Credit - Nimrod

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

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

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

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

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

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

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

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

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

"First bond tenders, then we will probably see debt to equity swaps for weaker peripheral banks with no access to term funding, leading to significant losses for subordinate bondholders as well as dilution for shareholders in the process." - Macronomics - 20th of November 2011.

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

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

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

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

-source Bank of America Merrill Lynch

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

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

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

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

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

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

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

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

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

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

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

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

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

- source Morgan Stanley

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

- graph source S&P Capital IQ

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

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

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

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

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

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

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

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

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

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

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

Stay tuned!

Credit - The European iterated prisoners' dilemma

"The only possible Nash equilibrium is to always defect. The proof is inductive: one might as well defect on the last turn, since the opponent will not have a chance to punish the player. Therefore, both will defect on the last turn. Thus, the player might as well defect on the second-to-last turn, since the opponent will defect on the last no matter what is done, and so on. The same applies if the game length is unknown but has a known upper limit." - source Wikipedia

In continuation to game theory references, given we recently touched on the subject in our conversation "Agree to Disagree", we thought this time around we would make a reference to the prisoners' dilemna. After all, in Europe, it is all about game theory, given than many pundits are arguing whether Germany will cooperate or not in resolving the on-going European woes, pledging its balance sheet in the process.

In game theory and in relation to our European iterated prisoner's dilemma we have :

"If it is supposed here that each player is only concerned with lessening his time in jail, the game becomes a non-zero sum game where the two players may either assist or betray the other. In the game, the sole worry of the prisoners seems to be increasing his own reward. The interesting symmetry of this problem is that the logical decision leads each to betray the other, even though their individual ‘prize’ would be greater if they cooperated. In the regular version of this game, collaboration is dominated by betrayal, and as a result, the only possible outcome of the game is for both prisoners to betray the other. Regardless of what the other prisoner chooses, one will always gain a greater payoff by betraying the other. Because betrayal is always more beneficial than cooperation, all objective prisoners would seemingly betray the other.

In the extended form game, the game is played over and over, and consequently, both prisoners continuously have an opportunity to penalize the other for the previous decision. If the number of times the game will be played is known, the finite aspect of the game means that by backward induction, the two prisoners will betray each other repeatedly.

In casual usage, the label "prisoner's dilemma" may be applied to situations not strictly matching the formal criteria of the classic or iterative games, for instance, those in which two entities could gain important benefits from cooperating or suffer from the failure to do so, but find it merely difficult or expensive, not necessarily impossible, to coordinate their activities to achieve cooperation." - source Wikipedia.

For now every European politicians in Europe seem to "Agree to Disagree", it looks to us increasingly probable that the outcome could be different to what is expected from Germany. The outcome for the European project is going to be rather binary. It is either "Federalism" or break-up. In fact it is Germany who has always pushed for more integration, more "Federalism". In September 1994 both Karls Lamers and Wolfgang Schauble from the CDU presented their project of accelerated integration to France. It entailed a faster integration within the European Union for Germany, France, Belgium, Luxembourg and Holland. France at the time was under "Cohabitation", Socialist French President Mitterrand had as Prime Minister Edouard Balladur from the opposing party, having lost ruling majority in the parliamentary elections leading to a political stand-off which lasted for two years. The European game is therefore in the political French camp. President François Hollande having garnered a strong political support in the recent parliamentary elections, it will be interesting to watch if French politicians will indeed accept to lose their powers for the collective good, or, if they decide to cling on their individual mandates and powers and a "Federal Europe" will not happen. Will the French surrender again? We dare to ask, staying politically correct in our conversation ("Cheese-eating surrender monkeys", being a derogatory description of French people that was coined in 1995 by Ken Keeler, then-writer for the television series The Simpsons).

Looking at the "social-clientelism" mentality which has prevailed in French politics in the last 30 years, and given the trauma stemming from the European 2005 referendum, one has to posit the French willingness in moving towards a full lasting Federal European Union.

While many are comparing the need for Europe to evolve in a comparable way to the evolution of the United States towards a full Federal Union. We do not have to go that far to find a more relevant example to the current European plight. In fact as our good credit friend mentioned in one of our most recent conversation, he pointed rightfully towards...Switzerland! The Federal Constitution adopted in 1848 is the legal foundation of the modern Swiss federal state. It is among the oldest constitutions in the world.

There are three main governing bodies on the Swiss federal level: the bicameral parliament (legislative), the Federal Council (executive) and the Federal Court (judicial).

Europe already has all three.

"The Swiss Parliament consists of two houses: the Council of States which has 46 representatives (two from each canton and one from each half-canton) who are elected under a system determined by each canton, and the National Council, which consists of 200 members who are elected under a system of proportional representation, depending on the population of each canton. Members of both houses serve for 4 years. When both houses are in joint session, they are known collectively as the Federal Assembly. Through referendums, citizens may challenge any law passed by parliament and through initiatives, introduce amendments to the federal constitution, thus making Switzerland a direct democracy.

The Federal Council constitutes the federal government, directs the federal administration and serves as collective Head of State. It is a collegial body of seven members, elected for a four-year mandate by the Federal Assembly which also exercises oversight over the Council. The President of the Confederation is elected by the Assembly from among the seven members, traditionally in rotation and for a one-year term; the President chairs the government and assumes representative functions. However, the president is a primus inter pares with no additional powers, and remains the head of a department within the administration." - source Wikipedia.

The Swiss cantons also have a permanent constitutional status and, in comparison with the situation in other countries, a high degree of independence. Under the Federal Constitution, all 26 cantons are equal in status (pari-passu...). Each canton has its own constitution, and its own parliament, government and courts. Switzerland also boasts, in similar fashion to the US, a Federal Supreme Court.

So could it be France derailing the whole European project in the end rather than Germany? We wonder.
But we ramble again, erring on the political side. Time for our credit overview, revisiting our pet subject of bond tenders and the ongoing issues in the peripherals, particularly in Spain, given we recently received the results for the Spanish Bank Recapitalisation independent estimate and 62 billion is the number.

"The Gap is closed" we indicated on the 16th of June in relation to the European space. Now both the Eurostoxx and German 10 year Government yields seems to be moving in synch, lower that is while credit spreads for financials as indicated by Itraxx Financial Senior 5 year CDS index is moving wider following rating agencies multiple downgrades and on-going concerns on peripheral sovereign yield levels - 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:

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

Last week Spanish risk premium reached a new historical high breaching easily the 7% level, with renewed concerns on Spanish banks given the rise in Spanish bad loans. (reaching 8.72% in April from 8.37% in March).

As Societe Generale clearly indicated in their recent global research alert, the markets have indeed lost confidence in Spain:

The challenge European leaders face at the 28-29th June summit is to come out with a big plan as indicated in their recent note by Societe Generale: "Comprehensive restructuring of the economy/the banking sector is  required to restore market confidence....due to a rise in national and regional public debt...".

Indeed, Government debt to GDP could reach 90% of GDP in 2012:

"Spain’s budget deficit is expected to end 2012 at 5.3%, vs 8.9% in 2011, so government debt could reach 90% of GDP this year. On top of that, Spain holds a rising amount of regional debt (which has doubled since December 2008) and contingent liabilities, such as the FROB (Fund for Orderly Bank Restructuring). Taking into account these two elements and the current recession in Spain, debt could rapidly reach unsustainable levels." - source Societe Generale.

Unfortunately, Spanish property market and bank restructuring go hand in hand and as many pundits have indicated, Spanish property bubble and deleveraging has yet to start effectively as indicated by the below graph from Societe Generale:

"House prices could decline by a further 20-25% in an adverse scenario (see last week’s results of the independent evaluation of the Spanish banking sector)." - source Societe Generale.

The Spanish Test Assumptions:

The Stress Test Property Assumptions may not be aggressive enough - source Bloomberg:

"A 19.9% yoy drop in Spanish house prices for the adverse scenario could easily be exceeded if confidence is not restored by the recently announced bailout. At 1Q, yoy declines ranged between 7% and 12% depending on the source, while from 1Q08 highs, house price declines total 21%. Should this rate of deterioration continue, the 4.5% 2013 forecast decline may prove conservative." - source Bloomberg.

The results from the independent audit, the Spanish Assumptions at least looks credible for retail, for corporate less so, according to Bloomberg:

"A 6.8% contraction of lending supply for 2012 and 2013 looks reasonable for retail lending when compared with experience through the crisis. A 6.4% and 5.3% decline for corporate loan supply looks far less cautious when considering that January 2012 data showed a 6% yoy drop, before sovereign fears heightened." - source Bloomberg.

Another issue with the results from the Spanish Test Assumptions comes from the GDP worst case scenario retained no lower than 2009 experience as shown by Bloomberg:

"A decline of 4.1% in Spanish GDP for 2012, the adverse scenario used in the stress test, is less severe than the 4.4% yoy drop of 1H09. While this scenario is calculated from a lower absolute GDP base, it is key for bad-debt experience, unemployment and credit supply. Coordinated EU action is needed to drive long-term interest rate assumptions lower." - source Bloomberg.

We do not want to be seen as party spoilers, but as we posited in relation to the numerous EBA (European Banking Association) test for financial institutions, no test, no stress, no stress, no test...

No wonder Spanish Financial CDS has been on widening trend - source CMA:

Unless significant steps are taken in the next European summit, and we mean "shock and awe", given Spain and Italy have significant funding needs until 2014, the game might be coming to an end leading to the defect of some players in the process of our "European iterated prisoners":

- source Societe Generale.

From this similar Societe Generale note, higher loan delinquencies and low industrial production are the main risks:
"Risk 1: Spanish loan delinquencies, back to the 90s
-Spanish bank delinquent loans increased again to 8.72% in April, from 8.37% in March, thereby reaching an 18-year high. This trend is likely to
persist as unemployment and bankruptcies continue to rise.
-Acceleration in number of delinquent loans means Spanish banks are likely to suffer from increasingly larger losses in the future
-Report carried out by two consulting firms estimates Spanish banks' capital shortfall at up to 62bn euros.
Risk 2: European industry deteriorates
-Eurozone industrial production fell 2.3% compared to the same month last year, driven down by the southern Europe countries.
-If the Eurozone fails to undertake the necessary structural reforms, the northern European countries could get drawn into southern Europe’s downward spiral.
-In contrast, US industry has remained quite resilient since the beginning of the year, with total industrial production in May up 4.7 percent yoy."

We will not delve again into the difference between "Stocks and Flows" central to our thought process namely the United States and Europe growth differentiation as we already touched on this subject in our conversation "Growth divergence between US and Europe? It's the credit conditions stupid...".

Moving on to our pet subject of subordinated bond tenders, as at some point, as we argued recently (Peripheral Banks, Kneecap Recap), losses will have to be taken, it is all going Dutch, Dutch auction that is. While ailing Portuguese bank BCP (Banco Comercial Português) announced on the 20th of June a bond tender relating to mortgage backed securities, BBVA bought back some asset-backed bonds too on 26 senior and 25 mezzanine portions of bonds backed by consumer loans, mortgages and business loans, with prices ranging from 46 to 95%. All part of "liability" management exercises to raise some capital and strengthen the capital base, meaning more pain for bondholders in the process.
While the 62 billion being the estimated amount earmarked by independent consultants Oliver Wyman and Roland Berger, burden sharing is currently being considered with the European Union in respect to a 100 billion euro rescue package for the Spanish financial system.

"The government in Madrid is also considering giving more power to the national regulator to restrict sales of loss-absorbing securities such as preferred stock to individuals, said the person. De Guindos has said that preference shares shouldn’t have been sold to retail investors.

Supervisors “failed” over the sale of preference shares to retail investors, said De Guindos June 5 in the Senate.

Spanish lenders sold 22.4 billion euros ($28.2 billion) of preferred stock to individual investors through retail branches. Banks have offered clients holding most of that amount to swap the securities into common stock or other subordinated instruments, according to data compiled by CNMV, the financial markets supervisor." - source Bloomberg

We correctly foresaw this process for weaker peripheral banks.

"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.

We wrote in October 2011 relating to bond tenders and the move towards debt to equity swap:
"We expected others to follow suit and given the difficulty for the weaker players in the peripheral space to access capital at a reasonable rate, as well as needing to boost their core Tier 1 capital base, it was of no surprise to see Portuguese bank Banco Espirito Santo following French bank BPCE in tendering some of its subordinated debt on the 18th of October, but this time around, we have a debt to equity swap."

It is still a game of survival of the fittest, even for some Italian banks, given Monte dei Paschi di Siena (MPS), Italy’s third-biggest bank, according to December 2011 EBA exercise, had a capital shortfall of Euro 3.3 billion. The bank, which must also repay 1.9 billion euros of state aid provided in 2009... Monte Paschi may use the government’s aid program, the so-called Tremonti bond, as part of its plan to boost capital by end of June 2012 (9% Core Tier 1 Capital), Il Sole 24 Ore reported. Also, S and P put MPS’s ratings on Watch Negative citing pressure on the bank’s financial position from a combination of deteriorating asset quality metrics, weakened earnings, and low financial flexibility. Separately, the main shareholder of MPS, the Monte Paschi Foundation has reportedly reached an agreement with its creditor banks to restructure its debt. S and P placed its 'BBB/A-2' L-T and S-T counterparty credit ratings on Italy-based Banca Monte dei Paschi di Siena SpA (MPS) on CreditWatch with negative implications. Agency also put all of its ratings on MPS' subordinated, junior subordinated, and hybrid debt issues on CreditWatch negative. The rating action reflects S and P’s view as the convergence of various negative pressures on MPS' financial profile. Monte Paschi First-Quarter profit fell 61% on higher write downs and has a market value of around 2.8 billion euros. MPS is considering selling its 2.5% stake in the Bank of Italy to the central bank to reach the June 2012 threshold.

As indicated by Bloomberg, Italian corporate and household bad debt totaled 109 billion euros ($138 billion) in April, an increase of 15 percent from a year earlier, according to Bank of Italy data.

Non-performing loans rose to 5.4% in March, up from 3% in June 2008, according to Italian Banking Association data. Impairments, excluding writedowns, rose to 58 billion euros from 50 billion euros. CDS on UniCredit, (Italy's largest bank) rose to 532 basis points on June 19 from 292 on March 19, according to data compiled by Bloomberg.

With unemployment rate at 10.2% in April the highest in most than 12 years, Italian banks as well as their Spanish peers are facing economic deterioration facing but are not plagued by housing related issues and high household private debt levels.

If it could be of any solace to European Banking woes, the new capital regime for US Banks will as well trigger at some point some "liability" management exercises namely bond tenders as indicated by CreditSights in their note - US Banks - The New Capital Regime - Bonjour Basel - 24th of June 2012:

"US banking regulators released proposals for new capital rules for banks aimed at complying with Dodd-Frank Basel III. The new guidelines apply to all US banks with some variations/differences for banks over 50 billion USD in assets and were mostly in-line with expectations.

The new guideline call for higher levels of capital, which could make the financial system safer but also reduce returns and cause banks to reassess their balance sheets. They believe that new requirements fortify the banks’ ability to absorb losses and withstand a potential systemic shock, which is a positive for fixed income investors and both positive and negative for equity.

US banks will now have a new set of minimum capital requirements, incorporate additional capital buffers and limitations outlined in Basel III and phase-out trust preferred securities in accordance with the Dodd-Frank Act. When the new limits are fully phased-in, banks are required to maintain a common equity Tier 1 ratio of 7% and Tier 1 ratio of 8.5%, including a capital conservation buffer of 250 bps. The limitations and changes to risk weights could influence business decisions including lending and mortgage servicing.

Trust preferred securities are phased-out reflecting the requirements of the Dodd-Frank Act.

Non cumulative preferreds continue to receive Tier 1 capital treatment and could make up the majority of non-common equity Tier 1 capital. As a result, they expect issuers and investors to focus primarily on preferreds to address their non-common equity Tier 1 Capital and yield needs, respectively."

On a final note Money Markets wager ECB will cut deposit rate as indicated by a recent Bloomberg Chart of the day:

"The CHART OF THE DAY shows that the Eonia-OIS measure, which estimates interbank borrowing costs over the next three months, fell below the 25 basis points the ECB pays for deposits. The last two times this happened the central bank cut the rate within two weeks." - source Bloomberg

"There are few ironclad rules of diplomacy but to one there is no exception. When an official reports that talks were useful, it can safely be concluded that nothing was accomplished."

John Kenneth Galbraith

Stay Tuned!

AAA ratings - 10 little indians...and debt deflation (why Irving Fisher is right).

The title of this post is a refence to the wonderful book by Lady Agatha Christie written in 1965, as there are only 15 countries left in the world with AAA rating at Standard and Poor's, and four from the G7, Germany, France, United Kingdom and Canada.

In my previous post, "AAA, the most endangered rating, regulating the rating agencies and Basel III", In June 2010, I was expecting more downgrade to come. I am not going to go through the analysis made in relation to the much needed regulations of the rating agencies as I did it in the post mentioned above. In relation to my well founded critics of the rating agencies, I also discussed how the rating agencies behaved in 2008 and 2007 in the following post: Markets and Macro Update - Dude where is my Risk?

The downgrade of the mighty USA by S&P to AA+ is a significant event because it can have significant consequences if S&P follows up with Germany, France and Italy. It could in effect, destabilise completely the EFSF funding vehicle and render it powerless if Germany, France and Italy gets dowgraded.
So, have we crossed the Rubicon?

As a reminder from my post "Europe, The end of the Halcyon days", this is the amount owned to Germany:

European debt map:

European countries cross border exposure:

In November 2010 in "The European Vortex" post, I went through the analysis of the EFSF. I stated at the time:
"There is 440 Billions Euros available (probably less given its similar resemblance to a CDO structure). Clearly not enough to bail out everyone. If the EFSF wants a AAA to issue bonds to fund the oncoming bailouts, it will need to overcollateralize to 120% and maintain a cash buffer. It cannot lend against backing of troubled nations. The more countries in trouble, the smaller the pot available for bailing out countries in trouble, simple as that. Given Austria is witholding already its funding for Greece, the entire unity of the European Union is being tested."

Therefore, it S&P follow up on the downgrade of the USA and start downgrading the core members of the EFSF structure, such as Germany, France and Italy, the whole structure is in trouble.

The EFSF mechanism:

The reserves held by the EFSF needs to be invested in AAA paper.

I previously argued that "a way of reducing the burden of debt for peripheral countries, would be to create a European Compensation house and to do some debt compression. They would need to allow creditors to swap the debt of peripheral countries into more solid Euro-bonds issued at the ECB level, provided there is a haircut on the existing peripheral debt". The latest proposed plan for Greece involves small haircuts, bond buy backs, reduced coupon and maturity extension as well as debt swaps, but so far no mention of Euro Bonds. Time is running out and we need decisive action from European politicians.

The economic picture for the US is already bleak, and the downgrade of the US, will indeed raise the cost of funding, not only for the US as a country, but for the banks and agencies, as you can expect, some rating actions following this decision by S&P.

In past crisis when Velocity dropped significantly, recession occurred, as I posted in "Nightmare on Main Street - The impact of the rise of energy and food prices on US Households".

And velocity is dropping, confirming we are heading for a double dip in the US. In the monetarist theory deflation is associated with a fall in the velocity of money. We are in a credit deflationary environment, comparative to the Great Depression and Japan.

Irving Fisher's theory has been largely ignored by our keynesians friends at the FED. It is of no surprise given that Ben Bernanke largely ignores its influence and wrote in 1995:
"Fisher's idea was less influential in academic circles, though, because of the counterargument that debt-deflation represented no more than a redistribution from one group (debtors) to another (creditors). Absent implausibly large differences in marginal spending propensities among the groups, it was suggested, pure redistributions should have no significant macroeconomic effects."
Ben Bernanke is wrong.
"Bernanke's dismissal of debt deflation is criticized as improperly applying the theory of general equilibrium – in equilibrium, marginal redistribution of income produces no macroeconomic effects, but financial crises are characterized by not being in equilibrium and markets failing to clear – debt ceasing to grow and instead falling, debtors defaulting, rising unemployment – and thus, it is argued, equilibrium analysis is inapplicable and misleading."
Ben Bernanke also added in 1995 about Fisher:
"Fisher envisioned a dynamic process in which falling asset and commodity prices created pressure on nominal debtors, forcing them into distress sales of assets, which in turn led to further price declines and financial difficulties."
For Keynesians, the fall in aggregate demand caused by falling private debt can be compensated by growth in public debt, a government credit bubble. It isn't working.
Here comes Irving Fisher solution for the debt deflation situation - Forward Tax Receipts.

Forward Year Tax Receipts

"Recognizing that the federal government issues liabilites (debt) in its own currency and thus can never go bankrupt, another solution is for the federal government to become more like the corporate capital markets with debt issuance at high real interest rates and equity like issuance at even higher real rates of appreciation. The likely candidate for equity like issuance by the federal government is forward year tax receipts. A forward year tax receipt is a receipt for taxes paid in advance that are due some time in the future. Like government debt issuance, forward year tax receipts have a rate of appreciation and a duration. Unlike, government debt, the rate of return is not guaranteed. The realized rate of return is totally dependent on the owner's future income and subsequent tax liability. And so savers are rewarded with a positive real rate of return and debtors can realize an after tax cost of credit that is significantly less. For instance if the federal government sells 30 year debt with a 3% real rate of return and sells forward year tax receipts with a potential 7% real rate of return, then a debtor can realize a -4% cost of credit. At that point inflation is not required nor should it be desired."

For those interested in the subject, I encourage you to review the post "The inflation debate or why you can have inflation in a deflationary environment" on the subject of the Austrian Business Cycle theory and Fisher's contribution to the debate.
"Debt deflation has been referred to alliteratively as the "D-process" by Ray Dalio of Bridgewater Associates, who suggests it as the template for understanding the financial crisis of 2007–2010."

In the post "Low rates environment and the risk of evergreening à la Japanese", I 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."

I can see a solution for the US deflation thanks to Irving Fisher equation of exchange.

Macro and Markets update - Combat stress reaction (CSR), the Danish standoff and much more!

Combat stress reaction (CSR) or post-traumatic stress disorder. It is probably what most are feeling after an epic month of July.

From the dowgrades of Portugal, additional dowgrades on Greece and Ireland, contagion to Italy, ongoing debt ceiling debate in the US, European banking stress tests,new European plan for Greece, poor economic data, and now threat of downgrade on Spain from Moody's, I am glad it is the end of the month and the week-end.

On Friday we have had some poor data coming out of the US in relation to GDP. The stand off goes on for the US debt ceiling goes on and we had Moody's adding some extra spice whith a threat of downgrade on Spain. And of course in that relaxed and friendly environment, Gold is making new highs.

Can someone please press pause?

Markets update:
Sovereign 5 year CDS in core countries, Denmark starting to feel the heat...

Denmark's sovereign CDS is now at 86.83 bps, rising 18.29%, widening by 13.43 bps according to CDS data provider CMA.

Update on the Danish situation:
Denmark's risk perception has reflected by the CDS market, has been increasing after S&P said that as many as 15 Danish banks could default.
Denmark is at war with the rating agencies. Very recently Danske Mortgage Unit sacked Moody's and declared it might hired Fitch:

Danske Unit Sacks Moody’s, May Hire Fitch - Bloomberg
On the 23rd of June, another Danish banked at sacked Moody's:
"Realkredit Danmark sacked Moody’s on June 23 after being told to provide an extra $6.14 billion in collateral to keep its covered debt graded Aaa."

The fight is on.
"Moody’s argues that Denmark’s adjustable-rate mortgage bonds represent a bigger refinancing risk because they, unlike other Danish covered bonds, don’t match the maturities on the loans linked to them. The adjustable-rate bonds tend to have maturities of one to three years compared with an average loan maturity of 20 to 30 years."
Fact is Denmark has one of the best mortgage system in the world.

The issues relating Danish Mortages bonds are tied to BASEL III. Will the EU classify danish mortgage bonds as highly secure and liquid (level 1 securities) like government bonds?
Denmark has the third largest mortgage bond market after the United States and Germany. Excluding Danish Mortgage Bonds from "Level 1" securities would trigger a sell-off and put the entire Danish Banking system under pressure (the current liquidity pool of Danish banks is made of 85% of Danish Mortgage Bonds and only 15% of Government bonds).

So far the EU has postponed its decision until 2015:

EU postpones key decision for Danish mortgage bonds - Reuters

The rating agencies are taking a very agressive stance relating to the Danish Mortgage Bond markets which is not entirely justified given the ongoing discussions between the EU and Denmark about its very specific and unique banking system.
As a reminder, the Danish mortgage markets is based on the "Principle of Balance":
Every mortgage is instantly converted into a security of the same amount and the two remain interchangeable at all times. Homeowners can retire mortgages not only by paying them off, but also by buying an equivalent face amount of bonds at market price. Because the value of homes and the associated mortgage bonds tend to move in the same direction, homeowners should not end up with negative equity in their homes. The Danish model, which has withstood many tests since it was brought into existence after the great fire of Copenhagen in 1795. For more on the subject of mortgage systems, and housing, you can check previous post "Are Fannie Mae and Freddie Mac on the path to a crash à la Thelma and Louise?"

Back to our market update!
The SOVx, which represents the index for Sovereign risk in Western Europe and comprising 15 countries including Greece, is drifting wider again:

Same story for the index representing corporate credit risk, Itraxx Main Europe 5 year index (containing 125 names rated at least investment grade):

But in relation to corporate leverage and debt, although companies are already facing margin compressions due to rising commodity prices, company debt in 2012 will slide to its lowest level since 1996 according to a study made by Societe Generale. Some are still deleveraging but most are sitting on a pile of cash and have managed to control and reduce costs (lean and mean?).

Source: Company Debt in Europe Will Slide to Lowest Since 1996: Chart of the Day - Bloomberg.

"Companies’ net debt as a proportion of earnings before interest, taxes, depreciation and amortization will fall its lowest level since 1996 next year, according to Societe Generale."

"The ratio of European companies’ debt to Ebitda will fall to 0.8 in 2012, according to Societe Generale. The last time that corporate debt dropped below Ebitda, European stocks rallied 154 percent over the following five years."

But at the same time, there is a lot of uncertainties due to sovereign issues, with the ongoing European debt issues and the current US debt ceiling debate.
The US 1 year CDS spread is now trading above the 5 year point, although the curve is inverted, there is no need to panic given the level of the spread indicates a very low probability of default (around 6% over 5 years):

But with the ongoing turmoils, "Risk off" is still the game "du jour".
Vix climbing up steadily, not yet reaching March levels but getting close:

Time for some Macro updates:
The great shock was the release of the US GDP figures for the second quarter as well as the revised figure for the first quarter. Truly appalling. GDP climbed 1.3% at annual space, from an median forecast of 1.8%, but following a 0.4% revised gain in the prior quarter! Revisions to GDP figures indicates that the 2007-2009 recession shrank 5.1% from the fourth quarter of 2007 to the second quarter of 2009, compared to a previously reported 4.1% drop. The second worst contraction in post WWII era was a 3.7% decline in 1957-1958 according to Bloomberg.

Household purchases, which represent 70% of the GDP rose at 0.1%. Slower job growth increases the risk for the second semester. Next week employment figures with the NFP (Nonfarm Payrolls) will be essential and so will be the ISM figures release. There is an increased risk of double dip for the US economy. Massive spending cuts would strike another blow to a faltering US economy.
I pointed out we had stagflation in the UK in my previous post, the US is as well stuck in a stagflationay environment.

The Chicago ISM's business barometer fell to 58.8 in July from 61.1 in June. Figures above 50 signal expansion. The median forecast was for a 60 print.

The US debt ceiling debate will certainly add on company's reluctance to hire in this environment.

So, yes it still "Risk Off" for the time being.

To be continued...

Markets update - Credit - Rates - Equities - Dude where's my flak jacket?

That Subprime contagion feeling in the market for the last two days...

Huge movements in the European government bonds space.
In the two year bucket in the morning:

Italy and Spain getting punished, wider respectively on the 2 Year notes by 32 bps and 30 bps.
Italy 2 year notes is wider by 272 bps this year so far.
Spain is wider by 174 bps so far this year.
In the 10 year bucket in the morning:

France is wider by 75 bps versus Germany on the 10 year government bonds. This is getting interesting. Portugal and Ireland, correlation is super close to 1, on both the CDS and the 10 year yield level, respectively yielding 12.28% on the 10 year and 12.747%.

The 5 year Sovereign CDS picture is even more blatant on today's price action:

France is drifting away from the core European countries and its 5 year CDS level at some point today was being quoted 115-120 bps on the 5 year level, bringing it to the same level Italy reached back in April this year.

In relation to Portugal and Spain, the 5 year CDS spread for Portugal is continuing its meteoric rise:

At 1200 bps, things are turning ugly.

When it come to Credit indices - here is a snapshot of this morning main credit indices levels:

Crossover indices wider by 30 bps on the 5 year.
Itraxx Financial 5 year Senior close to 200 bps whereas Itraxx Financial Sub 5 year at 345 bps, 145 bps wider than the Senior Index level.
Sovx Western Europe touching a new high at 310 bps on the 5 year level, bearing in mind Greece is 1/15th of the index, also affected by the widening of Portugal, Ireland, Spain, Italy, France and co.

From a Macro point of view, interesting to see in the SovX indices, that Western Europe is currently trading 170 bps wider than Asia Pacific and 70 bps wider than CEEMEA (Central Europe and Middle East and Asia).

And Moody's keeps piling it on, Ireland just cut to junk (Ba1 from Baa3) with negative outlook.
"The key driver for today's rating action is the growing possibility that following the end of the current EU/IMF support programme at year-end 2013 Ireland is likely to need further rounds of official financing before it can return to the private market, and the increasing possibility that private sector creditor participation will be required as a precondition for such additional support, in line with recent EU government proposals."
Cut and paste from the 5th of July Portugal downgrade note from Moody's?

In a related rating action, Moody's has also today downgraded by one notch to Ba1 from Baa3 the long-term rating and to Non-Prime from Prime-3 the short-term rating of Ireland's National Asset Management Agency (NAMA), in charge of dealing with the toxic assets previously transferred from the banking sector.

Also in the news, a selective default for Greece according to an official speaking on the sidelines, is no longer off the table. Germany inflation rate held at 2.4 percent from May. UK inflation came out at 4.2% in June year on year, smallest rise since March 2011, but only a temporary respite.

QE3 more likely? At least that's what the latest price action in Gold would suggest, reaching a new high of 1577 USD and the trade deficit in the US reached 50.2 billion USD in May (Oil and China factors).

And equities? Well, major roller coaster day, financials and insurers, leading the downward price action for the last two days, more of the same today.

FX also very agitated with USD/JPY at 79.4205, down 1.05% on the day.
EUR/USD down to 1.3973, a 0.40% drop.

Sticky gum deal of the day:

It looks like New-York Attorney General Eric Schneiderman has sent letters to 20 companies including Goldman Sachs, BlackRock in relation to their participation in the 8.5 billion USD mortgage settlement agreement between Bank of America and Bank of New-York Mellon Corp. But, at least Bank of America has reached a settlement on Monday with Bond Insurer MBIA Inc. relating to insurance-like products sold by Merrill Lynch previously to MBIA Inc.
Bank of America hit a fresh new 52 weeks low at 10.20 USD on the news.


Who said summer was nice and quiet?

Markets and Macro Update - Dude where is my Risk?

Trigger happy rating agencies strike again.

4 notches downgrade yesterday from Moody's for Portugal straight from Investment grade to junk. Moody's clearly in a downgrade mood, racing against S&P in the cutting contest...It's getting nasty.

Same rating agencies that were handing out AAA ratings like candies on dodgy structured credit transactions before 2008 (can you spell Abacus?), collecting big fees paid by the investment banks.

As a reminder: 11 Apr 2007 – Landsbanki received a 5 notch upgrade, from A2 to Aaa, when Moody's announced its new JDA rating methodology on 24th of February 2007. We know what happened to Landsbanki bank in Iceland. Can you spell default? This was one year after Icelandic banks experienced a liquidity scare and their 5 year CDS went through the roof in 2006.

JDA analysis: Moody’s fights back - Risk.net

And it wasn't only a joke on Landsbanki's rating...

"Glitnir was one of three Icelandic banks that found themselves at the centre of the JDA furore after receiving multi-notch upgrades that placed them above European heavyweights such as ABN Amro. Glitnir was promoted from A1 to Aaa in the first round of the JDA rollout on February 23, and then down to Aa3 when the refined methodology came out in April."

Funding was the issue for Icelandic Banks, the market knew it at the time, except Moody's:

Icelandic Banks - Not what your are thinking - Merrill Lynch - 7th March 2006.

And the rating agencies are failing again:

Iceland Credit Raters Miss Resurrection After Failing to Predict Collapse - Bloomberg

"While Moody’s kept a Aaa rating on Iceland until five months before its banks collapsed, reluctance to raise the island’s credit grade now is blocking the country’s access to a broader investor base. Debt derivatives show the low ratings may be unwarranted as credit default swaps on Iceland indicate it’s less likely to default than euro member Spain."

"CDS on Iceland’s debt have eased 14 percent this year. Contracts on five-year debt were 229 basis points last week, compared with 257 basis points for Spain, the fourth-largest euro member."

But back to the Portugal story:
Two-year Portuguese yields jumped 3.8% points to a new record high of 16.74%.

Leading to European Banks stocks getting hit and CDS 5 year spreads widening as well.

Ireland and Portugal 5 year CDS, displaying a correlation of 1 and moving up in tandem. Here is the picture, courtesy of CMA:


And the picture for the rest of Europe - wider:


Contagion to Italy?


Portugal Sovereign CDS wider than some Portuguese corporates:


Portugal and Ireland cumulated probabilities of default according to their respective 5 year CDS levels amount to around 50% chance.

CDS market watch: Think you are protected on Greek default risk because you're long CDS protection? Think again...

Greek debt rollover plan unlikely to be credit event-ISDA - Reuters

"Current proposals tabled by France to involve the private sector in sharing the burden of a second bailout for Greece are unlikely to trigger the payout of default insurance, ISDA's general counsel David Geen told Reuters on Monday."

Macro picture:
US ISM Non-Manufacturing PMI, not 53.9 verus previous number of 54.6.

China raised its benchmark interest rates for the third time this year, to 6.56 percent from 6.31%. The nation’s first audit of local-government debt found liabilities of 10.7 trillion yuan (1.7 trillion USD) at the end of 2010 and warned of repayment risks. The heat is on...but The World Bank forecasts the Chinese economy will expand 9.3% this year, compared with 8%for India, 2.6% for the U.S. and 1.7% for the euro area.

Good news for Estonia upgraded to A+ by Fitch. The rating is the second-highest in eastern Europe, behind the Slovenia at AA and on a par with the Czech Republic and Slovakia. Estonia’s 19 billion USD economy grew 8.5% from a year earlier in the first quarter of 2011.

Estonia’s Credit Rating Raised to A+ by Fitch on Economy, Public Finances - Bloomberg

"The government implemented austerity measures equal to 9 percent of GDP in 2009, preventing the budget shortfall from ballooning and keeping the country on course to adopt the euro. Estonia had the EU’s only budget surplus, 0.1 percent of GDP, and lowest public debt, 6.6 percent, last year."

Follow up on previous post "Stuck in the middle with you" part.
Bank of America's 8.5 billion USD settlement on Countrywide legacy mortgages with players like BlackRock, Pimco, New-York Fed and co, looking increasingly in jeopardy:

Primary Prosecutors of Mortgage Fraud? Pension Funds And Plaintiffs’ Lawyers - "Just when you think you’re caught up on all the troubles Bank of America is having with mortgage-related fraud, there’s another story. A group of bondholders calling themselves Walnut Place challenged the bank’s most recent settlement with bondholders for $8.5 billion."

Walnut Place, the nutcrackers:


Bond investors challenge $8.5bn BofA settlement - by Suzanne Kapner

“…The Walnut Place investors said that as many as two-thirds of the loans in two Countrywide trusts failed to meet underwriting guidelines, according to their own investigation. Extrapolating that failure rate to the 530 trusts covered by the bank’s settlement, the Walnut Place investors concluded that BofA could be liable to repurchase loans with unpaid principal balances of as much as $242bn.”

Bank of America stock currently 2.59% to 10.71 as I write this post.

July 19, 2011, we will get Q2 2011 Bank of America Corp Earnings Conference Call.
To be continued...

Liar's Poker winner à la Michael Lewis way: Goldman Sachs

Goldman Took Biggest Loan in Fed Program - Bloomberg