Credit - The road to hell is paved with good intentions‏

"The meaning of the phrase is that individuals may do bad things even though they intend the results to be good. An example is the economic policies of the 1920s and 1930s. These were intended to be a prudent response to the economic turmoil following World War I and the Wall Street Crash respectively, but they were one of the causes of the Great Depression and World War II in which millions of people suffered and died." - source Wikipedia

Back in January in our conversation "The European Overdiagnosis", our friends at Rcube Global Macro Research pointed out the inherent flaws of the European currency construct when discussing "The likelihood of a Euro Breakup": "By eliminating currency crises, which were common until the mid-1990s (and at the same time preventing evil “speculators” from making billions on them), the Euro built an economic crisis of far larger proportions. Once again, economics provides a good illustration of the old proverb “the road to hell is paved with good intentions”.

Indeed, while today's price action marked somewhat a respite in the recent sell-off, the unintended consequences of the numerous mistakes made during the ongoing European crisis have yet to be really understand by our European politicians, still struggling to address the many issues of our "European flutter". In our credit conversation we will therefore look at the direct consequences of their actions, as well as looking at the potential outcome for Spanish subordinated bond holders in relation to the necessary exercise of capital increases that will need to take place for the Spanish banking system. But first our credit overview.

The Credit Indices Itraxx overview - Source Bloomberg:

The Itraxx Crossover 5 year CDS index (50 European High Yield companies - High Yield credit risk gauge) was tighter by 33 bps, moving back towards the 700 bps level. It touched 790 bps on Friday. While most indices were overall tighter including Itraxx Financial Senior 5 year CDS index (cost of insuring the senior debt of 25 European banks against default) and Itraxx Financial Subordinated 5 year CDS index, the price action is akin to short covering.

Itraxx Financial Senior index fell to a low of 181 bps in March and has been widening since, reaching 309 bps on the 18th of May, the highest level since the 19th of December - The liquidity picture in four charts. ECB Overnight Facility, Euro 3 months Libor OIS spread, Itraxx Financial Senior 5 year index, Euro-USD basis swaps level - source Bloomberg:

"Mind the Gap" we indicated on the 8th of May - Top Graph Eurostoxx 50 (SX5E), Itraxx Financial Senior 5 year CDS index, German Bund (10 year Government bond, GDBR10), bottom graph Eurostoxx 6 month Implied volatility. - source Bloomberg:

While volatility has somewhat receded slightly in relation to the V2X Eurostoxx, the German 10 year Bund remains tightly below the 1.50% level indicating the "flight to quality" mode experienced so far.

The "Flight to quality" picture as indicated by Germany's 10 year Government bond yields (well below 2% yield),  with 5 year Germany Sovereign CDS above 100 bps. Back in November last year, when Germany's sovereign 5 year CDS went above the 100 bps level, the Bund experienced an impressive widening move above the 2% following the "failed" German auction. Could it be different this time? - source Bloomberg:

The current European bond picture, a story of ongoing volatility for Italy and Spain, with Spain 10 year yields receding towards the 6% level - source Bloomberg:

Truth is, the rising exposure of peripheral banks to government bonds has indeed boosted Sovereign Risk - source Bloomberg:

"While ECB cash injections significantly improved bank liquidity conditions, more than 300 billion euros of announced austerity measures have pressured the budgets of central and local governments. Total euro-zone bank lending to governments has grown 135 billion euros since 2009, tying banks' fates increasingly closely with their sovereigns." - source Bloomberg.

No wonder both the SOVx index (representing the sovereign risk of 15 Western European countries with Cyprus replacing Greece in the index) and the Itraxx Financial Senior 5 year index have moved in synch - source Bloomberg:

The ECB so far has been providing much needed support via LTRO operations to the European Financial sector, avoiding so far direct support of countries and suspending secondary government bonds buying via the Securities Market Programme (SMP). According to Fitch Ratings as reported by Gavin Finch in Bloomberg, a third LTRO operation could take place:

“If a third Longer Term Refinancing Operation is needed, we believe it will be provided,” James Longsdon, a managing director at Fitch’s financial institutions group in London, wrote in a report today. The timing is “unlikely to be imminent without a further significant shock, such as a Greek exit from the euro.”

It could be a possibility given that for weaker peripheral financial institutions, the ECB remains the ONLY source of funding for ailing institutions. The recent downgrades of both Spanish and Italian banks undertaken by rating agency Moody's means that many banks still face funding issues due to the over reliance of many European banks to wholesale funding.  According to Credit Suisse "Q2 issuance has been remarkably light so far, initially driven by earnings blackout periods, but since hampered by volatile market conditions. This lack of supply has been particularly acute for financials.":

"For senior unsecured benchmark deals, we have experienced negative net issuance of approximately EUR94bn since April 2011." - source Credit Suisse

Moody's downgrades of Italian banks were centered on the unsecured Italian Bank Maturities that needs to be replaced:

"Moody's Italian bank downgrade focused on poor wholesale funding access. In 2012 it suggests that only 20% of unsecured maturities will be replaced by new unsecured issues. A structural reliance on market funds poses "one of the biggest challenges for many banks," as Unicredit's 22.5 billion euros of 2012 maturities highlights." - source Bloomberg.

And with soaring Italian bad debt, increasing to 108 billion euros, shadowing Spain, the survival of the weaker players is conditioned by the willingness of the ECB in providing support:

"Moody's cited deteriorating conditions and risk of increasing bad debt in its downgrades of the Spanish and Italian banks. Italy's bad debt has risen 65 billion euros since the start of 2009, close behind Spain's 75 billion increase. Corporate bad debt now represents two-thirds of Italy's total and will likely rise should sovereign yields remain elevated." - source Bloomberg.

In relation to Spain, rising unemployment, rising Non-performing loans and increasing fears of deposit flights (in relation to deposits flight, Greece’s banking system lost 9 billion euros of deposits this year and has seen outflows of 73 billion euros since the 2009 peak according to Bloomberg), reducing therefore the ability for banks in providing credit to support economic growth to the Spanish real economy, doesn't bode well for the its recovery prospects and overly ambitious budget deficits targets. As shown by Bloomberg chart below, Spain's 148 billion euros worth of NPLs dwarf austerity cuts:

"While Spain's bad debt ratio of 8.37% remains below its February 1994 high of 9.15%, its current bad debt outstanding is more than 6x the 1994 equivalent. With provision requirements increasing and a fourth bank clean up underway, further real estate deterioration will materially offset 37 billion of announced austerity cuts". - source Bloomberg.

Many pundits expect that Spain's ability in restoring investor confidence will be determined by the results of the audit of the banks' balance sheets which will be undertaken by Roland Berger Strategy Consultants and Oliver Wyman. While this operation is laudable, we think it is more akin to an operation of damage control and we do not believe it will change investor's willingness in investing in Europe given the growing foreign buyers strike plaguing the European Government market courtesy of "unintended consequences". The Greek PSI created de facto subordination of private sector creditors while protecting both the interests of the ECB and EIB (goodbye "pari passu" - "The European Opprobrium",  classes of bonds or shares having equal rights of payment or level of seniority).

In retrospect, we think our title is uncannily accurate, in relation to Spanish woes, caught in a vicious deflationary spiral: the road to hell is indeed paved with good intentions. We will not comment further on the overly ambitious deficit targets set up by the European Commission as we have been through this exercise previously ("A Deficit Target Too Far"). But, as the explanation goes, in relation to the colloquial expression used in our title, many mistakes were made leading to a flurry of unintended consequences. These errors are forcing our European politicians to try to change tack aboard the "European Bounty" and calling for a "Growth Compact" and asking again for Eurobonds, clearly facing rising risks of mutiny:
-upcoming Greek and Irish elections
-blunt refusal by Germany and Austria in relation to Eurobonds provided the Fiscal compact is not abided by all.

In a note published today by French broker Oddo, Bruno Cavalier indicates clearly the many mistakes taken since the Sovereign debt crisis broke out in 2010:

"The first error was the diagnosis in 2010, namely that the crisis of the euro had its main source, if not unique, in loose fiscal policies. If this point is not debatable in the case of Greece, it is not true for Ireland and Spain. Before 2008, both countries had scrupulously respected the public deficit criteria. Their current difficulties were not caused by an excessive public debt; they appeared when foreign capital financing their housing bubble ended abruptly. In fact, current problems in the euro area therefore reflect as much a fiscal crisis than a balance of payments crisis. However, the policy prescriptions are not necessarily the same in one case or another. Faced with a budget crisis, as in Greece, it is essential to run a thorough reform of the state, forcing us to rethink the tax system to make it more efficient and reduce public funds waste. Faced with a crisis of balance of payments, jeopardizing the banking system, the priority is different. There is  an urgent need to recapitalize institutions in big trouble, if any, by nationalizing them, it should be the priority in Spain. In this country, controlling public deficits cannot  obviously be ignored, but it is secondary to the need of cleaning up the banking system.
The second mistake was to try to subordinate private sector creditors in the context of public assistance programs  for peripheral countries in trouble. This is the famous "Deauville agreement" announced in October 2010 at the end of a Franco-German summit. The ECB, under Jean-Claude Trichet as president at the time, saw its decision immediately criticized. In fact, it resulted in government securities issued by euro area countries ceasing to be considered as "risk-free assets", they were previously even considered "risk-free" when they were not AAA. Risk premiums increased and the appetite for these securities declined, making it more difficult to control debt dynamics."

Of course there is an urgent need to recapitalize Spanish banks, although Spanish Economy Minister expects Bankia to only need 7 billion to 7.5 billion euro to meet provisional rule and doesn't expect Spain Mortgage defaults to rise much.  According to the IMF Spanish Banks losses could reach 260 billion euro and the sector as a whole could need help to the tune of 80 billion euro (5% of GDP). Today saw as well an acceleration in the consolidation of the Spanish banking sector with the replacement of Bancaja Chairman Olivas by Antonio Tirado, the Vice Chairman.

Moving on to our pet subject of subordinated bond holders, Spanish bond holders are likely to experience similar pain than Irish and Portuguese subordinated bond holders given that the need for capital raising will undoubtedly lead to "liability" exercises taking place. In a recent note published by Barclays comparing Spain to Ireland published on the 17th of May, they indicate the following:
"Recent developments in the Spanish banking sector have led investors to draw comparisons between the Spanish and Irish banking systems and analogies between the two are evident, in our view. Most notably, both countries are experiencing severe real estate market adjustments, as large imbalances accumulated over the decade prior to 2008 correct.
Loan losses soared in Ireland: It has been four years since the Irish lending boom came to an end, and the implied loss rate on all Irish bank loans based on the most recent provisioning data is 24%.
Eventually leading to realised losses for subordinated bondholders: The real estate related loan problems at Irish banks eventually caused subordinated bondholders to accept substantial realised losses. On average, subordinated bondholders recovered approximately 20% of par value.
Spanish banks have subordinated debt that could be used for burden sharing: In light of the similarities with Irish banks and the expected need for government capital injections into the Spanish banking system, the question of whether Spanish subordinated bondholders will eventually meet the same fate as their Irish counterparts becomes a legitimate one."

Of course we agree. We have long been warning that, there would be more pain to come for both subordinated bond holders and shareholders alike (see our recent post "Peripheral Banks, Kneecap Recap").

Barclays in their note added:

"Although bank bondholder involvement could help reduce Spain’s debt burden, authorities may avoid coercive burden-sharing because of elevated retail ownership of subordinated bank debt. Nonetheless, we acknowledge that there is downside risk to our base case loss estimates and that the risk of burden-sharing for subordinated bondholders of Spanish banks is material."

The Irish example on a subordinated bond LT2 demise - source Barclays:

"The process was incremental, beginning with the nationalisation of Anglo Irish, advancing with the creation of NAMA, and culminating with the passage of the Subordinated Liabilities Order. Ultimately, subordinated bondholders recovered approximately 20% of par value on average". - source Barclays.

Oh dear...

Ireland also took coercive actions in relation to subordinated bondholders:
"The Credit Institutions (Stabilisation) Act led to the Subordinated Liabilities Order (SLO), which was published on 14 April 2011 and was a key factor in the unfortunate fate of subordinated bondholders. The SLO enabled the State to exercise a wide range of powers over banking institutions, including modifying the terms of subordinated liabilities.
Specifically, the terms of lower-tier 2s were amended such that interest payments became optional and maturities were extended to 2035. The terms of upper-tier 2s were amended to remove all requirements to pay missed coupons. In addition, dividend stoppers were removed from both upper-tier 2 and tier 1s, eliminating the last of the structural leverage previously included in these securities." - source Barclays

In relation to Spain, Barclays indicated:
"Spanish banks have €65bn of subordinated debt outstanding, or €47bn excluding Banco Santander and BBVA. Under our base case scenario, where lifetime loan losses reach €198bn, which would exceed the current stock of provisions by €88bn, the government could be required to contribute €45-50bn to the recapitalisation of the banking sector. The need for public sector support could be reduced substantially through coercive bondholder involvement."

Given the recent outrage by individuals investors relating to the performance of Bankia's share price following its IPO in 2011, it will be interesting to watch the subordinated bond space when looking at the difference in ownership between Ireland and Spain:

One has to wonder if Spanish retail investors will be inflicted additional pain...

On a final note a chart from Bloomberg indicates US Banks CDS track Europe's higher as Spanish yields rise:

"In mid- to late-2007 European bank CDS were driven by liquidity fears and did not track yields particularly closely. As Spanish spreads rose again recently, sovereign fears have this time chased EU bank CDS levels higher. Even with limited sovereign exposure, U.S. banks' spreads are tracking Europe's closely, as fears regarding global growth heighten." - source Bloomberg.

"The safest road to hell is the gradual one - the gentle slope, soft underfoot, without sudden turnings, without milestones, without signposts."

C. S. Lewis -

Stay tuned!

Markets update - Credit - A Tale of Two Central Banks

"It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us, we were all going direct to Heaven, we were all going direct the other way – in short, the period was so far like the present period, that some of its noisiest authorities insisted on its being received, for good or for evil, in the superlative degree of comparison only."
A Tale of Two Cities (1859), historical novel by Charles Dickens, opening paragraph of the novel.

“The European Central Bank has a different task from that of the US Fed or the Bank of England”
Chancellor Angela Merkel.

This week analogy with Charles Dickens' masterpiece, relates to the different stance currently being taken in Europe in relation to what the ECB's role should be in the ongoing Europe sovereign debt crisis. Given recent macroeconomic set of data, for both the US and Europe, indeed we can say we have a Tale of Two Central banks.
European PMI pointing towards recession:

But I wander again...

Last week, no sooner we had posted a credit update relating to the deterioration of liquidity in the financial system on the 30th of November, that we encountered the mighty coordinated intervention of 5 central banks to unfreeze somewhat a financial system, which is in dire need of dollar support. Well, we already knew from one of our very first credit discussion that liquidity issues always trigger a financial crisis: "It's the liquidity stupid...and why it matters again..." which was in August. We discussed at the time:
"Why liquidity matters again? Because bank funding is a key source for bank earnings, ability to lend, therefore a drag on the economic recovery if it doesn't happen smoothly."

We also noted the following:

"Lack of funding means that bank will have no choice but to shrink their loan books. If it happens, you will have another credit crunch in weaker European economies, meaning a huge drag on their economic recovery and therefore major challenges for our already struggling politicians."

But before we engage in another long credit conversation, revisiting the recent central bank intervention and discussing as well yet another tender, this time around by Lloyds in the UK and the implications, it is time for a quick credit overview.

The Credit Indices Itraxx overview - Source Bloomberg:

The Itraxx SOVx Western Europe index (15 European Western Europe Sovereign CDS) fell towards 328 bps, following the relief rally triggered by the joint intervention of the central banks.
The Itraxx Financial Senior 5 year index (CDS linked to senior bonds of 25 European banks and insurers) dropped as well below 300 bps to around 285 bps (weekly drop of 72 bps).

My good credit friend commented on the recent price action:

"While the equity market wants to believe in Santa Claus, the credit market does not. I know that credit market participants are often perceived as “negative”. No one seems to remember how positive they have been from 2004 until 2007. Nevertheless, the point is that credit market is the key to the future as the equity market will not perform over time if credit growth does not resume."

The current European bond picture, an impressive relief rally - source Bloomberg:

A significant tightening move as well between the spread of German 10 year government bonds and French 10 year government - source Bloomberg:

German 10 year government yield falling in lockstep with German 5 year sovereign CDS, following the intervention of the central banks - source Bloomberg:

Even our CPDO/EFSF benefited from the fall in European bond yields and fell in conjunction with French OAT 10 year government yields - source Bloomberg:

The somewhat "improved" liquidity picture in four charts. ECB Overnight Facility, Euro 3 months Libor OIS spread, Itraxx Financial Senior 5 year index, Euro-USD basis swaps level - source Bloomberg:

In relation to the acute liquidity issues we have been following, The Economist in their latest publication commented about the intervention of the central banks to ensure a flow of dollars into the system:
"While America has largely escaped spillover from Europe's banking squeeze so far, the shortage of dollars in Europe remains a problem. To relieve that pressure, the Fed lends dollars to the European Central Bank via a "swap" line, which the ECB then lends to its banks, for up to three months. Demand, so far, has been low, because of the stigma for any bank that uses the system, and the cost: 100 basis points more than a benchmark overnight rate.
On November 30th the Fed, ECB and other central banks sought to rectify this by lowering the spread to 50 basis points. Stock markets soared but the euphoria may not last: illiquidity is a symptom of Europe's crisis, not the cause. As long as sovereigns are at risk of insolvency, their banks are, too. If the euro collapses, the resulting chaos will not spare America's economy, despite the health of its banks".

We have discussed at length the issues relating to the oncoming wall of issuance for 2012 for both banks and sovereigns and the issue of circularity, leading to high correlation between both Sovereign credit risk and European banks credit risk.

My good credit friend commented:
"Pro-cyclical austerity budgets will affect a wide range of sectors, and when added to the European banks deleveraging, will have far reaching consequences all over the Globe. Non-financial corporations will not be immune from the slowdown and we should see credit metrics deteriorate further.
The market may breathe better, but health is far from being back. Psychology is key for a recovery, but how will investors react when they will realize that the road to recovery may take years. While US equities are priced for perfection, the risk is for more disappointment."

It brings us back to our "Tale of Two Central Banks" and the European political situation. Germany favors legally binding rules with a possibility to settle cases of fiscal mis-behaving before the European Court of Justice, at the same time President Sarkozy in his latest speech, is ready to crater to German demands of surrendering economic and fiscal sovereignty in exchange for more ECB involvement in helping out on the ongoing European debt crisis. Mario Draghi has also reacted positively to the ongoing French and German conversations: Europe needs a "fundamental restatement of [its] fiscal rules, together with the mutual commitments that euro area governments have made", before the ECB steps in.

We are all awaiting to see the outcome of the paramount meeting of the 9th of December. The most recent interesting proposal in relation to resolving the ongoing European debt crisis has been made by German Finance minister Wolfgang Schauble and the possibility of setting up "redemption funds", in effect pooling sovereign debts exceeding 60% of national GDPs, which would be supported by specific tax provisions and would remain in place for 20 years until all excess debt is finally reimbursed. This proposal was first made by the German Council of Economic Experts.

Credit Agricole Cheuvreux Nicolas Doisy, in his latest Microscope issue published on the 2nd of December entitled - Quantitative Easing euroZone (QE-Z): surviving Near-Death Experience had to say the following in relation to the ECB much needed support:

"Only the ECB has pockets deep enough to ring fence Eurozone sovereigns from market attacks, since Germany is still firmly opposing (i) Eurobonds now and (ii) making the ECB a lender of last resort. Thus, one of the few options for the Eurozone to survive its near-death experience is a QE-Z, i.e. a larger use of the Eurosystem's balance sheet.
Given the risk of governments free-riding such help, Germany is sensibly pushing for a strong safeguard in the form of very strict fiscal discipline through a rapid and limited change to the Treaty. This would limit such a QE-Z to legacy debts on top of the safeguards introduced on 21 July, whereby the EFSF is to conduct government bond purchases at the ECB's initiative and carry the risk.
This would give the ECB full control over its nonconventional
policy within its current mandate, i.e. provide liquidity at longer maturities (2-3 years)and fine-tune it with government bond purchases. This would also maintain sufficient leverage for an efficient use of the carrot & stick approach retained so far to force fiscal and structural reforms. A political accord on tight fiscal discipline at the European Council of 9 December should suffice."

There was as well an interesting rumor about the ECB channeling funds via the IMF which is worth commenting as related by Bloomberg James Neuger on the 2nd of December - Euro Central Banks Seen Providing Up to $270 Billion Through IMF:
"A European proposal to channel central bank loans through the International Monetary Fund may deliver as much as 200 billion euros ($270 billion) to fight the debt crisis, two people familiar with the negotiations said.
At a Nov. 29 meeting attended by European Central Bank President Mario Draghi, euro-area finance ministers gave the go-ahead for work on the plan, said the people, who declined to be named because the talks are at an early stage."

Credit Agricole Cheuvreux Nicolas Doisy commented on the above in his latest article previously mentioned:
"At the same time, informative (and very likely organised) "leaks" let it be known that something involving the ECB to a larger extent was being considered. One such leak was made public by Reuters which quoted un-named Eurozone officials about a "do-able idea": the ECB would lend to the IMF, "to provide the fund with sufficient resources for bailing out even the biggest euro zone sovereigns". Although neither endorsed nor denied by anyone, this "leak" was surely meant to acknowledge the receipt of the markets' demand for larger ECB involvement.
Indeed, it could not be about the IMF, since it would be strange to see the fund put in the very political position of a Eurozone Treasury just when the role of the EFSF was being discussed. The message was rather about securing the ECB’s independence."

We would have to agree with the above analysis. Like any good cognitive behavioral therapist, we tend to watch the process of how and why the message is delivered, rather than focus solely on the content of the message.

Truth is the German's fearful position relating to the ECB is consequent to the rise in ELA (Emergency Liquidity Assistance) in peripheral countries.

And, as Nicolas Doisy interestingly points out:

"The Eurozone's national central banks could go "rogue" and threaten to disorderly run their own quantitative easing."

He also added:

"One major risk arising from a free use of ELA by NCBs (National Central Banks) is a string of disorderly national quantitative easing on the back of free-riding by national governments. Ireland is a living illustration of such a strategy: up until October 2010, the Irish central bank has used ELA generously to keep its banks afloat. It has thus accumulated large amounts of bad assets in return for the commensurate amounts of cash to banks."

As we indicated in August in our post "It's the liquidity stupid...and why it matters again..."

"Conclusion for the banks in the peripheral countries:
The ECB is currently the ONLY SOURCE of wholesale funding for these smaller banks and have therefore prevented aggressive deleveraging to happen and liquidations."

In terms of liquidity issues, there is always what you see, and what you don't see and as Credit-Agricole Cheuvreux Nicolas Doisy puts it nicely in his latest report:

"Indeed, NCBs hold a wild card, as they can provide large Emergency Liquidity Assistance (ELA) at their own initiative and without the ECB's prior consent to their domestic banks. As the name indicates, such ELA is meant to be provided to illiquid but solvent credit institutions shut out of capital markets by exceptional events. Strangely, the NCBs' only legal obligation is to keep the ECB informed."

The Irish stealth QE...ELA as percentage of GDP.

"A year ago, Ireland's ELA operations were revealed suddenly and forcefully by the ECB due to the risk of continued monetary financing of the government. Indeed, the central bank of Ireland was sparing banks the need to restructure by providing them with cheap liquidity. It was thus also indirectly subsidising the Irish government by relieving it from the need to put expensive equity in its banks.
A two-third majority at the ECB's Governing Council would be needed to put an end to such (potentially very large) ELA operations by other NCBs in the future. With much more than one country concerned, such a game of chicken could well turn quickly into a nightmare. Indeed, such a vote would be politically very delicate to hold (the majority threshold is high) and thus likely to trigger panic in the market.
Hence, with contagion spreading to the Eurozone core, a very sensible fear on Germany's side is that monetary financing of fiscal deficit turns widespread. This would jeopardise two pillars of the European Monetary Union: (i) fiscal discipline would be even more relaxed because of the very monetary financing allowed by ELA and (ii) high (if not rising) inflation would eventually ensue from this feedback loop."
source Credit-Agricole Cheuvreux - Quantitative Easing euroZone (QE-Z): surviving Near-Death Experience.

This is the reason Germany is asking for stricter fiscal discipline. A sustainable fiscal federation in the long term is needed of course, backed by a European Central Treasury. In relation to our "Tale of Two Central Banks", you cannot ask the ECB to suddenly morph into a Fed. This process will undoubtedly take time and a due process, but a larger involvement of the ECB is so far conditional to stricter fiscal discipline. Truth is both Germany and France are trying to make amend for their mistake in violating the European Stability Pact in 2003, a subject we discussed in January 2011 in our post "The moral hazard mistake of 2003 - The violation of the European Stability Pact":

"The ECB had to step in and follow a tighter monetary policy.
Between 2003 and 2004 it allowed real interest rates in the Eurozone to fall to zero. The ECB also abandoned the so-called monetary pillar of its strategy -- "a prudent cross-check that looked at the rate at which money supply was growing". For several years, money growth exceeded the ECB's target rate of growth of 4.5 per cent a year. This equated to overreliance on credit in the Eurozone. It made the Eurozone government fiscal balances over dependent on tax revenues from activities that were based on borrowing, namely housing and construction: hence the housing bust in Spain, Ireland, etc."

On another credit note, and in direct relation to our previous warning to subordinate bondholders from our last post, Lloyds, this time around, announced a bond tender on LT2 (subordinate debt), John Glover and Gavin Finch in Bloomberg article - Lloyds Offers to Exchange Up to $7.7 Billion of Junior Notes - 1st of December 2011 indicated:

"Lloyds Banking Group Plc, 41 percent owned by the British taxpayer, offered to exchange as much as $7.7 billion of capital notes for new bonds to boost capital.
Lloyds asked investors in the Tier 2 securities to swap their holdings at a discount to face value of as much as 30 percent, it said in a statement. The transaction will contribute about 20 percent of the bank’s funding needs for next year, according to London-based spokeswoman Nicole Sharp.
“In light of ongoing market volatility and regulatory uncertainty, the group is undertaking an exchange offer on its Tier 2 capital securities which are eligible for call in 2012,” Sharp said in an e-mail. “The exchange offer also provides the group with an opportunity to improve the quality of the group’s capital base.” Regulators are pushing banks to boost their capital, or ability to absorb losses, before taxpayers have to step in. Bank of England Governor Mervyn King urged lenders today to step up efforts to bolster their defenses against the euro area’s debt turmoil, which now looks like a “systemic crisis.” By exchanging Tier 2 notes, banks are getting rid of securities that, under new rules, will start to lose their value as capital notes from 2013. Lenders also get a boost to their capital against losses by swapping the debt at a discount."

Lloyds launched an exchange on all (11 LT2 and 2 UT2) securities with call date in 2012 ("with the exception of those already being treated on an economic basis") into a new LT2 2021 "callable" in 2016 but without step up, coupon range 5yr MS+850-1000bp (depending of currencies) and added "It is the intention of the Group that all decisions to exercise calls on any Existing Notes (the securities targeted in this exchange offer) that remain outstanding after 31 January 2012, will be made with reference to the prevailing regulatory, economic, and market conditions at the time."

Meaning that future calls will be on "economic basis" for the new security. We could summarise the above as follows:
"Dear LT2 subordinated bondholders tender your bonds or the 2012 call gets it, but it doesn't mean the 2016 call won't get it either..."
Oh dear...
Lloyds Isin - XS0195810717 - source Bloomberg, closing cash price before tender 72.2, exchanged price 77.25. A 22.75% "haircut"...

And my good credit friend to opine:
"A nice “slow death” for subordinated bondholders…"

For more on this particular bond tender, FT Alphaville Joseph Cotterill goes into the detail in his post - "Debt swaps: we can do this the easy way or…"

In our previous post we voiced our concern on subordinated bank debt:
"Given the wall of refinancing for banks in 2012 we detailed previously, we would therefore disagree with the current credit market assumption that LT2 haircut will not happen again."
It still looks our concerns are clearly justified.

On a final note I leave you with Bloomberg Chart of the Day showing "Derivative traders are hedging for the risk that European policy makers fail to end the sovereign- debt crisis that a coordinated central-bank move this week to cheapen dollar funding didn’t resolve."

"The CHART OF THE DAY shows that the one-year U.S. interest-rate swap spread rose yesterday following a plunge the prior day after the Federal Reserve and five other central banks cut by half percentage-point the rate on emergency dollar swap lines. The chart also shows that options traders’ projection of the pace of future swap-rate swings is more than 27 percent above the year’s low.
Swap spreads are based on expectations for the dollar London interbank offered rate, or Libor, and are used as a gauge of investor perceptions of banking-sector credit risk. The swap’s floating rate is indexed to three month Libor, which fell yesterday for the first time since July 25."

"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.

Stay tuned!

Markets update - Credit - The Eye of the Storm.

"The fishermen know that the sea is dangerous and the storm terrible, but they have never found these dangers sufficient reason for remaining ashore."
Vincent Van Gogh

As we move towards the nth European summit of the last chance on the 9th of December and with liquidity becoming scarce by the day, in today's post we will review ongoing liquidity issues, as well as some recent market developments and some previous calls.

On the recent price action, my good credit friend commented:
"As equity traders still enjoy a kind of Bull Run based on very thin air, credit traders keep on focusing on facts that could alter the metrics for the months to come, or, on events that could change the credit momentum. Even though European politicians have finally understood what needs to be done to place their economies on a strong footing, they are facing many hurdles, as political agendas collide with the needed structural reforms. So, it will take a lot of time, and time is a luxury that market participants cannot afford. Why? Because the overall system and our society does value “time” as something that humanity as a whole is short of. Consequently, we are experiencing a major social shift in term of savings behaviour and capital allocation. This is what I call a global re-pricing of all assets, which bears a lot of risks if it occurs disorderly."

But first, as always, it is time for a credit market overview before our long conversation.

The worsening liquidity picture in four charts. ECB Overnight Facility, Euro 3 months Libor OIS spread, Itraxx Financial Senior 5 year index, Euro-USD basis swaps level - source Bloomberg:

The current European bond picture with contagion to core Europe - source Bloomberg:

German 10 year government yield rising in lockstep with German 5 year sovereign CDS, following the failed auction casting doubt on the safe haven status of German bonds which had prevailed so far this year - source Bloomberg:

The Credit Indices Itraxx overview - Source Bloomberg:

While we have somewhat receded since our last post, in relation to CDS credit indices levels, volatility remains elevated, and liquidity is becoming an issue, given bid-offer spread for Itraxx Financial Subordinate 5 year CDS is 10 bps whereas it is is only 5 bps on the Itraxx Crossover 5 year CDS index (European High Yield gauge).
A market maker commented:

"Another fairly thin session as we approach Dec 9. Environment continues to be tough to trade -- just take a look at some of the intraday index moves. It becomes increasingly more difficult if you're a single name bank cds trader and trying to "hedge" your book. You are guaranteed to lose money on almost every occasion as you cross bid/offer."

Intraday movement remains indeed very elevated in the Credit Indices space:
Itraxx Financial Senior 5 year index closed around 340 bps (today's range was 330-355).
Itraxx Financial Subordinate 5 year index closed around 588 bps (today's range 569-626...).

Itraxx Financial Senior 5 year CDS versus Itraxx Subordinate 5 year CDS - source Bloomberg:

The same market maker commented on the above:

"Snr vs Sub relationship in Index is also not moving. You would have expected the spread to decompress in the widening but it did not even blink. The only real explanation for this, is because nobody feels like buying Sub protection at these levels; which is fair if you don't think LT2 will get haircut and believe CDS will go to zero one day (post Basel III)."

In relation to LT2, as a reminder from our September 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."

In our September post we discussed:

"If a financial entity is able to buy back its LT2 debt below par, it generates earnings and then Core Tier 1 capital. It's a kind of magic...because this way a bank's total capital base goes down (by retiring LT2 debt) and given regulators care most about the Core Tier 1 ratio, everyone is happy (probably note the subordinate bondholder)."

We would have to disagree with the market maker in the sense that we could go wider still on the Itraxx Subordinate 5 year CDS index, given the market doesn't fathom the possibility of getting haircuts on LT2 subordinate bonds. It has happened and will happen again for weaker financial institutions in the peripheral countries.

Tracy Alloway in FT Alphaville on the 22nd of October described what happened in Ireland, for Anglo Irish Bank subordinate bondholders in her post - "Anglo Irish’s burden-sharing template":

"The bank is offering holders of some of its outstanding sub-debt to swap their notes for new Irish government guaranteed bonds that will be due in 2011 with a coupon of three-month Euribor plus 3.75 per cent. Holders of the €1.57bn worth of three Lower Tier 2 (LT2) bonds will receive just 20 cents on the euro. Investors in about €377m of perpetual junior debt will get even less — 5 cents on the euro."

And Tracy also reminded us what happened in 2009 in the UK in relation to the Bradford and Bingley precedent:

"In 2009, the nationalised British bank enforced burden-sharing on both LT2 debt and perpetuals — offering 45 pence for every pound of LT2, and 25 pence on perpetuals. That was a premium of about 10 to 12 points at the time.

Bradford and Bingley burden-sharing, however, also came with a ‘special resolution regime.’ The UK government went ahead and changed the terms of outstanding Bradford & Bingley subordinated bonds — allowing the bank to defer coupon and principal payments."

And Tracy concluded at the time:
"The future is here, and it bites for bondholders."

We already know the score given the flurry of bond tenders which we had seen coming fast and furious following Spanish bank Santander's bond tender. Given the wall of refinancing for banks in 2012 we detailed previously, we would therefore disagree with the current credit market assumption that LT2 haircut will not happen again and Itraxx Financial Subordinate CDS index could go wider still. This time is different? Probably not, given the European Banking Association's willingness to ensure European banks reach 9% Core Tier 1 capital ratio by 2012.

"Something has gotta give" - subordinated bondholders or shareholders, or both, we argued recently.

It seems Moody's Investors Services is confirming our September assumption given it is considering lowering debt ratings for banks in 15 European nations to reflect the potential removal of government support. This will likely help banks quietly retire their LT2 bonds at even more discounted levels, shoring up in the process somewhat their Core Tier 1 capital. According to Jacob Greber and Chitra Somayaji in their Bloomberg article - Moody’s Considers Bank Debt Downgrade in 15 European Nations published on the 29th of November:
"All subordinated, junior-subordinated and Tier 3 debt ratings of 87 banks in countries where the subordinated debt incorporates an assumption of government support were placed on review for downgrade, the ratings company said in a statement today. The subordinated debt may be cut on average by two levels, with the rest lowered by one grade, it said.
Lenders in Spain, Italy, Austria and France have the most ratings to be reviewed as governments in Europe face limited financial flexibility and consider reducing support to creditors, the rating company said. Moody’s has said that a “rapid escalation” of Europe’s sovereign debt crisis threatens the entire region."

The difficulties for banks to issue term funding debt have been a recurring theme in our conversations. The two journalists from Bloomberg also added:

"Banks will cut bond sales by 60 percent in Europe next year as the sovereign debt crisis drives up issuance costs, Societe Generale predicts. Lenders will sell 50 billion euros ($67 billion) of senior notes, down from a euro-era low of 121 billion euros so far this year, according to the French bank.
The extra yield that investors demand to hold European bank bonds is the highest since May 5, 2009, widening to 424 basis points on Nov. 25 from 336 on Oct. 31, Bank of America Merrill Lynch’s EUR Corporates Banking index shows."

In the great European bank deleveraging process, not even German bank Commerzbank is immune according to Bloomberg journalists Nicholas Comfort and Aaron Kirchfeld - Debt Crisis Puts Commerzbank Back to Drawing Board Fighting Aid:

"Commerzbank AG Chief Executive Officer Martin Blessing spent the last three years trying to free Germany’s second-largest lender from the shackles of government aid needed to survive the 2008 credit crunch. Europe’s debt crisis may put him right back where he started.
Blessing, 48, this year pulled off a capital increase of 11 billion euro($14.6 billion), among the biggest ever in Germany.
The stock sale, a conversion of shares held by the government and excess capital enabled the Frankfurt-based lender to repay 14.3 billion euros of government aid in June. Blessing has pledged not to accept state funds again, even as Commerzbank comes under pressure to boost capital to meet tougher requirements.
European leaders are demanding banks bolster their capacity to withstand losses after financial firms agreed to accept losses on Greek sovereign debt. Commerzbank, told by the European Banking Authority last month that it may need 2.94 billion euros in fresh capital, may have to raise as much as 5 billion euros in a worst-case scenario, people familiar with the situation said last week. “If the bank’s capital requirements rise significantly, it would be very hard for Commerzbank to reach them with the traditional measures they have to hand,” said Michael Seufert, an analyst with Norddeutsche Landesbank Girozentrale in Hanover. “Taking state aid again would be the very last option they’d try as it would be seen as a signal of weakness.”

So subordinate bondholders beware as the article added:
"Commerzbank is exploring options including buying back hybrid bonds and placing sovereign holdings in an external entity, or bad bank, one of the people said. The goal remains to avoid taking state aid. The bank already announced plans to scale back risk-weighted assets and new loans, and to sell non-strategic businesses.
The bank may have to seek assistance from Germany’s Soffin bank-rescue fund, which the government plans to reactivate, if the EBA significantly raises its capital requirements, one person said last week.
Commerzbank’s consideration of putting sovereign debt into a bad bank was reported by the Financial Times on Nov. 25, while the Financial Times Deutschland said yesterday the bank is weighing buying back as much as 1 billion euros of hybrid bonds in exchange for new shares."

In our conversation "Goodwill Hunting Redux", we were expecting this eventuality of debt to equity to materialise:
"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."

As for mortgage insurer PMI we mentioned in our post "Credit Terminal Velocity", in August, where we discussed the future for the mortgage insurance business, it is indeed goodbye PMI.
By Mary Childs and Sapna Maheshwari, November 29 (Bloomberg):
"Bondholders are unlikely to recover as much as PMI Group Inc., the guarantor of U.S. home loans that filed for bankruptcy protection last week, indicated in its Chapter 11 petition, debt-market trading shows.
PMI, which pays lenders when homeowners default and foreclosures fail to recoup all of the mortgage debt, reported $225 million of assets and $736 million of debt as of Aug. 4 in its Nov. 23 filing. That means senior bondholders would get about 30 cents on the dollar. Credit-default swaps on Walnut Creek, California-based PMI signal a recovery expectation of 20 cents on the dollar for its senior bonds, according to data provider CMA. The company’s $250 million of 6 percent senior unsecured notes due in September 2016 traded at 22.75 cents on the dollar on Nov. 23
The insurer’s assets may have deteriorated since August, according to analysts at debt researcher CreditSights Inc. They said in a Nov. 27 note that the assets in the filing were higher than they are now and the company likely would be liquidated."

The Bloomberg team interviewed a fixed-income strategist on the subject:
"“The fundamental question behind whether a company can restructure or must liquidate in bankruptcy is whether that company has a viable business model,” Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott LLC in Philadelphia, said in an e-mail. “Whether PMI is able to restructure or ends up in liquidation is essentially a referendum on the mortgage insurance industry as a whole.” Mortgage insurance may not be a sustainable business because home prices have proven to move in sync, making it difficult for providers to diversify, he said.
If mortgage insurance pricing rebounds, PMI’s liquidation would reduce competition and allow for better conditions for those who remain such as Radian Group Inc. and Genworth Financial Inc., LeBas said."

Survival of the fittest...PMI 5 year CDS in upfront price, indicating the recovery for Senior bonds will be in the region of 26 cents to the dollar, definitely less than the assumed 40% recovery rate in the senior CDS - source Bloomberg:

On a final note I leave you with Bloomberg Chart of the day, showing that "Investors are shifting haven demand out of core Europe and in to foreign markets as the region’s debt crisis reaches its most fiscally sound nations, according to UBS AG."

"The CHART OF THE DAY shows the 120-day correlation coefficient between French and German 10-year yields and the euro-dollar has fallen from highs earlier this month. The correlation between U.S. Treasuries and the currency pair continues to increase as the common currency is sold to buy debt outside the euro zone. The measure for 10-year U.K. gilts also remains stronger than Germany and France."

"The only safe ship in a storm is leadership."
Faye Wattleton

Stay tuned!

Markets update - Credit - Bedtime story and the European issue of circularity

"Nothing is more frequently overlooked than the obvious."
Thomas Temple Hoyne

Volatility again today. We had a better tone in the morning in the European space credit wise, but we were back to flat at the end of the day. Following the G20, everyone expecting in a week's time big resolution coming out of the European summit. They should be bracing themselves for some disappointment.

As per Bloomberg article today by Tony Czuczka and Rainer Buergin:
"German Chancellor Angela Merkel has made it clear that “dreams that are taking hold again now that with this package everything will be solved and everything will be over on Monday won’t be able to be fulfilled,” Steffen Seibert, Merkel’s chief spokesman, said at a briefing in Berlin today. The search for an end to the crisis “surely extends well into next year.” Group of 20 finance ministers and central bankers concluded weekend talks in Paris endorsing parts of Europe’s emerging plan to avoid a Greek default, bolster banks and curb contagion. Providing a week to act, they set the Oct. 23 meeting of European leaders in Brussels as the deadline."

In this post we will have a look again at bank recapitalization, given it is still the ongoing subject, as a follow up on our previous discussion. We will also discuss the issue of circularity. We touched on the subject in our post - "Macro and Markets update - It's the liquidity stupid...and why it matters again..." in relation to European banks liquidity issues:
"The circularity issue weighting on liquidity:
In highly-indebted Euro zone countries, the issue of circularity comes from the high correlation with their sovereign creditworthiness, meaning they are experiencing very high level of stress on their current funding."

So here we go for another long conversation.

But first, a credit overview.
The Itraxx Credit Indices picture today - Source Bloomberg:

While the tone had been much positive at the open, on credit indices with at one point Itraxx Crossover 5 year index (High Yield) tightening by 23 bps, the market closed the day roughly unchanged, as equities moved from the positive territory to negative. German Finance Minister Wolfgang Schaeuble comments weighted heavily on the market by the end of European close.

Enel, Italy's largest power company came to the market with 2014 and 2015, with a new issue premium to secondary of around 50 bps for the 2014 bonds and a new issue premium of 90 bps for the longer tranche.

There was as well some resurgence in news issues in the financial space with an interesting 2 year Senior Unsecured Floating Rate note from Commerzbank, rated (A2/A/A+ outlook : stbl/neg/stbl), which priced at Euribor +158 bps. On the 12th of October SEB (Skandinaviska Enskilda Banken AB - A1 / A / A+) priced a similar note at around Euribor +120 bps.
We know from the post "Markets update - Credit - Misery loves company" that ABN Amro (Aa3 /A/A+ all stable outlook), priced a similar floater on the 30th of September at around Euribor +130 bps, as a follow up on Deutsche bank which priced at around +100 bps.

So no surprise there, new issues are not only repricing the secondary issues, but coming with big concessions given the need for banks to raise capital. It is interesting to note that apart from these 2 year Senior unsecured notes, for some prime issuers, it seems the subordinated market is still completely shut down.

In relation to flight to quality, convergence of German 10 year Government Yield and German Sovereign CDS seems to have stopped in its tracks - Source Bloomberg:

From 2.18% Yield to 2.08% on the 10 Year German Bund.

But the interesting part today was the new record set in terms of spread between the German 10 year Bond and the French 10 year Bond (OAT), which reached 95 bps - Source Bloomberg:

France still in the crosshairs of the European bond vigilantes.

The liquidity picture - Source Bloomberg:

Some improvement but nothing major so far.

And Nomura had a good comment relating to recent market action in their recent Rates Strategy Europe weekly from the 14th of October:
"Convalescence with relapse risk:
Beyond October, we are worried by the possibility of a relapse in market sentiment. There is ample scope for disappointment on the euro plan (see Euro plan: Bazooka or damp squib?). Our take is that the "bazooka" will not happen. But in a risk-on phase partly triggered by better economic sentiment, it would take a really disappointing announcement to immediately derail markets. In July, there was a very incomplete announcement in a very negative market; the background is different this time. So at this stage, we are not necessarily waiting for a major risk off, but we are aware of the risk of relapse in the aftermath. There are several triggers: (1) the PSI will be revisited with tougher terms, paving the way for a possible CDS trigger, (2) the political situation in Greece is very unstable and the Troika returns to Athens no later than end-November (assuming the next tranche is paid, the government has money only until January), and (3) it is not clear how the ECB's bond buying will continue and how the central bank will react to a GGB default (the collateral issue can be by-passed in the event of a temporary selective default; it would be more complicated with a CDS-triggering event)."
Ouch...so much for all the recent European politicians "Bedtime story"...

And Nomura to add relating to the periphery:
"The market has largely shaken off the recent euphoria over possible quick fixes to the Eurozone and sovereign spreads have come under pressure to some extent as a consequence. While many would look for a large scale solution on the horizon, from the possibility of extra IMF funds (possible with many caveats), to large scale recap of banks (obviously not a solution in and of itself), to various insurance schemes (which could come with practical and legal challenges), the likelihood of any single solution arriving imminently appears remote.

Against this backdrop we continue to believe that sovereign spreads that are unsupported by the ECB will come under pressure."

So, unfortunately, no Bazooka to be expected anytime soon.

And that leads us to the issue of circularity we previously mentioned. And, in relation to bank recapitalization, don't expect wizards, fairy tales and magic tricks in our "Bedtime story".
The issue of circularity we mentioned earlier again cannot be clearer than the graph realised by Martin Sibileau in his latest post - "The EU must not recapitalize banks":

And as indicated by Martin Sibileau:
"The circular reasoning therefore resides in that the recapitalization of banks by their sovereigns increases the sovereign deficits, lowering the value of their liabilities, generating further losses to the same banks, which would again need more capital."

To illustrate further the issue of circularity, here is a table from Bloomberg displaying Greek debt ownership:

The 6 top owners of Greek debt are 6 Greek banks.

And I have to agree with Martin Sibileau's view:
"What would be a solution for the EU? We have repeatedly said it: Either full fiscal union or monetization of the sovereign debts. Anything in between is an intellectual exercise of dubious utility."

And the clear difference between the ECB and the FED in relation to bond purchases is as follows, as pointed out by Martin Sibileau:
“…The Fed was financing what we call in Economics a “stock”, i.e.( mortgages) “…a variable that is measured at one specific time, and represents a quantity existing at that point in time, which may have accumulated in the past…”
"The ECB is financing “flows”, deficits, or “…a variable that is measured over an interval of time…” Therefore, by definition, we cannot know that variable until the interval of time ends…When will deficits end? Exactly!! Nobody knows! Thus, it is naïve to ask more clarity on this issue from the ECB. The only thing that is clear here is that the Euro, i.e. the liabilities of the ECB will necessarily have to depreciate as long as that interval of time exists, until a clear reduction in the deficits is seen…”
Stock and flows:
"Economics, business, accounting, and related fields often distinguish between quantities that are stocks and those that are flows. These differ in their units of measurement. A stock variable is measured at one specific time, and represents a quantity existing at that point in time (say, December 31, 2004), which may have accumulated in the past. A flow variable is measured over an interval of time. Therefore a flow would be measured per unit of time (say a year). Flow is roughly analogous to rate or speed in this sense."

And following the circularity, let's discuss current recapitalization issues as there were some interesting developments today namely involving subordinated Tier 1 debt.

BPCE, the French bank decided to launch a tender and offered to buy back subordinated bonds as much as 1.8 billion Euros of four subordinated hybrid securities:

Why so? Given we know that "access to capital is depending on growth outlooks", a cheaper way for a bank to beef up its Core Tier 1 capital is to buy back at a discount its Hybrid Subordinated perpetual bonds in the secondary market.

We discussed this very subject in the post "Markets update - Credit - Crash Test for Dummies":
"In 2009, the game was for weakly capitalised banks to quietly retire bonds at distressed levels to create/boost Core Tier 1 capital, which was precious as long as they could finance the purchase with term debt.

If a financial entity is able to buy back its LT2 debt below par, it generates earnings (the beauty of FAS 159, on that subject see my post "Statement 159 - Debt Valuation Adjustments - Déjà Vu 2008.") and then Core Tier 1 capital. It's a kind of magic...because this way a bank's total capital base goes down (by retiring LT2 debt) and given regulators care most about the Core Tier 1 ratio, everyone is happy (probably note the subordinate bondholder)."

and bingo! French bank BPCE strikes today!

And a market maker to comment following the BPCE tender:
"Very big moves in T1 space mainly driven by BPCE T1 tender which came approximately 13 points above secondary (for the low coupons bonds). The market rapidly drew the conclusion that similar moves would be coming on in French names - with a particular focus on low-cash, step-up bonds."

BPCE Tier 1 subordinated perpetual bonds indicative round up:
BPCEGP 4.625% 07/15 (call date) cash price - 61/64 +13.75 points
BPCEGP 5.25% 07/14 (call date) cash price - 62/65 +11 points
BPCEGP 6.117% 10/17 (call date) cash price 61/64 +9 points
BPCEGP 9% 03/15 (call date) cash price 78/80 +4 points
BPCE 9.25% 04/15 (call date) cash price 76/79 -

BPCEGP 5.25% 07/14 (call date) - Source Bloomberg

BPCE commented on its tender:
"The Tender Offer is being undertaken in order to further enhance the quality and efficiency of the Company's capital base."
Of course it is!

On a side note, FAS 159 is fashionable again in the banking space:
DVA/CVA in earnings:
UBS = 1.6 billion USD
JP Morgan = 1.9 billion USD
Citi = 1.9 billion USD
To be continued...(Bank of America, Goldman Sachs, Morgan Stanley, etc.).

And on a final note I leave you with Bloomberg chart of the day, showing that Asian stocks are yet to reach bear-market floors:

According to Bloomberg:
"Stocks in Asia excluding Japan may extend a bear-market rally for “several” weeks before resuming declines that could send them to new lows next year, according to Mizuho Securities Asia Ltd. The MSCI All Country Asia excluding Japan Index rebounded 13 percent in the six days through Oct. 13, following a 31 percent plunge from its April 28 intraday high. In the four previous periods when the Asian gauge dropped more than 30 percent from peak to trough closing levels since records began in 1988, all were interrupted by rallies of between 14 and 45 percent, before the routs resumed. A minimum drop of 20 percent from a peak signals to some investors a bear market."

"There cannot be a crisis next week. My schedule is already full."
Henry A. Kissinger

Stay tuned!

Markets update - Credit - Crash Test for Dummies

I had previously extended an invite for next post title, given one of the reader had already used my previous analogy relating to the "Chandrasekhar limit", but I have not received a suggestion yet. I felt the urge of posting an update after another eventful session today.

All credit indices went through the roof, once again:
Itraxx Crossover 5 year index (European High Yield - 40 companies in the index):

Risk of contagion is truly on, and Greece is drifting wider still, with two years notes yielding more than 60%.
For Greece, we already know the score with the central government's budget gap hitting 22% in the first eight months. The Greek goverment is now expecting the economy to contract by more than 5% in 2011, more than the 3.8% forecast by the European commission.

Here is the picture for Greece today:
Greek Yield one 1 year government bond - 117% yield:

Greek 2 year bonds yielding 63.4%:

Greek 10 year bonds, 21.87% yield:

Greece's fate is signed, sealed and delivered.

What caught my attention today was Italy's auction on T-bills with yields hitting a new three year record at above 4.153% from 2.959% a month ago. Contagion is still on.

And liquidity indicators were still worsening today,

But the deterioration seems to be accelerating still as the Euro-USD Basis swap 3 months indicator is telling us:

Banks have now 181 billions euros of deposits parked at the ECB, up from 152 billions when I wrote "Markets update - Credit - Crossing An Event Horizon" on the 5th of September:

So yes, flight to quality it is, and flight to quality we have. Correlation between 10 year Swedish government bonds and 10 year German government bonds is 1:

And financials, both in the equity space and in the credit space, took the brunt of the sell-off / widening today:
Itraxx Financial Senior 5 year index flying through 300 bps:

Itraxx Financial Subordinated 5 year index, widening faster:

This movement in credit indices was summarised by a dealer today as following. We had capitulation in the Financial Subordinate space and in relation to Financial Senior, the widening was strong but not sustained by flows. Size for hybrid Tier 1 trades was around 1 million euros, with significant downwards movement, 10 points down. In relation to High Yield volumes, they are very light. Whereas CDS so far had been leading the widening move, in last couple of days, cash has been underperforming CDS today.

In relation to bank capital structure, it is important at this juncture to go through the architecture, from the most senior to least subordinated bank debt.
Covered bonds backed by prime pool of loans are deemed senior to Senior debt.
Below senior debt, you have subordinated debt:
Lower tier 2 (LT2), Upper tier 2 (UT2), Tier 1 debt and finally equity (preferred shares).


And we know by now that European and UK banks face more funding pressures than US banks:


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 deffered 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.

A typical LT2 Structure is as follows:
10 years, non-callable for 5 years (10-NC5)
-Final maturity is hard, meaning no get out clauses.
-No coupon deferral. A coupon deferral would constitute a credit event and therefore trigger a credit event and the relating CDS.
-Ratings: 1 notch below senior debt (Moody's / S&P).
-More standardised structure than Tier 1 or UT2. Given regulatory capital treatment decreases as it moves towards maturity (as it gets closer to 5 years to maturity) so many deals structured have had callable features, meaning the issuer can decide to call the bond.

Why am I going through these details relating to Bank Capital structure? Simply because mister Market "sometimes" has a short memory span. On the 17th of December 2008, Deutsche Bank decided to skip the call option on a 1 billion euro LT2 bond. Not so good for their reputational risk at the time.

In 2009, the game was for weakly capitalised banks to quietly retire bonds at distressed levels to create/boost Core Tier 1 capital, which was precious as long as they could finance the purchase with term debt.

The big issue today is that we know from previous credit posts that they cannot at the moment issue term debt given current market dislocation and the only bonds which, so far have been issued, have been the most senior ones, namely covered bonds backed by pools of prime loans but by only for top issuers.

If a financial entity is able to buy back its LT2 debt below par, it generates earnings (the beauty of FAS 159, on that subject see my post "Statement 159 - Debt Valuation Adjustments - Déjà Vu 2008.") and then Core Tier 1 capital. It's a kind of magic...because this way a bank's total capital base goes down (by retiring LT2 debt) and given regulators care most about the Core Tier 1 ratio, everyone is happy (probably note the subordinate bondholder).

But, it is clear that not all banks have the same liquidity/funding costs, particularly today. So the game is going, once again to be as follows, remember: "The recent significant increase in credit spreads for many financials have been driven by the markets concerned about the ability of the weaker players to access credit at reasonable rates." (Macro and Markets update - It's the liquidity stupid...and why it matters again... ), banks with access to cheaper senior term funding than the cost of their outstanding LT2, for them, an early call could make sense, compared to the cost of issuing senior debt. For the others, I am not so sure...

Survival of the fittest.

And is this fully priced in the subordinate space? I don't think so, given borrowers are expected generally to repay subordinated bondholders at the first opportunity and the bonds are valued on that basis.

So, dear credit friends, I am afraid to say that, skipping calls, are going to happen, and will trigger losses because end of the day, why would you call a bond, if it costs you more to issue a new one?

This time is different? Nope. It is still deleveraging.

And my good credit friend agrees on the above, I am not alone:
"Do not forget that in 2008, when funding became an issue (and it is becoming an issue right now) Deutsche Bank decided not to call a LT2 bond at its call date, and all participants suddenly woke up to the reality that subordinated bonds could not be called.

Needless to say that it could and …… should happen again."

And given UK banks have just been given the ICB slap, recommending on ring-fencing retail banking and increasing loss absorbency, meaning lower ratings (downgrades), lower profitability and higher funding costs, this might bring some solace to their French counterparts (Moody's fear of downgrades), which recently have been at the receiving end of the cricket/baseball bat, you can expect additional widening unfortunately.


Until next time, I give you Bloomberg Chart of the Day, pointing towards additional pressure on the Euro:

Stay tuned!