Credit - Promissory Hope

"The man who promises everything is sure to fulfil nothing, and everyone who promises too much is in danger of using evil means in order to carry out his promises, and is already on the road to perdition." - Carl Jung

"A promissory note is a negotiable instrument, wherein one party (the maker or issuer) makes an unconditional promise in writing to pay a determinate sum of money to the other (the payee), either at a fixed or determinable future time or on demand of the payee, under specific terms." - source Wikipedia 

Promissory notes differ from IOUs in that they contain a specific promise to pay, rather than simply acknowledging that a debt exists.

While looking at the political success of Ireland in obtaining finally some debt-relief, which could be seen as an interesting step for European politicians in helping struggling European countries, we thought our chosen title should be "Promissory Hope" given S&P has just raised Ireland's outlook from negative to stable, in the footsteps of rating agency Fitch's revised outlook on the 14th of November. Our title also reflects that while the ECB agreement brings some relief, it doesn't reduce in no way the stock of debt and the impact on the Irish budget deficit will be limited to 0.6% in 2014 and 2015.

No doubt the liquidation of IBRC (the remnants of former Anglo Irish Bank and Irish Nationwide Building Society has put to rest the burden of 3.1 billion euros of annual repayments for the next 10 years.

But, our chosen title is also directed towards the negative spread reaction in subordinated CDS and Lower Tier 2 cash bonds (used as reference obligation in the CDS space) since the announcement of the SNS nationalization and expropriation. We discussed this touchy subject in our previous conversation "House of pain and House of cards":
"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.
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 nationalization, 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..."

Therefore in this conversation, we will focus on the implication for the Credit markets in general and the CDS market in particular.

While subordinated bondholders met their makers in the case of the nationalization process of SNS, at least Senior Unsecured bondholders got some welcome respite as indicated in the below Bloomberg graph on a specific SNS bond:

But given Germany, the Netherlands and Finland are looking at speeding up the European plans as soon as 2015 rather than 2018, to force losses on senior unsecured bondholders of failing European financial institutions, the bail-in push to protect European taxpayers looks to us that, rather that financial unsecured bonds are now more akin to "Promissory Notes" (or hope) rather than plain IOUs.

As indicated by Jim Brunsden and Rebecca Christie in their Bloomberg article from the 4th of February entitled "German Push to Accelerate Bank Bail-Ins Joined by Dutch, Finns":
"Senior bank bondholders so far have mostly avoided losses, while European governments and the International Monetary Fund have committed to 486 billion euros of aid since 2010. Under the EU plans, drawn up by the European Commission, regulators would be given the power to impose losses on holders of senior unsecured debt, as well as derivatives counterparties, once a lender’s capital and subordinated debt are wiped out. Regulators could also force debt to convert into common shares, so shoring up a struggling bank’s equity. 
Once the new rules take effect, national authorities would be expected to exhaust bail-in options before resorting to public money to stabilize the bank. 
 The nations are seeking a date as soon as 2015 because it would provide time to adjust to the measures while not putting individual countries at a competitive disadvantage if they apply bail-in rules ahead of 2018, one of the officials said."

Arguably this is what we have discussing in various conversations and is even more likely to happen sooner rather than later, we think as we posited in"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.

As usual the credit markets are only waking up to the rising risk and acceleration of what pains could be inflicted higher up in the capital structure. On that specific subject, we would have to agree with CreditSights note from the 10th of February entitled "Exploring the Sub-Conscious":
"The market is much more used to the idea of "burden-sharing" in hybrid debt, be it through non-calls, coupon deferrals, discounted tenders or principal write-downs. Even so, most of the latest crop of announcements does not help sentiment across the subordinated asset classes." - source CreditSights.

In similar fashion that the Greek CDS saga, followed up by the ban on naked Sovereign CDS last year questioned the existence of the Sovereign CDS market, the SNS episode is no doubt, raising serious questions on the value of subordinated protection as we argued in our previous credit conversation.

On this specific subject, CITI's note from the 11th of February entitled "What bail-in means for CDS" poses some serious questions:
"CDS protection in question – The consequences for CDS may be at least as far reaching as for bonds. Even if expropriation is deemed to be a trigger event, there is a real risk that no subordinated bonds will be left outstanding to be delivered into the contract. This would render subordinated protection practically worthless in the particular case of SNS (given that senior bonds are trading close to par)." - source CITI

In similar fashion to the sovereign CDS markets, it could no doubt, inflict some serious liquidity constraints to the credit markets as well as much needed reality check as per CITI's note:
"If any bank bondholders had not previously noticed that the rules were being rewritten on them, then the 80-point drop in SNS subordinated debt ought to have served as a wake-up call. Yet to our minds the implications for CDS may be almost as dramatic, and yet ironically may cause the market to rally rather than to sell off. 
Broadly speaking, the problem is that CDS contracts were designed prior to the invention of bail-in. Unless lawmakers are careful, they risk situations in which CDS protection turns out to be worth much less than protection buyers would have hoped and expected, either because it is not triggered at all, or because of problems with a lack of deliverable obligations. This would not only be very damaging for the CDS market; it would have very negative consequences for bank bond liquidity too." - source CITI

The Greek PSI in conjunction to the naked ban on naked Sovereign CDS have indeed somewhat "killed" the trading in the Itraxx Sovereign index SOVX as indicated by CITI:

We have as well to agree with CITI that, increased likelihood of bail-in is probably negative for cash bonds but how negative?

EDHEC-Risk Institute in their January 2012 note entitled "The Link between Eurozone Sovereign Debt and CDS Prices" provides us with some insight on the aforementioned impact:
"To examine the difference between these spread measures, we priced a 5-year bond with a 5% coupon in an environment where the default-free yield curve is assumed flat at 3% and the Libor risk-free curve is also assumed to be flat at 3.5%. We considered two cases - first an expected recovery rate of 40% and second an expected recovery of 0%. We then varied the 5-year survival probability assuming a flat term structure of default rates11 and calculated the implied bond price and spread measures. In all cases we assumed k = 1.

Figure 2 Comparison of the model-implied CDS, bond yield-spread and par asset swap spread measures as a function of 

the full price of a 5-year bond with a 6% coupon. We show this for an expected recovery of 40% (above) and 0% (below).":

"The results are presented in Figure 2. When the expected recovery rate is 40% we find that as the 

bond price falls (and it cannot fall below 40), the CDS spread grows and asymptotically tends to infinity while the yield-spread and asset swap spread tend to different large but finite numbers. However, if we set the expected recovery rate to zero then the yield-spread also tends to infinity and is very close in value to the CDS spread as the bond price falls to zero." - source EDHEC-Risk

Therefore, as we indicated in our previous conversation, if the recovery rate for SNS LT2 subordinated bonds is zero, the significance for the European subordinated CDS market is not neutral to say the least 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.

What are the implications and "unintended consequences" for the financial credit markets? CITI's note gives some additional insights:
"Likewise, lawmakers may feel that the decline in liquidity in sovereign CDS following the ban on naked shorting may not seem to have had an immediate effect. But here too we would argue that this is mostly because we happen to have been in a rallying market, and that the future consequences may stretch well beyond just CDS itself. If investors become forced sellers following downgrades to junk for Spain and Italy, as we think quite likely, the lack of liquidity in CDS would exacerbate the movement in bonds. While some liquidity remains in single-name sovereign CDS, the effect on the SovX index of the shorting ban has been quite dramatic (see graph above on Itraxx SOVX weekly trading). 

The potential problem in bank CDS is almost as large. Although net notional outstandings for single-name European bank CDS are only $68bn,7 DTCC data show that traded volumes are some $36bn/month. This compares with gross turnover in €-denominated bank bonds of only €15bn/month (on €600bn of outstandings). CDS plays an extremely important role in terms of index trading and price discovery, and is often actively used as a hedge for bond portfolios by investors because of its greater liquidity. 
These issues over triggers and deliverables could all too easily jeopardise the validity of the CDS market as a hedge. If it were accidentally “killed off”, the consequences for the bond market would be severe. Unlike in sovereigns, where the underlying cash market has normally been more liquid than CDS, in the corporate market liquidity is heavily fragmented. Without the signaling and hedging role of an active CDS market, bond transparency would fall, trading would become more lumpy, and ultimately the cost to bank issuers would increase, as an increased illiquidity premium became factored into spreads. This hardly seems a desirable outcome." - source CITI

On a final note, as far as Europe is concerned, whereas the US was all about the "fiscal cliff" recently, we think investors in Europe should be focusing on the potential "earnings cliff" given we think analysts are somewhat a little bit too optimistic in their expectations. As an illustration Dutch KPN fell 18% recently to its lowest level since September 2001, following a 4 billion euros right issues in conjunction with earnings well below expectations, leading S&P to downgrade the credit to BBB-, one notch above junk - source Bloomberg:

"Everyone's a millionaire where promises are concerned." - Ovid

Stay tuned!

Credit - The World of Yesterday

"Every wave, regardless of how high and forceful it crests, must eventually collapse within itself."  

Stefan Zweig (1881-1942)

Our chosen title this week is a direct reference to the great writer Stefan Zweig's final masterpiece "The World of Yesterday". With the growing unrest in Europe and in particular Spain, we thought a reference to the great Stefan Zweig was appropriate given he remained all his life a pacifist and advocated the unification of Europe. It was unfortunately the growth of intolerance, authoritarianism and nazism and his feeling of hopelessness for the future that led to his suicide on the 23rd of February 1942 in the Brasilian city of Petropolis, but that's another story. 

Back in June in our conversation "Agree to Disagree", we indicated that until US Treasury Yields rose significantly in response to stronger growth and a healthier global economy, a secular bull market is not in the cards if history is any guide, although lower yields are indeed giving arguably more incentive to shift from bonds to stocks:
"When looking at the growing divergence between US stocks and US Bond yields, and softening US economic data, one can wonder our long US investors can "agree" to "disagree".

In our previous conversation we argued that the latest round of QE policy followed by the Fed would be hindered by US Corporate Borrowing given the already very low levels of funding which might overwhelm any growth in bond demand. Once again it seems to us that the latest policy enacted by the Fed looks farfetched and is that of engineering yet again another attempt in "wealth effect" in order to trigger shareholder spending as indicated by Bloomberg:

"Spending by households invested in stocks may determine whether the Federal Reserve’s efforts to bolster the economy bring more jobs, according to Jack Ablin, chief investment officer at Harris Private Bank. As the CHART OF THE DAY shows, the Conference Board’s consumer-confidence index has failed to keep pace with gains in retail sales during the past three years. Ablin cited a similar chart in a note yesterday after the board said the sentiment gauge rose to a seven-month high in September. The Fed is building confidence by holding down interest rates, which has lifted share prices along with home values, he wrote. The Standard & Poor’s 500 Index rose to its highest level since 2007 after policy makers agreed to open-ended purchases of $40 billion of mortgage-backed debt each month. “Retail spending is the next step in the Fed’s convoluted job-creation policy,” Ablin wrote. Sales growth brings higher corporate profits, which in turn lead to additional hiring, according to the Chicago-based strategist’s note." - source Bloomberg.

Yes, September's reading from the Conference Board, for the sentiment index was indeed at 87.4, more than any other time since January 2008, exceeding by 17.1 points the estimate. But, consumer "fear" might derail this plan and magnify the US fiscal cliff woes as indicated by Bloomberg:

"A slump in consumer spending may exacerbate any U.S. recession stemming from the so-called fiscal cliff of automatic tax increases and government spending cuts, according to Mike Englund, chief economist of Action Economics LLC. The CHART OF THE DAY shows Englund’s baseline forecast of a slow recovery in U.S. growth if the automatic fiscal changes are avoided, and his projection for gross domestic product if lawmakers fail to avoid the cliff. “I would assume that GDP growth would drop to a zero-to-1 percent contraction rate in first quarter and second quarter,” Boulder, Colorado-based Englund said in an e-mail. “A ‘fear’ or ‘panic’ effect might add to this if households pulled back in fear of the economic consequences of the news flow, and if stock prices fell and yields rose as markets feared sovereign defaults.” The economy expanded at a 1.7 percent annual rate from April through June after a 2 percent gain in the first three months of the year, Commerce Department figures showed Aug. 29. Consumer purchases, which account for about 70 percent of the economy, also grew 1.7 percent, the weakest in a year. Spending has cooled as the labor market struggles to improve. Employers added 96,000 workers to payrolls in August, less than economists projected, after July’s 141,000 gain, Labor Department figures showed Sept. 7." - source Bloomberg.

As far as we have seen as of lately, considerable data improvement has been priced in current stock prices, leading us to feel rather "uneasy" in this sea of "easiness". "Fundamentals" wise, economic support is indeed lacking for additional US stock gains as reflected by Bloomberg so "Mind the Gap":

"As the CHART OF THE DAY shows, the Standard & Poor’s 500 Index’s ratio to projected earnings has risen in the past four months as the Institute for Supply Management’s new-orders index for manufacturing has slumped. Knapp showed the contrast with a similar chart in a Sept. 14 report. Since June, the ISM gauge has been below 50, indicating more companies reported a drop in new orders than an increase. The index was last below the threshold in April 2009, when the U.S. economy was in recession. Indicators like this need to rebound for stocks to move higher, Knapp wrote in the report, because the economic outlook is one of two forces weighing on share prices. The other is the prospects for public policy, specifically regarding the federal government’s debt and deficits." - source Bloomberg.

Not only does the projected earnings have been rising but an upcoming earnings recession may soon put some additional pressure on US stocks as we moved towards the third quarter earnings season, hence our title give projected earnings as reflected in current stock prices look to us increasingly indicating "The World of Yesterday" and not 'The World of Tomorrow", sticking with our deflationary stance.

"Lower second-quarter profit has paved the way for an “earnings recession” that will hurt stocks, according to Jonathan Golub, chief U.S. equity strategist at UBS AG. As the CHART OF THE DAY illustrates, earnings at the Standard & Poor’s 500 Index’s non-financial companies fell in the second quarter and may drop again in the third. The result would be the first back-to-back declines since 2009, according to data that Golub presented yesterday in a report. “It’s very hard for the market to move forward when earnings aren’t progressing,” the New York-based strategist wrote on the 5th of September in an e-mail." - source Bloomberg.

On top of that the large Capital Good Orders drop at the end of August which have declined in four of the past five months is as well an early warning signal about future shipment growth turning negative in the near future:

“When the level of orders falls below the level of shipments, this tends to be a warning signal that future shipment growth will turn negative,” Feroli, chief U.S. economist at JPMorgan Chase and Co. in New York, said in a research note on the 24th of August. While orders have had a spotty record in predicting sales, when the degree of divergence gets this large, the correlation is tighter, Feroli said. He cited research by economists at the Federal Reserve in Washington that showed once orders are 1 percent to 2 percent weaker than shipments, the latter will probably shrink, hurting GDP. Bookings were 5.2 percent lower than sales in July, today’s Commerce Department report showed. Minutes of the Fed’s last meeting issued this week said many policy makers thought further action would probably be needed “fairly soon” without evidence of “substantial and sustainable” improvement in the recovery." - source Bloomberg.

While orders for durable goods slumped 13%, the most since January 2009, consumer confidence in the US climbed for a fifth straight week to -39.6 from -40.8. The "somewhat" improving housing market is indeed supporting the markets but as far as Europe is concerned Europe Economic confidence is in the doldrums, and dropped from 86.1 in August to 85 in September. Record unemployment and a deepening slump with euro-area contracting 0.2% in the second quarter are putting a strain on consumer confidence.

Following up on our previous conversation dealing with "Zemblanity" and why these Central Banks operations will eventually fail, we would like at this juncture to remind ourselves of what we wrote back in May 2010 in our conversation "The inflation debate or why you can have inflation in a deflationary environment":
The initial MV = PT Fisher equation means that a rise in ‘M’ leads in reality to a fall in ‘V’ leaving no net benefit.
Fisher's equation:
MV = PT where:
M is the amount of money in circulation
V is the velocity of circulation of that money
P is the average price level and
T is the number of transactions taking place
"We are currently in a deflationary environment which poses no short term threat of massive inflation, but creates a risk of high inflation, if there is no debt restructuring at some point, as well as some profound structural reforms in public finances in the very near future, which will push us towards a double dip recession. It is unavoidable."

As a reminder:
"In Fisher's formulation of debt deflation, when the debt bubble bursts the following sequence of events occurs:
Assuming, accordingly, that, at some point of time, a state of over-indebtedness exists, this will tend to lead to liquidation, through the alarm either of debtors or creditors or both. Then we may deduce the following chain of consequences in nine links:
1.Debt liquidation leads to distress selling and to
2.Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes
3.A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be
4.A still greater fall in the net worths of business, precipitating bankruptcies and
5.A like fall in profits, which in a "capitalistic," that is, a private-profit society, leads the concerns which are running at a loss to make
6.A reduction in output, in trade and in employment of labor. These losses, bankruptcies and unemployment, lead to
7.pessimism and loss of confidence, which in turn lead to
8.Hoarding and slowing down still more the velocity of circulation.
The above eight changes cause
9.Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest." - (Fisher 1933)

We wrote at the time:
"Therefore a perceived inflation can happen in a deflationary environment, it can co-exist."

In the post "Low rates environment and the risk of evergreening à la Japanese", we described the following:
"Companies "are hoarding and in fact not hiring. The paradox of thrift versus the paradox of debt. Companies hoarding cash and households paying down their debt, typical of a deflationary environment and the fear of uncertainty. Households are busy rebuilding their balance sheets and companies have been busy defending their balance sheet."
We concluded our December 2010 conversation making the following important point:
"It is therefore critical to avoid evergreening à la Japanese, the sooner the restructuring of debt, the better and the faster the economic recovery."

To illustrate the above important point, we think the convergence between Iceland's  5 year CDS and Ireland is a compelling display of the impact an accelerated restructuring can have on economic recovery. We have discussed at length this important point back in our conversation in March entitled "Equities, there's life (and value) after default"): "By preventing default, creative destruction cannot happen in true Schumpeter fashion"- source Bloomberg:

Iceland and Ireland are now only around 68 bps apart when looking at their CDS spreads ("Iceland - The Great Debt Escape" - August 2011). - "He who rejects restructuring is the architect of default." - Macronomics.

We agree with the recent comments from Exane BNP Paribas from their QE3 FAQ from the 21st of September:
"The effective impact of QE3 may be less elevated than suggested by econometric models, for two reasons. First, interest rates and mortgage rates have already reached record lows, without triggering much additional business investment. In other words, investment has been much less sensitive to interest rates than in the past and it is uncertain whether a further decrease in yields can change this situation. Second, the mortgage market remains impaired, as close to 50% of households with a mortgage cannot refinance or get a loan at the record low market rates due to their lack of equity."

"In sum, while QE3 will certainly help the economy in sustaining asset prices and financial conditions, this support should remain modest in the short term due to the excessive leverage that remains in the household sector. If financial conditions stay at their current level, we would expect a positive impact of around 0.25 points over the next year. Of course, this is a static estimate. Financial conditions may continue to improve as the Fed continues to buy long-term assets, or they could deteriorate if another shock hits markets. In any event, monetary policy would not be able to offset a sizeable fiscal shock that might occur in the coming quarters. Our base scenario is that fiscal policy would wipe out 1.2% of 2013 GDP, much more than monetary policy can currently add to growth." - source Exane BNP Paribas.

We think Dr Bernanke is indeed going "all in", expecting the "bluff" will be enough to raise expectations and therefore boost the economy and changing expectations.

There would be an easier way to boost the prospect for a return of economic growth and it would mean improving service for struggling homeowners given US banks have been failing to adhere to at least two sets of servicing guidelines since 2010. The Home Affordable Modification Program, that required speedy response from banks has repeatedly been ignored. As indicated by Bloomberg in their article - "Banks That Flunked Servicing Tests Face Watchdog" by Hugh Son from the 25th of September:
"One in five U.S. residential units are underwater, or tied to loans that are bigger than the value of the home, according to CoreLogic Inc., a Santa Ana, California-based mortgage data firm. Of those 10.8 million properties, 15 percent have fallen behind on payments."

We believe accelerating the restructuring process and the deleveraging of US households would be far greatly effective in helping out the US economy in the on-going deleveraging process otherwise the US risk facing "evergreening" à la Japanese as indicated above and might never move back towards "The World of Yesterday".

From the same Bloomberg article:
"The five biggest servicers have given about $10.6 billion in relief through June, mostly in the form of short sales in which a delinquent borrower’s home is sold for less than the amount owed, Smith said last month in a report. That results in fewer credits because servicers get less than 50 cents on the dollar for short sales. They are expected to ramp up loan modifications in the coming months."

Moving on to credit, we believe credit is becoming incredibly expensive and crowded akin to a potential  "Bull Trap" as indicated by CreditSights in their latest Euro Issuance Performance review from the 26th of September:
"With two days left before the end of September, fixed rate-euro denominated issuance has already easily exceeded all previous September issuance volumes with 52 billion Euro of investment grade and high yield deals brought to market. 
Those deals have broadly performed well, especially those from the stressed-eurozone countries. 
But outperformance remains reliant on improvement in the sovereign situation. And so while stressed-country new issues offers attractive yields and compelling new issue premiums, they could prove a trap for investors when volatility returns and liquidity disappears."

We already discussed at length the risks of dwindling liquidity in credit markets. Back in our July conversation "Hooke's law" we argued:
"Given the "Yield Famine" we are witnessing, we believe our credit "spring-loaded bar mousetrap" has indeed been set and defaults will spike at some point, courtesy of zero interest rates. (The first spring-loaded mouse trap was invented by William C. Hooker of Abingdon Illinois, who received US patent 528671 for his design in 1894)."

In our last conversation we also indicated the following worrying trend:
"This latest credit market "euphoria" has been marked by the significant return of Covenant lite issuance. Back in May 2012, we specifically discussed this return in our conversation "The return of Cov-Lite loans and all that Jazz..."."
Our concerns have been duly validated by the following information relating to the covenant quality of new deals from the following Bloomberg article - "Bond Sales Approach $1 Trillion in Third Quarter: Credit Markets" - 27th of September:
"Bond investors are also accepting looser terms from speculative-grade companies. A Moody’s measure of weakness in bondholder protections included in U.S. junk-rated debt increased to 3.94 in September, the worst since November. The gauge, known as a covenant-quality score, compares with 3.71 in August and a 2012 average of 3.72 through last week, according to Moody’s. “In environments where there is a lot of demand, investors will have less say in the covenant package,” said Matthew Musicaro, an associate analyst at Moody’s. “Either you invest in the deal or you don’t.” Moody’s reviewed covenants on 41 bonds sold through Sept. 21 and focused on covenants including those that restrict the use of cash, investments in risky assets and leverage. The deals are rated on a scale of one to five, with five representing the weakest covenants."

Mouse trap, or Bull Trap, it is indeed definitely loaded...

"We can't forever be spending our lives paying for political follies that never gave us anything but always took from us, and I am content with the narrowest metes and bounds provided I have peace and quiet for work." - Stefan Zweig

 Stay tuned!

Markets - Credit - Mutiny on the Euro Bounty

"The ship of democracy, which has weathered all storms, may sink through the mutiny of those on board."
Grover Cleveland - 22nd and 24th President of the United States.

Recently in one of our usual credit rambling "Plain sailing until a White Squall", we ventured towards sailing analogies. Looking at the recent developments aboard our European ship, while the weather has clearly been slightly less accommodative in recent weeks with deterioration of economic indicators (Spanish unemployment reaching 24.4%, France unemployment highest since September 1999, Economic sentiment indicator tumbling to 92.8 from 94.5 in March, etc.), we thought our reference to the mutiny which occurred on the Bounty, would be very appropriate in the current context.
The mutiny on the Bounty was a mutiny that occurred aboard the British Royal Navy ship HMS Bounty on 28 April 1789. The mutiny was led by Fletcher Christian against the commanding officer, William Bligh. According to most accounts, the sailors were attracted to the "idyllic life" on the Pacific island of Tahiti and repelled by the harsh treatment from their captain.
As well as Fletcher Christian and part of the crew, our European "sailors" (politicians) were attracted to the "idyllic" initial cheap funding environment provided by a single currency umbrella. The recent austerity "harsh treatments" measures imposed by the captain of the ship (European Commission) which we reviewed in our recent conversation ("The Charge of the Light Euro Brigade") seems to be clearly pushing some of the members of the crew towards mutiny. This explains somewhat, why the European ship is attempting to change tack, moving towards growth, and like our good credit friend put it:
"The word “Growth” will be added to the title of the existing Fiscal Compact. It will make a lot of European politicians happy !
Please celebrate the new name of the "Plan": The Fiscal and Growth Compact!
To paraphrase the famous: “The King is dead ! Long live the King !”...The Austerity is dead ! Long live the Austerity !”

In addition to the rebellion of various crew members aboard our European ship, although the captain is trying to change tack towards growth (with good intent, but growth, like wind speed, cannot be decided solely by political intent...), the Spanish Treasury, in the ship's bunker, might encounter some problems in placing Spanish debt, which until recently had been absorbed by docile domestic banks. The two largest Spanish banks, Santander and BBVA have said they had reached the maximum levels allowed in terms of their policy in risk concentration and consequently will not increase their purchases of Spanish debt from now on, according to their respective CEOs, Alfredo Saenz and Angel Cano according to Spanish newspaper El Confidencial. This is the direct result of the Greek fallout and the disappearance of "Risk-free" ("The curious case of the disappearance of the risk-free interest rate and impact on Modern Portfolio Theory and more!" - Macronomics, September 2011) or political free lunch (we could not resist the irony). The European Banking Association has directed its members to establish a maximum of allocation of capital specifically towards public debt, therefore imposing limits and guidelines. As a reminder, banks are required by the EBA to reach a 9% level of Core Tier 1 Capital by June 2012. Unintended consequences, once more...
Back in our September conversation, we quoted Dr Jochen Felsenheimer from asset management company "assénagon", we would like to quote him again looking at the current context:
 "Banks employ too much debt, because they know that they will ultimately be bailed out. Governments do exactly the same thing. Particularly those in currency unions with explicit - or at least implicit guarantees. It is just such structures that let government increase their debt at the cost of the community. For example, in order to finance very moderate tax rates for their citizens so as to increase the chance of their own re-election (see Italy). Or to finance low rates of tax for companies and at the same time boost their domestic banking system (see Ireland). Or to raise social security benefits and support infrastructure projects which are intended to benefit the domestic economy (see Greece). Or to boost the property market (Spain and the USA). This results in some people postulating a direct relationship between failure of the market and failure of democracy."

So, one has to wonder whether the mutiny aboard our European Ship will lead to our European politicians "sailors" taking control of the ship, sailing away from austerity and conserve popular support, or will  our European banking "sailors" backed by the ECB (courtesy of LTRO 1 and 2) will take control of the ship.
Before we go through our usual quick credit overview and focus on the Spanish banking situation in addition to interesting bond tenders this time in the Spanish RMBS space, here is a final rambling of ours relating to the "Mutiny on the Bounty". The name of the ship sent on the 7th of November 1790 to search for the Bounty and the mutineers was HMS Pandora, under the command of Captain Edward Edwards. Ironically, the fourteen, mutineers and loyal crew alike captured were imprisoned in a makeshift cell on Pandora's deck, which they derisively called "Pandora's Box". Pandora was wrecked on the Great Barrier Reef on 29 August 1791 during the journey home from the South Pacific.  Four mutineers and 31 of Pandora's crew died in the wreck and Captain Edward Edwards was court-martialed on 17 September 1792 for the loss of the ship, but that's another story...(or is it really?). Time for an unfortunate, but necessary (we think) long conversation.

The current European bond picture with the recent rise in Spanish and Italian yields - source Bloomberg:

Spanish 10-year yields briefly topped 6 percent again early on Friday after Standard and Poor's ratings firm late on Thursday cut the country's credit rating to BBB+ (Investment Grade still) on concern about the government's exposure to its ailing banks, ending below 6% at around 5.89% for Spain. Meanwhile Italy sold 5.95 billion euros worth of bonds at higher interest rates than at last month's auction. The yield on the 10-year notes offered at the auction rose to 5.84% from the 5.24% coupon generated in the March 29th auction. Investors bid for 1.48 times the amount offered, down from 1.65 times in March. The Italian Treasury sold as well 2.42 billion euro worth of five-year bonds, with the yield rising to 4.86% from 4.18% compared to a month ago.

The pain in Spain - Spain 5 year Sovereign CDS versus Italy's 5 year sovereign CDS falling to 25 bps (35 bps in our previous post) above Italy, with both countries widening in synch - source Bloomberg:

The "Flight to quality" picture as indicated by Germany's 10 year Government bond yields well entrenched below 2% yield (near the lows of 2011) - source Bloomberg:

Many pundits have recently asked if "Europe was turning Japanese", of course it is. It's D,  D for deflation. German 2 year notes versus Japan 2 year notes - source Bloomberg:

We agree on the Japanese outlook but differ on the reasons they put forward in their conclusion relating to the current strength of the Euro versus the dollar (Sorry George).
We believe the Euro is strong for two reasons, first being swap lines between the FED and the ECB, second being the FOMC decision to delay its interest rate decision until 2014 effectively putting a floor to the Euro. At the beginning of the year many strategists were forecasting a weaker Euro, since the FOMC decision on the 25th of January, it has not happened. In our conversation "The law of unintended consequences" - Macronomics 25th of January 2012, we had already referred to Martin Sibileau's analysis:
Why would we see the Euro flirting with a $1.33 level?
"That should be the case, if the US dollar had been the main funding currency. But we think the game may have changed. Since the LTROs (liquidity lines) from the ECB are in place, and we’re talking about more than trillion Euros, it could well be that the Euro is now the main funding currency within the Eurozone. That would explain a lot of the things we saw.
Indeed, if sovereign debt placed as collateral with the European Central Bank widens, margin is called and banks need to sell first Euro-denominated assets or assets denominated in other currencies, to later buy Euros. This hypothesis would explain why the Euro appreciates as EU stocks fall, commodities fall, US stocks have a hard time appreciating and the cost of USD liquidity falls. In fact, it could also explain why we saw (last week) gold depreciate at the open of the European trading session and appreciate later in the day, as the North American markets open.
There are however unexpected, unintended and negative consequences here, as a result of this fundamental change, namely the implementation of collateralized liquidity lines by the European Central Bank. We drew a graph below to visualize this horrible circularity: As the sovereign risk of EU members deteriorates, margin is called by the ECB, assets need to be sold, Euros have to be bought, the Euro appreciates making the EU members less competitive globally (particularly the peripheral countries) and crowding the private sector out of the Euro funding market. With a more expensive Euro, Germany is less able to export to sustain the rest of the Union and growth prospects wane. At the same time, the private sector of the EU looks for cheaper funding in the US dollar zone, which will eventually force the Fed to not be able to exit its loose monetary stance."  - Martin Sibileau

Europe's horrible circularity case - Martin Sibileau

By tying itself to Europe via swap lines, the FED has increased its credit risk and exposure to Europe:
"If the ECB does not embark in Quantitative Easing, the Fed will bear the burden, because the worse the private sector of the EU performs, the more dependent it will become of US dollar funding and the more coupled the United States will be to the EU." - Martin Sibileau

More downgrades mean more margin calls, more margin calls means more liquidation and more Euros being bought and dollars being sold, with a growing shortage of AAA assets, Europe is moving towards mutiny on the Euro Bounty ship...
"Europe’s economy is faltering as spending cuts across the region undermine hiring and consumer confidence. Investors have favored German government bonds amid rising fiscal tension in Italy and Spain and the resignation of Dutch Prime Minister Mark Rutte this week after failing to garner support for proposed spending cuts." - source Bloomberg. German 2-Year to U.S. Bill Rate: Chart of the Day:

"The CHART OF THE DAY shows the yield on the German note declined on the 26th of April, touching a record 0.089 percent, while the rate on the three-month U.S. Treasury bill was unchanged at 0.0864 percent. The German note yield is down from a 2012 high of 0.357 percent on March 16, and a five-year average of 1.93 percent. The three-month U.S. bill rate rose to a 2012 high of 0.117 percent on Feb. 14, after touching zero on Jan. 10." - source Bloomberg.

Moving on to the subject of the Spanish banking sector, quite frankly we have been baffled by Santander CEO  Alfredo Saenz deriding Spain defaults surge: "“Mortgages get paid in good times and in bad”. He also added: "“Anyone raising this problem as one of the issues for the Spanish financial system is saying something stupid.”
We discussed Spanish issues at length in our conversation "Spanish Denial".
It looks to us, that Alfredo Saenz is, like many, in denial, as a reminder:
"Denial (also called abnegation) is a defense mechanism postulated by Sigmund Freud, in which a person is faced with a fact that is too uncomfortable to accept and rejects it instead, insisting that it is not true despite what may be overwhelming evidence. The subject may use:
-simple denial: deny the reality of the unpleasant fact altogether
-minimisation: admit the fact but deny its seriousness (a combination of denial and rationalization)
-projection: admit both the fact and seriousness but deny responsibility.
The concept of denial is particularly important to the study of addiction." - source Wikipedia
No offense taken, we have heard similar denials before:
"Our liquidity is fine. As a matter of fact, it's better than fine. It's strong." Kenneth Lay - CEO and chairman of Enron from 1985 until his resignation on January 23, 2002.

Time for some facts and "inconvenient truths, as CreditSights put it in their recent report on Spanish banks - We Need to Talk About Real Estate:

"BBVA and Santander reported 1Q12 ROEs that look resilient in the current context, but they are likely to be as good as it gets this year, with the impact of the new real estate provisioning rules postponed into the remaining nine months of the year, and other nonperforming loans still rising."

ROE respectively at 10% for BBVA and 8% for Santander.

Spanish banks actual total return on CDS since the 13th of February: Bankia's CDS was -7.85% (Bankia was formed on December 3, 2010 as a result of the "union" of seven Spanish financial institutions and has been recently facing additional pressure by the Spanish government for another merger...), compared with a negative return of -1.35% on the benchmark, iTraxx Senior Financials. BBVA and Santander are meaningful underperformers, with negative returns of -5.29% and -5.13% respectively over the same period.

The Royal Decree Law enacted in February 2012 established the provisioning needed for the Spanish banking sector at 35 billion euros with another 15 billion of real estate coverage coming in the form of a separate capital buffer to be completed by December 2012. Banks going through an integration process, which expands their balance sheet by at least 20%, can get an extension until June 2013 at the latest but, according to CreditSights, doesn't apply to the major banks such as BBVA, Santander.
And, when it comes to provisioning, as CreditSights put it frankly in their report, the job has not really been done meaningfully:

"In pre-tax terms, BBVA and Santander need to provide around €2.3 bln each in 2012 under the RDL, and neither charged a meaningful portion of this in the first quarter (zero for Santander, and €174 mln for BBVA), postponing the impact to the next three quarters of this year. This contrasts with CaixaBank, which met its 2012 RDL requirement of €2.4 bln in the first quarter, through the combination of a €1.8 bln release of generic provisions and a €601 mln impairment charge through the income statement. BBVA has said that it expects to spread the remaining impairments about evenly through the next three quarters, for a post-tax impact of approximately €500 mln per quarter. Santander is likely to take more than a third of its RDL charge in the second quarter, when it will get the offsetting benefit of around €900 mln capital gains on the sale of a minority stake in its Colombian unit."

Relating to real estate outstanding exposure for BBVA and Santander and transparency, CreditSights added:
"Neither of the major international banks splits out how much of its total 1Q12 impairments are against real estate (either developers or mortgages), and this lack of disclosure about the P and L impact of real estate is frustrating, even if better breakdowns are provided for the balance sheet, in terms of outstanding exposures and accumulated reserve coverage."

Sovereign exposure for Santander and BBVA according to CreditSights:

Santander - "Santander revealed that it had taken €35 bln across both LTROs in Spain, but said that all of this and more remains at the ECB, where it has deposits totalling €37 bln. Nevertheless it did increase its exposure to the Spanish sovereign somewhat, mentioning a €6-7 bln increase during the quarter to €35 bln within the asset/liability management portfolio, which is accounted for as Available-for-Sale."

BBVA - "BBVA said that it took €11 bln in the December LTRO, and then a similar amount again in February, for a total in the region of €22 bln. About two-thirds of this has been allocated to repay other short-term collateralised funding and meet upcoming maturities of covered bonds and other debt. Of the remaining third, about half has been left on deposit at the ECB, and the other half has been invested in the asset/liability management portfolio. However, exposure to the Spanish sovereign has not been increased, and new investments for the portfolio have been concentrated in instruments issued by core eurozone sovereigns or supranationals, plus non-Spanish covered bonds and senior bank paper. BBVA says that it now has €53 bln in Spanish sovereign exposure (both debt and loans)."

There is increased speculation about the creation of a "bad bank" to manage the real estate and other problems plaguing Spanish banks balance sheets. We have indeed, seen this movie before in Ireland as indicated by JP Morgan's recent note "Chronicle of a Banking Crisis Foretold", published on the 26th of April:

"While concerns with the Spanish banking sector have focused mainly on real estate developer exposures, we think that residential mortgage portfolios are potentially the next leg downward in a prolonged banking  crisis where sector solvency remains at risk. Despite the relatively resilient performance of residential mortgage portfolios to date, which can be rationalized by specific factors such as social security support, lender forbearance and mortgage affordability, we think that the readacross from the developments in the Irish mortgage market highlight the scope for a material worsening as unemployment levels increase. In a scenario where the PD (Probability of Default) and LGD (Loss Given Default) in Spain approach those currently witnessed in Ireland, we would expect net post provisioning losses of €59bn for sector mortgage portfolios."

As our good credit friend put it:
"Main Spanish banks have so far refused the government suggestion to create a bad bank which would carry all property toxic assets, arguing that they could manage their assets on their own. The dire reality is that the creation of such bad bank will bring transparency to asset prices, which is not what Spanish bankers want! The murkier the market, the better it is to extend and pretend..."

The ticking bomb of unemployment benefits exhaustion:

"In our mind, the social security net that operates in Spain has therefore done much to initially shield mortgage portfolios from having to recognise significantly deteriorating performance owing to the increase in unemployment. However, owing to the fact that these relatively generous welfare benefits are time-limited, the system has likely provided a postponement in mortgage portfolio performance deterioration rather than a solution to the underlying problem." - JP Morgan

JP Morgan is wondering in their note if Ireland could be used as a proxy for the real estate Spanish woes:

"Ireland: Predictive Paddy Power?

Having attempted to rationalise the behaviour of mortgage NPLs, it is important to determine where these indicators can go to from here and the impact that this can have on sector solvency. In our opinion, the risk posed by the residential mortgage portfolios is of a non-trivial nature given this asset class represents circa 37% of the total loan portfolios for Spanish financial institutions."

For JP Morgan analysts, moving from a Spanish to an Irish scenario could cost the system an extra 55 billion euros. Consolidation of the banking system has been so far the approach to resolving the issues by the regulators in Spain:
"Spanish banks will be given 12 months to comply with the new provisioning requirements, unless they are involved in further sector consolidation in which case they would be allowed 24 months to comply. In our opinion, this is indicative that domestic Spanish policymakers are still adopting the same strategy since the outset of the banking crisis, which is basically using consolidation as a means of improving the robustness of the sector, a strategy which to date has yielded limited results in our opinion." - JP Morgan

JP Morgan also estimates there is material further downside risk in relation to the "Non-Problematic" Real Estate Developer Loans which could potentially lead according to their analysts to an additional losses/provisioning requirements of 68 billion euro against the current non problematic real estate developer portfolio in the event that this would experience significant asset quality issues:

"Downside Risk in the ‘Non-Problematic’ Real Estate Developer Loans:

While the thrust of the provisioning reforms have focused on the problematic real estate developer exposure, which totals €175bn, there has been less attention paid to the real estate developer loans, which are currently deemed performing (€148bn), with only a 7% general provision being required. We think that given the rate of attrition, both in terms of non-performing loans and asset deflation pressures, it would be particularly heroic to assume that a 7% general provision would be sufficient to cover eventual losses for this segment of the loan portfolio. We would have to make the assumption that potentially a material proportion of these assets may already be subject to significant asset quality issues and where the actual losses may require a similar level of coverage as proposed for the problematic assets. As a result, if we contrast the required 7% provisioning rate for the performing real estate developer loans versus the 53% provisioning rate expected by the Bank of Spain for the currently problematic real estate developer exposures, then this would require an additional provisioning requirement of 46%. This would imply that the Spanish banks would require additional provisioning for losses of €68bn in a worst case scenario that the entire real estate developer lending portfolio had to experience asset quality issues."

Spanish Corporate Loan Portfolio Profile - source JP Morgan - Bank of Spain:

Spanish Corporate Loan Portfolio NPLs evolution - source JP Morgan - Bank of Spain:

"While the scale of the NPLs in the real estate developer and construction portfolio have experienced a rapid initial acceleration, mainly as a result of these sectors being at the heart of the crisis, we would expect that with a broadening of economic pressures to other corporate sectors that the level of delinquencies should invariably increase as well. We do not think that the new provisioning regime makes any allowance for this, which is in our opinion a significant weakness given that this would represent a significant part of the overall loan portfolio." - JP Morgan

Interestingly enough, while consolidation is being underway and encouraged by Spanish authorities, this week two bond tenders caught our attention, this time in the Spanish RMBS space, from Banco de Sabadell for an aggregate principal outstanding post amortisation amount of around 1,270 million euro and Banco CAM for 5,693 million euro. The decline in prices for these securities would have been steeper if not for the tender offers...

On a final note, following the rating downgrade of Spain by two notches by Standard and Poor's, Spanish Financial CDS widened on Friday given rating downgrades for these institutions will undoubtedly follow, as indicated by CDS data provider CMA:



"Am I a fool? I don't think I'm a fool. But I think I sure was fooled.
Kenneth Lay - CEO and chairman of Enron from 1985 until his resignation on January 23, 2002.

Stay tuned!

The European Clunker - European car sales, a clear indicator of deflation

Clunker definition: "A thing that is totally unsuccessful."

1. A decrepit machine, especially an old car; a rattletrap.
2. A failure; a flop.

While we recently we focused on Shipping as a leading deflationary indicator, we thought this time around we would focus our attention on European car sales. We will look at the impact various "cash for clunkers" plans in Europe have had on European car sales and their recent evolution, pointing towards more evidence of a serious bout of deflation in the European space. In addition to reviewing the evolution of car sales in various European countries, it is important, we think, to look at the age segmentation of the European car markets by countries and demographic trends as well.

We will start by the recent evolution of European Car Sales in various European countries.

PASSENGER CARS: registrations down 7.7% in first quarter 2012- source ACEA

Brussels, 17/04/2012 - "In March, demand for new cars in the EU* was negative for the sixth consecutive month, with a decline of 7.0% compared to March last year. While retaining their importance in terms of volumes (1,453,407 new cars), March registrations have not been at this level since 1998. Over the first quarter, the EU market shrank by 7.7%, compared to the same period a year ago, with a total of 3,312,657 new registrations.

Results in March were diverse across the EU* as Italy (-26.7%), France (-23.2%) and Spain (-4.5%) saw their markets contract whereas the UK (+1.8%) and Germany (+3.4%) performed better than they did in the same month a year earlier."

Whereas the drop in car sales were much more severe in Portugal and Greece, respectively by: -49.2%) and -42.6%.

Meanwhile, in Iceland, car sales were up by + 101.1 % March. Re-Iceland, we rest our case...(Iceland - The Great Debt Escape).
For the complete breakdown, by countries for March please check:

Car Sales Statistics.

Evolution of Car sales in Spain from 1995 onwards - source Bloomberg/OECD:

Falling of the proverbial cliff back to...1995 levels.

Evolution of Car sales in Italy from 1995 onwards - source Bloomberg/OECD:

Below 1995 levels...

Evolution of Car sales in Portugal from 1995 onwards - source Bloomberg/OECD:

Evolution of Car sales in Ireland from 1995 onwards - source Bloomberg/OECD:

Again back to 1995 levels...

Evolution of Car sales in Greece, we could only go back to 1999 onwards - source Bloomberg/OECD:

A bottomless pit?

We previously mentioned the uptick in car sales in Iceland for March (+101%).
Evolution of Car sales in Iceland from 1995 onwards - source Bloomberg/OECD:

Again back to 1995 levels but you can clearly notice the upward trend in car sales from the abysmal bottom reached early 2009 at 110K but, still a long way to go to move back to the average of 1136K from 1995 to 2012.

Evolution of Car sales in France from 1995 onwards - source Bloomberg/OECD:

The noticeable spike in car sales in the 2009 and 2010 period in France but as well noticeable in additional countries can be attributed to the various "cash for clunkers" programs implemented in various countries:
Austria, Cyprus, France, Germany, Italy, Luxembourg, Portugal, Romania, Slovakia, Spain.
The summary of the various "cash for clunkers" programs by countries can be found here:
Cash for Clunkers, Here and There - Bill Chameides, April 24th 2009.

In relation to France, the former French minister of Economic Affairs, Christine Lagarde, announced in September 2009 that the country's cash-for-clunkers scheme, called "prime à la casse", would be extended for two additional years at the time. The initial plan was to end the program by the end of 2009, but the government believed at the time that the car market would likely crash if the stimulus Euros were withdrawn. Of course it would have crashed; it was only delaying the inevitable. Particularly because of the "sensitivity" of French car manufacturers to European car sales in peripheral countries.

Renault and PSA Peugeot Citroën car sales have dropped by 20% in the first quarter, whereas GM, Ford and Toyota Europe dropped by respectively 10%, 7.6% and 2.1% on the same period.

Therefore it isn't really a surprise, looking at the performance of the Peugeot stock price, to see the share back to 1991 levels... - source Bloomberg:

On a Credit level, Moody's downgraded Peugeot's credit rating to junk status with a negative outlook, citing "severe deterioration" of its finances, General Motors recently bought more than 335 million dollars worth of shares of PSA Peugeot Citroen giving them a 7% stake in the French company. 10 years ago, GM did a similar deal with FIAT which eventually cost GM 2 billion dollars to get out of the tie up but that's another story...

Moving back to our "European clunker" story, it is important to look at the age segmentation of the European car markets by countries as a follow up on European car sales. Every year French consumer credit company CETELEM publishes a report relating to the trends in driving habits of youths. While the 2012 is not yet available, the 2011 makes some very interesting points:

"Beyond the economic context, the list of facts and societal trends limiting the potential growth of the automobile trade is long. A sluggish demography in conjunction with a saturation of car rates ownership condemn the expansion of the car market. Economic growth will limit the speed of the renewal of European car parks and therefore car sales. Also, in this already unfavourable context for the automotive industry, car usage continues to decline in European countries. The number of kilometers traveled each year has been steadily declining over the last ten years."

Evolution of average kilometers per year since 2000 in selected European countries, (index basis 100 in 2000) - source BIPE, Enerdata, Insee:

Clearly the high level of youth unemployment in Europe is a BIG negative for the European car industry given, on average, according to CETELEM, the average age of a buyer of a "new car" is...50 years old.
Average age of a buyer of a new car in Europe in 2009 by countries - source BIPE

51.5 years on average in France...

According to CETELEM, 29% of buyers of a new car in Europe had more than 60 years old in 2009 whereas 11% were below 30 years old. The secondary market is the main source for youths to access the car market in Europe.

Here is the structure of the European market in 2009 per age brackets - source BIPE:

More interestingly in the CETELEM market survey, in countries such as Spain and Italy, the proportion of buyers of new cars below 30 years of age has been higher than in France or Germany in percentage terms - source BIPE:

CETELEM indicating in their report that 63% of below 30 years old by second hand cars, 18% more than above 50 years old. It is in Spain that young Spanish have displayed the biggest attraction to "new cars". Two thirds of young Spanish have indicated in their 2009 survey they had purchased a new car, followed closely by young Italians and Belgians.

With unemployment in Spain closing on 25% and youth unemployment above 50% in 2012, new car sales will undoubtedly fall even more in the near future...

The car market in Europe is saturated. In the US you can find 800 light vehicles for 1000 inhabitants whereas in Europe it is below 700 in the eight countries studied by CETELEM according to their report. The European market will never reach the American level. The European car market is not only saturated but matured, hence the growing reliance of car manufacturers on emerging markets. In addition to this, the rising prices in gas prices, is weighting even more on the industry as a whole.

Add to the mix demographic trends in Europe, the future for the European car market is bleak to say the least:

Part of below 30 years old of age in the total population by European countries in percentage terms - source BIPE-Eurostat:

Youths in Europe are in the front line in relation to repaying the massive debt accumulated by the previous generation as well as maintaining the pension system. We have indeed an interesting toxic cocktail mix, which not only doesn't bode well for the car industry (with a saturated market), but doesn't bode well either for the "relations" between generations and trigger a "generational conflict" with the increasing worrying trend in youth unemployment. The evolution of the economic situation in Europe, could well lead to a European "Fall", in the footsteps of the Arab "Spring"...we might be rambling again...

"Events are called inevitable only after they have occurred."

Mason Cooley

Stay tuned!

Equities, there's life (and value) after default! - Russia, Argentina, Iceland, examples for Greece.

"Hope is definitely not the same thing as optimism. It is not the conviction that something will turn out well, but the certainty that something makes sense, regardless of how it turns out."
Vaclav Havel

As a follow up to our recent credit conversations, it appears to us interesting this time around to focus on Greek equities, given Argentina and Russia are living proof there is life (and value!) after default. Having a brief overview to what happened to the Russian and Argentinian equity indices, could be used as long term proxy to what could happen to Greece's equity index ASE, following a default and a return to a "new" drachma.

Before we look at the possible medium to long term outcome, it is important, we think, to look at the evolution of the Greek index over time and its current composition.

ASE Greek index members as of the 24th of February 2012 - source Bloomberg:

The outstanding weight of "Financials" in the ASE Greek index, 21.70%:

Greek debt ownership as of 24th of February 2012 - source Bloomberg:

We know from our conversation "Schedule Chicken":
"The immediate write-down of the remaining 53.5% of principal on Greek debt equates to a net present value loss of over 70%. Given Greek banks have the largest exposure to their domestic debt, you can expect a lot more of additional pain for the likes of National Bank of Greece. Taking a 75% coverage on their Greek bond portfolio (12.9 billion euros as of June 2011) implies an additional pre-tax charge of just over 8 billion euros, or around 6.5 billion euros allowing for a tax credit according to CreditSights. National Bank of Greece's core tier one capital was only 6.3 billion euros in September 2011. The 30 billion euros capital shortfall derived from the EBA (European Banking Association) exercise in 2011, was based on 50% private sector value loss. An impairment of 70 to 75% loss would equate to an additional 45 billion euros worth of aggregate recapitalisation for the Greek banking system."

Given the outstanding weight of financials in the Greek ASE index and knowing their current Greek debt holdings, Alpha Bank, National Bank of Greece, EFG Eurobank and Piraeus bank respective equity is probably worth zero. It should in theory equate to an additional write down of at least 16.74% of the ASE Greek index.

ASE Index evolution from 1990 to May 1993 - source Bloomberg:

The ASE index is currently trading around May 1993 levels.

ASE Index evolution from 1994 to 2003 - source Bloomberg:

Since 1999, it has all been downhill from then.

ASE index year to date, picture taken on the 24th of February 2012, back to 1993 levels- source Bloomberg:

While discussing the subject with our friends at Rcube Global macro research, we thought it would be interesting to compare the evolution of the Greek Index relative to the GDP - Source Bloomberg:

Indeed, the ASE index matched the GDP level in November 2007, and today only represents 12.5% of GDP.

Argentina's Merval index in dollar terms, yes, there is life after default (2002) and value as well! Monthly evolution from March 1992 to March 2012 - source Bloomberg:

Argentina's Merval index in dollar terms relative to the local currency ARS from 1997 to December 2011 - source Bloomberg:

Russia equity index evolution from 1995 to March 2012 following the default in 1998 in USD terms:

From a low of 37.74 on the 30th of October 1998 to a high of 2498.10 on the 30th of May 2008.

Life and value after default, you have to be patient.

Greece has already reached its "Minsky" moment.
"A Minsky moment is the point in a credit cycle or business cycle when investors have cash flow problems due to spiraling debt they have incurred in order to finance speculative investments. At this point, a major selloff begins due to the fact that no counterparty can be found to bid at the high asking prices previously quoted, leading to a sudden and precipitous collapse in market clearing asset prices and a sharp drop in market liquidity." - source Wikipedia.

By preventing default, creative destruction cannot happen in true Schumpeter fashion. Minsky was a disciple of Schumpeter.

The work of Joseph Schumpeter, Hyman Minsky and Irving Fisher (see our post "AAA ratings - 10 little indians...and debt deflation - why Irving Fisher is right") should not be ignored, as highlighted by the recent work of Steve Keen - “A much more nebulous conception”

Schumpeter:
"There is another method of obtaining money...the creation of purchasing power by banks...It is always a question, not of transforming purchasing power which already exists in someone’s possession, but of the creation of new purchasing power out of nothing...which is added to the existing circulation."
(Joseph Alois Schumpeter, 1934, The Theory of Economic Development: An Inquiry into Profits, Capital, Credit, Interest and the Business Cycle).

Minsky:
"If income is to grow, the financial markets, where the various plans to save and invest are reconciled, must generate an aggregate demand that, aside from brief intervals, is ever rising. For real aggregate demand to be increasing, it is necessary that current spending plans, summed over all sectors, be greater than current received income and that some market technique exist by which aggregate spending in excess of aggregate anticipated income can be financed. It follows that over a period during which economic growth takes place, at least some sectors finance a part of their spending by emitting debt or selling assets."
(Hyman P. Minsky, 1982, Can “It” Happen Again? : Essays on Instability and Finance. Armonk, N.Y.: M.E. Sharpe).

On a final note, it is not a surprise for us to see a strong recovery for Iceland ("Iceland - The Great Debt Escape", August 2011), which was recently upgraded to BBB- by ratings agency Fitch.
Iceland in recovery mode Iceland stock market from March 2009 to March 2012 - source Trading Economics:

Iceland 5 year  Sovereign CDS versus Ireland 5 year Sovereign CDS, 24th of February 2012 - source Bloomberg:

Since the start of the European debt crisis of 2010 and the significant widening in CDS peripheral spreads, Iceland has seen its CDS spread significantly tighten versus Ireland, 241 bps versus 571 bps, 330 bps apart as of the 24th of February. Iceland Sovereign 5 year CDS has tightened by 1230 bps since its 2008 demise.

In August 2011 we wrote:
"While Iceland is back from the brink by deciding not to save its banks, Ireland is still trying to recover from that ill-fated decision of bailing out its entire banking sector."

"I am not a pessimist; to perceive evil where it exists is, in my opinion, a form of optimism."
Roberto Rossellini

Stay tuned!