Credit - The year of the empty hand

"Men occasionally stumble over the truth, but most of them pick themselves up and hurry off as if nothing had happened." - Winston Churchill

"This is the year of the empty hand 
Oh you hold on to what you can 
And charity is a coat you wear twice a year 

These are the days of the guilty man 
Your television takes a stand 
And you find that what was over there is over here"
George Michael - Praying For Time

"emp·ty-hand·ed (mpt-hndd) adj.
1. Bearing nothing.
2. Having received or gained nothing."
source the American Heritage Dictionary

While we recently looked into Spain's record surge in Nonperforming loans making a comparison with storm surges and Hurricane Sandy versus the 1991 "Perfect Storm", and looking at the epic performance in credit pointing towards a record year in similar fashion to 2009 (performance now close to 11% in Total Return), we thought this week we would be using part of the lyrics from George Michael's 1990's single hit "Praying for Time" for our title. James Hunter of Rolling Stone magazine described the song as "a distraught look at the world's astounding woundedness".We think our title is appropriate given the astounding woundedness caused by Balance Sheet Recessions (BSR). Looking back at the level of support provided in Europe to the financial system in conjunction with drastic austerity measures for some, the performance in the financial credit space has been epic while yielding no benefits to the real economy. The irony of our chosen title lies in the extraordinary returns for credit in 2012 with admittedly a very clear disconnect with valuations and fundamentals which we discussed last week and as indicated by the below graph from BNP Paribas:

Expensive credit markets you think? You bet!

But, given the on-going "Yield Famine" in the credit space, the theme in the cash market remains the same. Investors are underinvested and full of cash, and with the latest pause in issuance in the corporate space, there is technically no natural supply. As a market maker commented recently on this market context:

"So bonds remain bid and it is difficult to buy bonds even as corporate cash looks expensive. CDS remains quiet but generally feels a little weak in low beta."

In this week conversation, we will look at how to play credit in a deleveraging environment, as well as the upcoming pain for Spanish junior subordinated bondholders and we will finish with the future for credit returns after a record year for the asset class.

In a world facing "Yield Famine" and "River of No Returns" courtesy of a deleveraging environment, what is the investment recipe one should follow?

"All real-world investors face funding constraints such as leverage constraints and margin requirements, and these constraints influence investors’ required returns across securities and over time. Consistent with the idea that investors prefer unleveraged risky assets to leveraged safe assets, which goes back to Black (1972), we find empirically that portfolios of high-beta assets have lower alphas and Sharpe ratios than portfolios of low-beta assets. The security market line is not only flatter than predicted by the standard CAPM for U.S. equities (as reported by Black, Jensen, and Scholes (1972)), but we also find this relative flatness in 18 of 19 international equity markets, in Treasury markets, for corporate bonds sorted by maturity and by rating, and in futures markets." - source Betting Against Beta, Andrea Frazzini and Lasse H. Pedersen - October 9, 2011.

"These are the days of the beggars and the choosers" - George Michael - Praying For Time

The BAB factor (Betting Against Beta) explain the returns of some investors such as Warren Buffett:

"Leveraged buyout funds and Warren Buffett’s firm Berkshire Hathaway, both of whom have access to leverage, buy stocks with betas below 1 on average, another prediction of the model (BAB). Hence, these investors may be taking advantage of the BAB effect by applying leverage to safe assets and being compensated by investors facing borrowing constraints who take the other side. Buffett bets against beta as Fisher Black believed one should". - source Betting Against Beta, Andrea Frazzini and Lasse H. Pedersen - October 9, 2011.

The on-going forced deleveraging for large parts of the European financial system, which have been "begging" for liquidity and provided vast amounts of it, courtesy of our "Generous Gambler" aka Mario Draghi, is no doubt a golden opportunity for cash rich "choosers".

"And you find that what was over there is over here" - George Michael - Praying For Time

Europe is indeed finding out that the deleveraging (which has started earlier in the US) is accelerating over here in Europe hence the tremendous deflationary forces at play and the traumatic effect on the real economy with the EBA (European Banking Association) forcing banks to reach a target of 9% of Core Tier 1 capital in June 2012 in conjunction with austerity measures and unrealistic deficit targets but we ramble again...

As we reminded ourselves in our previous conversation Chadburn, on Full Ahead?:
"One of the most important indicator we think in relation to our Credit Chadburn and the growth divergence between the US and Europe is the evolution of the Loans-to-Deposit ratio progress."

The growing divergence between US and European PMI indexes - source Bloomberg:

US PMI versus Europe PMI from 2008 onwards.

Which as we pointed out recently, this growth difference can be seen in the credit prices between the USA and Europe. The divergence of growth between the US economy and the European economy is reflected in credit prices such as the US leveraged loan cash price index versus its European peer - source Bloomberg:

For Europe, the deflationary forces at play are tremendous. When looking at Spain, one can see the correlation of rising unemployment and rising nonperforming loans - source Bloomberg:

We could go even further by looking at the evolution of the Spanish misery index (inflation + unemployment) in conjunction with nonperforming loans- source Bloomberg:

As far as the Spanish hurricane is concerned, the amount of funding needed for 2013 is significant - source Bloomberg:

One could as well posit that our title could be a veiled reference to a game of high stake poker being played out in Europe. The beggars are indeed not the choosers when it comes to our chosen title and Europe. Pushing the analogy further, we would like to quote Dr Jochen Felsenheimer from his latest credit letter for November 2012 from credit asset management house "assénagon" :
"There are two games in particular whose mechanism is closed to that of capital market: Poker and chess. The development of recent years sadly suggest that the former has gained the upper hand. The central banks have shown their aces of spades, the European Union is using the Spanish Opening to fight for the center of the euro, investors are checking if they don't have anything in their hand after the flop, and the markets are using the Queen's gambit to bet on the same gameplay being repeated again and again. But there is also the possibility that it will be different this time. The financial markets are facing changes which might change the rules of the game for ever. Traditional investment approaches are about to be superseded and long decades of valid mechanisms will be influenced by new developments."

While the political game being played is a game of Chess (see our conversation "The Game of the Century"), we agree with Dr Jochen Felsenheimer's assertion relating to financial markets being currently a game of high stake poker:
"Having the ace and the king as your hole cards is somewhat disparingly know in Texas hold'em as an "Anna Kournikova" - "looks great but never wins". That describes the current situation in the markets extremely aptly. The markets' first reaction to the concerted action by the ECB (Draghi effect) in combination with the political developments (Spanish banks, ESM, etc.) was, of course, positive. The imminent breaking up has been averted for now, even if the fundamental problems are far from solved. The thin line between austerity and growth will continue to dominate the political discussions in Europe and regulatory measures are limited to a few segments and are seamlessly merging into the tradition of combating the symptoms, while the causes largely persist. The European monetary union's basic problem is due to nothing more than the heterogeneity of the member states. This is just what is causing the current problems - the necessity of transfer payments which are currently reflected in the massive TARGET2 balances. The close ties between the banking sector and governments are not solved by Basel III and a banking union - but only raised to another (European) level. And ultimately the economic environment will continue to represent the greatest challenge, as this makes the elegant escape of "growing out of the crisis" seem highly unlikely. Necessary structural reforms (which are known to take time) and the long-drawn-out reconstruction of the European architecture confirm us in our assumption that we are currently on the "Japanese path". And this is more similar to the Way of St. James than a walk in the park."

Indeed, European politicians have been praying for time, we think, and so is the Spanish financial  system!

The Spanish bad bank SAREB will have between 45 billion euros and 90 billion euros in assets. The estimated of assets to be transferred to SAREB taking into account Group 1 of banks (BFA-Bankia, Catalunya Banc, Novagalicia Banco and Banco de Valencia) is 45 billion euro. The average haircut for the transferred assets is between 46% and 63% based on Oliver Wyman's baseline scenario plus an additional discount. What amounts, we think, into wishful thinking from the Spanish government is that it ambitions to keep its stake in the structure below the 50% threshold so that SAREB stays private and Spain's public accounts are not affected and to avoid taking a hit on its public debt level. What caught our attention is that the Spanish government is already facing "mutiny" in the sense that BBVA has already balked at investing into the bad bank. Angelo Cano, BBVA's CEO has already voiced is concern and said last Wednesday he had no interest in investing in the bad bank in true Banker's algorithm fashion:
"When the system receives a request for resources, it runs the Banker's algorithm to determine if it is safe to grant the request. The algorithm is fairly straight forward once the distinction between safe and unsafe states is understood."
Request denied...from BBVA. "We have no real obligation"  - Angelo Cano, BBVA CEO.

Supposedly most of the funding for the SAREB is to come from private investors (8% equity) with an expected ROE of 14-15% (according to FROB). Three main sources of funding are envisaged:

-State-guaranteed senior debt

-Perpetual subordinated debt

-Common equity

Both the perpetual debt and the common equity will be subscribed in part by the restructuring Spanish fund FROB (Fund for the Orderly Restructuring of the Banking Sector) but with a majority subscribed supposedly by private investors.

Why has the request has been denied by BBVA, simply because of pending provisions to comply with the two RDLs (Royal Decrees relating to real-estate provisioning for banks) as displayed in the Exane BNP Paribas table below from their recent report on the Spanish Bad Bank SAREB from the 30th of October:

Only 31% of provisions have already been booked by BBVA, hence the rejection...

As far as losses are projected in relation to real estates exposure (all credit - performing or not - + foreclosed) - RD1 + RD2 versus Oliver Wyman's adverse scenario versus the Bad Bank Sareb and Deutsche Bank estimates versus NAMA, the below table from Deutsche Bank indicate the expected losses:

"Hanging on to hope when there is no hope to speak of" - George Michael - Praying For Time

Hanging on hope is exactly what Banco Popular Espanol junior subordinated boundholders are hanging onto. They are counting on being rescued by the Spanish lender's equity investors from avoiding being wiped out on 6.4 billion USD of junior debt as reported by Estaban Duarte from Bloomberg on the 1st of November in his article -  Popular Bond Wipe-Out in Shareholder Hands:
"The bank wants to raise as much as 2.5 billion euros ($3.2 billion) in shares to avoid seeking state aid that would trigger losses on subordinated bonds under European Union rules. Popular’s 5.702 percent junior notes due 2019 rose 15.8 percent in the past month to 7O cents on the euro, according to Bloomberg prices, compared with an average 1.93 percent increase for securities in the Bank of America Merrill Lynch Euro Financial Subordinated & Lower Tier-2 Index. Failure to raise funds through a share sale could mean Popular having to conduct a restructuring under the eyes of regulators, cap salaries and dispose of assets. The lender is a victim of Spain’s real estate collapse, failing the latest government stress tests which revealed the Madrid-based lender has a 3.22 billion-euro capital shortfall. “The share sale is the last hope for Popular subordinated bondholders since a failure would mean that the state would have to step in,” said Ignacio Victoriano, head of fixed-income at Renta 4 SGIIC, which manages 1.5 billion euros of assets including some Popular subordinated bonds. “We are confident that they will get the deal done.”" - source Bloomberg.

We " agree" to disagree", with the above statement from Ignacio Victoriano and we would rather side with the comment from Jean-Luc Lepreux, senior bank analyst at Societe Generale SA in Paris from the same Bloomberg article:
"Raising 2.5 billion euros when your market capitalization is 2.6 billion euros will be hard without running the extra mile,” Lepreux said in an interview. “Subordinated debt holders should be prepared to face high haircuts for banks needing public funds, up to 100 percent for fully nationalized institutions."

Banco Popular Espanol share price evolution since 1989- source Bloomberg:

"Popular wants its customers to buy 60 percent of the new shares being offered because Chief Financial Officer Jacobo Gonzalez-Robatto said Oct. 1 that “the bank has enormous goodwill of its customers.” The stock was at 1.20 euros today and has slumped 29 percent since the day before the share-sale announcement on Oct. 1, valuing the lender at 2.6 billion euros.
Bankia followed the same strategy in July last year when it tapped about 347,000 individual investors as it was seeking to boost capital. Bankia stock has fallen almost 70 percent since then.
Popular’s third-quarter profit fell to 75.6 million euros from 98.6 million euros in the same period a year earlier, the lender said Oct. 26. That surpassed the 42 million-euro median estimate in a Bloomberg survey of nine analysts." - source Popular Bond Wipe-Out in Shareholder Hands, Bloomberg.

As far as asset quality is concerned for Banco Popular in general, and Banco Popular's shareholders in particular, Banco Popular has still some significant provisions to book based on the two RDLs (4.9 billion euro) as reported by Nomura on their recent note on Banco Popular:

"Popular still has significant provisions to book based on the new legislation introduced this year of c.EUR 4.9bn. These provisions, plus additional ones highlighted by management, making a total of EUR 9.3bn will be booked following the upcoming rights issue." - source Nomura

This is exactly how our story is unfolding for junior subordinated bondholders:
"At some point, as we argued recently (Peripheral Banks, Kneecap Recap), losses will have to be taken."

We correctly foresaw this process for weaker peripheral banks.

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

"Oh, you hold on to what you can" - George Michael - Praying For Time

Moving on the subject of future returns for credit, it is indeed a question of holding on what you can.

Nomura in their recent Quantitative Strategies update from the 31st of October ask the following important question:
"Will future credit returns be a trick or a treat?"

Following up on the concept of "Betting on Beta" earlier in our conversation, one has to remember these fundamentals concepts when approaching credit as indicated by Nomura's note:
"Many investors understand that what they get from credit exposure depends on how high credit spreads are when they buy.
But relatively few grasp just how high credit spreads have to be to earn decent risk-adjusted returns. Only top-quartile spreads will do- "above-average" -is not good enough as shown below:

Spreads in 2009 were in the top decile, and credit has performed well since then. Spreads today are above-average but not top quartile. Adjusted for regulatory changes, they would probably be even lower.
The trick: average credit returns (stripping out funding and duration) are mediocre, as spreads barely cover the cost of fallen angels or defaults.
The treat: credit returns are semi-predictable, due to their links with trends in corporate fundamentals, rating actions, and business cycles. This makes credit a good fit for systematic long/short strategies.
Balancing carry, momentum and value investment styles to position long/short in credit indices outperforms, with a Sharpe ratio of 1.01." - source Nomura

Is buying and holding an issue in credit? Nomura indicates these empirical elements:
"Long-only credit returns have been poor over time 
In Figure 2 we show the cumulative duration-adjusted excess returns of US corporate bonds since 1997 and the bonds‘ average OAS":

"A long-only investor would have received very little additional return for the extra risk they were taking in this 15-year period. In our paper Making credit beta work for real we show how credit spreads tend not to compensate investors for the costs of fallen angels and defaults – investors sell bonds as they are removed from indices at a substantial loss to par. Even a small number of fallen angels or defaults can wipe out the positive carry from performing names. While there are periods where excess returns are positive, these tend to follow periods of spread widening."

Finally how does one generate future credit returns going forward? Combining long/short strategies makes credit perform as indicated by Nomura:

"A styles-based strategy combining carry, momentum and value to position in a basket of CDS Indices delivers solid returns since 2006. The index has a Sharpe of 1.01, Calmar of 0.92 and skew of 0.86 (vs. long-only Sharpe of 0.36, Calmar of 0.13 and skew of -0.7)." - source Nomura


"Nothing is enough for the man to whom enough is too little." - Epicurus 

Stay tuned!

Credit - Banker's algorithm

"An algorithm must be seen to be believed." - Donald Knuth, Professor Emeritus at Stanford University.

"The Banker's algorithm is a resource allocation and deadlock avoidance algorithm developed by Edsger Dijkstra that tests for safety by simulating the allocation of predetermined maximum possible amounts of all resources, and then makes a "s-state" check to test for possible deadlock conditions for all other pending activities, before deciding whether allocation should be allowed to continue" - source Wikipedia

"The Banker's algorithm is run by the operating system whenever a process requests resources. The algorithm avoids deadlock by denying or postponing the request if it determines that accepting the request could put the system in an unsafe state (one where deadlock could occur). When a new process enters a system, it must declare the maximum number of instances of each resource type that may not exceed the total number of resources in the system. Also, when a process gets all its requested resources it must return them in a finite amount of time" - source Wikipedia

Given the on-going discussions relating to Greece negotiating with its creditors and trying to buy some additional time, as well as the much anticipated Spanish official rescue request, with the ECB waiting on the fateful 12th of September German Constitutional court ruling, we thought this time around we would venture towards computational analogies in our title. In similar fashion to our "Banker's algorithm" analogy, it remains to be seen if our European algorithm will avoid deadlock by denying or postponing the Spanish request if it determines that accepting the request could put the European system in an unsafe state.

In similar fashion to our banker's algorithm analogy, the coming months will indeed be decision time given Europe will have to decide at some point whether "allocation" should be allowed to continue.

In reference to Spain, the recent decision by the Spanish State to "allocate" an urgent transfer of 6 billion euros to its bank rescue fund FROB, which controls stakes in Spanish lenders such as Bankia group, will indeed appear in central government budget data once the payment is made:
"Spain is about to boost the capital of the rescue fund after writing down investments in lenders including Bankia group, according to the fund’s annual report dated July 26. The fund posted a net loss of 10.56 billion euros in 2011, sparking a negative equity of 1.86 billion euros." - source Bloomberg, Angeline Benoit and Estaban Duarte, 24th of August 2012 -

We think our analogy this week is once again appropriate. In our computational reference, namely the Banker's algorithm, in similar fashion to the upcoming Spanish rescue request, in our Banker's algorithm:
"When the system receives a request for resources, it runs the Banker's algorithm to determine if it is safe to grant the request. The algorithm is fairly straight forward once the distinction between safe and unsafe states is understood.
1. Can the request be granted? If not, the request is impossible and must either be denied or put on a waiting list
2. Assume that the request is granted
3. Is the new state safe?
-If so grant the request
-If not, either deny the request or put it on a waiting list.

Whether the system denies or postpones an impossible or unsafe request is a decision specific to the operating system."

On the 31st of August, the Spanish government will detail the rules for the Spanish lenders to access funds from the European bailout of as much as 100 billion euros earmarked in June to support the Spanish financial system. Spain must create a "bad bank" as a condition for accessing the loan from the 16 other European countries. The European Commission has asked Spain to delay by another week the plans to create this very "bad bank" so that its experts in Brussels can review the project. We might be speculating again but maybe the European Commission is as well using the "Banker's algorithm".

The Spanish government is introducing new rules to restructure and, if needed, dismantle non-viable financial institutions according to Bloomberg. One can therefore posit that Spanish FROB could indeed use as well the Banker's algorithm in its allocation process...but here is the catch:

 "Like other algorithms, the Banker's algorithm has some limitations when implemented. Specifically, it needs to know how much of each resource a process could possibly request. In most systems, this information is unavailable, making it impossible to implement the Banker's algorithm." - source Wikipedia
Oh well...

CreditSights in their note from the 9th of August entitled - Spanish Government - We Need to Talk about Cutting made the following points:
"The Spanish government has negotiated with Eurozone partners a budget-deficit target for 2012 of 6.3% of GDP. The plan is then to reduce the deficit to below the 3% Maastricht Criterion by 2014. But this year’s target has already been revised up twice from the original 4.4% illustrating how difficult cutting government spending and raising taxes is when the economy is deep in recession.
Following Spain’s 1990s recession, the budget deficit exceeded the 3% Maastricht Criterion in all but two quarters in the eight years between 1991 and 1998. Since the 2007 recession, budget deficits have been larger, but have so far only exceeded the 3% Maastricht Criterion for three-and-a-half years.
Yet, the problems facing the Spanish economy are this time around much larger than they were in the early 1990s. The private-sector debt position at the start of the 2007 recession was equivalent to 215% of GDP. At the start of the 1992 recession, household and business debt was 65% of GDP.
And in the 1990s, Spain’s exit from the ERM allowed the currency to depreciate and the current account to move into surplus. In this recession, Spain’s membership of euro means there is no ability to recover competitiveness via currency depreciation;
The result is that the Spanish government will need to run budget deficits that are far larger than the targets it has negotiated with its Eurozone partners. But it is impossible to see the market continuing to buy the bonds to fund such deficits, Spain is all but certain to need a full government funding programme from the EFSF/ESM."
The process whereby lenders to Spain are paid back thanks to an implicit loan from the Eurosystem to the Spanish government won’t be allowed to persist indefinitely. And when it stops, the money to repay those Spanish government bonds won’t be available.
Absent the Spanish people tolerating a wrenching reduction in their incomes within an unrealistically short timeframe in, they believe a government request for EFSF / ESM funding is all but inevitable."

We would have to agree to the above key points from CreditSights, both Italy and Spain pose the biggest threat to the survival of the Euro. In fact the Spanish Misery index beats Greece as crisis bites as indicated by Bloomberg:

"Record unemployment is cementing Spain’s position as Europe’s most miserable nation, widening the gap over twice-bailed-out Greece, as the debt crisis deepens.
The CHART OF THE DAY shows a composite gauge of Spanish jobless and inflation rates, known as the misery index, is rising quicker than those of other European economies, and as Greece’s retreats from a 2012 high. Globally, only South Africa is faring worse, according to data compiled by Bloomberg News. Spain’s misery index is 26.83 percent, comprising a jobless rate of 24.63 percent and inflation at 2.2 percent. Greece’s score is 23.9 percent and that of the euro region is 13.6
percent. South Africa, which has an inflation rate of 5.5 percent and 23.2 percent unemployment, has a misery reading of 28.7 percent, according to data compiled by Bloomberg News.
The misery index is calculated by adding the 12-month percentage change in the consumer price index to the jobless rate. Arthur Okun, an adviser to Presidents John F. Kennedy and Lyndon Johnson, created the indicator in the 1960s." - source Bloomberg.

In our credit conversation we would like to focus on the changing corporate bond environment and focus once again on the structural change in market liquidity as well as default risk, in the credit space. But first our credit overview!

The Itraxx CDS indices picture, ending the week on a weaker note in the credit derivatives space - source Bloomberg:

Credit indices were overall wider on Friday, ahead of the long week-end in the United Kingdom. Overall quality cash credit from investment grade core issuers has been the clear outperformer during the summer. While last week Itraxx Crossover 5 year index (High Yield risk gauge based on 50 European entities) came closer last week to its lowest level since March, it widened back by the end of the week towards 600 bps, on the back of weaker economic data (European PMI).

Both the Eurostoxx and German 10 year Government yields seems to be moving are still moving in synch. It seems the short burst of "Risk-On" is marking a pause, with fast falling German Bund yields towards 1.30% yield level and a slightly weaker Eurostoxx 50 at the end of the week  - 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:

In relation to the European bond picture, Spanish 10 year yields remain elevated at 6.43, slightly below 7% whereas Italian 10 year yields are below 6% around 5.76% and German government yields fell towards 1.33% - source Bloomberg:

Severing the Sovereign risk / Financial risk link has been the main concern of European authorities as indicated by the difference in spreads between the Itraxx SOVx 5 year CDS index and the Itraxx Financial Senior 5 year index. The recent rise of Itraxx Financial Senior CDS 5 year above the Itraxx SOVx Western Europe 5 year index is only indicative of the respite provided to Sovereign CDS spreads for Italy and Spain provided by the recent discussions surrounding ECB intervention. - source Bloomberg:

 

The widening of Italy and Spain in the sovereign CDS markets has been increasing by the end of the week (Spain back above 500 bps and Italy at 461 bps on 5 year markets) during which both also touched their lowest level since April 2012 - source Bloomberg:

The spread difference since March between both countries has been relatively stable as indicated in the lower graph.

Our "Flight to quality" picture marking a pause in "Risk-On" with Germany's 10 year Government bond yields falling again towards 1.30% and the 5 year CDS spread for Germany rising above 60 bps after having touched a low point as well during the week - source Bloomberg:

Credit wise, while in our last conversation "Desperado" on the 21st of August  we touched on Santander 2 year senior unsecured 2 billion euro new issue, which had been the first Spanish bank to issue since mid-march, we were taken aback by the latest "liability management" exercise which Santander followed immediately after its new issuer with. Banco Santander and Santander Financial Exchanges (each an Offeror and jointly the Offerors) inviting holders of certain Tier 1, Upper Tier 2 and Lower Tier 2 securities to tender such securities for purchase for cash at prices to be determined pursuant to an Unmodified Dutch Auction Procedure (as such term is defined in this Tender Offer Memorandum). The maximum aggregate principal amount of Securities that the Offerors intend to accept for purchase jointly pursuant to the Offers, will be an amount equivalent to €2,000,000,000. The impact of the announcement triggered a rally in some of the securities being proposed for the "liability management" exercise:

As we argued recently (Peripheral Banks, Kneecap Recap), "losses will have to be taken, it is all going Dutch, Dutch auction that is". The moment for losses to be taken has arrived at least for preference shares holders given Spain will impose losses of as much as 80% on owners of preference shares of banks that have received state aid and may be liquidated courtesy of an operation "Banker's algorithm" but we ramble again...In relation to Bankia, being clearly in the crosshair of such "exercise", back in June (Agree to Disagree - 16th of June 2012) we indicated:
"Spain has yet to apply the full extent of the Irish recipe which we discussed in "The road to hell is paved with good intentions":"Given the recent outrage by individuals investors relating to the performance of Bankia's share price following its IPO in 2011, it will be interesting to watch the subordinated bond space when looking at the difference in ownership between Ireland and Spain. One has to wonder if Spanish retail investors will be inflicted additional pain..."
The pain is definitely about to be inflicted.

This latest move reminded us of some of the comments our good credit friend had relating to Spanish banking woes back in April in our conversation "Mutiny on the Euro Bounty":
"Main Spanish banks have so far refused the government suggestion to create a bad bank which would carry all property toxic assets, arguing that they could manage their assets on their own. The dire reality is that the creation of such bad bank will bring transparency to asset prices, which is not what Spanish bankers want! The murkier the market, the better it is to extend and pretend..."

In it is not the first time we have been surprised by Santander, back in April we also indicated:
Moving on to the subject of the Spanish banking sector, quite frankly we have been baffled by Santander CEO Alfredo Saenz deriding Spain defaults surge: "“Mortgages get paid in good times and in bad”. He also added: "“Anyone raising this problem as one of the issues for the Spanish financial system is saying something stupid. (We discussed Spanish issues at length in our conversation "Spanish Denial")."

When it comes to Spanish woes and the difficulties in tackling Spain's economic woes, one might wonder how it can be achieved given when Rajoy came to power he split the finance ministry and decided not to give the title of deputy premier for economy to either Montoro or De Guindos, which is creating additional headaches for wary investors as indicated by Ben Sills in his Bloomberg article from the 23rd of March - Montoro Outburst Highlights Rajoy Paralysis as Cabinet Splits:
"The divisions at the heart of Rajoy’s government have hobbled Spain’s ability to operate on a European level. While De Guindos, who represents the government at European meetings, inspires confidence in the bloc’s other finance ministers, they question his ability to deliver on his promises
because he is often contradicted by Montoro, according to an official who takes part in finance ministers’ meetings. In January, De Guindos’s efforts to persuade investors and officials that Spain was fixed on its budget targets was undermined by Montoro’s calls for more flexibility on the pace of deficit reduction."

Moving on to the subject of the changing corporate bond environment and the structural change in market liquidity, we wanted to tackle again this issue of dwindling liquidity and its implication on the credit markets (which we discussed in our conversation "Yield Famine") given yields on corporate bonds worldwide fell to a record low on the 23rd of August as indicated by Bloomberg in their article -
Global Corporate Bond Yields Decline to Record After Fed Minutes:
"Borrowing costs for the most creditworthy to the riskiest companies fell to an unprecedented 3.76 percent yesterday, from 3.8 percent on Aug. 21, according to Bank of America Merrill Lynch index data. Yields on global investment-grade debt dropped to a record 2.97 percent. The extra yield investors demand to own global corporate bonds of all ratings rather than government debt narrowed to 261 basis points Aug. 21, the lowest level since August 2011, Bank of America Merrill Lynch index data show. The gauge widened 1basis point to 2.62 percentage points on the 23rd of August."

Liquidity risk is a concern we share with Thames River Credit fund which indicated the following in their July 2012 letter:
"A structural decline in liquidity has been taking place in the corporate bond market, which has serious repercussions for credit investors. The term liquidity may sound like an obscure, even technical, word but it reflects the ease with which a security can be bought and sold. The most efficient markets are those that benefit from deep pools of willing buyers and sellers, facilitating the transfer of risk. Unlike the equity market, the majority of trading in the corporate bond market is not transacted through centralised securities (also known as market-making).
One of the reasons why corporate securities have traded off-exchange is their greater complexity compared to asset classes such as equity. Features such as duration, maturity, credit risk and subordination can differ even amongst the debt of a single issuer making credit a highly heterogeneous asset class. The trade-off for the greater customisation of corporate securities is diminished liquidity. Of the US$ 8 trillion US corporate bond market only a small proportion of issues will trade with relative frequency. This highlights the important role banks have played in the corporate bond market. A changed regulatory environment, however, is putting increased strain on banks’ ability to make markets in corporate securities."

Thames River conclude their July letter with the following important point in relation to the issue of liquidity for benchmarked credit funds:
"Regulation and bank deleveraging is forcing change on credit markets. This is most notable in the area of liquidity. Without the lubrication of market-making activity, long-only corporate bond mutual funds stand exposed to the risk of a significant sell-off in credit markets. When combined with weakness in the rates market,such an outcome could create a perfect storm for benchmarked corporate bond funds. This is why the decline in corporate bond liquidity matters."

We could not agree more, the risk is real. We used a reference to Bastiat in relation to liquidity and Credit Markets in our conversation "The Unbearable Lightness of Credit":
"That Which is Seen, and That Which is Not Seen"

The Bond Bubble:
"In 5 out of the past 7 years, inflows to bond funds have exceeded 5% of AUM. Inflows to bond funds are running at an annualized $259bn (versus prior 2010 alltime high of $183bn). Inflows to Investment Grade & High Yield bonds funds thus far in 2012 account for a staggering 63% of total fund flows to all equity, bond & commodities." source Bank of America Merrill Lynch:

"Investor preference for Bonds over other classes is clear to see. Since 2007 there has been $650 billion into Fixed Income. Over the same period, Equities including ETFs saw outflows of $52bn." - source BofA Merrill Lynch.

When it comes to our final subject of default risk, in the credit space, CreditSights in their High Yield Market Trends published on the 20th of August indicated the following:
"The current relationship with HY (High Yield) and HG (High Grade) is more in line with what is seen in high default rate periods in the US such as 2002 and 2009. That still holds true today in both the US and Europe. The 127% quarter-to-date average (113% in 1H12) comes against the current default rate of 3.3% and is dramatically above the 76% long term average. The current HY incremental yield % versus HG is more in line with 2H02 levels of 127% when the trailing default rate declined from 10% to 8%. During the 1H2009 crisis, the 129% average came against a backdrop of 11.5% default rates. In 4Q07, when default rates ran at 1.7% the premium was 50%. Obviously that did not price in a jump in the default rates to over 14% by the end of 2009. There certainly has been a legitimate discussion that the HY market remain cheap by any of these comparisons unless you see a massive spike in defaults ahead.
With respect to the European data, they would add a caveat that the relative lack of depth in the crossover and middle tiers of the corporate universe and the relative absence of industry breadth (i.e. beyond TMT) in the “early years” of the European HY market impairs the usefulness of these metrics in Europe. In terms of framing the very low default rate levels in Europe today with what we saw in late 2007 in HY markets globally, there is an eerie similarity in that systemic is what drove the spike after the subprime mortgage crisis took out Lehman Brothers and the structured finance market while sending banks into a counterparty-driven interbank meltdown. The mere discussion of such risks in the Eurozone could make the risk of a bank system liquidity event more of a threat to the Euro HY market than the US HY market. While all HY markets (and equities) would sell off dramatically in such an event, the fact that actual default rates would more likely spike in Europe (and for a protracted period) would increase the risk of forced realization of such losses. That in theory would be when the price gap between US HY index and Euro HY index would widen more notably and losses would be “crystallized”. While that is a fat tail, they often highlight that still could end more just as a tall tale. The reaction of the HY and equity markets in Europe are voting “tall tail” at this point.
At the end of the analytical process used to frame the relative value of HY assets, it is defaults that matter most, and a material differential in actual defaults will be required to generate a more notable decoupling of returns in the rolling returns over longer time horizons across the US and Euro HY markets. As they look out towards mid-2013, it will take a systemic crisis and more than economic contraction to drive that in their view. To this point the roll-up of individuals credits still shows very manageable defaults in both the US and Euro HY markets."

On a final note, in relation to liquidity and volumes, as far as our equities friends are concerned, Christmas came early volume wise, it came in August as indicated by Bloomberg Chart of the day:

"The CHART OF THE DAY tracks the number of shares changing hands on the benchmark Stoxx Europe 600 Index since 2002, based on weekly data. About 9.34 billion shares were transacted last
week, according to data compiled by Bloomberg. That’s the fewest since 2002 except for during the traditionally slow periods at the end of the year, when business across the continent all but grinds to a halt.
Investors are staying on the sidelines as European politicians and central bankers wrestle with the region’s debt crisis, which has spread to Italy and Spain as it enters its third year, said Graham Bishop, a strategist at Exane BNP Paribas in London. European Central Bank President Mario Draghi said Aug. 2 that the lender would consider buying distressed countries’ bonds to help lower borrowing costs. “Christmas has come early,” said Exane’s Bishop. “We are now in sight of replicating Christmas in August with investors in wait-and-see mode until the ECB does what they said they will do. There’s a combination of policy uncertainty and the normal summer lull.” - source Bloomberg.

"Complacency is a state of mind that exists only in retrospective: it has to be shattered before being ascertained." - Vladimir Nabokov

Stay tuned!

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

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

So what?

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

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

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

Its death came in October 2008:

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

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

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

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

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

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

Here is why:

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

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

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

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

But back to our market overview:

The liquidity picture:

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

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

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

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

The luck of the Irish.

10 year German Government bond versus 5 year German CDS:

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

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

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

• "Merkel is safe (for now)

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

• Germans like Europe (for now)

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

• It’s the economy, stupid

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

And Exane BNP Paribas to add:

• "Will EFSF reform pass the Bundestag?

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

• What about Eurobonds?

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

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

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

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

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

And given Merkel's big u-turn relating to the Japanese nuclear disaster this year, and that next general election in Germany are to be held in September 2013, and we know that Merkel is already committed to a third term, I would really follow closely the German economy in general and the German labour market in particular.

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

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

German unemployment rate - January 2007 to September 2011:

German GDP growth rate from January 2007 to September 2011:

Stay tuned!