297, a 25% and 16% discount according to CreditSights."
In November we commented:
HUF/EUR rate was 297 at the time, and is now much higher (315), meaning losses for European banks and in particular the likes of Austrian Erste Bank exposed to these mortgages will be significantly higher - source Bloomberg. Given HUF/EUR is reaching new highs, Austrian banks exposed to these mortgages face significant additional losses. So yes, contagion to EM, and in particular Central Eastern Europe, which was highlighted as a key risk for 2011, is indeed starting to materialise early in 2012.

But before we delve more into the Hungarian dances (as a reference to the 21 lively Hungarian dance tunes by Johannes Brahms), and discuss some of our previous call for concerns, it is time for a quick market overview.

The 36 months LTRO set up on the 21st of December by the ECB is far from having the expected results in relation to alleviating concerns that banks will use the cheap funding provided to generate generous positive carry by buying peripheral bonds. 455 billion euros are deposited at the ECB earning a paltry 0.50% of interest for now - The liquidity picture in four charts. ECB Overnight Facility, Euro 3 months Libor OIS spread, Itraxx Financial Senior 5 year index, Euro-USD basis swaps level - source Bloomberg:

The Credit Indices Itraxx overview - Source Bloomberg:

Most credit indices remain in the "concern" area, with Itraxx Financial Subordinate 5 year CDS index around 530 bps, still indicating the unsecured subordinated financial market is shut down, while Itraxx Financial Senior 5 year CDS index is rising again towards the 300 bps in a very thin market. As indicated by a market maker, so far both clients and dealers are on the sidelines. The Itraxx SOVx index tied to 15 European Government sovereign CDS is on the rise as well getting closer towards its 385 record set up on the 25th of November. Similar story to what we wrote in January 2010, "European problems not going away in 2011", and not going away in 2012.

The current European bond picture, a story of ongoing volatility, with Spain now rising as well with Italy following recent news of regional funding issues in Spain (Valencia) - source Bloomberg:

So what about our CPDO EFSF? It seems French yields are now rising faster as we start a new year, Investors demanded a yield of 3.29% on the 3.25% OAT due in October 2021, last auction on 1st of December was 3.18% - source Bloomberg:

German 10 year government yield falling (flight to quality) while German 5 years sovereign CDS rising - source Bloomberg:

In relation to the deflation story still playing out in Europe, here is an update on 30 year Swiss bond yields now below 1%, nearly 100 bps lower than Japan 30 year bond yields - source Bloomberg:

But back to our main story, namely the Hungarian situation and contagion to Emerging Markets (EMEA).

During various credit conversations, we argued that the name of the game is survival of the fittest in the race to raise much needed capital. It seems Deutsche Bank is sharing our views as indicated in their Emerging Markets special publications published on the 6th of December entitled amusingly "Survival of the fittest":
EMEA dominates our list of the most vulnerable countries. Five countries (Hungary, Ukraine, Romania, Poland, and Egypt) show up as highly vulnerable, though for different reasons. Egypt’s underlying vulnerabilities, for example, are fiscal first and external second. Ukraine’s risks are mostly external. Hungary’s vulnerability reflects a combination of risks in all four areas."

According to Deutsche Bank, for 2012, EMEA countries will be facing many difficulties and will need IMF support:

"Current account balances have improved in the last few years and central banks have been able to build bigger buffers of foreign reserves. But the large stock of external debt accumulated during the middle of the last decade still leaves the region with large external burden. Much of this borrowing took place in foreign currencies – Swiss franc mortgages in Hungary (20% of GDP) being just one example – the local currency burden of which is now being inflated as those currencies come under pressure. With these debts needing to be serviced on an ongoing basis, many countries still face large external financing needs even as their current account positions have improved. This is particularly true of Hungary and Ukraine, which have gross external financing needs of 30% of GDP or above in 2012 despite a moderate current account deficit in Ukraine and a small surplus in Hungary."

IMF support?

"Three of these countries (Hungary, Ukraine and Egypt) may well need to tap the IMF for financial support next year. Ukraine already has an IMF program (of which USD 12bn or 6.5% of GDP is potentially still available) but is currently looking first to Russia for cheaper gas prices to reduce its external financing needs. Hungary is seeking the reassurance of a precautionary IMF program although negotiation on the policy condition has not yet started and could well be difficult. Egypt had reached agreement in principle on a USD 3bn (1.2% of GDP) arrangement with the IMF but has yet to proceed with the deal for political reasons."

In our conversation "Leda and the (Greek) Swan and why Europe matters more for Emerging Markets", we already discussed at length the Western Europe banking deleveraging impact will have on Emerging Markets and in particular Central Eastern Europe. In their December note, Deutsche Bank also commented:

"The buildup of foreign currency debt was probably largely a reflection of relatively high and volatile inflation in some cases, leading to a large spread between domestic and foreign interest rates. But the availability of foreign currency loans was also facilitated by the rapid expansion of western European banks throughout much of the region. This has left many countries exposed to deleveraging by foreign banks as they seek to meet additional capital requirements imposed by the European Banking Authority. These requirements are largest for Greek, Italian, and Spanish banks, which may be a concern for Romania and Hungary (as well as Croatia, Serbia, and Bulgaria outside our sample) where Greek and Italian banks are most active. But other banks may also be reluctant to maintain their exposures in the region. Germany’s Commerzbank, for example, has indicated that it will temporarily suspend new lending outside of Germany and Poland. Austria’s central bank has also imposed limits on new lending in CEE by the subsidiaries of Austrian banks. And countries without strong parent-subsidiary ownership linkages are also unlikely to be immune. Turkish banks, for example, have substantially increased their short term external borrowing in the last couple of years (from foreign banks) and may face some difficulties in rolling these loans."

As indicated by Deutsche Bank, given Hungary exports to the euro area account for 40% of GDP, Hungary is arguably more exposed to a recession in Europe. The recent failed Hungarian auction and additional pressure on the Forint is definitely not helping.

And my good credit friend to comment on the 5th of January:

"The Hungarian Forint is under pressure again (EurHuf @ 321.50), and the country had problem raising 1 year T-Bills this morning (35 billion HUF instead of the 45 billion planned, the average yield rose to 9.96% versus 7.91% for the same kind of maturity on December 22nd). The cost of insuring Hungary’s debt through CDS reached an all-time high at 750 bps!

Basically, the country is now in a worst situation than Portugal, and without the IMF and EU assistance, the risk of a hard default is rising very quickly. Consequences for European banks exposed to this country are difficult to assess, but Erste Bank, Raiffeisen and some other players should suffer…"

And suffer they already have, not only with the legislation capping the exchange rate on currency mortgages provided to Hungarian households (putting them in a difficult situation) we mentioned above but, also in relation to Goodwill impairments (which we discussed in our conversation "Goodwill Hunting Redux").
As a reminder:

"Erste Bank in fact, wrote down the value of its Hungarian and Romanian units by a combined 939 million euros in October."

"UniCredit wrote down goodwill on assets in its home market, eastern Europe and former Soviet Union countries in its third-quarter earnings report in November (8.7 billion-euro impairment charge)".

It wasn't therefore a big surprise to us and our good credit friend to see a decline of 37% of UniCredit shares in three days following its 7.5 billion right issues priced with a 43% discount (selling shares for 1.943 euros each...).

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


Given we already know that UniCredit made 60 billion USD worth of acquisition between 2005 and 2008, tracking goodwill impairments will indeed be a necessary exercise in 2012 as they can take a real chunk out of bank earnings in the process.

In relation to current bank exposure to Hungary, Deutsche Bank in their latest Hungarian sovereign risk review published on the 6th of December indicated the following:

"During the past days the Hungarian sovereign risk exposure has increased
significantly, taking the development of CDS prices as an indicator. Austrian banks have material exposure to Hungary, both via sovereign bonds and through loans. Erste Group has a total of EUR11bn in assets invested in Hungary (some EUR8bn in loans, some EUR3bn in sovereign exposure) while Raiffeisen Bank International has a total of EUR8bn in Hungarian assets (some EUR6bn in loans, some EUR2bn in sovereign exposure.
According to latest EBA data, as of 30 Sept 2011 the largest European banks have a total sovereign exposure of EUR31bn vis-a-vis Hungary. The data indicates the largest absolute exposures (combined net trading and banking book) are held by KBC with EUR6.9bn (of which EUR2.6bn was due within 3 months, so might have left the balance sheet by now), OTP with EUR4.2bn, Erste Group with EUR3.3bn, BayernLB with EUR2.2bn, Commerzbank with EUR2.0bn, Intesa with EUR1.7bn, ING with EUR1.7bn, RBI with EUR1.6bn. In some cases the maturity profile in the EBA spreadsheet was biased to short-term exposures, in some cases biased towards long-term exposures.
In relation to current market cap, high ratios result for KBC (c.220%), Erste Group (c.70%), RBI (c.40%) and Commerzbank (c.30%). A haircut on Hungarian sovereign exposure therefore would have meaningful implications for these institutions."

Continuing on the same Hungarian theme in Deutsche Bank EMEA Daily Compass published on the 6th of December, we have to agree with their assessment of the situation for Hungary:
"The failure of yesterday’s a12M bill auction has ignited fears that the situation in Hungary may spiral into a solvency crisis triggered by an inability to roll-over upcoming LOCAL debt maturities.
From a medium term perspective, a useful rule of thumb for assessing debt sustainability is to compare the marginal real yield required to roll-over the existing stock of debt and the real growth rate of the economy Over the past 10 years, real growth has averaged 2.4% y/y while yearly inflation stood on average at 5.9%, which suggests that at the current blended (local and external) marginal rate of refinancing (10.5%), a consistent fiscal primary surplus of 2.2% would be required to maintain current public debt levels stable. It is clear to us that such a theoretical outcome is not credible for the market, i.e. paradoxically yields have reached a level that is too high to motivate buyers to participate in the financing of an issuer that is running an unsustainable debt position."

Deutsche Bank to conclude their note making the following point:
"As a conclusion, we expect events to unfold rather quickly in Hungary. It may come down to a choice between a partial loss of sovereignty in economic management or of a debt restructuring, to be made at the highest political level."

And has clearly indicated by Bloomberg's Chart of the day of the 4th of January, we have seen this movie before...

"Hungary’s failure to secure an international bailout has pushed the cost of insuring its debt against default above that of Ireland for the first time since September 2010.
The CHART OF THE DAY shows that credit-default swaps on Hungary rose to 720 basis points in London on the 3rd of January, compared with 709 for Ireland, according to CMA, which is owned by CME Group Inc. and compiles prices quoted by dealers in the privately negotiated market.

Hungary’s default swaps surged to the highest on record on the third of January and the forint weakened to an all-time low versus the euro after Citigroup Inc. said an International Monetary Fund deal is unlikely in the next six months and European Commission spokesman Olivier Bailly said the European Union has no plans to resume aid talks."

"When there's uncertainty they always think there's another shoe to fall. There is no other shoe to fall."
Kenneth Lay - CEO and chairman of Enron from 1985 until his resignation on January 23, 2002.

Stay tuned!

Markets update - Credit - The European Flutter

"Even as I approach the gambling hall, as soon as I hear, two rooms away, the jingle of money poured out on the table, I almost go into convulsions."
Fyodor Dostoevsky, The Gambler - 1867

As a follow up to our "Generous Gambler" from 1864, our title analogy, this time around has many dimensions.

A flutter is a colloquial term for a bet or a wager in gambling, but, in relation to the European situation, an "Aerolastic" flutter seems more appropriate to the current predicament of the European failing structure.

"An Aerolastic Flutter is a self-feeding and potentially destructive vibration where aerodynamic forces on an object couple with a structure's natural mode of vibration to produce rapid periodic motion. Flutter can occur in any object within a strong fluid flow, under the conditions that a positive feedback occurs between the structure's natural vibration and the aerodynamic forces. That is, the vibrational movement of the object increases an aerodynamic load, which in turn drives the object to move further. If the energy input by the aerodynamic excitation in a cycle is larger than that dissipated by the damping in the system, the amplitude of vibration will increase, resulting in self-exciting oscillation. The amplitude can thus build up and is only limited when the energy dissipated by aerodynamic and mechanical damping matches the energy input, which can result in large amplitude vibration and potentially lead to rapid failure." - source Wikipedia.

And "Flutter" can occur on other structures than aircraft (the 1940 Tacoma bridge failure for example). Indeed, when discussing recently our European Peregrine Soliton, we already touched on nonlinear resonance shift, leading to formations of "rogue" waves and circularity issues.
Therefore, our European flutter could lead to another type of flutter, the "Atrial" type (heart failure)...So, could the European Union face the same outcome as the 1940 Tacoma Narrow Suspension Bridge? But here I go again in my usual rambling habit.

Before we enter in a longer than usual credit conversation, our last for 2011, discussing LTRO, revisiting upcoming goodwill impairments for European banks, IMF, deleveraging and the Eurozone's core issue, courtesy of my global macro friends at Rcube Global Macro Research, namely Unit Labor Cost Divergence, it is time for a quick credit market overview.

The Credit Indices Itraxx overview - Source Bloomberg:

Better tone in the CDS space with German IFO coming better than expected at 107.2 (106.1 expected), but given the absence of liquidity, it is of no surprise to see somewhat some sort of relief rally on the eagerly extended LTRO by the ECB. Yesterday was roll date for single name CDS rolling to March, whereas credit indices roll every 6 months.

Itraxx Financial Senior 5 year index (linked to senior debt of 25 banks and insurers) and Itraxx Financial Subordinate 5 year index still remain elevated as we move towards year end - Source Bloomberg

Most interestingly in the sovereign space is the ongoing divergence between Spanish 5 year Sovereign CDS and Italy - source Bloomberg:

The much expected 3 year LTRO has had a significant impact as well on government bond spreads.

The current European bond picture, a story of ongoing volatility, also displays similar divergence between Italy and Spain - source Bloomberg:

Spain today successfully placed 5.64 billion euros, above the maximum target (4.5 billion euros) at much improved yields of 1.735 for three months compared to 5.11% at the previous auction of November 22nd, at similar demand levels 2.86 times versus 2.85 times last month. 6 months paper was placed at 2.435% down from a previous 5.227%, at a lower bid to cover of 4.06 times compared to 4.92 previously.
Bank of Spain is encouraging Spanish banks to borrow at the ECB and buy Spanish government bonds.

The loosened collateral rules by the ECB is helping the peripheral banking sector in borrowing more at the ECB but the liquidity picture is far from improved - The liquidity picture in four charts. ECB Overnight Facility, Euro 3 months Libor OIS spread, Itraxx Financial Senior 5 year index, Euro-USD basis swaps level - source Bloomberg:

Every cloud has its silver lining?
Truth is the Spanish banking sector is a long way from being out of trouble as indicated by Charles Plenty in Bloomberg on the 19th of December in his article - Spanish Bad Loans Jump to 17-Year High as Lending Falls: Economy

"Spanish banks reported more bad loans and lower lending and deposits in October, hurt by the fallout of the country’s property crash and the European sovereign debt crisis.
The ratio of bad loans as a proportion of total lending climbed to 7.42 percent, the highest level since 1994, from 7.16 percent in September and 5.68 percent a year earlier as the value of borrowings in default rose to 131.9 billion euros($171.9 billion), the Bank of Spain in Madrid said in a statement today. Lending fell 2.5 percent from a year ago, following a record 2.6 percent drop in September, and deposits slid 2.2 percent to their lowest level since 2008.
Rising defaults and declining loans and deposits show how banks are suffering from the fallout of Spain’s property slump and a wider European debt crisis that has shut them out of wholesale debt markets."

When austerity bites...

Also from the same article:

“What we have been saying for a while, and I think the banks themselves have been in denial on this, is that the asset quality decline has not bottomed out yet because unemployment is still going up,” said Inigo Lecubarri, who helps manage about $300 million at Abaco Financials Fund in London. “A non- performing loans ratio of 7.4 percent is already very bad. Ten percent would be catastrophic and it’s not impossible we could get there.”

In our previous conversation we argued the following:

"In addition to this, the sovereigns 2012 massive funding needs will result in a deadly competition between the protagonists to raise whatever money is available, resulting in much higher funding costs and the collapse of those with weaker balance sheets."

Ignacio Lecubarri seems to agree with us as he indicated in the same Bloomberg article:

"Spanish bank deposits are shrinking at a time when lenders are being forced to compete for funds between themselves and also with the government, Lecubarri said."

It is still the same game of survival of the fittest which leads to touch again goodwill impairments for European banks, a subject we discussed back in November in our post "Goodwill Hunting Redux", CreditSights in a note published on the 18th of December entitled - Season of Impaired Goodwill, seems to be sharing our concerns:

"The UK veto impaired a lot of political goodwill, both within the country's coalition government and with its EU partners. But Crédit Agricole (-16%) took the theme directly into the banking sector, announcing large write-downs of financial goodwill across a range of businesses with its profit warning on Wednesday. Coming on top of a €500 mln negative effect on net income from deleveraging, goodwill impairments totalling €2.5 bln will push the quoted entity Crédit Agricole S.A. into an overall net loss for the full year. The negative impacts of €3 bln compare with €1.6 bln earnings in the first nine months and a former consensus forecast of just over €400 mln for the fourth quarter, implying that the FY11 net loss could be €1 bln or more.

While goodwill is already deducted from Core Tier 1 capital and therefore does not affect ratios, the earnings effect can be highly damaging in the equity market, and there are bound to be more goodwill impairments to come in the near future from other banks, as they adjust projections of their subsidiaries' earning capacity to the current business and regulatory environment. The timing of impairment decisions is the hardest thing to second-guess, though."

Large goodwill impairments can affect a company stock price and spreads, as well as its debt ratings.

In this difficult funding environment, as per our previous conversations, not even our CPDO/EFSF has been successful enough in raising much needed funds. The CPDO/EFSF picture - source Bloomberg:

The potential downgrade of both France and the EFSF, would render it useless or far more dangerous as we indicated in our post "Much ado about nothing and CPDO redux in European Style", namely that:

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

This would basically mean, that the more downgrades you get, the more leverage you need in order to make up for the increased shortfall in quality collateral...

Natixis bank in their latest 2012 Credit Yearbook indicated that the EFSF could raise 60 billion euros in 2012, taking into account the first Greek plan (compared to the 16 billion euros only raised in 2011...). Clearly not enough firepower to backstop European Sovereign debt for peripheral countries. ESM which should be deployed by 2012, is also depending on the economic situation of the members of the European Union as well as in the faith of investors.

One the most interesting point from Natixis latest Credit Yearbook was their simulation on Eurobonds and the impact they would have on European government yields:

Emphasis ours (click graph to enlarge). Natixis in their exercise take into account GDP growth projections, deficit and debt levels as well as funding needs for 2012, assuming 10 year Eurobond could be issued at z-spread +30bps (assuming quantitative rating of AA+ for the Euro zone as a whole). This would amount to 10.9 billion euros savings in funding, representing 1.4% of total funding needs.

My good credit friend and I discussed the following in relation to the latest IMF involvement or the rescue funds:
"To repeat what we discussed in our last conversation, neither the IMF nor the rescue funds can sort the solvency problem out. France is about to be downgraded, bringing down the EFSF structure. So anyone who thinks that the EFSF and the ESM will run in parallel has it wrong. Of course the ESM will remain, but its firepower will be far less than the Euro 500 billions earmarked, not enough to rescue all the peripheral countries under pressure. Of course, the IMF may help sovereigns funding issues but, it will do in accordance with specific rules: liquidity issues will be faced, solvency one will not. While we do not foresee major problems right now for the core European countries, the environment could change very quickly."

As the Head of the Canadian Central Bank just declared, “developed economies have regularly increased their debt leverage over dozens of years. But this period is now over. If the deleveraging trend is now clear, the speed and size of the process are not. This process could last and be done in an orderly way, or be abrupt and disorderly.”

Simon Johnson, who served as chief economist at the International Monetary Fund in 2007 and 2008, and is now a professor at the MIT Sloan School of Management and a senior fellow at the Peterson Institute for International Economics, had an interesting column in Bloomberg relating to the IMF involvement in the European Sovereign debt crisis on the 19th of December - IMF Bazooka Is Between Meaningless and Dangerous:
"Today’s proposed bazookas are about providing enough financial firepower so that troubled European governments do not necessarily have to fund themselves in panicked private markets. The reasoning is that if an official backstop is at hand, investors’ fears would abate and governments would be able to sell bonds at reasonable interest rates again.

This idea is just as dubious as Paulson’s original notion. Markets are so thoroughly rattled that if a financial backstop is put in place, it would need to be used -- probably to the tune of trillions of euros of European debt purchases from sovereigns and banks in coming months. Whether or not it is used, a plausible bazooka would need to be huge."

Simon Johnson also adding:
"Even if the IMF went all in for troubled Europe -- an idea with little support in emerging markets -- it wouldn’t make much difference. Italy’s outstanding public debt of 1.9 trillion euros is bigger than that of Greece, Ireland, Portugal and Spain combined. The country faces about 200 billion euros in bond maturities in 2012 and an additional 108 billion euros of bills, according to Bloomberg News. The euro area’s 2012 sovereign funding needs are estimated at more than $1 trillion next year alone, and any credible financing plan needs to fully cover 2012 and 2013 at a minimum. It remains unclear who is willing to fund European banks in this stress scenario.

The idea that the IMF could tap emerging markets for additional capital to lend to Europe is met with polite public demurrals. Behind closed doors, it’s not so polite.

The more innovative ideas involving the IMF include some financing provided by the European Central Bank or national central banks within the euro area to the IMF, with the fund then lending this back to Europe.

This would constitute a misguided or even dangerous form of financial innovation. If the precise arrangement involves the IMF taking credit risk, its membership should be worried about losing their capital. The U.S., as the largest single shareholder, would have the most to lose."

Similar to our "Generous Gambler" conclusion ("The greatest trick European politicians ever pulled was to convince the world default risk didn't exist", Martin - Macronomics), Simon Johnson ends his column with the following points which also resonate with our European Flutter analogy, namely failing structures due to inadequate design:

"Eighty years ago, most prominent officials and private financiers were confident that the gold standard should and would remain in place. Starting in 1931, the gold standard failed as a global financing system, with unpleasant consequences for many.

As 2011 draws to a close, the age of the global bailout also seems to be fading. Perhaps the Europeans will find a way to scale up their own rescues using their own money. Perhaps they will manage to protect creditors fully, and convince investors to lend to Italy again. More realistically, the bazooka standard is about to collapse."

Our European structure suffered from poor design such as the 1940 Tacoma Narrow Suspension Bridge. On a final note, the most evident Euro zone structural problem as highlighted by my macro friends from RCube in their recent paper comes from Unit Labor Cost divergence:

"In addition to being a political symbol, the Euro was supposed to offer two irresistible benefits to its members: (1) the Deutsche Mark’s low interest rates for everyone and (2) no more exchange rate volatility within the Eurozone.
Until 2008, the first benefit (lower interest rates) kept its promises. Italy’s yield spread against Germany went from 12% in 1982 to a mere 20bp in 2007. It actually worked so well for some countries that it led to huge housing bubbles, consumer credit bubbles and fiscal largesses, as deficits were easy to finance. Unfortunately, as we can see nowadays, these were all sources of phantom growth, i.e. growth that resulted from stealing from the future and not from increasing productivity. The debt crisis in the Eurozone is a direct result of this unchecked debt bubble.
The Euro’s second “benefit” (no more currency volatility) created another imbalance that will probably be even more painful to resolve than the first one. Since the last competitive devaluations of the early nineties, we have witnessed a huge divergence of Eurozone members’ unit labor costs (especially against Germany), as evidenced by the following chart 1:

1 We use unit labor costs rather than raw labor costs to take into account changes in productivity.

We start the series in 1995, 2 years after Europe’s last major devaluations.

"While Germany was going through painful social reforms, labor costs increased faster than productivity for many Euro members on a relative basis (average increase vs. Germany: 38% between 1995 and 2012).
The divergence ended during the 2008 financial crisis, as some countries (most notably Ireland) started to converge back towards Germany’s unit labor costs. However, we can see that we are still very far away from levels that could restore Eurozone members’ relative labor competitiveness against Germany.
Interestingly, we can notice that the five countries whose unit labor costs grew the most are the PIIGS. This is probably not a coincidence. Low labor competitiveness hurts the economy, thus lowering tax revenues, while public spending is used to hide the underlying decline of the economy. This leads to a degradation of the fiscal situation.
In a nutshell, labor forces in many Eurozone countries are now getting paid in a currency that is vastly overvalued compared to their productivity (this can also be seen in the degradation of the trade balance of many European countries including France).
To restore to competitiveness of PIIGS (and to a lesser extent France and Belgium), labor costs will therefore have to decrease significantly. There are many ways this could happen. We can think of at least four:
1) Very high unemployment rates combined with a dismantlement of welfare states (due to the debt crisis), would force people to discount the value of their labor.
2) As some economists proposed in the case of Greece during last summer, it could also be enforced through internal devaluations. These would obviously be much more difficult to accept than current austerity plans (which concern mostly public finances). Italy’s welfare minister bursted into tears after she announced an end to pension indexing. What would she do if she had to announce an across-the-board reduction in wages by 5% every year for the next 5 years?
3) Rather than living through a decade of austerity, some countries might end up preferring to leave the Euro. The pain would be very intense in the short-term, as inevitable devaluations would destroy the purchasing power of workers and savers, but it would eventually restore the competitiveness of their labor force.
4) The ECB could crash the Euro. Monetizing huge amounts of sovereign debt would contribute to this (in addition to solving the liquidity situation of PIIGS). However, Germany and other countries that are already competitive will oppose this. Additionally, it would not solve the structural problem of unit labor cost divergence, which would inevitably lead to new crises further down the road.
It is difficult to predict what path (or combination of paths) will be chosen by politicians. The one thing we strongly believe is that, whatever the path, real aggregate demand is going to crash a lot further in large parts of the Eurozone. Growth expectations remain way too optimistic.
This is why we consider that Europe’s P/Es of 8 are not cheap by any standards, and that the Euro is poised to fall against other currencies."
Reproduced courtesy of RCube Global Macro Research.

“I don't attempt to be a poker player before this crowd”
Dwight D. Eisenhower

Stay tuned in 2012! In the meantime we wish you all a Merry Christmas and a Happy New Year!

Markets update - Credit - Goodwill Hunting Redux

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

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

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

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

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

But first it is time for a market overview:

The Credit Indices Itraxx overview - Source Bloomberg:

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

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

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


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

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

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

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

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

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

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

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

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

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

Love me tender?

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

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

Given we already know 2012 is going to be a significant year for term issuance for banks ("Mind the Gap..."), you can expect more of the same. First bond tenders, then we will probably see debt to equity swaps for weaker peripheral banks with no access to term funding, leading to significant losses for subordinate bondholders as well as dilution for shareholders in the process.

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

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

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

And added:

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

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

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

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

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

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

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

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

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

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

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

Liam Vaughan and Charles Penty also commented in their article:

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

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

"When a bank acquires another one, goodwill as intangible asset goes on its balance sheet. When a medium bank acquires a smaller one, goodwill is created onto the balance sheet. But, when the medium bank is acquired by a larger one, there is a compounding effect given that the larger bank will also create some more goodwill of its own and therefore inflates its balance sheet.
As the process goes on and on, for banks on the acquisition war path, you find more and more goodwill making up the capital."

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

We also indicated at the time:

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

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

And we concluded back then:

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

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

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

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

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

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

Stay tuned!