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!

Markets update - Credit - Rates - Equities - U can't touch this...Hammer time...

I told you homeboy u can't touch this
Yeah that's how we're livin' and you know u can't touch this
Look in my eyes man u can't touch this
You know let me bust the funky lyrics u can't touch this

MC Hammer - U can't touch this lyrics

Markets in a spin again, equities, you definitely can't touch this...It's hammer time in the markets!

10 year German Government Bund still experiencing flight to quality:

In the two year government bond space, Greece widening again:

In the Credit Space, credit indices widening as well:
Itraxx Crossover 5 year index:

Itraxx Financial Sub 5 year index (synthetic index comprising subordinated CDS levels of European Banks, the reference bonds in these CDS being subordinated debt):

and Italy's sovereign CDS and Government bond spreads an ongoing concern:

Italian Financial Senior 5 year CDS widening as well:

France 5 year Sovereign CDS is quoted at 135 bps.

Meanwhile the aggressive cut from the Swiss National Bank seemed to have had little effect on curtailing the EUR/CHF trend, here is the intraday picture:

Yen is still hanging at record low level suggesting Bank of Japan is on the lookout, we are at intervention levels but what kind of intervention?

Gold reaching a new record, here is the intraday move:

No more Ipads for the US consumer as per Bloomberg's Chart of the day:

And US consumption is 70% of US GDP. It is called deleveraging.

The other chart of the day, again from Bloomberg is more worrying as it shows the average Debt/Ebitda Ratio for closely held US companies, hold your breath it isn't pretty:

In relation to my previous post relating to the toxicity of stimulating high ownership rates, please find another "Chart of the day", from Bloomberg. As I mentioned in my post "Is the policy of achieving a high home ownership rate the biggest threat for an economy?", Australia is facing the same issues relating to its housing market as the UK have been facing and the US:

Yes indeed, house prices in Australia are over-valued and no, it's not different this time for housing and not different for LBO loan costs in Europe which, now exceeds Lehman crisis according to Bloomberg article from Patricia Kuo and Stephen Morris.

Private-Equity firms face funding costs for European LBO which exceeds even the aftermath of the Lehman collapse. Interests on loans to finance LBOs have risen to average 450 basis points more than benchmark since June, from 413 bps in the first five months. The record was at 437 bps following Lehman's demise.
But it is not LBOs that are in trouble to fund themselves. The recent rise in bond yields for Italy and Spain, spell similar funding issues.
According to Bloomberg, European leveraged loans fell to 91.08% of face value at the end of July, whereas in the US, leveraged loans stand at 94.41%. Leveraged loans are deemed High Yield and are rated below Baa3 by Moody's and lower than BBB- by S&P. The Itraxx Crossover index displayed previously is a good proxy.

The reality is slowly sinking in, everyone is competing for funding and costs will rise.

In the CMBS space, there is a disturbing trend as well:

Commercial-Mortgage Late Payments Increase to Record in July - Bloomberg

"Delinquencies on the debt jumped 51 basis points in July to a record 9.88 percent, according to real estate data provider Trepp LLC. The increase follows two months of declines, the New York-based firm said today in a statement. The jump is partly because of how loan servicers report mortgages that are in foreclosure, Trepp said."

This is very significant because it will have a very big impact on Banks level of provisions and will increase losses. It also justifies my previous stance on this blog, relating to US bank stocks and the reason to avoid them. For more on the subject, you can read what I have written on the subject: "Extend and Pretend" - Banks bloated balance sheets and the Impact of Real Estate crisis.

"Wall Street lenders may incur ”hundreds of millions of dollars” in losses as prices on commercial-mortgage bonds tumble, Barry Sternlicht, the chief executive officer of Starwood Capital Group LLC, said on a conference call with investors today for Starwood Property Trust, a unit of the firm."

And on the economic data, it was another disappointing day, Factory orders down 0.8% as durable goods decline (Highlighted above in one of the chart of the day) and ISM services slightly below consensus at 52.7, confirming the ongoing weakness in the US economy.

To be continued, now back to the bunker...

Macro and Markets update - from SNAFU to FUBAR?

While the happy ending everyone was expected seems to be playing out with the debt ceiling debate, the ISM came out very ugly today, and I was afraid it would. It was a big miss at 50.9 from 55.3 in June ( a print below 50 would equate to recession). The confirmation of a double dip is more and more evident, and the NFP figures next Friday with the US unemployment rate will be key. It was another big miss for the Wall Street economists expecting 54.5 on average. The weakening data in between the two ISM from June and July was ominous. I really don't understand how these economists got it so wrong this time around (estimates were ranging from 51 to 56).

Let's face the facts, the US is in a "stagflationay light" environment. While inflation is clearly not a huge concern as it was in the 70s, the inflationary pressures coming from higher fuel prices and food prices are taking their toll on the US consumers (still 70% of GDP).
Housing is still depressed and corporations in the US, while presenting so far much better earnings than they counterparts in Europe, thanks to a weaker US dollar, are not hiring in the face of all uncertainties and sitting on a pile of cash, sitting idle, for the moment.

Manufacturing from Asia to Europe fell last month, how could it had been different for the US?

Demand has weakened on a global scale.

In the US, the production index fell from 54.5 in June to 52.3. New orders dropped to 49.2, the first contraction since June 2009.
The measure of orders waiting to be filled dropped to 45, the lowest level since April 2009.
A jobless recovery means a sluggish demand (household spending rose at 0.1%).

So what's the driving force behind some solid corporate earnings? Very simple, emerging markets strong growth and the expansion of the middle class in emerging markets. Manufacturers, in Europe and in the US have to rely on overseas demand, and the weak US dollar is helping more US exporters than European exporters.

So what happened today, is yet another session of flight to quality in Europe, while equities got pounced, the 10 year German government bond yield dropped to 2.47%. Two weeks ago roughly, it stood at 2.94%. Swiss Franc against both the US dollar and the Euro reached another record.

EUR/CHF intraday move, 1.14 to 1.10...

USD/JPY as well moving to a new high for JPY against dollar:

Bloomberg chart of the day:

Yep, running for the hills, and by the way 2 year Swiss bonds yields are at 0.17%.


2 year Swiss Yield falling fast from May' top (source Bloomberg).

And VIX index, surging still but not yet at March highs:

European peripherals? Well Greece touched 25% yield on the two year, following the new European plan and there was a furious short tightening squeeze on the 22nd of July, but it looks more and more like a distant memory:

Greek two bonds at 31% again.

And it is only Monday...

Now, back to the bunker.

Markets and Macro update - What a difference a day make...

Not much...
If you thought Wednesday wasn't great, Thursday and Friday were pretty dire when it comes to market movements and macro updates.

Macro updates:
China’s trade surplus higher than forecasted to the tune of 22.3 billion USD in June 2011, highest level in seven months. Imports grew at the slowest pace since 2009. This mean no stop in money tightening from the PBOC hence the latest rate increase on July 5 because Consumer prices climbed 6.4% last month, the most in three years. Reserve requirements will be raised again during the second part of the year, in an attempt to cool things down. Good news is Imports, which jumped 19.3 percent to 139.7 billion USD, have had the weakest expansion since gains resumed in November 2009 after a year-long decline. Slower imports means the economy is cooling.

The U.S. unemployment rate climbed in June to 9.2% following a very weak NFP, which printed at a miserable 18K, from a previous weak 54K in May revised down to 25K. What really transpired from the ugly unemployment data, was the fall in the participation rate to 64.1% (percentage of the working age population in the labor force). The employment population ratio in the US fell to 58.2%, matching the lowest level reached during the current employment crisis.As a reminder, in terms of unemployment, the 2007 crisis is still the worse since WWII.
For the US summary - CalculatedRisk - Summary for Week Ending July 8th
This is clearly a threat to consumer spending in the world’s biggest economy.
The European Central Bank raised its benchmark interest rate on July 7 by 25bps as expected to 1.50%.

The US debt ceiling saga goes on like a bad soap opera. Ending season is 2nd of August as a reminder.
Next week we get US CPI on the 15th and Ben Bernanke gives us is semi-annual Monetary Policy report to Congress.
Thusrday 14th we also get the weekly unemployment claims report in the US. Consensus is for a decrease to 405K from previous 418K. We will as well, ge the data around retail sales in the US for June. Retail sales were impacted postively by a fall in gasoline prices, what matters theregore is the reading ex-gasoline prices.
What we need to watch closely next week is the Empire State Manufacturing index, for July. Will it display a return to expansion?

Update on bank failures in the US: 3 more banks closed on Friday (51 so far in 2011). First Chicago Bank & Trust, Chicago, IL (959 million USD); Colorado Capital Bank, Castle Rock, CO (718 million USD); and Signature Bank, Windsor, CO (67 million USD).

US Bank Failures Abate In 1st Half But Likely To Stay Elevated - WSJ

"U.S. bank failures have slowed in 2011 from the flood of recent years, but a large reservoir of problem banks will keep the failure rate relatively high as regulators slog through the backlog."

"The first half included 48 bank failures, down from 74 in the second half of 2010 and 86 in the same period last year, which was marked by three large failures in Puerto Rico. The total assets at failed banks also dropped sharply from a year earlier, off 73%, but remained relatively steady sequentially."

For the backlog - one very good source - CalculatedRisk blog!
Problem Bank List July 8, 2011 (Unofficial)
1004 institutions as of July 8th.

Finally we get next Friday the results of the European bank stress tests. No test, no stress, no stress, no test...

Market updates:
Records keep being broken in Europe...
Portuguese bond yields posted their biggest weekly gain in more than 14 years.
Portuguese two year notes climbed 453 bps to close at 17.50%. Biggest increase since April 1996 according to Bloomberg. On July 7, the yield reached an all time high of 18.28%. The 10 year climbed 199 bps, as well biggest advance since at least 1997.
Contagion?
Italian 10 year yields up 40bps to 5.27%, highest level since 2002. Italy 5 year Sovereign CDS trading at 243 bps, wider by 24 bps.
Italian banks stocks and CDS got seriously whacked in the process:
UniCredit, Italy's biggest bank, down 7,8% to 1.23 euros (lowest level since April 2009). Unicredit 5 year Seniort CDS wider by 31bps to 260 bps.
Intesa, second largest bank, down 4.6% to 1.65 euros. Intesa 5 year Senior CDS wider by 13bps to 200 bps.
Monte Paschi, down 3% to 51.6 euro cents. Down 39.42% since the 1st of January and down 70.91% for the last three years.

Italian banks raised so far 10.5 billion euros this year to strengthen their capital.

Eur/USD closed the day to 1.4228, erasing all the gains registered following Jean-Claude Trichet's speech on Thursday following the rate hike.

Potential CDS payout on Portugal, Ireland, Greece and Spain in the case of a credit event:

Total net notional payout amounts to 33.5 billion USD.

So much for a nice and quiet summer.

To be continued...

Macro update - Scaring off the Stymphalian birds (or the bonds vigilantes) and "Stuck in the middle with you"

After cleaning the Augean Stables, Heracles was given the task of defeating the Stymphalian Birds, man eating birds with beaks of bronze and sharp metallic feathers.

This week's analogy follow up on the post relating to our hero's task of cleaning the Augean stables, relating to the amount of toxic greek debt plaguing the Augean stables (European banks...).

Although our Heracles hero, shot many of Stymphalian birds with his arrows and the rest flew far away, supposedly never to return, the Argonauts later encountered them. In the European Greek saga, our Stymphalian birds (or the bonds vigilantes), will indeed return at some point, like they did for the Argonauts. The problem with Greece, is an acute problem of solvency rather than a funding issue. M Market's big relief at both the Greek agreement on another round of austerity measures (155-138, a Pyrrhic victory?),
as well as a welcomed decent print for the ISM in the US (ISM came at 55.3 which was better than expected the 52), gave us some welcome respite in all this recent price action and excitement. Question being now, will this ISM print prove transitory and when will our greek friends come back to haunt us?

Time for some macro and markets updates!

Greek 5 year Sovereign CDS, some respite in its stratospheric rise:


Similar story for European Sovereign CDS:


Given the correlation between Sovereign CDS and Banks Senior 5 year CDS, no suprise even there on the tightening move:


In Portugal, tightening for Portuguese banks 5 year senior CDS:



and in France:


On the 29th of June according to CDS data provider CMA, Ireland CDS 5 year was standing at 783 bps, giving a cumulated probability of default of 47.5% over 5 year, and Portugal was standing at 775 bps with a similar level of CPD (Cumulated Probability of Default) of 48%. Greece was at 2132 bps, with a CPD of 81.5% over 5 year. Clearly the solvency issue for Greece is not resolved. Please note Greece 5 year CDS is still trading upfront, meaning, that rather than making a quarterly payment for the yearly spread, it is "cash only" upfront please for the premium. At this level of spread we are talking about a premium of around 35%, meaning for a 10 million notional trade, you would have to fork out 3.5 million USD to get covered, cheap...

Meanwhile on the 30th of June, the Italian government introduced additional fiscal austerity measures that aim to reduce the general government deficit by €47 billion (3% of 2011 GDP) by 2014. S&P said there was onne in three chance it will cut ratings of Italy in the next 24 months. Italy's debt to GDP ratio was at 119% at end-2010.

On the 30th of June we also got Unemployment Claims in the US at 419k versus 429k previously. Unemployment is still a major drag. Same story so far.
Chicago PMI came at 54.1 versus a previous print of 56.6. This set the tone for the ISM which was announced on the 1st of July. ISM manufacturing index rose to 55.3 in June from 53.5 in May
From that point Mr Markets mood changed from "Risk off" to "Risk on". Equities should continue to rise in the short term.

Nearly two thirds of the total beat of the ISM came from a jump in inventory levels, this is not great: from 48.7 to 54.1. Why ? Because an increase in inventories is a negative for future activity. Let's keep an eye on the ISM.
We are getting confusing data, The University of Michigan Consumer Sentiment index fell to 71.8 in June from 74.3 in May, well below the 74.0 that was expected.

Emerging Markets Top Gun: Welcome to danger zone...


The Economist Overheating index:

The Economist - Temperature Gauge"THIS chart, based on an analysis by The Economist, ranks 27 economies according to their risk of boiling over. We take each economy’s temperature using six different indicators: the inflation rate, the unemployment rate relative to its ten-year average, GDP growth relative to trend, excess credit (the growth in bank lending minus the growth in nominal GDP), real interest rates, and the forecast change in the current-account balance in 2011."

Emerging Markets Consumer Prices, percentage increase on year ago, thank you QE2?

Source - The Economist

Emerging Markets Real interest rates:

GDP Growth Forecasts for 2011:

Also in the news: China's official Purchasing Managers Index fell to a 28-month low to 50.9 in June with imports index tumbling to 48.7, lowest since August 2010.

UK PMI below expectations, coming at 51.3 on consensus of 52 and below May's 52.3, the fifth consecutive decline since the series' record high of 61.9 in January. UK is entrenched in stagflationary territory. I posted extensively on this blog on the UK situation. It is bleak. The Bank of England is facing higher inflation, weak growth, weak industrial output, high unemployment.

Risk aversion, the big picture, who is weak, who is strong:

A continuation on the story on US banks and why you need to avoid their common stock, David Goldman sums it up nicely in his blog:

Inadequate Loan Loss Reserves: You Read It Here First

“Bad Mortgages Weigh on Banks” is the headline of Nick Timiraos’ WSJ report that nearly 20% of US banks’ mortgage holdings are delinquent.

"The market knew this perfectly well, and reflected this knowledge in the pricing of commercial and residential mortgage-backed securities, as I explained in a blog post June 28. My calculations suggested that US banks will have to increase loan loss reserves."

WSJ Report: Troubled Mortgages Still Plague Banks - By Nick Timiraos"The report said 19.7% of mortgages in banks' portfolios were delinquent at the end of March. By contrast, nearly 6.8% of mortgages backed by Fannie and Freddie were nonperforming, as were 11.4% of all mortgages."

Stealers Wheel's 1972 - Stuck in the middle with you
"Clowns to the left of me, jokers to the right, here I am..."

"While many subprime and other risky mortgages were packaged into securities and sold off to investors, banks chose to keep certain loans or were stuck with them after securitization markets froze in 2007. Loans held on bank balance sheets “in and of themselves are reflective of lesser quality loans” than those backed by Fannie, Freddie, or federal agencies, said Bruce Krueger, a senior OCC mortgage examiner."
Ouch...

and Nick's article as well:
"Banks and thrifts hold around $2.6 trillion in mortgage debt, including around $765 billion in second mortgages and home-equity lines of credit. Regulators said that because banks write down loans long before a foreclosure sale occurs, the longer delinquency and foreclosure timelines couldn’t be used to avoid losses.

But some analysts said the figures should raise concerns over banks’ loan-loss reserves, especially if home prices take another tumble. The loan delinquency rates “suggest that the banks are severely under-provisioned relative to potential losses,” said Daniel Alpert, managing director of Westwood Capital. “Even without the [second mortgage] issue, it’s qualitatively not good.”

So, for some the result will be:

BofA to Book Massive Charges Tied to Mortgages - WSJ - David Benoit
"NEW YORK—Bank of America Corp. will take a massive blow of more than $20 billion in the second quarter for various mortgage-related costs, including $14 billion the bank will put aside to repurchase soured mortgage loans from investors.

The costs show the continuing impact on the nation's biggest bank from the housing crisis and its purchase of home lender Countrywide Financial.

The bank will pay $8.5 billion to settle claims brought by a group of high-profile investors, including BlackRock Inc., MetLife Inc. and Pacific Investment Management Co., or Pimco, that purchased mortgage-backed securities that subsequently went sour."

From Bloomberg - New York Fed Halts AIG Bond Auctions on Market Conditions

"The Federal Reserve Bank of New York is halting its sales of mortgage bonds acquired in the rescue of American International Group Inc. "Given prevailing market conditions” for residential mortgage-backed securities, “we do not anticipate any sales of bonds in the near term or until such time as the New York Fed deems it will achieve value for the public," Jack Gutt, a New York Fed spokesman said in an e-mail.

Funny foreclosure story of the week:

Donald trump versus Bank of America

Donald Trump squeezes Bank of America - Kim Peterson

The Fall of the House of Kluge Leads to the Rise of the Yard of Trump - WSJ
Mortgage on the estate was 22.8 million USD.
Bank of America bought it back for 15.3 million USD during foreclosure auction.
Donald Trump's bid during auction, 3.6 million USD.
Thing is, the Donald had already snapped up in February before the auction: the lawn, the driveway of the foreclosed Kluge Mansion, and the Bank is, well not amused.

Truly "stuck in the middle" with Trump...

Markets and Macro update - "Risk Off" mode is truly on.

The balance sheet recession is still lean and mean. Macro picture remains weak. It will be essential to monitor the next ISM print on the 1st of July. If it points below 50, the US will be again in recession territory.

Great question by Steve Keen and great analysis:

Dude! Where’s My Recovery? - by Steve Keen on June 11th

The fears expressed in my blog of the risks of a double dip in the US are coming closer to realisation unfortunately.

New Home Sales in May at 319K, down from 326K in April. New Home Sales are still in the dumpster:

Take a closer look on a 5 year scale, it ain't pretty:
New One Family Houses Sold: United States

Average Sales Price for New Houses Sold in the United States - Volatile:

Initial claims going up again in the US, it isn't going to help President Obama's re-election:

Initial Claims for Unemployment Insurance rose by 9000 last week to 429000. Worse than the expected level of 413000.


In the rates and credit spaces, we had another volatile session.

Huge movement on the 10 Year German Bund government bond today, signifying a huge flight to quality move:
The 10-year German bund yield fell eight basis points to 2.86%, getting very close to a 5 months low. September bund future made a new contract high of 127.04.

Meanwhile Portuguese 2 Year notes reached a new record to 14.39%, 70 basis points wider.

Irish yields widened by 46 bps to 13.70%.

Spanish 2 Year notes widened by 16bps to 3.59%.

iTraxx SovX 5 year index reached 233 bps (record was reached on the 16th at 236bps). Greece represents 1/15th of the index as a reminder.

For Standard & Poor’s and Moody’s, a rollover of Greek debt would mean default.

And to add to the nasty sell-off Moody's warned it could downgrade 16 Italian banks including Intesa Sanpaolo, Banca Monte dei Paschi di Siena, Banca Nazionale del Lavoro and Cassa Depositi e Prestiti.

Italian Banks CDS trading wider today:


A classic scenario we've seen before, first the shots are fired accross the Sovereign country, then the banks get impacted next. Why? Banks are like second derivatives of an economy, if a country gets downgraded, so will its banks, pushing them even more into difficulties.

Whatever happens to Greece, as I posted in "European issues and the Greek jinx - Macro update, a focus on Iceland and more", its banks are in big trouble:


The ECB has threatened not to accept Greek government bonds as collateral if Greek debt was restructured. If the ECB follow through its threat, a liquidity crisis in Greece, bank runs and other social unrest on a big scale will occur, make no mistake. The AESE Greek equity index would get smoked in similar fashion as the ICEXI icelandic index got whacked given its composition and bank weighting.
A reminder from my previous post - ICEXI got obliterated:


EUR/CHF still displaying the ongoing flight to quality mode, breaking another record today: EUR/CHF hit 1.1902 during European afternoon trade, the pair's all-time low...

Also today, Oil fell 4.6% as the International Energy Agency announced the release of 2 million barrels a day for 30 days beginning next week. Looks like they want to release the pressure on US households finances with this move. A very little too late?