Credit - Nimrod

"I made Nimrod great; but he built a tower in order that he might rebel against Me" (Ḥul. 89b). 

While looking at Spanish 10 year government bonds "Bonos" breaking the 2.50% level, a level not seen since 1789 and French OAT 10 year at 1.51%, a level as well not seen since 1746 in conjunction with the German bund 10 year making new record low at around  1.119%, it seemed to us a clear validation of the "japanification" process we have long been depicting in our numerous credit conversations namely of a deflationary process taking place particularly in the light of the recent print of the European CPI estimate YoY coming at 0.4% in conjunction with very weak CPI pointing towards outright deflation for both Spain and Italy.

The European bond picture and the "japonification" process - graph source Bloomberg:

While we have already used a reference to central bankers' deception tricks in our conversation "Deus Deceptor" (being an omnipotent "deceptive god" as posited by French philosopher René Descartes), we decided this week to venture towards a religious analogy in our chosen title. We already touched on the "Omnipotence Paradox" back in November 2012 when it comes to central bankers and the market's perception of their "omnipotence" in sustaining asset price levels. In fact, last week we mused around  the notion of "perpetual motion" and its physical impossibility. As far as deities and omnipotence go:

"1. A deity is able to do absolutely anything, even the logically impossible, i.e., pure agency.
2. A deity is able to do anything that it chooses to do.
3. A deity is able to do anything that is in accord with its own nature (thus, for instance, if it is a logical consequence of a deity's nature that what it speaks is truth, then it is not able to lie).
4. Hold that it is part of a deity's nature to be consistent and that it would be inconsistent for said deity to go against its own laws unless there was a reason to do so.
5. A deity is able to do anything that corresponds with its omniscience and therefore with its worldplan." - source Wikipedia.

In continuation to the past reference of "omnipotence" in regards to central bankers actions, we decided to venture towards the biblical character Nimrod when choosing this week's title as he is generally considered to have been the one who suggested building the Tower of Babel and who directed its construction to challenge the "almighty".

By birth, Nimrod had no right to be a king or ruler (such as central bankers). But he was a mighty strong man, and sly and tricky (such as Mario Draghi, Janet Yellen and her predecessor Ben Bernanke), and a great hunter and trapper of men and animals (in their relentless hunt for yield). His followers grew in number, and soon Nimrod became the mighty king of Babylon, and his empire extended over other great cities, but that's another story and we ramble again.

In this week's conversation we will look at the increasing risk in the much "crowded" credit market, namely investment grade and high yield which could be impacted by the rise in interest rate volatility as well as a rise in default rates. We will also look at the Banco Espirito Santo (BES) story which is a continuation of what we discussed recently in our conversation "The European Polyneuropathy":

(see our conversations, "Peripheral Banks, Kneecap Recap", "Subordinated debt - Love me tender?" and "Goodwill Hunting Redux"):

"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.

When one looks at the "new credit Tower of Babel", which construction has no doubt been directed by our "omnipotent" central bankers reaching dizzying height (or spread compression that is), we wonder how long this mighty tower will continue to hold given the recent outflows in the High Yield ETF HYG and the disconnect with stocks as depicted in the below Bloomberg graph warrants caution we think for our "equities friend":

HYG and JNK are the two largest High Yield ETFs accounting for 80% of assets.

Given Investment Grade is a more interest rate volatility sensitive asset, whereas High Yield is a more default sensitive asset what warrants caution for both we think is, the risk of rising interest rates for the former and the risk of rising default rates for the latter. And, as we indicated in November 2012 in our conversation "The Omnipotence Paradox", zero growth should normally led to a rise in default rates, in that context, a widening in credit spreads should be a leading indicator given credit investors were anticipatory in nature, in 2008-2009, and credit spreads started to rise well in advance (9 months) of the eventual risk of defaults. What credit investors forget in this deflationary environment, is that, as we argued in November 2011 in a low yield environment, defaults tend to spike and it should be normally be your concern credit wise (in relation to upcoming defaults) for High Yield, not inflation.
(For a more in depth analysis on credit returns and valuation, please refer to our friend Rcube's guest post "Long-Term Corporate Credit Returns").

In relation to the outflows seen in the aforementioned High Yield segment of the market as illustrated by the above Bloomberg Graph, the recent note from Bank of America Merrill Lynch entitled "Greed Retreat" from the 24th of July indicates the largest weekly outflows from HY bonds since June 2013:

-source Bank of America Merrill Lynch

When it comes to our "new credit Tower of Babel" analogy, bonds ETFs in Europe have swollen as reported by Bloomberg by Alastair March on the 25th of July in his article entitled "Bond ETFs Swell in Europe as Debt Trading Slows":
"Bond buyers are pouring record amounts of money into exchange-traded funds in Europe that buy debt as central bank largess boosts demand and makes investors less willing to part with their fixed-income assets.
 Investors deposited more than $16 billion into ETFs that purchase debt from high-yielding corporate notes to sovereign bonds, almost quadruple the amount in the same period last year, according to data compiled by Bloomberg. BlackRock Inc., the world’s biggest provider of ETFs, estimates bond-fund inflows will climb to about $20 billion by year-end.
The unprecedented era of near-zero benchmark interest rates that’s fueling demand for debt shows no signs of abating in Europe, with European Central Bank President Mario Draghi pledging to keep borrowing costs at record lows for an extended period. Deposits into bond ETFs across the region are growing twice as fast as flows in the U.S. as Federal Reserve Chair Janet Yellen said rates in the world’s largest economy may rise sooner than it currently envisions if the labor market improves." - source Bloomberg

But, with volatility making a come back in the US Treasury space with US 10 year touching 2.59% following the better than expected US macro data as well as four-week average of jobless claims, considered a less
falling to 297,250, the lowest since April 2006, from 300,750 the prior week, given the spread compression seen in the Investment Grade space, there is no real buffer left to support a sudden rise in interest rate volatility, putting the YTD bond flows in Investment Grade at risk. As Bank of America put it in their flow report "quality" is a crowded trade:
"Quality-crowded: YTD bond flows show IG bonds (31 straight weeks of inflows) most at risk from crowding (Chart 2)

31 straight weeks of inflows to IG bond funds ($4.2bn)" - Source Bank of America Merrill Lynch

In true Japanese fashion, credit in a deflationary environment does indeed tend to outperform as we have previously discussed in our conversation from April 2012 entitled "Deleveraging - Bad for equities but good for credit assets":
"As volatility of credit is much lower than equities, investors could have taken a suitable amount of leverage on credit to convert this into high absolute returns"

As per our conversation "Deus Deceptor:
"The "japonification" process in the government bond space continues to support the bid for credit, with the caveat that for the investment grade class, there is no more interest rate buffer meaning investors are "obliged" to take risks outside their comfort zone (in untested areas such as CoCos - contingent convertibles financials bonds)."

When it comes to US default, the trend is up as indicated by Fitch's recent report on the matter in their note entitled "Another Jump in US HY Default Rate Looms"
"A potential bankruptcy filing from another struggling giant, Caesars Entertainment Operating Co., would propel the trailing 12-month US high yield default rate to 3.4% from its June perch of 2.7%, according to Fitch Ratings. With its $12.9 billion in bonds in Fitch's default index, the gaming company's impact on the default rate is pronounced - similar to Energy Future Holdings' (EFH) April bankruptcy. Caesars also adds to notable trends of busted LBOs and the exclusive camp of serial defaulters.

There have been 10 LBO related bond defaults thus far in 2014, compared with nine for all of 2013. The failed LBOs affected $21.8 billion in bonds this year and 26% of all bond defaults since 2008. Caesars would bring the latter tally to 29%. In addition, a Caesars filing would follow two prior restructurings via distressed debt exchanges (DDEs). Since 2008, 24% of issuers engaged in DDEs have subsequently filed for bankruptcy.

June defaults included Affinion Group, Allen Systems Group, MIG LLC, and Altegrity Inc., bringing the year-to-date high yield default tally to 20 issuers of $23.7 billion in bonds versus an issuer count of 19 and dollar value of $8.4 billion in first-half 2013. July defaults have so far included Essar Steel Algoma and Windsor Petroleum Transport.

Notwithstanding the likes of EFH and Caesars, the otherwise low default rate environment has some significant near-term support. Banks continue to ease standards on commercial and industrial loans, according to the Federal Reserve's Senior Loan Officer Survey, and they report stronger demand for such loans. The latter trend is an especially important gauge of economic activity and is consistent with the widely held view that GDP will improve in the second half of 2014.

At midmonth, approximately $33 billion in high yield bonds were trading at 90% of par or less - a relatively modest 2.9% of the $1.1 trillion in bonds with price data." - source Fitch Ratings-New York-29 July 201 - "Another Jump in US HY Default Rate Looms"

Given High Yield is a default sensitive asset class, no wonder the rising level of the default rate has triggered some outflows in the High Yield ETFs space as discussed above.

Our new Nimrod of the central banking world has no doubt pushed further down the line the day of reckoning as the "new credit Tower of Babel" continues to rise. For instance the recent CLO weekly report from Bank of America Merrill Lynch from the 18th of July entitled "Credit Outlook Benign Despite Loosening Lending Standards" indicates the following:
Credit Outlook Benign Despite Loosening Lending Standards
"Leveraged loan markets posted total returns of 2.6% and 2.9% in H1 in the US and Europe respectively, as compared to 5.4% for the HY markets. Up to the end of H1, institutional new-issue volumes totaled $242bn and €39bn in the US and in Europe. Repayment rates were subdued in the US in H1 with many deals having already refinancing in 2013, but hit a record high in Europe as many borrowers took advantage of favorable lending conditions to refinance their debt. If we look at the average leverage statistics for deals issued both in the US and Europe as well as the percentage of issuance that are cov-lite and second-lien, we clearly see that lending standards have loosened since the credit crunch. Despite this, the credit outlook for the loan markets remain benign largely due to a maturity wall that has been pushed out following all the refinancings that have taken place over the last two years and continued improvements in the economy." - source Bank of America Merrill Lynch

When it comes to illustrating our "new credit Tower of Babel" analogy we think that the below graphs from Morgan Stanley's Leverage Finance Chartbook from the 28th of July clearly shows our point:

- source Morgan Stanley

Moving on to the subject of Banco Espirito's woes, it is indeed the continuation of our 2011 prognosis, namely that weaker peripheral banks shareholders and bondholders would face further pain and losses down the line as reminded in our recent conversation "The European Polyneuropathy". The continuous widening in the CDS spread of Banco Espirito Santo illustrates the difficulties of the 2nd largest Portuguese lender:

- graph source S&P Capital IQ

The bank posted a €3.6 billion first-half net loss seeing its market capitalization falling to €1.2 billion. BES stock price - graph source Bloomberg:

Of course the junior subordinated bondholders were not spared either as it looks even more likely that a debt-to equity swap (in similar to what already happened to BES a couple of years ago) is in the pipeline - graph source Bloomberg:

Given the Bank of Portugal requires the lender to raise the money after it set aside 4.25 billion euros for bad loans in the first half, cutting its common equity Tier 1 ratio to 5 percent, below the 7 percent regulatory minimum, you can expect subordinated bondholders to face the Dutch SNS treatment, namely being wiped-out during the recapitalization process needed.

When it comes to the capital needed for the troubled BES, Bank of America Merrill Lynch in their note from the 28th of July entitled "Muddle, toil and trouble" put the capital needs at €6.5 billion but that was when the market cap was at €2.5 billion. Today it is 50% lower:

"Quantum of capital = substantial compared to market cap
BES’s capital needs are potentially substantial, we believe. First, there is the direct exposure to the Espirito Santo Group (GES) of up to €2bn. We think it would be best to adopt a ‘provide now, recover later’ strategy with this to be credible. Second, there is the Angola unit. This subsidiary is clearly in difficulty. Some relief came today with press reports that Angola would basically nationalise BESA but also repay the €3.2bn credit line BES had granted to its subsidiary ‘over time’ which we didn’t find that convincing. We think there is a world of difference between lending €3bn to a controlled subsidiary versus a Government-entity in Angola and would expect that to be reflected in the marks on the equity and debt exposures – perhaps at least another €1bn here at risk? Third, we are mindful of the large book of restructured loans for BES’s conventional lending and the low provisioning rate here which we think also is a risk ahead of the upcoming AQR. This is before we consider other third party risks, undeclared exposures or more contingent risk from investors who could claim that BES mis-sold them GES paper. We estimate a starting point of €4bn of potential capital needs, without the benefit of any tax effects. These compare with a €2.5bn market value today. In any case, a large recap number is required, in our view, for the market to turn the page on this affair."  - source Bank of America Merrill Lynch

What is of course of interest is that Junior Subordinated debt only represents €1.2 billion. When it comes to confidence, which is the name of the game in this credit story, a lot of investors believe that BES senior debt will be spared this time again as indicated in the Bank of America Merrill Lynch note:
"Senior
Lots of people are telling us that in BES, senior is ‘the trade’. Many of our investor interlocutors also appear to have done well out of buying BES senior – even if it is based on the simple equation that ‘senior won’t be touched’ in any scenario. This facile assertion may or may not prove to be correct. In any case, the trade has worked – for those who bought at the lows. At current levels, senior is less compelling in any case, we think – there are cheap AT1 securities that offer the yield and the cash price appreciation but potentially with less headline risk, for example.
If the market really believed the ‘senior won’t get touched’ theme, we would not have, we think, the sharply inverted credit curve that prevails for cash senior bonds – if senior isn’t touched, the inverted curve doesn’t make sense. 
Our base case is that there will not be a rush to bail-in senior under most scenarios but that the capital needs of BES are potentially high which could test this proposition. We are not rushing to load up on ‘less risky’ senior as we still lack sufficient data to be confident about outcomes, even the ‘senior won’t get burned’ scenario. We are also concerned about senior in the context of what might be a less than convincing quantum of capital raised by the bank and what the bank will look like in the future. But clearly, the shorter-dated seniors would be the first port of call if we get clarity on the bank’s future." - source Bank of America Merrill Lynch

We think the only reason senior could be spared would be in a "Dexia scenario" with the government taking in effect control of the bank. If the solution has to remain "private", then we do agree with Bank of America Merrill Lynch's take that an inverted credit curve and a spiking senior CDS spread indicates trouble ahead in particular in the light of the capital needed to restore confidence in the ailing Portuguese lender. As a reminder, BES debt distribution as shown in our conversation "The European Polyneuropathy":

Subordinated bonds cushion is not material enough in the light of the capital needed. "Bail-in" for senior bondholders likely? Possible and probable outcome unless the state gets involved. So either the state gets involved or the senior bondholder gets it....we think.

On a final note, and as we stated recently, the much vaunted US "recovery" depends on an acceleration in wage growth. We have yet to see this trend coming to fruition as displayed by Bloomberg's recent Chart of the Day:

"Miserly pay increases for working Americans back Federal Reserve Chair Janet Yellen’s view that
inflation isn’t about to accelerate, making the case for continued central bank stimulus.
The CHART OF THE DAY shows wage growth remains stuck around 2 percent a year, where it’s been since the recession ended five years ago, even as the Fed’s preferred measure of inflation has recently picked up. Slack in the labor market, including people in part-time positions because they can’t find full-time jobs and those who have stopped searching for work because they are discouraged over prospects, probably means it will be difficult for earnings to accelerate.
“Inflation doesn’t happen with lots of slack and when wage growth falls behind,” said Jonathan Wright, an economics professor at Johns Hopkins University in Baltimore who worked at the Fed’s division of monetary affairs from 2004 until 2008.
Yellen told Congress today that the Fed needed to press on with monetary stimulus because “significant slack remains in labor markets,” while inflation is projected to be between 1.5 percent and 1.75 percent this year. The difference between the underemployment rate, which takes into account discouraged workers and part-timers who want to work a full day, and the unemployment rate was 6 percent in June, compared with a 3.8 percent average from 1994 through 2007.
Critics of central bank policy, such as Harvard University’s Martin Feldstein, have argued the Fed is already behind in fighting a coming surge in price gains. Feldstein, a former chairman of the White House Council of Economic Advisers, said in June “we are facing a problem of rising inflation” and the Fed is “probably going to respond too weakly, too slowly.”
“Martin Feldstein and others have been warning since 2008 that accommodative monetary policy would lead to a repeat of the 1970s,” said Wright. “This prediction has clearly been false.” - source Bloomberg.

"Do you wish to rise? Begin by descending. You plan a tower that will pierce the clouds? Lay first the foundation of humility." - Saint Augustine

Stay tuned!

Credit - The Unbearable Lightness of Credit

“Liquidity is a backward-looking yardstick. If anything, it’s an indicator of potential risk, because in “liquid” markets traders forego trying to determine an asset’s underlying worth – - they trust, instead, on their supposed ability to exit.” - Roger Lowenstein, author of “When Genius Failed: The Rise and Fall of Long-Term Capital Management.” – “Corzine Forgot Lessons of Long-Term Capital“

Looking at the on-going grab for yields, with investors happy seizing up any good supply of new issues at very tight levels (the new Procter and Gamble 2% 2022 bonds were launched at German Bund +66.5 bps and traded as low as Bund +52 bps, amounting to around 1.89% yield), we thought this week we would use in our title analogy a veiled reference to Milos Kundera's 1982 literary masterpiece "The Unbearable Lightness of Being" given: the tightness of the credit markets, the lightness of the secondary markets and the prevailing complacency.

In similar fashion to the characters of Kundera's book taking place in 1968 during the Prague Spring in Czechoslovakia before the Russian invasion to impose "normalization", credit markets seems to be experiencing similar "lightness". According to Milos Kundera's work, the Occident lives in "lightness" (credit markets), which was becoming unbearable whereas the Soviet Union was living in "severity" (Italian and Spanish government yields).

Yes, we are wandering again but we do see similarities in the current European "complacent" situation with the Brezhnev Doctrine, first and most clearly outlined by S. Kovalev in a September 26, 1968 Pravda article, entitled "Sovereignty and the International Obligations of Socialist Countries". This doctrine was announced to retroactively justify the Soviet invasion of Czechoslovakia in August 1968 that ended the Prague Spring, along with earlier Soviet military interventions, such as the invasion of Hungary in 1956. "In practice, the policy meant that limited independence of communist parties was allowed. However, no country would be allowed to leave the Warsaw Pact, disturb a nation's communist party's monopoly on power, or in any way compromise the cohesiveness of the Eastern bloc. Implicit in this doctrine was that the leadership of the Soviet Union reserved, for itself, the right to define "socialism" and "capitalism"." - source Wikipedia.

The Brezhnev Doctrine is interesting in the sense it was the application of  the principal of "limited sovereignty". No country would be allowed to break-up the Soviet Union until, the "Sinatra Doctrine" came up with Mikhail Gorbachev.
"The "Sinatra Doctrine" was the name that the Soviet government of Mikhail Gorbachev used jokingly to describe its policy of allowing neighboring Warsaw Pact nations to determine their own internal affairs. The name alluded to the Frank Sinatra song "My Way"—the Soviet Union was allowing these nations to go their own way" - source Wikipedia

"The phrase was coined on 25 October 1989 by Foreign Ministry spokesman Gennadi Gerasimov. He appeared on the popular U.S. television program Good Morning America to discuss a speech made two days earlier by Soviet Foreign Minister Eduard Shevardnadze. The latter had said that the Soviets recognized the freedom of choice of all countries, specifically including the other Warsaw Pact states. Gerasimov told the interviewer that, "We now have the Frank Sinatra doctrine. He has a song, I Did It My Way. So every country decides on its own which road to take." When asked whether this would include Moscow accepting the rejection of communist parties in the Soviet bloc. He replied: "That's for sure… political structures must be decided by the people who live there." - source Wikipedia 

Could Europe allow for the adoption of the "Sinatra Doctrine"? We wonder when reading the following from the Bloomberg article of Rainer Buergin and Brian Parkin -  Germans Talk Up Referendum as Court Ruling on Crisis Role Nears:
"Germany faces the prospect of a referendum at some point in the future on its relationship with Europe after senior coalition members said the country’s role in tackling the euro-area crisis should be put to a public vote.
A referendum on closer European Union integration may become inevitable if proposed legislative changes rob national governments of budgetary rights, said Rainer Bruederle, the parliamentary floor leader of Chancellor Angela Merkel’s Free Democratic coalition partner. The Constitutional Court will signal in a Sept. 12 ruling when the boundaries of law in ceding rights to supranational institutions have been reached, he said.
“We may come to a point where a referendum about Europe becomes necessary,” Bruederle told the Hamburger Abendblatt newspaper in comments that were confirmed today by his office. “The future development of the debt crisis will show how much the EU countries will be asked to give up sovereignty.” Referendums are traditionally shunned in Germany since a 1934 plebiscite backed the fusing of the posts of chancellor and president, allowing Adolf Hitler to become supreme leader, or Fuehrer.
Finance Minister Wolfgang Schaeuble, a Christian Democrat like Merkel, first raised the possibility of overturning that tradition in June, when he said in an interview with Der Spiegel magazine that Germany’s role in the crisis meant the boundaries of the constitution would be reached sooner than he had thought a few months earlier." - source Bloomberg.

Back in June, in our conversation "Eastern Promises" we did write the following:
"We think the breakup of the European Union could be triggered by Germany, in similar fashion to the demise of the 15 State-Ruble zone in 1994 which was triggered by Russia, its most powerful member which could lead to a smaller European zone. It has been our thoughts which we previously expressed (which we reminder ourselves in "The Daughters of Danaus")."

Remember, it is still a game of survival of the fittest after all:

Euro Breakup Precedent Seen When 15 State-Ruble Zone Fell Apart - by Catherine Hickley, Bloomberg:

"While differences between the Soviet Union and the EU are greater than their similarities, there are parallels that may prove helpful in assessing the debt crisis, historians say. Both were postwar constructs set up in response to a collective trauma; in both cases, the founding generation was dying out as crisis hit and disintegration loomed." - source Bloomberg.

Following our "light" credit overview, we would like to touch again on  the subject of liquidity in the credit space  as well as the consequences of the gradual disappearance of "implicit guarantees" in the banking space (with the "bail-ins" depositor preference potential impact on senior unsecured financial bondholders).

The Itraxx CDS indices picture, a much quieter week with spreads slightly flat overall in the credit derivatives space - source Bloomberg:

Overall economic data weakness from China, Europe and the US should put some pressure on Credit indices in the coming weeks as the decline in economic activity should start weighting on corporate cash flows as well as on companies' abilities in servicing debt obligations. As investor confidence deteriorates further, Itraxx CDS risk gauge should rise, so watch closely next week Zew index for investors' confidence. While this week the movement for credit indices was subdued courtesy of poor liquidity during this summer lull, this "unbearable lightness of credit" is unlikely to last.

As we posited in our conversation "Hooke's law" end of July:
"The deterioration in speculative-grade European company credit is being worsened by the outlook for economic growth, hence the risk of seeing a spike of defaults, in this low yield, deflationary environment. Lack of growth means lack of employment prospects and reduced tax revenues with increasing pressure in cash flows as indicated by the pressure in the terms of payments from the AFTE (French corporate treasurers) monthly survey. It is still a game of survival of the fittest."

Yes, European High Yield returned +2.5% over the past month, with CCCs outperforming, and Investment Grade bonds by contrast returned +1.7% and the 12 month European speculative-grade default rate fell 2.7% from 3.0% at YE 2011 according to Morgan Stanley. But deflation is still the name of the game, as we indicated back in November 2011 in our "Complacency" credit conversation. It still should be your concern credit wise (in relation to upcoming defaults), not inflation as per Morgan Stanley's note:
"While one could argue that default rates could be high during times of higher yields owing to higher debt service cost, the opposite is actually true. High inflationary environments allow corporations to inflate away their nominal debt as their assets (and revenues) grow with inflation, leading to lower default rates. Low inflation environments, like the one we’ve had for the past 25 years, tend to be ones where defaults can spike."

In our last conversation we also indicated the following:
"Considering the lack of liquidity in the credit space and the very high correlation between asset classes driven by the European politicians, the coming weeks could see another significant spike in volatility in the European space so watch out for that "sucker punch". " Same applies to European stocks in relation to the recent rally which has clearly broken ties with Economic data and Dr Copper (cooper prices being a leading indicator):

"The five-month rally in European stocks has broken from underlying economic data and will probably end as the European Central Bank disappoints investors seeking further steps to support growth, according to strategists at Barclays Plc.
As the CHART OF THE DAY shows, Germany’s benchmark DAX Index tends to move in tandem with the Ifo institute’s index of business sentiment in Europe’s largest economy. The Stoxx Europe 600 Index has historically tracked copper prices, which are driven by projections for demand. That movement has diverged since early June, with the Stoxx 600 rallying for nine consecutive weeks." - source Bloomberg.

Both the Eurostoxx and German 10 year Government yields seems to be moving again in synch in what seems to be another short burst of "Risk-On", with rising German Bund yields and a higher Eurostoxx 50  - 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:

As far as the European bond picture is concerned, lack of ECB intervention means Spanish 10 year yields remain elevated at 6.87, slightly below 7% whereas Italian 10 year yields are below 6% around 5.88% and German government yields fell slightly below 1.40% around 1.36%  - source Bloomberg:

The late tightening of the German 10 year yield was linked to the declaration of Mr Katainen from Finland who clearly voiced Finland's lack of support for using the ESM for secondary market buying:
"After a few months we would have spent all our money on bond purchasing programs and we wouldn't have a firewall at all," Mr. Katainen told The Wall Street Journal in an interview in his Helsinki office Wednesday".
Mr Katainen also added:
"It is always good if there is a threat of growing bond yields if a country doesn't behave responsibly."
It looks to us, Finland is indeed adding pressure on Spain to "tap out" in our European mixed martial arts "Fight of the Century" and validating the analogy we made last week relation to operant conditioning chamber (also known as the Skinner box):"When the subject correctly performs the behavior, the chamber mechanism delivers food or another reward. In some cases, the mechanism delivers a punishment for incorrect or missing responses. With this apparatus, experimenters perform studies in conditioning and training through reward/punishment mechanisms." - source Wikipedia

As far as Finland is concerned, they won't support issuing joint euro-zone bonds, debt backed by all 17 nations in the currency zone, spreading the burden.

In this European rumble it seems that the more Spain hold on, the more pressure builds on Italy, as indicated by Andrew Frye in Bloomberg - "Monti’s Bond Frustrations Mount as Yields Stay High":
"Italian Prime Minister Mario Monti’s frustrations with the bond market are surfacing as spending cuts destroy growth without the reward of cheaper borrowing costs. Italian gross-domestic product contracted an annual 2.5 percent in the second quarter as Monti sought to appease lenders by trimming the budget and increasing taxes. Even though Monti will bring the deficit within European Union limits this year, Italy still pays 453 basis points more than Germany to borrow for 10 years, within 50 basis points of the gap when Monti took office on Nov. 16. Monti, with eight months left to serve, is campaigning to prevent a bailout on his watch." - source Bloomberg.

From the same article:
"Monti outraged German politicians with an Aug. 5 interview in Der Spiegel magazine where he said European leaders need to show more independence from legislatures. Bolder action to fight surging borrowing costs is needed, he said, such as backing his call for the euro region’s permanent rescue fund to secure a bank license, boosting its fire power. A day after releasing a statement saying he still believed in democracy, the Wall Street Journal released a month-old interview where Monti said that Italy’s yield premium to Germany would be 1,200 basis points if Berlusconi, who sustains his non-
political government, were still in power. Prior to Monti’s apology, a senior member of Berlusconi’s People of Liberty Party threatened to topple the government." - source Bloomberg.

Was Mario Monti in favor of a Brezhnev Doctrine as far as European woes are concerned? We wonder.

In relation to Italian woes, what really caught our attention was Standard and Poor's downgrade on Friday of all Patrimonio Uno CMBS Italian ratings:
"We have lowered all of our ratings in Patrimonio Uno CMBS, to reflect our view on the risk of a possible departure of the principal tenant before loan maturity, and on the transaction's sensitivity to country risk."
Patrimonio Uno CMBS is an Italian CMBS transaction that closed in 2006, and is currently backed by a loan secured on 49 properties mostly let to the Italian Ministry of Economy and Finance. The notes are backed by a senior loan arranged by Banca Intesa SpA, Banca Nazionale del Lavoro SpA, and Morgan Stanley Bank International Ltd. in December 2005. The loan financed the acquisition of 75 commercial properties from the Italian Ministry of Economy and Finance (MEF; BBB+/Negative/A-2) and other public entities. It is ultimately backed by the net proceeds from the liquidation of, and the
availability of rental income from the properties in the portfolio, of which 49 remain. At closing, 60% of the acquisition was funded by the loan, while the balance was funded through equity via the issuance of fund units sold to institutional investors. The notes will mature in 2021.
The properties backing the transaction can be generally classified into four
groups:
-Office buildings: Most of these properties are occupied by local the
MEF departments and agencies, or by other public entities. The properties vary in quality and are located throughout Italy.
-Police training centers: This category includes 12 complexes with multiple uses including offices, training classrooms, and dormitories. We consider that, in general, these centers could be used as office properties without any significant conversion costs.
-Fire departments/police stations: This category includes six properties across Italy.
-Others: This category comprises three hotels and a single retail property.
The properties were revalued in 2011 at EUR593 million, and the current loan balance is about EUR294 million. In their analysis, they have considered the recovery value expectations, but also a scenario in which the MEF vacates the properties in 2014. In this scenario, their analysis has assumed that the properties would be relet at lower rents. They consider that the indexation under the MEF lease has resulted in the passing rents being slightly over-rented when compared with current market rents. A departure of the tenant in 2014 would also result in the amortization credit being diminished.

It is still deleveraging and deflation with additional cost cutting involved from the Italian government and more assets shedding in the process.

Moving on to the subject of liquidity in the credit space and given it has been five years now since the BNP Paribas fund freeze marking the beginning of the financial crisis (On Aug. 9, 2007, Paris-based BNP Paribas halted withdrawals from three investment funds that had declined 20 percent in less than two weeks because it couldn’t “fairly” value their holdings.), we would like to start by a quote from Frederic Bastiat in relation this very subject of liquidity in the credit market:
"That Which is Seen, and That Which is Not Seen"

BNP Fund Freeze Shrinks Holdings Five Years After Crisis Ignited - by Matthew Leising and Mary Childs, Bloomberg:
"When a Brookfield Investment Management Inc. analyst saw bonds of Accuride Corp., the wheel manufacturer in Evansville, Indiana, at 94 cents on the dollar in December, he decided it was time to buy. The problem was the price wasn’t real. The debt was only available at 104 cents. “When it actually came time to shake them loose from somebody’s hands, that’s where the disconnect came in,” said Richard Cryan, co-manager of high-yield corporate debt at the New York-based firm, which oversees $150 billion of assets. Unable to find a seller at the lower price, they gave up."

The unintended consequences of banks deleveraging  and increased regulations means banks are in risk reduction mode leading to lower inventories provided to the market place which are at the lowest levels since 2002. Traders are as well  jumping ship towards Hedge Funds. We already touched in liquidity issues in our conversation "Yield Famine":
"While everyone is happily jumping on the credit bandwagon in this "yield famine" environment, we would advise caution given liquidity, as we discussed on numerous occasions (and liquidity mattered a lot in 2011...), is an important factor to consider in relation to investor confidence and market stability. Deleveraging for banks means a significant reduction in RWA (Risk Weighted Assets) leading to dwindling liquidity for cash rich investors as dealers play close to home."

As indicated by the Bloomberg article quoted above, "Mind the Gap":
"Even though the crisis is over and there’s no lack of money for those who need it, the credit market is still going through fundamental changes as Wall Street’s traditional role evolves.
For Melissa Weiler, a money manager who helps oversee $10 billion at Crescent Capital Group LP, the message came through recently when it took her team took two months to unwind a
retailer’s bonds from their portfolio. Before the crisis, that would have been done in less than a week, she said. “If you decide to exit a name because the credit is deteriorating -- guess what? -- you’d really like to sell at the quoted level of 95 but you might have to be willing to accept a price of 90 or less given the lack of liquidity on a given day,” Weiler said in a telephone interview from the alternative credit-asset manager’s office in Santa Monica, California. “Timely execution has increasingly become a challenge.” - source Bloomberg.

In credit markets, liquidity can fast become an issue, hence our initial quote from Roger Lowenstein, author of “When Genius Failed at the start of our credit conversation.

In addition to the impact on liquidity due to the on-going bank deleveraging, it is important to discuss the consequences of the gradual disappearance of "implicit guarantees" which, we think were the direct causes of the financial crisis. On the anniversary of the financial crisis,  we think it is very important to look at the complex subject of implicit guarantees and its meaning. Given we regularly read Dr Jochen Felsenheimer's monthly letter from Assénagon Credit Management, we would like to quote him from his most recent letter which is a must read:
"Implicit guarantees are multi-dimensional problem and exist within the financial system in a wide variety of ways. It should be emphasised that in this case there is no active guarantor in the sense of someone issuing a guarantee. It is more the case that the market is left with the opinion that a particular party will step in an emergency, thus the guarantee which the market assumes is implied on an explicit character precisely when the guarantee becomes more valuable, i.e. when the probability of it being used rises.
The odd thing about implicit guarantees (also abbreviated to IG below) can be seen in the fact that they
1. cause misallocations
2. ...result in incentive problems,...
3. ...can force the involuntary guarantor to issue a hard guarantee because the bets on the IG have reached systemically important proportions and...
4. ...the guarantor being pushed from a passive to an active role means the anticipation that there will be a guarantee is met and the game starts over again.
Now you will find a large number of IGs in the global financial system. These remain inoperative in quiet times, as the probability of the guarantee being used is very small. In recent years, however, some IGs have become evident, now representing a central problem in the global financial system:
1. The implicit government guarantee for (systemically important) banks
This topic is the central issue of not just the euro crisis, but all banking crises. The market assuming that governments will stand by distressed banks in various ways in an emergency causes multiple misallocations within the system.
a). It is these IGs which make the banks systemically important in the first place. A prime example of this is the aforementioned case of Lehman Brothers. Banks themselves have an incentive to become systematically important, as this increases the likelihood that an implied guarantee will turn into an explicit one in an emergency.
b). Banks operate too riskily and hold to little capital, as in the race to become systematically important they can achieve a competitive advantage against their peers by means of bloated balance sheet.
c). The link between the banking system and the state is inevitably increasing. By buying government bonds banks even improve their position, as doing so in turn increases their systemic importance. In an emergency, the state will become the owner of the bank or will buy bank bonds and will thus become an explicit guarantor.
d). Banks strengthen their procyclical behavior by definition. It would be erroneous to think (as some economists have suggested) that you can break the procyclicality of banks by allowing them more latitude now, as the basic problem described above will not be solved. Establishing laxer rules for banks now would do nothing more than prove the market was right in expecting IGs - with the aforementioned consequences.
e). On the other hand, investors are demanding too low an interest rate when they lend banks money and are thus stoking the cycle.
A large number of financial products in which the banks' default risk is wrongly priced in develop. And do so for this reason alone! These financial products attract investment money and thus contribute to misallocation.

2. The implicit guarantee for EU member states
The basic problem in the EU can be boiled down to the fact that there was an attempt to achieve a convergence of economic development in the member states by means of a lax common monetary policy. In view of the IG priced in by the market, the risk premiums demanded of the peripheral countries were too low. In 2010, the credo of European politics was still that no member state would be dropped. In 2012, Greece was restructured, no explicit guarantee could be given and since then the market has struggled even more to value IGs. IGs thus render the market mechanism inoperative and worsen the problem in Europe. Investors' money flows to the countries with the highest spreads and what initially looked like conversion has turned out to be a speculative bubble. Without a firm set of guidelines, the market is not able to assess the probability of default within the EU. This uncertainty is reflected in the yield spreads in Spain and Italy, which explains the question posed by many economists about the difference between these countries and the situation in the UK and the US."

Of course many more interesting points can be found in this aforementioned Assénagon monthly letter from Dr Jochen Felsenheimer, but as far as banks are concerned in relation to the disappearance of IGs (Implicit Guarantees),  the prospect of bail-ins and depositor preference regimes in Europe justify a greater focus on asset encumbrances according to a recent report by Fitch (Major European Banks' Balance-Sheet Encumbrance and the Creeping Subordination of Senior Bondholders), as reported on the 8th of August by "The Covered Bond Report" note - "Bail-ins depositor preference justify senior fears, says Fitch":
"The rating agency said it believes “there is a growing risk that asset encumbrance, bail-in concerns and possibly even depositor preference will trigger an ever-increasing cycle of asset encumbrance at European banks and that low or even ‘zero recovery’ assumptions for senior bank debt might become the norm”, which would reduce the supply of senior unsecured debt in the long term.
Fitch notes that asset encumbrance and unsecured bondholders’ potential recoveries relative to secured creditors only matter if a bank actually defaults, and that such events are rare, as demonstrated by the chart below. This plots the five year global cumulative default rate over 20 years to the end of 2009 (0.9%) for the banks that Fitch rates against the five year global cumulative failure rate (7.1%)."

“Consequently, that secured creditors benefit from collateral protection has, historically, only rarely mattered in concrete terms for unsecured bondholders,” it said, adding that it would hardly be worth progressing with an analysis of encumbrance if such a very low bank default rate could be confidently predicted to continue.
However, James Longsdon, co-head of EMEA Financial Institutions at Fitch, said that bank defaults are likely to become more frequent as legislators move to make shareholders and creditors, rather than taxpayers, bear the losses of a failed bank.
“This gradual erosion of implicit sovereign support for senior debt is in fact a greater threat to senior unsecured debt ratings than subordination risk,” he said.
In its report Fitch said that the explicit possibility of bailing-in certain creditors in a going-concern scenario adds “a whole new dimension” to the debate about encumbrance, as eligible bail-inable creditors will be exposed to enforced write-down or write-off, while other excluded liabilities are not." - source "The Covered Bond Report"

As far as the supply of senior unsecured bank debt in concern please note that the supply is already falling:
"The proportion of senior unsecured debt issued by banks in Europe this year has fallen below 50 per cent of new issuance for the first time in five years, underlining how problems in the eurozone and new regulations are driving banks to tie up more of their assets to access funding. The amount of senior unsecured debt, traditionally seen as the bedrock of bank funding, issued by European banks fell 28 per cent to €182bn in the first seven months of this year, according to Fitch. As a proportion of total debt issued by banks in Europe, senior unsecured debt accounted for just 43 per cent. Northern European banks and even some Italian and Spanish banks have continued to issue senior unsecured debt this year. However, bond investors are concerned that banks are tying up too much of their capital to secure funding." - source Financial Times.

Yes, in this "unbearable lightness of credit / low yield" environment default will indeed spike at some point even for banks, consequence of the gradual disappearance of IGs (Implicit Guarantees). One can also argue that the advantage of explicit guarantees is that markets tend to "function" better under them. To quote again Dr Jochen Felsenheimer from his latest monthly letter:
"The advantage of explicit guarantees is that the market can value them and that the guarantee can be taken up - even in a crisis! For this reason, we can quote the "last man standing" at this point, the president of the German Federal Constitutional Court, Andreas Vosskuhle:"The constitution also applies during the crisis". That is a hard guarantee, both for politicians and for investors!"

On a final note and in continuation of the theme of "implicit guarantees" given Hungary is our pet subject when it comes to "systemic risk" as shown in the below graph  relating to Serbian dinar and Romanian leu: “An IMF deal is the quickest and easiest route to regain investor confidence,” according to Neil Shearing, the chief emerging markets economist at London’s Capital Economics Ltd:

 "The CHART OF THE DAY shows the dinar and the leu are trading close to all-time lows against the euro as the Balkan countries face a delay in loan talks with the International Monetary Fund. Those movements mirror the forint’s fall earlier this year after Hungary’s negotiations with the IMF stalled on concern the central bank’s independence was being clipped. The forint rose after Prime Minister Viktor Orban backed down. The three countries have turned to the IMF and the European Union as slumping currencies hampered central bank efforts to reduce rates after the debt crisis prompted an  economic contraction. Serbia’s law restoring the government’s influence over the central bank and Romanian political tension delayed talks with the lenders, eroding investor confidence." - source Bloomberg.

"When forces that are hostile to socialism try to turn the development of some socialist country towards capitalism, it becomes not only a problem of the country concerned, but a common problem and concern of all socialist countries." - Leonid Brezhnev speech at the Fifth Congress of the Polish United Workers' Party on November 13, 1968 - The Brezhnev Doctrine

Stay tuned!

Play it again Sam ! - European problems not going away in 2011...

Portugal came back to the market today and auctioned 500 millions euros worth of bills repayable in July. The yield stood at 3.686% from 2.045% back in September 2010 for similar maturity bills.

A year ago Portugal was only paying 0.592 % to borrow for six months.
Portugal need to raise 20 Billions Euros this year and it is not going to be cheap for them to do so.

On the 23rd of December, Portugal was downgraded by Fitch Ratings from AA- to A+. S&P might downgrade further Portugal to A- in April, which will automatically increase its cost of funding.

Moody’s said on Dec. 15 it may cut Spain’s Aa1 credit rating and on Dec. 16 placed Greece’s Ba1 bond ratings on review for a possible downgrade. Ireland’s credit rating was cut by five levels by Moody’s on Dec. 17.

Below table displays the European Government spreads versus Germany in early 2010 and the situation at year end:

Early 2010:

By year end:

2011 is the raising money race year. Competition between Sovereigns and Banks to raise money fast will be furious. It is already happening. Deutsche Bank and Rabobank kicked of the race on the 4th of January by selling US bonds. Deutsche bank issued 1 billion USD of 5 years notes paying 3.25% (130 bps more than comparable Treasuries), while Rabobank sold 2.75 USD billion of securities, according to data compiled by Bloomberg. On the 5th of January, it was the turn of Societe Generale and Intesa to tap the market and issue bonds.

Europe Banks Race Sovereigns to Bond Investors:
http://www.bloomberg.com/news/2011-01-05/europe-crisis-drives-banks-to-sell-bonds-before-sovereigns-credit-markets.html

“There are several European government bonds paying more than banks for debt so it’s hard for lenders to raise cash in this situation,” said Serafi Rodriguez, a fixed-income trader at Banc Internacional d’Andorra.

Both funding costs for banks as well as for sovereigns is going up as reflected in the widening of CDS spreads we saw last year.
Evolution of CDS spreads between the 21st of September until the 21st of December:

European Sovereigns CDS spreads widened:

Asian Sovereigns CDS spreads were stable:

The risk of "Crowding Out" is alive and real. I previously posted on this very subject in February 2010: Crowding Out.

Banks need to raise 1.1 trillion USD this year.
From January 2010 until December 2012 the amount needed to be raised by banks amounted to 2.2 trillions Euros.

The important issue of rising global yields is a very important one. Debt markets are going to be more and more discriminating. This has serious implications in the development of the government finance bubble. Some cracks appeared with Greece in 2010 and you can expect similar cracks to show in 2011. After Greece and Ireland, Portugal seems to be the most obvious next weakest link to unfold.

In this race to funding, and with the markets becoming more and more selective, the competition will be fierce in 2011. The implications for public finances will be great. The era of cheap funding is definitely over.

Western countries are still trapped in a secular bear market. Particularly the US. Unemployment is still hovering around 9.8% after 4 trillion USD increase in government liabilities in just 9 quarters in conjunction with an extended near zero interest rate policy. Dear Ben, there is nothing to be proud of and QE2 is not going to be the remedy for the structural issues and housing mess which are still plaguing the US economy.

In this environment, Gold can continue to rise in 2011 as illustrated by the current term structure for Gold futures:

In relation to the evolution of yield on 10 year European Government debt, Ireland and Greece have reached new highs:

Evolution of Greek 10 year yield in the last 6 months until the 5th of January 2011:

Evolution of Ireland 10 year yield in the last 6 months until the 5th of January 2011:

Play it again Sam...