The Fright of the Bumblebee

"It's about focusing on the fight and not the fright." - Robin Roberts, American athlete

Looking with interest at the plunge in the Euro with the resurgence of "Grexit" (the risk of a Greek exit from the euro) as well as the continuation in the fall in oil prices and early 2015 market turmoil, we remembered the wise words of our "Generous Gambler" aka Mario Draghi in relation to Bumblebee and the European currency when choosing our title for our first 2015 post:

"The euro is like a bumblebee - it shouldn't fly, but it does," - Mario Draghi

Of course our title reference is a veiled reference, already used by many pundits to Nikolai Andreyevich Rimsky-Korsakov's orchestral opera interlude "Flight of the Bumblebee composed in 1899-1900. But, there is more to our chosen title than from the choice of the word "Fright" instead of "Flight". The 1936 radio program about fictional hero "The Green Hornet" also used "Flight of the Bumblebee" as its theme music. When it comes to "stinging analogies", no doubt this year the "greenback" aka the US dollar could indeed be stinging even more Emerging Markets investors who got "carried" away by many years of negative real interests rates inflicted on them by the Fed.

When it comes to the European QE and the musical analogy from our title, we hope our "Generous Gambler" (aka Mario Draghi) is indeed a violin expert because the road to become a virtuoso goes through playing the "Flight of the Bumblebee". It is according to the Guinness World Records, the fastest violin tune around and the expert fiddler needs to play it the fastest way possible (around 1 minute and twenty seconds). With nearly uninterrupted runs of chromatic sixteenth notes for the "Flight of the Bumblebee", it requires a great deal of skill to perform. Same thing goes with QE. So good luck with that, dear central banker "virtuoso" in training!

When it comes to global deflation risk which can be ascertained by the continued fall in sovereign bond yields making new lows on a daily basis, we think investors, as per our initial quote, should be focusing on the "fight against deflation", rather than on the "fright" in Europe coming from a "Grexit" risk. We have long been sitting in the deflationary camp as our readers know by now from our numerous musings. We haven't changed our stance in early 2015. Since early 2014 we have indicated our long duration exposure, which we have partly played via ETF ZROZ as an illustration of us playing and understanding the "macro" game. We will continue to play it in 2015 rest assured but, we ramble again...

In our first conversation of 2015 we would like to look at where we stand in the credit cycle and what it means in terms of "allocation. We also discuss the need to refocus on potential additional goodwill writedowns for European banks (particularly the ones exposed to Eastern Europe, Russia and Ukraine). We will also touch on the oil conundrum and the repercussions it can have with a rising dollar in the coming months.

As a starter, we have decided to look at early on in 2015 where we stand in the credit cycle by looking at the "Global Credit Channel Clock", as designed by our good friend Cyril Castelli from Rcube Global Asset Management:

In terms of "allocation", we think we are looking more towards the upper left part of the Credit Channel Clock which means:

-a continuation of flattening yield curves, 

-being long volatility as we enter a higher volatility regime

-a continued exposure to US long government bonds. Long dated US government bonds from a carry and roll-down perspective continue to be enticing at current levels compared to the "unattractiveness" of the mighty German 10 year bund indicating a clear "japanification" process in Europe.

-adding again some gold exposure in early 2015. We hinted a "put-call parity" strategy early 2014, eg long Gold/long US Treasuries as we argued in our conversation "The Departed", it is going to be working again nicely in the first part of 2015:

"If the policy compass is spinning and there’s no way to predict how governments will react, you don’t know whether to hedge for inflation or deflation, so you hedge for both. Buy put-call parity, if there is huge volatility in the policy responses of governments, the option-value of both gold and bonds goes up."

What we have been seeing is indeed the continuation of a flattening yield curve in the US with re-leveraging courtesy of buy-backs financed by debt issuance.

When it comes to assessing the re-leveraging, we read with interest CITI's Credit Strategy note for Q1 2015 entitled "The State of the Credit Markets". 

"Company Re-Leveraging Very Dramatic
We calculated leverage for two baskets of names — the overall IG universe updated quarterly since ’06, and for a basket comprised of credits that held an IG rating at any time since ’06 (to capture falling angels). Either way, it doesn’t look good.

What’s Driving the Rise? Not Cap-Ex
Of course, if leverage is going up today because it’s funding tomorrow’s growth that might not be a bad thing. Unfortunately, that’s not what’s going on.
Leverage Likely to Continue Rising
In theory, a company that buys its own shares will boost its EPS, but unfortunately its default risk is likely to rise as well. This may not be good for share price. But recently buybacks are up while default risk is down." - source CITI

Taking into account central banks generosity with them providing abundant liquidity, it has indeed reduced default risk down as indicated by CITI but, a continuation in the fall of oil prices and a continued rise of the "Green Hornet" aka the US dollar could indeed put a serious dent in the trend in the Energy HY space in general and in the EM $ Corporate space in particular. 

When it comes to the switch towards a higher volatility regime in the credit space, it can be ascertained from the surge in the High-Grade space as indicated in the recent CITI note:

"QE has certainly had a downward influence on volatility, but by some measures vol has actually increased. For example, we have seen more meaningful drawdowns in recent years relative to previous periods at the same point in the credit cycle.

More Volatility in Other Markets as Well
And it’s not just drawdowns in credit, as we’ve seen similar trends in HY, EM, and the Treasury volatility markets. For example, in aggregate these markets had 15 meaningful jumps in risk back in the ’03-’07 period, vs. 27 in the current environment.

Choppy Price Action Likely in the Future
Less diversity and limited dealer balance sheets create volatility, and for a variety of reasons we see little reason why either of these trends will change in the period ahead. Drawdown frequency will remain elevated."

-source CITI

Indeed, as well as CITI, we have always highlighted the risk in the liquidity factor not being priced accordingly. 

"Investment Grade credit is like a bumblebee - it shouldn't fly, but it does" - Macronomics

When it comes to performances and flows, as we rightly pointed out in 2014, in the credit space, Investment Grade was a big winner with more than $66 billion added to the asset class according to Bank of America Merrill Lynch latest Follow the Flow note entitled "2014: The year of quality yield":

"High-grade credit dominates in 2014
With ECB QE around the corner, and the growth outlook in Europe still low, High Grade credit was the dominant asset class in 2014, amid a search for quality yield. More than $66bn was added to the asset class in 2014, setting a record year with not a single week of outflow. Inflows into government bond funds in 2014 also surpassed any other year historically, with an $18bn inflow.
However, flows elsewhere were not as upbeat. High-yield credit had $11bn of outflows, while equity funds had only $11bn of inflows. Notably, 2014 was the year of two halves; while equity funds saw $44bn of inflows in H1, during the second half they saw $33bn of outflows. For high-yield, it was the same, with $17bn of inflows to start, but $28bn of outflows to finish the year." 

- source Bank of America Merrill Lynch

So much for the "Great Rotation" story of early 2014...

While it is true that the "interest rate buffer" in case of a surge in rates is nearly exhausted in the current low yield environment, but the environment for investment grade credit is still favorable due to lack of alternative with institutional money moving up the quality spectrum as discussed back in 2014. The current "deflationary" environment is indeed a golden age for credit, much more in Europe  compared to equities where Investment Grade has had its second best performance in 2014 since 2009 (above 7% versus 5% for European High Yield) and with the largest issuance number since 2007:

"This somewhat validates Nomura's take on the golden age for credit we discussed back in 2012 in our conversation "Deleveraging - Bad for equities but good for credit assets":

"-Corporates around the world have been deleveraging for longer than most people realise, starting around the time of the tech bubble in 2000.

-Deleveraging is generally bad for equities, but good for credit assets.

-In the US, Europe and Japan, credit has outperformed equities by any reasonable measure (e.g. volatility, drawdowns, absolute).

-As credit is far less volatile than equities, some leverage is sensible. Even leveraged credit can be less risky than unleveraged equities." - source Nomura

Given the re-leveraging has been more pronounced in the US when it comes to Investment Grade credit, European Investment Grade is still more enticing than European equities in the on-going "japanification" process as we wrote in our conversation the "Hidden Fortress" in November:

"When it comes to Europe, the deleveraging continues and amounts to goldilocks period for credit particularly in the banking space whereas banking equities will continue to underperform we think." - source Macronomics

But, as we pointed out in our conversation "Actus Tragicus" in 2014, flattening yield curves are still "credit supportive":

"Of course while the "Actus Tragicus" continue to play out in Europe in the "real economy", US and Europe Investment Grade credit continue to benefit from the flattening of the yield curve. The evolution of flows of course validates the "Great Rotation" namely the gradual move of investors from low beta towards higher quality while retail investors continue to be significantly exposed to lower quality credit as we concluded our last conversation.
And what has happened in the last few years courtesy of Central banks generosity has been the multiplication of carry trades in various segments of the market. The goldilocks period of "low rates volatility / stable carry trade environment of the last couple of years is likely coming to an end as we move in the US towards the upper quadrant of the Global Credit Channel Clock." - Macronomics

When it comes to the fresh sell-off in equities, we argued in our October conversation the following:

"As we posited in our conversation on the 13th of June 2013 "The end of the goldilocks period of low rates volatility / stable carry trade environment?":
"The huge rally in risky assets has been similar to the move we had seen in early 2012, either, we are in for a repricing of bond risk as in 2010, or we are at risk of repricing in the equities space."
Looking at the continuation in both outflows from the equities space and the very strong compression in  the long end of core government bond space (US Treasuries and German Bund), it much more likely for us that we are indeed at risk of a significant "repricing" in the equities space." - Macronomics, October 2014

We also added credit wise:

"The current interest rate differential between the US and Europe, supported by a weakening Euro and negative interest rates in the front-end of some European government bond yield curve points towards a larger allocation to US fixed income we think.
To avoid paying negative rates, investors have to either take more duration risk or more credit risk." - source Macronomics

We concluded at the time:

"We therefore do think (and so far flows in US investment grade are validating this move) that interest rate differential will indeed accelerate inflows towards US fixed income, contrary to Bank of America Merrill Lynch's views. We do not expect a rapid rise in US interest rates but a continuation of the flattening of the US yield curve and a continuation in US 10 year and 30 year yield compression and therefore performance, meaning an extension in credit and duration exposure of investors towards US investment grade as per the "Global Credit Channel Clock" (although the releveraging of US corporates means it is getting more and more late in the credit game...)."

The weaker macro outlook as part of the "Japanification" process is supportive of credit and the continuation of lower yields. In fact when it comes to the economic activity outlook, as indicated by Société Générale from their 2014 review, it peaked during the summer:

"World economy growth
-Growth momentum peaked over the summer

-US doing the heavy lifting, India shines among BRICs"

- source Société Générale

When it comes to High Yield price behavior CCCs have been indeed the canary in the credit coal mine in 2014 during the second semester as we pointed out in our conversation "Wall of Voodoo", (even single Bs weren't spared).

As a reminder and going forward, the greater the volatility, the greater the disadvantage of owing negative convexity bonds like you find in the High Yield space. In the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger!

Furthermore, the European High Yield space has seen further from Eastern Europe worries, with more downgrades on the horizon in the financial space given Austrian bank Raiffeisen has become the 12th largest financial issuer in Bank of America Merrill Lynch €HY indices thanks to the downgrade of Raiffeisen's dated subordinated debt (rated Ba1/BBB-/NR) dropped into High Yield territory following Moody's downgrade of RBI (Raiffeisen Bank International) standalone rating on the 23rd of December. For some Christmas does come early. According to Bank of America Merrill Lynch's note from the 5th of January 2015, over €2 billion of RBI sub debt has entered the BofAML HY indices this month, equivalent to 2.5% of the Euro HY Fins index and 0.7% of the generic Euro HY index overall:

"Raiffeisen: more questions than answers

Raiffeisen T2 bonds have dropped by 7-12pts in Q4 following macro developments in Russia; the outlook for this market, which historically has been the group’s most profitable one, remains challenging and uncertain. RBI’s Q4 results (25 March) are likely to be messy, with higher impairment charges and potential write-down of DTAs and goodwill in Poland and possibly Russia, where a second impairment test is being conducted. RBI will likely end the year with CET1 less than 10%, given the RUB decline in Q4. Questions also remain over its long-term strategy; for instance, Reuters reported recently that the bank may sell its Polish unit, so far considered strategic." - source Bank of America Merrill Lynch

So get ready for some additional goodwill writedowns in the European banking space, a pet subject of ours which we discussed in our conversation in November 2011 entitled "Goodwill Hunting Redux":

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

Banks that paid a premium for businesses when the outlook was better will need to reassess the goodwill on their balance sheets. We already discussed Austria's exposure to Eastern Europe ("Long hope - Short faith"). Erste Bank in fact, wrote down the value of its Hungarian and Romanian units by a combined 939 million euros in October 2011. It will happen again in 2015 rest assured.

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

"Looking at non-cash intangible assets (i.e., goodwill) can be a good indicator and used as a proxy to determine the health of banks.
The significance of the write-downs on Goodwill is often presaged as rough waters ahead. These losses often take a real bite out of corporate earnings. It is therefore very important to track the level of these write-downs to gauge the risk in earnings reported for banks."

On another note, you should also track deferred-tax assets aka DTAs in banking lingo, as it represents what a bank estimates it will save on taxes in the future assuming it will be profitable of course. In case of crisis, of course these "assets" are pretty much worth zero. Why is it important? Because DTAs were allowed in European banks to be counted as part of their regulatory capital (unlike goodwill) before Basel III regime but, in some instance were converted as tax credits (Italy and Spain) therefore counting towards a bank's capital cushion, therefore allowed under the new regime. For Spanish bank Liberbank DTAs make up 50% of its "capital", for Caixabank, 20%, for Bankia 80% of tangible book value. As a reminder, the government of Spain authorised some Spanish banks to reclassify €30 bn worth of DTAs as tax credits to bolster their regulatory capital in November 2013 ahead of 2014 ECB's stress tests.

Moving on to the subject of oil, we re-read with interest Douglas-Westwood presentation made in February 2014 at Columbia University entitled Oil and Economic Growth. We came across a compelling slide relating to the current issue of persisting oil prices on the industry on page 45 of their thorough report:

"The Industry Needs $100+ Oil Prices

Oil Price Required by Oil Companies to be Free Cash Flow Neutral After Capex and Dividends - source Goldman Sachs

•Costs have outpaced revenues by 2-3% per year. Profitability is down 10-20%.
•The vast majority of public oil & gas companies require oil prices of over $100/bbl to achieve positive free cash flow under current capex and dividend programs
•Nearly half of the industry needs more than $120/bb. The 4th quartile, where most US E&Ps cluster, needs $130/bbl or more." - source Douglas-Westwood

Their very interesting report concludes with the following remarks:

"•Demand-constrained models dominate thinking about oil demand, supply, prices and their effect on the economy
•The data have not supported these models in recent years; the data do fit a supply-constrained model
•A supply-constrained approach will not be applicable if China falters, US short term latent demand is sated, and oil supply growth is robust.
•For a supply-constrained model to be valid, oil must be holding back GDP growth as an implicit element of model construct.
•If the supply-constrained approach is right, then GDP growth depends intrinsically on increasing oil production.
•Without such increases, OECD GDP growth will continue to lag indefinitely, with a long-term GDP growth rate in the 1-2% range entirely plausible, and indeed, likely.
•In turn, if this is true, then current national budget deficit levels and debt levels will prove unsustainable, and a second round of material and lasting adjustment will be necessary." - source Douglas-Westwood

As a reminder, when it comes to our outstandingly rewarding 2014 contrarian stance in relation to our "long duration" exposure (disclosure: long ETF ZROZ since January 2014) it is fairly simple to explain:
Government bonds are always correlated to nominal GDP growth, regardless if you look at it using "old GDP data" or "new GDP data". So, if indeed GDP growth will continue to lag, then you should not expect yields to rise anytime soon making our US long bonds exposure still compelling regardless of what some sell-side pundits are telling you and told you in 2014.

As we reminded ourselves in our last 2014 conversation the "QE MacGuffin", the dollar surge and falling oil prices are on top of our 2015 worries. This is related to a particular type of rogue wave (currency crisis) we discussed back in November 2011, the three sisters, that sank the Big Fitz - SS Edmund Fitzgerald, an analogy used by Grant Williams in one of John Mauldin's Outside the Box letter:

"In fact we could go further into the analogy relating to the "three sisters" rogue waves that sank SS Edmund Fitzgerald - Big Fitz, given we are witnessing three sisters rogue waves in our European crisis, namely: Wave number 1 - Financial crisis Wave number 2 - Sovereign crisis Wave number 3 - Currency crisis In relation to our previous post, the Peregrine soliton, being an analytic solution to the nonlinear Schrödinger equation (which was proposed by Howell Peregrine in 1983), it is "an attractive hypothesis to explain the formation of those waves which have a high amplitude and may appear from nowhere and disappear without a trace" - source Wikipedia." - Macronomics - 15th of November 2011

Wave number 3 - Currency crisis:

We voiced our concerns in June 2013 on the risk of a rapid surging US dollar would cause with the Tapering stance of the Fed on Emerging Markets in our conversation "Singin' in the Rain":

"Why are we feeling rather nervous?
If the Fed starts draining liquidity, some "big whales" might turn up belly up. Could it be Chinese banks defaulting? Emerging Markets countries defaulting as well due to lack of access to US dollars?
It is a possibility we fathom." - Macronomics - June 2013

Monetary inflows and outflows are highly dependent on oil prices. Oil producing countries can either end up a crisis or trigger one.
Since 2000 the relationship between oil prices and the US dollar has strengthened dramatically.

We also added in December:

"A structural slowdown in economic activity like we are seeing is accentuating the fall in oil prices we think. Declining profitability and misdirected investments into unproductive assets and infrastructure projects have been triggered by years of Zero Interest Rate Policy (ZIRP) in Developed Markets (DM). This is having negative consequences in Emerging Markets given oil demand growth has been exclusively supported by strong EM growth. Lower GDP growth trend is therefore pushing for lower oil prices. "

Also please note the following in relation to the HY energy sector. In 1986, oil prices fell hard and fast to below 10 $ starting a regional crisis for the oil patch and the industries serving it. This led to the Texas economy and the banking industry to experience a traumatic crisis due to overextension of credit to energy-related industries. The High Yield rug was pulled out from under the house of card in 1989, triggered by rising interest rates and the collapse in the price of oil and the associated erosion of real estate investments as the economy of the Southeast US slid into recession. So we would watch Texas closely and the HY energy space in the coming months. 

In relation to EM risks and as a reminder of the 1997 Asian currency crisis, investors lured to higher yielding assets due to ZIRP and Fed induced negative interest rates.

What we are witnessing right now is indeed "reverse osmosis" in Emerging Markets, and the osmotic pressure which has been building up is no doubt leading to an "hypertonic solution" when it comes to capital outflows in Emerging Markets as discussed in our August conversation "Osmotic pressure":

"As the Osmosis definition goes:
"When an animal cell is placed in a hypotonic surrounding (or higher water concentration), the water molecules will move into the cell causing the cell to swell. If osmosis continues and becomes excessive the cell will eventually burst. In a plant cell, excessive osmosis is prevented due to the osmotic pressure exerted by the cell wall thereby stabilizing the cell. In fact, osmotic pressure is the main cause of support in plants. However, if a plant cell is placed in a hypertonic surrounding, the cell wall cannot prevent the cell from losing water. It results in cell shrinking (or cell becoming flaccid)." - source Biology Online.
Nota bene: Hypertonic"Hypertonic refers to a greater concentration. In biology, a hypertonic solution is one with a higher concentration of solutes on the outside of the cell. When a cell is immersed into a hypertonic solution, the tendency is for water to flow out of the cell in order to balance the concentration of the solutes." - source Wikipedia

Let us explain:In a normal "macro" osmosis process, the investors naturally move from an area of low solvency concentration (High Default Perceived Potential), through capital flows, to an area of high solvency concentration (Low Default Perceived Potential). The movement of the investor is driven to reduce the pressure from negative interest rates on returns by pouring capital on high yielding assets courtesy of low rates volatility and putting on significant carry trades, generating osmotic pressure and "positive asset correlations" in the process. Applying an external pressure to reverse the natural flow of capital with US rates moving back into positive real interest rates territory, thus, is reverse "macro" osmosis we think. Positive US real rates therefore lead to a hypertonic surrounding in our "macro" reverse osmosis process, therefore preventing Emerging Markets in stemming capital outflows at the moment."

If the fall in oil prices continues to fall rapidly and the dollar continues to rise strongly, then, there is indeed a high risk of "excess osmosis", triggering sovereign defaults in the process.

 It seems to us that the "carry tourists" have forgotten basic rules: 

1. Do not lend to countries with heavy fiscal deficits (like Mexico at the time...). 

2. If you do lend to these countries, make sure they have "friends in high places". 

The LTCM explosion of 1998 came on the back of Russia defaulting. EM exposure following the lending boom of 1996-97: 

"1. By the time Korea fully devalued the won in November-December 1997, the total stock of EM external bonds (public and private) had climbed from just $266 billion at the end of 1994 to $413 billion.
2. From end of 1994 to the end of 1997, foreign banks had racked an additional $276 billion of exposure to EM. Foreign banks EM assets hit an all time high as a share of total credits, at 3.66% up from 2.70% at the end of 1994. By 2000, that figure would be back down to 2.70%.
3. Almost 40% of total net lending to EM from 1994 to 1997 went to just five East Asian economies: Indonesia, Korea, Malaysia, Taiwan and Thailand. Most of that was short-term dollar borrowing by the banks that was lent locally to fund real estate and other long-term ventures creating a massive liability mismatch." - source Creditsights "Crises'R Us, August 2007.

In the light of recent BIS presentation from the 4th of December to the Brookings Institution made by Hyun Song Shin, US dollar credit to non-banks outside the United States has not been trivial to say the least:

Notes: Bank loans include cross-border and locally extended loans to non-banks outside the United States. For China and Hong Kong SAR, locally extended loans are derived from national data on total local lending in foreign currencies on the assumption that 80% are denominated in US dollars. For other non-BIS reporting countries, local US dollar loans to non-banks are proxied by all BIS reporting banks’ gross cross-border US dollar loans to banks in the country. Bonds issued by US national non-bank financial sector entities resident in the Cayman Islands have been excluded.

Sources: IMF, International Financial Statistics; Datastream; BIS international debt statistics and locational banking statistics by residence; authors’ calculations.

- source BIS

On a final note, what matters more than the Fright of the Bumblebee is indeed the sting of "The Green Hornet" aka the US dollar and the velocity of the rise given the redemption profile on international debt securities of EM non-bank corporations:

"Emerging market economies, in billions of US dollars"

- source BIS

Whereas bumblebees are peaceful insects and will only sting when they feel cornered (QE in Europe) or when their hive is disturbed (Grexit), the stings of the Asian giant hornet (Vespa mandarinia japonica) are the most venomous known but that's another story...

"Don't poke a hornet's nest and expect butterflies to come out."

Stay tuned!

Credit - Bold Banking

"Dives sum, si non reddo eis quibus debeo. I am a rich man as long as I don't pay my creditors." 

 - Titus Maccius Plautus (c. 254-184 BCE),

While watching the volatility in currency markets and the decent moves in both EUR/USD and USD/JPY currency pairs, prior to the much anticipated G-20 Moscow meeting to avoid a broader currency war from developing in the world, we thought our title should simply be this week "Bold Banking".

Listening to the many conversations relating to a potential early exit from QE in 2013 and the conflicting analysis around the dire potential for losses the rise of government bonds could have on Credit in particular (Investment Grade), and assets classes in general,  we would have to agree with Exane BNP Paribas recent strategy note from the 14th of February 2013 entitled "When doves cry", namely that 1994, which was a nasty year for risky assets is indeed a case study of the risk scenario:

"A surprise rate hike in February 1994 sent 10-year Treasury yields some 200bps higher in just 3- months. This sparked a period of significant de-leveraging. Fixed income investors fared worst, but equity markets suffered too. The S&P500 fell around 9% in 2-months. But when the US sneezes….European markets were hit harder." - source Exane BNP Paribas

We do agree with their views, namely that while early 2013 are most likely to be still supportive for risky stories, the second part of the year might be a different story altogether:
"Make your money in H1 
The macro backdrop should remain supportive of equity markets through the early months of the year. The global growth / inflation backdrop looks favourable – and equity valuations are likely to rise as a result. We think the oft-cited event risks – be it European elections or US sequestration - are unlikely to result in sustained market weakness. 
H2 could be tougher 
The risk to equity markets rests in the evolution of the macro cycle. The debate around US monetary policy is likely to intensify later in the year. The first move to withdraw monetary stimulus usually prompts a correction in equity markets. This time that move is likely to take the form of an ending of QE rather than a policy rate hike - but we expect similar price action to result." - source Exane BNP Paribas

But, as one looks at the bold central bankers actions taken so far in the US and Europe, with Japan, joining the party as of late, taking its Japanese currency and its Nikkei index to higher levels in the process, as the old pilot saying goes:

"There are old pilots and there are bold pilots; there are no old, bold pilots!" 

Japanese stocks rising in conjunction with Yen weakening versus the Euro - source Bloomberg:

"Stocks in Japan may rally more than those in Europe as Prime Minister Shinzo Abe’s push to halt deflation weakens the yen, according to Morgan Stanley. As the CHART OF THE DAY shows, the benchmark Nikkei 225 Stock Average’s performance relative to the Stoxx Europe 600 Index has tracked moves in the Japanese currency against the euro. Japan’s equities, which have surged 9.4 percent this year, will climb further as investors account for the impact Abe’s policies, Morgan Stanley said. “Japan’s recent strong equity-market performance has substantially further to run as the market further discounts the positive impact of Abenomics,” Morgan Stanley strategists led by Jonathan Garner wrote in a report last week. “Meanwhile, European equities have recently experienced a bigger re-rating than those in other regions versus recent average levels.” The Stoxx 600 has advanced 23 percent from its June 4 low as European Central Bank President Mario Draghi pledged to preserve the euro and U.S. lawmakers agreed on a compromise budget. That has driven the gauge’s valuation to 12.3 times estimated earnings, compared with the five-year average of 11.5 times, according to data compiled by Bloomberg. The yen has dropped 20 percent in the past six months, the worst performer of 10 developed-nation currencies tracked by Bloomberg Correlation-Weighted Indexes, as the Bank of Japan announced a 2 percent inflation target and a shift to open-ended asset purchases. In the same period, the euro surged 8 percent for the biggest gains." - source Bloomberg 


While 1994, was the year of a big sell-off in many risky assets courtesy of a surprise rate hike, 1994 was as well the year of the demise of "Czar 52" on the 24th of June 1994 which saw the tragic crash of a Boeing B-52H "Stratofortress" assigned to 325th Bomb Squadron at Fairchild Air Force Base during practice maneuvers for an upcoming airshow. The demise of the BUFF (the nickname among pilots for the B-52 meaning Big Ugly Fat Fellow) was due to Colonel Bud Holland's decision to push the aircraft to its absolute limits. He had an established reputation for being a "hot stick".

So what is the link, you might rightly ask, between "bold banking" and "bold piloting"?

A subsequent Air Force investigation found that Colonel Bud Holland had a history of unsafe piloting behavior and that Air Force leaders had repeatedly failed to correct Holland's behavior when it was brought to their attention (not  French president Hollande in that instance but we digress...).

When it comes to "reckless banking" and "reckless piloting", we found it amusing that current leaders have repeatedly failed to correct central bankers' policies, like the ones pursued by former Fed president Alan Greenspan and current Fed president Ben Bernanke, or, the ones pursued by Japan. These policies are instigating, bubbles after bubbles at an inspiring rate. When one looks at the fragile state of the "House of cards" and the "boldness" of credit investors dipping their toes, once again in very risky credit structures such as CLOs made up more and more with Cov-lite loans, we think our title, and our analogy to the crash of "Czar 52" is this time around very appropriate, but once again our thoughts keep wandering.

In this week's conversation, we would like to look at the binary risks posed by not only rising rates and the pain that can be inflicted in the investment grade space, in conjunction with the rising tide of corporate impairments and write-downs (goodwill being one of our long standing pet subject) and its implications but, looking as well into the rising risks in the credit space with the returns of all the riskiest structures of the recent 2007-2008 credit crisis. First a quick credit overview.

The divergence between the performance in US equities (S and P500) and the Eurostoxx 50 has been clearly growing in early February, the red line in the graph being Italian 10 year yields - source Bloomberg:

This growing divergence can not only be explained by the difference in credit growth we have discussed on numerous occasions, you need to factor in the Corporate Credit Cycle.

As displayed by BNP Paribas in their February Credit Markets conference called entitled "Giving Equities too much Credit",  as far as the Corporate Credit Cycle is concerned, the US is ahead of the games:

- source BNP Paribas

This distinction clearly explains the outperformance of European High Yield Credit in 2012 versus US High Yield.  In the deleveraging process, US Households have indeed been able to deleverage more as indicated in the below graph from the same BNP Paribas note:

But, for the "Great Rotation" theory put forward by many pundits such as Bank of America Merrill Lynch, to play out, much more deleveraging is needed.

As far as Europe is concerned and the Eurostoxx 50, we think European stock analysts should be seen as having an established reputation for being "hot sticks" in similar fashion to Colonel Bud Holland, given they are still expecting double digit EPS growth in the European space as per BNP Paribas' note:

And we know that "Great Expectations" can lead to huge disappointments, when ones looks at Economic consensus continuing to be revised down in Europe:

So "mind the gap", because, one the indicator we have been following, has been the 120 days correlation between the German Bund and its American equivalent, namely the US 10 year Treasury notes. This correlation is rising. In "Risk Off" periods we have noticed that the 120 days correlation had been close to 1 in 2010, 2011 and 2012, whereas in "Risk On" periods, the correlation was falling to significantly lower level. Currently the correlation is rising towards 78%, albeit at small pace, but it warrants caution we think  - source Bloomberg:

The European bond picture, with Spanish 10 year yields staying around 5.18%, whereas Italian 10 year yields below 5% hovering around 4.36% and German government yields rising around 1.63% levels - source Bloomberg:

More and more, peripheral risks appears to have taken the back seat and remain fairly muted. But, we think it could come back at center stage quite rapidly. On that note we would have to agree with CreditSights take from the 12th of February in their note - Spanish Deficit: An Entirely One-Sided Risk:
"•The Spanish government is confident that it will deliver on its 6.3% 2012 deficit target, only missing the target by roughly one percentage point of GDP due to the 4Q12 bank bailouts. 
•But meeting the 6.3% target (excluding bank bailout cost), would mean the government balanced the budget in the fourth quarter. The government last ran a balanced budget in the first quarter of 2008 when the economy grew at 2% on an annualised basis. The economy shrank by 1.7% on an annualised basis in the fourth quarter last year. 
•What's more, a one point cost for the bank bailouts might be too low. Bank bailouts contribute to the deficit to the extent that the values of the stakes received by the government are deemed to be worth less than the price the government paid. 
•The three main bailouts that are so far included in the economic accounts (worth a combined €14 bn) appear to have been ascribed very little value. If the government's stakes from the 4Q12 bailouts are treated as harshly, then the deficit will incorporate the full €34 bn cost (nearly 3.5% of GDP). 
•We believe investors should consider lightening up on Spanish government and credit risk, especially beyond the 3-year horizon of the ECB's bond purchases going into late February when the deficit numbers will be announced. If the government misses its target it is likely to undermine confidence in the sovereign. Whereas the government hitting the target is largely priced in." - source CreditSights

Moving to the subject of binary risks posed by rising rates and the pain that can be inflicted in the investment grade space, higher mark-to-market losses could prompt investment grade credit to come under pressure, which has been the case in January in Europe, when Investment Grade credit was hurt in total returns terms by a rising bund (-1.20%). The hunt for yield has, no doubt increased the risk for pain for low coupon, long duration credit investors given a small surge in yields could inflict some significant losses due to bond convexity. For instance a US rate hike in similar fashion to 1994, could inflict considerable pain to bondholders as indicated by the previously mentioned Exane BNP Paribas note above:

The US asset Class performance through 1994 is indicative of the level of peak to through adjustment that Investment Grade credit could face, should a similar risk scenario plays out, as indicative in the below graph from Exane BNP Paribas:

- source Exane BNP Paribas / Datastream

But if you think bondholders would be in their own world of pain, think again, given that the European equity space wasn't spared either in 1994 as indicated below by Exane BNP Paribas graph:

- source Exane BNP Paribas / Datastream

The rising tide of Corporate Impairments and Write-downs, which has been a pet subject of ours, have, we think, serious implications from an earnings point of view. If ones look at a graph displaying stock prices, impairments and purchases in terms of M&A activity as displayed in Fitch's recent report entitled Corporate Impairments and Write-downs:

"Over recent years, write-downs were largely driven by aggressive acquisitions (often at inflated prices / multiples), money ill-spent on large asset investments or weaker cash flow expectations (leading to lower sale values) for specific assets where market conditions weakened rapidly since the onset of the financial crisis at end-2008. 
To combat negative pressure, corporate issuers have been taking stock and refocusing operations on core assets in an effort to conserve cash. Management strategies centred on disposing of marginal / non-core assets in an attempt to weather weaker demand. Weaker growth forecasts, higher cost of capital in certain markets and increasingly uncertain cash flow projections led to the revaluation of assets held for sale as weighted average cost of capital increased across underperforming sectors, reducing the values realised in disposals." - source Fitch

The current level of European equities, do not reflect these growing risks we think, particularly in the light of accounting changes which have been taking place when it comes to the amortization process which had previously prevailed, meaning that now, the risk for earnings, as we have seen recently is binary.

What are Impairments?
"An asset becomes impaired when the company holding the asset is unable to recover the carrying value of the asset either through the use (cash generated over the usable life) or the sale of the asset. An accounting impairment would occur if the carrying amount of the asset is considered to be less than the intrinsic value management believe it can get from the asset, or the price, less selling costs of the asset.
The standard IAS 36 accounting treatment considers there to be several explicit triggers which could lead to an impairment event.
 Significant decline in assets market value.
 Indication that expected performance of the asset is reduced.
 Increase in market interest rates (as seen in Europe during 2011).
 Cash flows from the asset are significantly different from what was originally budgeted.
All, or part of the above, have occurred to varying degrees across different market since the onset of the financial crisis in 2008. This has, however, been more prevalent in more capital intensive sectors, or sectors with weaker fundamentals (such as nickel and pig iron) or competitive pressures (notably telecoms), have reduced profitability expectations.
A recent example is Peugeot, who in Feb 2013 announced that it would write-down the value of its automotive and financial assets in Europe by EUR4.13 billion. This reflects the extent Europe's economic woes are affecting some of the region's biggest companies, particularly in the auto industry. The write-down is a noncash charge, and its timing is partially driven by European regulators, who have urged companies to adjust the valuation of their assets to reflect prospective business more realistically."  - source Fitch

For instance BNP Paribas posted a 33% decline in its fourth quarter profit, missing estimates, on a goodwill writedown at its Italian branch network BNL of 298 millions euros on and due to an accounting charge tied to its own debt (see our post: Credit Value Adjustment and the boomerang effect of FAS 159 accounting rules on Banks earnings). French bank Societe Generale posted a fourth-quarter loss on a goodwill write-down in its stake in broker Newedge as well as taking a hit courtesy of 686 million euros courtesy of debt value adjustments.

Why does goodwill represent nowadays a binary risk to corporate earnings?
"Under IFRS goodwill is no longer amortised. Pre-IFRS, goodwill was amortised and faded over time - now it remains at the original level and it is likely that it may have to be impaired in a weaker economic / cash flow environment." - source Fitch

Goodwill: "When a firm makes an acquisition for more than the fair value of identifiable assets acquired, the additional value is held in the form of goodwill on the balance sheet. Should the value of the purchased asset become permanently less than its initial value, then the asset must be written down." - source Fitch

What are the risks and consequences of low growth / low yields on impairments and the volatility of earnings?
"Old Acquisitions and Investments, New Economic Reality:
Before 2008, many firms in Europe purchased assets, or invested heavily, with the expectation of continued strong growth. There was a belief that high cash flow projections were acceptable considering the boom period preceding the downturn. Acquisitions reached their height in 2007, leaving companies. balance sheets reflecting large amounts of goodwill. However, as the economy soured, many firms were left with assets which were unlikely to produce the significant cash flows which had been projected previously, forcing revaluations and in some cases asset disposals at prices well below original acquisition costs and multiples. Similarly, corporate capex relative to sales reached a peak in 2008 (7.52% capex/revenue). Nominal capex however continued to rise in 2011 and 2012, notably in the utilities and industrial sectors, peaking at USD503.6bn in 2012. This, coupled with weaker growth expectations, may drive increased levels of impairments over the next two years to end-2014." - source Fitch

What are the consequences of cheap credit, consequences of our "Bold bankers" policies?

Falling Return on Capital:
"Capital invested and large acquisitions pre-crisis in 2007 and 2008 have in some cases been on the premise that cash flows would continue in line with, or even accelerate, compared with historical performance. Firms which acquired or invested heavily in assets pre the 2008 financial crisis saw a significant fall in CFO return relative to the amount of capital employed.
Following acquisitions at inflated prices and money ill-spent on significant capex, economic reality hit hard between 2009 and 2012, requiring these assets to be written-down as its value in use decreased significantly, along with market value, leading to lower market and sale values of these underperforming assets.
The chart below highlights the sectors that had the largest impairments in 2011, with the telecoms sector recording by far the largest impairments, followed by the retail and technology sectors."

- source Fitch

Our bold bankers have effectively with their policies completely distorted corporate balance sheets:
"Judging Impairments by Market Sentiment:
Market capitalisation is driven partially by market sentiment and, although typically volatile and pro-cyclical, includes an expectation of future cash generation and returns on assets. When a firm's market capitalisation falls below its equity value, it may indicate that assets are overvalued relative to market expectations." - source Fitch

"An equity / market capitalisation ratio above 100% is considered in assessing the realistic values of assets. IAS 36 states that assets may be impaired when the carrying amount of the net assets of an entity is more than its market capitalisation. The average equity / market capitalisation ratio of the 235 firms used in the ESMA study rose from 100% at end-2010 to 145% at end-2011. At end-2011, 43% of the sample showed a market capitalisation level below equity, compared with 30% in 2010 – indicating that impairments / write-offs are likely to accelerate if the weak market conditions continue." - source Fitch

The ESMA study (January 2013) found that 47% of issuers whose equity exceeded market cap recognised impairment losses.

On top of the rising risks in corporate earnings courtesy of our "bold bankers" repeated intervention and distortions, the rising risks in the credit space with the returns of all the riskiest structures of the recent 2007-2008 credit crisis is a clear signal that in similar fashion to "hot stick" Colonel Bud Holland, our central bankers have decided to "push it to the limit".

Maybe our "bold bankers should reflexionate on the quote below:
"Any statistician will tell you, a good outcome for a bad risk doesn't mean the risk wasn't bad; it just means you happened to get lucky."

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

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

Deutsche Bank in their recent sector analysis from the 13th of February ask an important question:

"Are credit markets overheating?"

"If we look at new issue volumes in Figure 27 we see that the loan issuance in 2012 was very close to the 2006 level, although around $100 billion short of the 2007 level. The HY bond market, on the other hand, has continued growing rather steadily post-crises with 2012 more than doubling the issuance of 2007." - source Deutsche Bank

"Not only has there been a rise in overall volume of cov-lite loans. Cov-lite loans' share of all institutional loans has risen dramatically lately to almost half of all new loans in the fourth quarter of last year at and at the start of this year. Cov-lite loans now amount to about 30% of the outstanding volume (Figure 30)." - source Deutsche Bank

"Cov-lite loans have been a hot topic in the CLO universe for some time now. The focus of this discussion has been whether or not CLO managers should be constrained in how big a portion of a CLO’s collateral can be invested in cov-lite loans. Most would agree that it is better for a lender to have covenants, other things being equal. But managers have correctly pointed out that cov-lite loans have historically been made to the more creditworthy of borrowers that, precisely because of their creditworthiness, are not deemed to need covenants to ensure repayment. So, by restricting investments in covlite loans, investors may actually be preventing investment in the best credits. But as more CLOs allow ever bigger portions of cov-lite loans the aggregate CLO universe can purchase ever more of those loans. And so as CLOs, the biggest investor group in institutional loans, are allowed to buy more cov-lite loans, the more cov-lite loans are issued. Figure 31 shows how average cov-lite buckets in newly issued CLOs have crept up as the cov-lite share of new issued loans has grown. Now, this doesn’t change the earlier argument from the viewpoint of a single CLO. A loan universe where a minority of loans has covenants is likely to mean that those loans are considered quite risky credits and it would probably not be a good thing to be constrained to buying those. But it does mean that the benefit of covenants is gradually being removed from the loan market and hence lowering borrowing costs and expected investment returns in loans, other things being equal." - source Deutsche Bank

So we might have some "hot sticks" in the credit cockpit at the moment but at least, one member of the pilot crew at the Fed is getting jittery like us: "You're a little low. You're a little low. Come on, buddy, pull up. Pull up, Cougar." Top Gun - Maverick to Cougar

Federal Reserve Board Governor Jeremy Stein recently discussed credit markets and overheating credit markets in general and is monitoring the situation.

Deutsche Bank concluded their note with the following comment:
"The credit markets and financial stability are not the key concern of the Fed right now but there is clearly someone on the Board watching credit markets with policy implications on his mind so we will do the same."

Watching credit markets: this is exactly what we have been doing for a while...

"There are old wise central bankers (Paul Volcker) and bold bankers (Ben Bernanke); we have no old central bankers, just bold central bankers". - Macronomics. 

 Stay tuned!

Credit - House of pain and House of cards

"Criticism may not be agreeable, but it is necessary. It fulfills the same function as pain in the human body. It calls attention to an unhealthy state of things." -   Winston Churchill

While looking at the action this week in the credit space in general and, in the banking space in particular, we initially thought about "House of pain" as the main title for our post, given the goodwill writedowns we witnessed and expected in the banking space (for example 2.7 billion EUR for Crédit Agricole) as well as the nationalisation of Dutch bank SNS in conjunction with the total wipe-out of subordinated bondholders. 

Goodwill writedowns and subordinated bondholders' pending punishments have long been a "pet subject" of ours in various conversations such as "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.

After all, in the banking space, and in this deflationary environment, it is has been all about the "survival of the unfittest".

In a "Central Banks" world dominated by the "Sorcerer's apprentice" aka Dr Ben Bernanke and our "Generous Gambler" aka Mario Draghi, the "creative destruction" in a Schumpeter way has been prevented by "all means". It has in effect maintained various "zombie" financial institutions standing up until they finally paid the piper such as SNS bank.

In relation to the added "House of cards" part of our title, when one looks at the record-low yield touched of 5.61% touched by the US High-Yield index on the 24th of January and that Barclays's index for lower junk-rated companies dropped to a record 7.87% for issues with ratings about Caa from Moody's Investors Services and CCC from Standard & Poor's being the lowest since London-based Barclays began the indexes in 1983 as reported by Bloomberg, we thought we had to extend our aforementioned title.

As reported by Bill Rochelle from Bloomberg in his article "Junk, Nortel, Madoff, Hostess, A123, ResCap" published on the 30th of January, credit investors have to keep dancing until the music stops, and rest assured, at some point it will.

We therefore have to agree with David Tawil, co-founder of Maglan Capital LP which was interviewed by Bloomberg:

"Some of the refinancing deals getting done now are starting to get laughable, in the sense of the credit quality of the borrower and the low interest rates,” Tawil said in an interview. “The government has incentivized lenders to lend to unworthy borrowers,” and even for credit-worthy companies, “rates are unjustifiably low,” he said. HD Supply Inc., the wholesale-supply business once owned by Home Depot Inc., is an example of a low-rated company benefiting from rock-bottom rates. Yesterday, Atlanta-based HD was selling $1.28 billion in senior unsecured notes in a private placement rated CCC+ by Standard &Poor’s. The new debt was expected to yield about 7.375 percent. Proceeds will be used to refinance existing debt. While companies gain, “the government has left the unemployed out in the cold during this free-money fest,” Tawil said." - source Bloomberg

On one hand we have the "House of pain" in the banking space and on the other hand, the credit space is increasingly looking wobbly hence the "House of cards" reference.

In our usual credit overview we will look at the "House of Pain" in the credit and banking space and the "unintended consequences" for remaining subordinated bondholders with the latest SNS case and the "House of cards" in the credit space.

The indicator we have been tracking in relation to "Risk-On" and "Risk-Off" phases, has been the 120 days correlation between the German Bund and its American equivalent, namely the US 10 year Treasury notes and this week it did change course which warrants caution, we think - source Bloomberg:

Back in our conversation "River of No Returns" in June 2012, we indicated that in "Risk Off" periods we had noticed that the 120 days correlation has been close to 1 in 2010, 2011 and 2012, whereas in "Risk On" periods, the correlation is falling to significantly lower level. The correlation between both the German Bund and US 10 year note has risen this week above 74%, indicative of a potential "regime change" from "Risk-On" to "Risk-Off".

Nota Bene: ("Risk On" refers to a period of time in which investors are putting money into risky assets such as stocks, commodities, etc. "Risk Off" meaning the exact opposite with investors putting money into safe haven assets such as cash and treasuries or German Bund).

Another indicator we have been following in various credit conversations has been the spread between 10 year Swedish government yields and German 10 year government yields. It looks like this relationship is now broken with Swedish yields rising - source Bloomberg:

Sweden is one of only 7 remaining AAA rating countries with stable outlook. As we posited on the 3rd of January, Sweden has indicated it's done with the "easing policy" hence the normalisation of Swedish government bond yields versus their German counterpart. Riksbank, Sweden's central bank has clearly decided to hold the line in 2013.

In relation to credit indexes, the Itraxx Crossover index (European High Yield risk gauge for 50 European entities) versus the Itraxx Main index (Investment Grade risk gauge in Europe for 125 entities) is indeed very tight, indicative of the spread compression we have seen in recent months - source Bloomberg:

Core European Investment Grade credit is definitely in the "expensive territory" area.

While the difference between the US PMI and the European PMI is a "credit" story, the divergence between both PMI's will remain in 2013 - source Bloomberg:

 The ISM in the US rose to 53.1 in January from 50.2 a month earlier whereas in Europe Markit's PMI gauge rose to 47.9 from 46.1 in December indicative of manufacturing contraction, albeit recession.

Not a surprise as the US leveraged loan cash price index versus its European peer picture has an uncanning resemblance with the evolution of the PMI index - source Bloomberg:

The weakness in the credit space this week in Europe saw the widening by 25 bps of the Itraxx Financial Subordinate index (high beta financials) in conjunction with a weakness seen in cash with the IBoxx Euro Corporate index (commonly used as a benchmark for credit funds) giving away 6 bps, marking somewhat a pause in the continuous rally in credit in Europe we have seen in Europe since last summer.

Unsurprisingly, the continued weakness in PMI in Europe has led to a reversal in the risk gauge in Europe in investment grade credit indices seeing the Itraxx Main Europe underperforming versus its US equivalent CDX IG, indicative of the weaker tone in the European space, now 23 bps apart and climbing - source Bloomberg:

As far as investment grade is concerned, as indicated by Bank of America Merrill Lynch recent note entitled "Dude, where's my return?" from the 23rd of January, investment grade credit has indeed been in the "House of pain": "What if you have been used to fat returns for years, but one day wake up after the party and can’t find returns? For nearly three months – since the end of October last year – stocks are up more than 6% and high yield corporate credit in excess of 4% (Figure 7). However, the total return on high grade corporate bonds over the same period is zero (and that was before Friday’s big move higher in interest rates). Such a positive environment for risk assets with higher interest rates highlights our outlook for mediocre total returns in high grade this year – at best. We now consider it most likely that total returns will fall short of our low 1.6% target, as the risk of the rotation out of bonds, into equities starting in 2013 has increased enough to become our base case." - source BAML.

- source BofA Merrill Lynch Global Research

Bank of America Merrill Lynch also added in their note:
"A disorderly rotation out of bonds, into equities – where interest rates increase significantly, leading to massive outflows from high grade bond funds and much wider credit spreads – is the biggest risk to investment grade this year and the one we are getting increasingly concerned about. Thus high grade credit spreads and 10-year swap spreads share the property that significant increases in interest rates can lead to spread widening." - source BAML

Given that about half of HG (High Grade) investors consider themselves total return investors according to BAML, rising interest rates could cause a selling stampede following the rise of the retail investor through mutual funds and ETFs, a move from the "House of pain" to the "House of cards" that is, but we digress.

The European bond picture, with Spanish 10 year yields rising towards 5.17%, whereas Italian 10 year yields below 5% hovering around 4.25% and German government yields rising towards 1.70% levels, hurting investment grade bond investors in the process with other core European bonds yields rising as well - source Bloomberg:

Moving on to the subject of the "House of pain" in the banking sector this week, as we pointed out last week in our conversation "The Donk bet":
"Looking at non-cash intangible assets (i.e., goodwill) can be a good indicator and used as a proxy to determine the health of banks.

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

For instance Deutsche Bank reported a larger than expected 4Q12 losses of 2.6 billion Euros including 1.9 billion euros in goodwill impairments. It was a similar story for Crédit Agricole which reported 2.68 billion euros of goodwill write-downs in the fourth quarter. We indicated last week that the bank had 16.9 billion euros worth of goodwill on its balance sheet as of the end of September:

"The European Securities and Markets Authority called on Jan. 21 for improvements in disclosures after reviewing 800 billion euros of goodwill assets at 235 companies in 23 countries across Europe. Goodwill is an accounting convention that represents the amount paid for an acquisition over and above the fair value of its net assets. While writing down goodwill doesn’t deplete capital, it reduces profit and signals a company overpaid for acquisitions. Deutsche Bank AG, Germany’s largest bank, yesterday took 1.9 billion euros of write-downs on goodwill and other intangible assets. ArcelorMittal, the world’s largest steelmaker, said in December it will write down the goodwill in its European businesses by about $4." - source Bloomberg, Credit Agricole to Book EU2.68 Billion in Goodwill Writedowns.

So how do goodwill impairments affects credit you might rightly ask?

A previous article from Standard &Poor's written in March 2012 dealt with this precise point - Why U.S. And European Banks’ Goodwill Assets Are Under Pressure:

"How Impairments Affect Credit:

While companies may downplay impairment charges as noncash, nonrecurring accounting charges, they often have implications for an issuer's credit quality. An impairment charge often signals that a business unit to which the intangible asset relates is suffering some level of stress; as a result, management's view of future operating performance (e.g., revenue and earnings projections) of the unit and perhaps the organization as a whole needs to be reevaluated. An impairment charge can also be a reflection on management, which may need further examination in our analysis. It could mean management at the time of the acquisition misjudged the extent of some synergies during an acquisition, or executed poorly on some plans that seemed to justify a higher-than-market purchase price. A management change may also sometimes precede an impairment charge, because the charge allows certain balance-sheet metrics to be reset (e.g., removing goodwill may improve the quality of assets on the balance sheet). Such an event could affect future M&A activity. 

Headline and reputation risk from impairment write-downs is another factor that could have consequences, particularly when the impairment charges are unusually large or unexpected. For example, a bank's ability to tap the equity or debt markets may be constrained if the capital markets react poorly to its recognition of a significant impairment charge. Such an issue could spill over and adversely affect operating performance. An impairment charge, especially when significant, could affect a company's existing and future dividend policy. In addition, while we believe most debt covenants exclude charges related to noncash impairment charges, some covenants could be affected. Lastly, in rare circumstances, outsized impairments and resulting losses may have a direct or indirect impact on the servicing of hybrid capital instruments, a risk that may affect our ratings on these instruments." - source Standard & Poor's

"House of Pain" - Potential goodwill impairments impact, a few examples as per S&P's article as of December 2011:

- source Standard & Poor's

To bring some solace to banks, the world's biggest mining and steel companies have already wiped out50 billion dollars off project valuations in 2012 according to Bloomberg's article "Writedowns Near $50 Billion as M&A Haunts Mine CEOs" from Thomas Biesheuvel and Jesse Riseborough on the 30th of January:

"The world’s biggest mining and steel companies have wiped about $50 billion off project valuations in the past year and the purge is poised to continue this earnings season as managers reassess expensive takeovers. Anglo American Plc, Vale SA and Rio Tinto Group led the writedowns as declining metal prices, rising project costs and slowing demand forced reviews. Glencore International Plc may write down some nickel and copper assets acquired through its takeover of Xstrata Plc, Liberum Capital Ltd. has said. BHP Billiton Ltd. may trim aluminum operation valuations, according to Goldman Sachs Group Inc. and Sanford C. Bernstein Ltd. Executives and shareholders are paying the price for a $1.1 trillion M&A binge over a decade. Failed deals in aluminum and coal caused $14 billion in writedowns at Rio and cost Chief Executive Officer Tom Albanese his job this month. Cost overruns contributed to Cynthia Carroll’s departure as CEO of Anglo American, which slashed $4 billion off the value of its Minas- Rio iron-ore project in Brazil yesterday. She leaves in April." - source Bloomberg

The SNS case this week has had some major significant risks to the "House of pain" in the European banking sector that warrants additional close attention for the remaining subordinated bondholders.

On Friday the Minister of Finance in the Netherlands has issued a Decree by which the state expropriates "the securities and capital components of SNS Reaal NV and SNS Bank NV in connection with the stability of the financial system, and to take immediate measures with regards to SNS Reaal NV".

Meaning Tier 1 bonds and LT2s losses equates to 100% as indicated by BNP Paribas's European credit note published on the 1st of February - Nationalisation and Expropriation in the EU: The SNS Case.

"We understand that, as of 8.30am today, the property of SNS Reaal NV and SNS Bank NV have

been transferred to the Dutch State. So, effectively, subordinated bondholders are currently suffering a100% loss on their investment. The paper from the Finance Ministry stipulates in Article 50 that the

expropriation makes it possible for the sub debt to be exchanged into equity in order to improve the solvency of the entity, but this would be equity owned by the Dutch state." - source BNP Paribas

As we discussed in our conversation "Kneecap Recap" in May 2012, the liability management exercises of bond tenders were opportunities for the subordinated bondholders to "get to the exit while they can" and take their losses...

Why is the SNS case significant? From the same BNP Paribas note:

"-The SNS intervention clearly pushes the envelope on how far national authorities are willing (and able) to go in the resolution of a failing financial institution.

-This action is the harshest we have seen since Amagerbanken in Denmark and certainly the harshest treatment to bondholders (including LT2) for any large European bank

- Northern Rock had nationalised some preference shares in the past (which had no recovery so far), but the other hybrids were not nationalised and in fact offered a generous LME later on." - source BNP Paribas

The budget deficit of the Netherlands will widen by 0.6% in 2013 as a result of the SNS intervention and the previous forecast was for a budget deficit of 3.3% of GDP in 2013.

The broad picture for European subordinated bondholders from the BNP Paribas note:

"We believe the SNS precedent, while very important, has limited read across to other European jurisdictions. That said it does change the realm of what is possible. To put it in mathematical terms, prior to this precedent the downside recovery for LT2 (using the Irish precedent) was generally assumed to be 20%. This should now be 0%. Also, given the SNS precedent one could argue the probability of this outcome in the distressed situations has gone up. Therefore investors are justified to demand higher yield, which will put pressure on the prices of subordinated debt securities for special situations such as Bankia and other distressed Cajas, Monte dei Paschi and HSH Nordbank. But we still believe every situation is different and needs to be analysed in the context of the country, circumstances of the bailout and perhaps even holders of the bonds. For instance we have seen a very different attitude to bondholder burden-sharing in Spain where due to large retail ownership of the preferred shares the government has tried to minimize the losses for these investors (although retail investors are also invested in some SNS subordinated bonds). Last but not least, the SNS precedent reinforces our view that EU policy makers are in no mood to impose senior burden-sharing at this point in time" - source BNP Paribas

Why the change in recovery rate from 20% to 0% matters in the CDS space?

As we pointed out in "European Derecho", implied recovery rates matter enormously in relation to the determination of the payout for subordinated CDS referencing LT2 debt:

"Fixing the recovery of subordinated debt and taking the spreads on senior and sub debt observed in the market, it becomes possible to solve for a recovery rate on senior." - source Morgan Stanley

In relation to LT2, as a reminder from our September 2011 credit conversation "Credit - Crash Test for Dummies":
"Typically, in subordinated CDS single names, the bond reference is a Lower Tier 2 bond (LT2), and not Tier 1 (T1) bonds or Upper Tier 2 bonds (UT2), as coupon payments can be deferred in these structures. For Tier 1 bonds and UT2, missing a coupon does not constitute a credit event, therefore they cannot be used as a reference for a single name financial subordinate CDS, so no CDS on these bonds."

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

On top of that, a nationalisation, such as SNS case, is not by itself a credit event trigger. Appointing an insolvency official is.

As far as delivery of LT2 underlying subordinated bonds referenced in any CDS contract referencing SNS, you would have to ask the Dutch state for delivery (if the subordinated bonds are not simply cancelled or converted into equity...).

So what's the value of your subordinated single name CDS on SNS? Could it mean single name subordinated CDS are a "House of cards"? We wonder. Oh well...

On a final note, while goodwill impairments are bad news for European banks, as indicated by Bloomberg's recent Chart of the Day, goodwill may as well be bad news for US asset values:

"Paying too much for takeovers represents a risk to the value of U.S. companies, according to Erin Lyons, a Citigroup Inc. credit strategist. The CHART OF THE DAY tracks goodwill, or the amount by which purchase prices exceeded asset values, for companies in the Standard &Poor’s 500 Index during the past decade. Lyons had a similar chart in a report two days ago. Goodwill more than doubled to $245.9 billion, and climbed to 7.8 percent of assets from 5.2 percent in the 10-year period, according to quarterly S&P 500 data compiled by Bloomberg. The chart displays dollar amounts and percentages. “In some cases, companies are realizing that paying a high premium for acquisitions may not have been worth it,” Lyons, based in New York, wrote in the report. Cliffs Natural Resources Inc., the biggest U.S. iron-ore producer, said last week that it will write down $1 billion of goodwill from a deal completed in 2011. Caterpillar Inc., the world’s largest maker of construction and mining equipment, disclosed a $580 million writedown earlier in January on a Chinese unit acquired last year. Three S&P 500 companies -- Frontier Communications Corp., Nasdaq OMX Group Inc. and L-3 Communications Holdings Inc. -- have more goodwill than market value, based on Bloomberg’s data. They were among 44 companies listed on U.S. exchanges that Lyons named as potential candidates for writedowns."  - source Bloomberg

"The worst pain a man can suffer: to have insight into much and power over nothing." - Herodotus

Stay tuned!