Credit - The Raft of the European Medusa

"The man who has experienced shipwreck shudders even at a calm sea."
Ovid

"The Raft of the Medusa (French: Le Radeau de la Méduse) is an oil painting of 1818–1819 by the French Romantic painter and lithographer Théodore Géricault (1791–1824). Completed when the artist was 27, the work has become an icon of French Romanticism. It is an over-life-size painting that depicts a moment from the aftermath of the wreck of the French naval frigate "Méduse", which ran aground off the coast of today's Mauritania on July 5, 1816. At least 147 people were set adrift on a hurriedly constructed raft; all but 15 died in the 13 days before their rescue, and those who survived endured starvation, dehydration, cannibalism and madness. The event became an international scandal, in part because its cause was widely attributed to the incompetence of the French captain perceived to be acting under the authority of the recently restored French monarchy." - source Wikipedia

Following up on the theme of navigation and sailing dear to our heart, given "The Tempest" raging and the unraveling of the "Mutiny on the Euro Bounty" courtesy of the high stakes poker game being played by Greek politicians and their European creditors (reminiscent of "Schedule Chicken" once more...), we have decided to use yet another sailing analogy but this time referring to Géricault's painting masterpiece "The Raft of the Medusa".

"In an effort to make good time, the "Méduse" (Medusa) overtook the other ships, but due to poor navigation it drifted 100 miles (161 km) off course. On July 2, it ran aground on a sandbank off the West African coast, near today's Mauritania. The collision was widely blamed on the incompetence of De Chaumereys, a returned émigré who lacked experience and ability, but had been granted his commission as a result of an act of political preferment." - source Wikipedia.

Similar to the fate of the Medusa ship, the story so far has been the European Commission in an effort to make good time in reducing budget deficits, decided to impose unrealistic budget reduction objectives ("A Deficit Target Too Far") while imposing drastic reduction in bank leverage and balance sheets, courtesy of the European Banking Association (EBA) June 2012 deadline of 9% of Core Tier 1 capital. These combined actions led to credit contractions, no surprise there, leading to reduced economic growth in Europe compared to the US ("Growth divergence between US and Europe? It's the credit conditions stupid..."). While utter financial meltdown disaster was narrowly avoided thanks to the ECB's LTRO operations, the lack of experience or ability (or both...) of the captains of our "European Flutter" ship have indeed landed the European project on a sandbank, with of course, a "raft" full of "unintended consequences" such as mutiny, with Greek bond subordination during the recent PSI leading to insubordination (a buyers strike...) in parts of the European bond market.

So in our long credit conversation, we will of course look at the recent price actions, but we will focus on Greece and the recent comparisons made with Argentina being the comparison "du jour" (of the day), rebuking in the process some "urban legends" and economic myths.

But first our credit overview!

The Credit Indices Itraxx overview - Source Bloomberg:

The price action was undoubtedly experienced in the European morning session with a significant widening of most Itraxx Credit indices coming from rising tensions in the European Government bonds space. Itraxx Crossover 5 year CDS index widened to 751 bps (50 European High Yield entities), before receding in the afternoon to end up around 740 bps. Itraxx Main Europe 5 year CDS representing 125 Investment Grade entities widened as well, and moving towards the 200 bps, indicating significant risk perception rising in the European credit space. This index, like most, has been steadily rising for the last seven days. Both indices have reached their highest level since the 9th of January according to Bloomberg. The financial space wasn't spared either with Itraxx Financial Senior 5 year CDS index, representing a gauge for renewed financial tensions, touched 300 bps before receding slightly in the afternoon, whereas the Itraxx Financial Subordinated 5 year CDS index jumped towards the 500 bps level, closing around 480 bps. Upcoming additional Moody's downgrades of additional European banks (Moody's has already cut 26 Italian banks), will cause this index to drift wider still. We have discussed the impact of the upcoming downgrades on subordinated bank debt in our last conversation "Interval of Distrust".

The relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge):

High Yield Risk perception rising in conjunction with Volatility.

At the same time we are seeing Financial risk reconnecting fast with Sovereign risk, as indicated by the convergence of Itraxx Financial Senior Spread 5 year CDS and SOVx Western Europe 5 year CDS - source Bloomberg:

The spread between the Itraxx SOVx Western Europe and Itraxx Financial Senior is moving towards 0 clearly indicating the LTRO effect is a becoming a distant memory with an increased correlation of both indices with rising sovereign risk concerns (Spain, Italy). The drop witnessed in March in the graph is due to Greece falling out of the SOVx index (15 Western Europe countries) and replaced by Cyprus ("SOVx Western Europe - And Then There Were 14...").

The current European bond picture with Spain experiencing a serious bout of volatility in conjunction with Italy- source Bloomberg

Spanish 10 year government yield intraday movements on the 16th of May - source Bloomberg:

Moving fast and furiously towards 6.50% yield levels before receding due to rumors of ECB emergency meeting and possible re-activation of SMP (Securities Market Programme).

As indicated by Bloomberg, Spain spread over bund at 450 bps, has been previously a key level for previous European bail-outs - source Bloomberg:

"With Spain's CDS reaching new highs (544 bps), the spread of its 10-year sovereign over the German bund has reached 4.5%, a level viewed as significant for triggering bailouts in both Portugal and Ireland. At a time when profitability is falling thanks to new provision rules, elevated sovereign CDS and spreads will also drive higher funding costs for Spain's banks." - source Bloomberg.

The slump in Spanish bonds risks LCH margin increases which is concerning. This margin increase on the LCH exchange could happen given in the past the 450 bps difference with German Bund has been the threshold as indicated by Bloomberg:

"LCH said in October 2010 that a yield premium of more than 450 basis points would “be indicative of additional sovereign risk,” and may cause it to “materially increase the margin required for positions in that issuer.” Clearing houses guarantee trades are completed by standing in the middle of two counterparties, and raise margin requirements to protect themselves against losses should one side of the trade fail."

"Spanish government bonds risk incurring higher trading costs at LCH Clearnet Ltd. as their performance relative to Europe’s safest assets deteriorates. The CHART OF THE DAY shows the difference in yield between Spanish 10-year bonds and a benchmark of AAA rated euro-region sovereign debt is approaching 450 basis points for the first time since the shared currency was created. LCH, Europe’s biggest clearing house, increased the cost of trading Irish and Portuguese bonds by 15 percent when yield spreads for those securities climbed to similar levels." - source Bloomberg.

The 10 year German Bund and the Eurostoxx seem to reconnect at least from a directional point of view with volatility rising as indicated in the bottom part of the graph - source Bloomberg:

Some change in the "Flight to quality" picture, with wider Germany 5 year CDS closing towards 100 bps and 10 Government bond well below 1.60% yield level - Source Bloomberg:

As a reminder, bear in mind we previously saw a spike in Germany's sovereign CDS back on the 29th of November 2011 ("The Eye of The storm"), prior to the German "failed" auction which lead to a significant widening of the German Bund yield above 2.30%, when Germany's sovereign 5 year CDS went above the 100 bps level. We are getting closer to 100 bps for Germany's sovereign CDS. The cost of insuring German debt is rising fast, even as its bond yields are falling. Credit-default swaps on Germany jumped 10 basis points this week to a four-month high of 98, signaling worsening perceptions of German credit quality. The German Sovereign CDS was at 67 basis points on March 19 according to Bloomberg.

In relation to Spanish banking woes, Bankia share price is indeed suffering from the "partial" nationalization process undertaken by the Spanish government and from the plight of its real estate issues and significant exposure, being the focus of attention - source Bloomberg:

The second phase of real estate provisioning reforms announced on the 11th of May, enforces a 30% generic reserve coverage of performing loans instead of 7% and make it compulsory for banks to transfer all problem foreclosed assets into a separate work-out subsidiary at "fair value", which will have to be appraised by an independent auditor, in similar fashion to what Ireland did for the set-up of its work-out entity NAMA. The additional cost to banking giant Santander will be 2.7 billion euro of provisions in addition to the 2.3 billion euro ear-marked for provision to be passed before end of 2012. While Santander, has not provisioned the 2.3 billion needed under RDL 1 (Royal Decree Law 02/12), BBVA has so far provisioned 175 million euro in the first quarter. The total cost for each of them will amount to one or two quarters worth of earnings on a net basis according to CreditSights (5 billion euro for Santander, around 4.025 billion for BBVA). For our ailing Bankia, the cost will amount to 4.7 billion euro pre-tax, which is more than ten times 2011 pre-tax profit...Oh dear...

According to CreditSights, the New Real Estate Rules means significant additional provisioning under RDL 2:

"Additional provisioning under phase 2 will cost the whole banking system almost 30 billion euro in 2012, on top of 39 billion euro from Phase 1, most of which has still to be charged to income statements over the next three quarters."

As we type, Bankia shares have touched a new low, falling another 26% to 1.29 euros experiencing a similar fate witnessed with Portuguese banks Banco Espirito Santo and Banco Comercial Português (BCP).
Banco Espirito Santo stock price evolution - source Bloomberg:

Banco Comercial Português (BCP) stock price evolution - source Bloomberg:

We believe subordinated debt to equity swaps are coming for some weaker financial institutions with more pain for both shareholders and bond holders ("Peripheral Banks, Kneecap Recap"). Bankia's IPO initiated in July 2011 drew 347,000 investors, most of them individuals, have lost as of today's price action two-thirds of their ill-fated 2011 investment. The IPO, as indicated by Bloomberg was successful because it was made on "illusory promises":

"To lure buyers, Bankia held out the promise of distributing about 50 percent of its net income as dividends. “The IPO was mainly a dividend play, so it appealed particularly to retail investors when interest rates elsewhere are so low,” said Ipox’s Schuster. “Bankia has a strong retail network and that’s basically how the deal got done. Now not only their shares get diluted, it’s also a question mark whether Bankia will be able to deliver future dividends.”

15 underwriters or undertakers, one as to ask oneself, given as indicated by Bloomberg:

"A total of 15 underwriters led by Bank of America Corp., Deutsche Bank AG, JPMorgan Chase & Co. and UBS AG earned a commission of about 1.2 percent on the 3.1 billion-euro IPO, or about 37 million euros, data compiled by Bloomberg show. While managers were taking orders for Bankia’s IPO, investor concern about Europe’s deepening debt crisis was already propelling Spanish bond yields to what was then a euro-era record. The lender had to reduce its IPO price by about 26 percent from its initial range in order to complete the sale.

The IPO “has been considered a reference point for the Spanish banking industry” and was completed “in the middle of a true storm in the markets that imposed the toughest financial conditions of the last decade,” Rodrigo Rato, Bankia’s chairman at the time, said in a speech on July 20."

Individuals bought about 60 percent of the shares on sale in the IPO...

Back in November we gave a clear warning:
"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.

Like experienced shipwreckers we did shudder during the calm sea ("Plain sailing until a White Squall?").

Moving on to the subject of Greece being compared to Argentina by many pundits, we would like to make the following points:
Most Greek Banks are most likely bust. Greek Banks 5 year CDS on the 16th of May - source CMA:

Greek banks had negative equity given their very large exposure to Greek government bonds. As a reminder Greek banks are required to reach 9% Core Tier 1 by September 2012 first via private sources and if it fails then government. We discussed the issues of raising private sources faced by Apostolos Tamvakakis, chief executive of National Bank of Greece, launching a recent desperate last-ditch attempt in securing private funding in our recent conversation "Kneecap Recap". Greek private bank shareholders will be wiped-out. 30% of National Bank of Greece shares are in the hands of foreign investors such as Bank of New York Mellon, BlackRock, Allianz, Pictet, Prudential Financial, Aviva, AXA, HSBC and BBVA, according to Bloomberg data as we indicated in our recent post.

No wonder the Greek stock index is still tanking on the 16th of May - source Bloomberg:

We already touched on the value of Greek financial shares in our conversation "Equities, there's life (and value) after default! - Russia, Argentina, Iceland, examples for Greece":

"Given the outstanding weight of financials in the Greek ASE index and knowing their current Greek debt holdings, Alpha Bank, National Bank of Greece, EFG Eurobank and Piraeus bank respective equity is probably worth zero. It should in theory equate to an additional write down of at least 16.74% of the ASE Greek index." - Macronomics - 4th of March 2012.

At the time of our conversation the ASE index was at 741...Now below 555.
Financial weights as of the 16th of May 2012 in the ASE index, Banks =15.44% - source Bloomberg:

Greek Banks May Face Same Dilemma as Argentine Banks in 2001-02 according to Bloomberg:

"A key problem faced by the Argentine banks as fears of devaluation drove depositors to switch to foreign currency was the resultant currency mismatch on its balance sheet. Pressure to address this drove many banks to increase foreign-currency lending, which brought with it increased default risk, an issue which Greek banks may need to address."

Greece is not Argentina, and will fare worse as indicated by Bloomberg:

"GDP growth was negative in Greece during the last 14 quarters. While Argentina's banks and economy recovered quickly with 9% GDP growth and a rebound in consumer spending in 2003, austerity measures and lingering sovereign concerns suggest that Greece and its consumers may struggle to achieve this, implying a slower return to profitability for its banks."

Argentine Banking Asset Loss a Stark Warning to Greek Banks - source Bloomberg:

"While Argentina suffered significant deposit outflows prior to devaluation, deposit growth was 19% by the end of 2002, rising to 26% in 2003. By contrast, loans in the system did not return to growth until 2004 and many years later the recovery in assets is far behind deposits. Should a similar fate befall Greece, funding for recovery may be hard to secure." - source Bloomberg.

In relation to Greece, its neighbor Bulgaria (475 kms of frontier with Greece) enjoy a 10% corporate tax rate and a 20 tax rate on individuals. A record rise has been registered in the number of people crossing the Bulgarian-Greek border at Easter:

A total of 220,000 people and 77,600 vehicles crossed the border at the five checkpoints between Bulgaria and Greece on the four days off at Easter (between Friday and Sunday). For comparison, nearly 48,000 vehicles and 142,000 people crossed the border at Easter in 2011...

We have long been enthusiast readers of Dr Felsenheimer from Asset Management Assénagon monthly credit letter. In his latest letter Dr Felsenheimer clearly indicates Dr Krugman lack of understanding of the banking system, core to the current European crisis:

"Dr Krugman now suggests a solution based on three elements: Firstly, the ECB should buy government bonds. Secondly, the foreign trade imbalances between the member states should pursue an expansionary policy to help countries reduce their debt through moderate inflation."

Dr Felsenheimer's clearly indicates why Dr Krugman's assessment is incorrect, given Dr Krugman seems to ignore the interdependence of banks and governments:

"The purchase of government bonds by the ECB (however it is implemented) increases precisely this interdependency further still. You don't need to be a market moralist (if such a thing exists) to see the purchase of government bonds by a central bank as a Ponzi game. But to force the reduction of foreign trade imbalances is to argue against all microeconomic reason. Such a policy would of course solve the problem of the target II balances en passant. However, we should first of all ask how such an imbalance reduction could be achieved. It is clear that reducing a trade surplus is easier than reducing a deficit. This means that Germany in particular would have to accept export restrictions, which would be in direct opposition to the desire for growth impetus. Ultimately, the ECB's extremely expansionary policy must be held partly responsible for the crisis. The demand for further expansion in turn represents the danger of further speculative bubbles.

The US has pursued a response to the crises of recent years very close to that of Krugman's theory, at least regarding the role of the FED (the largest investor in US government bonds). Any sustained success however is questionable. Even though Europe has pushed the US out of the headlines in recent months, the US debt situation has not improved at all.

Should we not maybe do exactly the opposite of what classical theory suggests? Does a restrictive monetary and fiscal policy not mean that the entire banking system has to "deleverage" and shrink its enormous balance sheets? It could be argued that the state should step in to help during such a transition (e.g. by partially compensating for the cuts in lending that would be expected), however that is something completely different to pursuing expansionary policies itself.

Less liquidity in the banking system reduces the danger that speculative bubbles will form, it forces the necessary consolidation in the banking system and it puts pressure on countries to pursue a sustainable economic policy to attract investors. The logical consequences of the European solution (assuming that this is largely continued even during Hollande's presidency) is that it involves a painful adjustment process that already been underway for two years. The Anglo-Saxon method does not promise a solution, but rather a postponement of the problem. It does not solve the fundamental problems of the euro zone."

A bank is a leverage play on the economy. It is the second derivative of a sovereign.

This is exactly the solution Sweden implemented during its 1990s crisis.

Sweden, suffered a banking crisis in the early 1990s and then again in 2008 and 2009. They chose to inject capital into struggling banks only in return for equity to avoid raising deficits and burdening taxpayers. The government in 2008 set up a financial stability fund by charging banks an annual fee and enacted various crisis-management measures including a bank guarantee program to help support lending.The fund will grow to 2.5 percent of gross domestic product by 2023 and stood at 35 billion kronor ($5.2 billion) at the end of 2010, including shares in Nordea Bank AB, according to the Swedish National Debt Office.

The Swedish example comes to mind when thinking about the ongoing interdependence between banks and governments. Cheuvreux in their recent note "Why the nordics are a safe haven" touched on the deep restructuring process followed by Sweden, which lead to the disappearance of some banks (survival of the fittest) and the following results:

"The rule is only: spend less than you earn…

In addition to substantial tax increases to balance the budget and reduce debt, the social security payments were capped resulting in real decreases as the pay-outs were not kept in line with GDP growth. In addition, checks and balances were introduced with automatic stabilisers which did not allow spending to outstrip growth, such as seen in the pension system where significant reform was passed by all the major political parties in 1995.

Furthermore in the budgetary process the role of the Ministry of Finance has been strengthened forbidding spending ministries to launch proposals without financing, not allowing parliament to make unfunded amendments, introducing a rolling budget ceiling that must not be breached as well as a 1% budgetary surplus intended as a saving to handle the retirement of the baby boomers in the 2020s, i.e. a Swedish balanced budget includes a 1% extra margin of safety which can be compared to the European average budget deficit of around 6%." - Cheuvreux - Why the nordics are a safe haven - 2012.

In addition to Dr Krugman's unwillingness of understanding interdependence, the idea that Germany's economic prosperity has been built on "vendor financing" to peripherals countries is a myth. In a recent paper published by François Chauchat from Gavekal we learned that: "exports to Southern Europe have contributed to only 13% of the increase in German exports since 2000 and never amounted to more than 5% of German GDP. In comparison, exports to non-EMU countries rose to 25% of GDP recently, from 15% in 2000. So even though Germany lent a lot to southern Europe - making its financial sector very vulnerable - this financing was used more to buy Chinese products, oil and commodities than German goods."

Eastern promises for Germany according to Moscow-based economist Liam Halligan:
"Russo-German trade Europe's 'biggest untold story' says top economist" - Chris Sloley - Citywire:
"Russia’s biggest trading partner is now Germany and Germany’s biggest trading partner is now Russia, having overtaken France,’ he said.
‘It is the biggest untold story but western papers don’t want to talk about it. It is part of a trend of Germany looking increasingly east and you feel it much more strongly if you are working in the east and how this has changed on the ground.’"

Finally the Argentina crisis should be a warning on Spanish Banks' Sovereign Holdings (we already know what happened to Greek banks bond holdings...):

"Spanish banks increased their sovereign holdings by 48% since November 2011, Italy increased theirs by more than 30%. Argentine bank sovereign holdings and government loans rose to 21% from 10% of total assets in 1995-01. A consequence of this was less private sector funding, a risk for Spain and Italy should conditions worsen and deleveraging continue." - source Bloomberg.

“Panics do not destroy capital – they merely reveal the extent to which it has previously been destroyed by its betrayal in hopelessly unproductive works” - John Mills, “Credit Cycles and the Origins of Commercial Panics”, 1867

Stay tuned!

Credit - Peripheral Banks, Kneecap Recap.

"That's the method: restructure the world we live in in some way, then see what happens." - Frederik Pohl

We already touched at length in our past credit conversations on the liability exercise management taken by many weaker peripheral banks in relation to raising capital to reach the 9% Core Tier 1 Capital target set up by the European Banking Association for June 2012 (see our conversations "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.

In 2011 as well as very recently, bond tenders have been a recurring theme in the credit space.
As a reminder on bond tenders:
Debt tender offer:
"When a firm retires all or a portion of its debt securities by making an offer to its debt holders to repurchase a predetermined number of bonds at a specified price and during a set period of time. Firms may use a debt tender offer as a mechanism for capital restructuring or refinancing."

We believe additional debt to equity swaps will have to happen for weaker peripheral banks, similar to what we witnessed with Banco Espirito Santo in October 2011, as well as for German bank Commerzbank ("Schedule Chicken" - 25th of February 2012).

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."

Banco Espirito Santo stock price evolution - source Bloomberg:

Survival of the fittest...On October 18 Banco Espirito Santo announced a capital increase in effect via its bond tender which meant at the time a 83.5% dilution for shareholders. This was followed by another capital increase of 1 billion euro announced mid-April, to be completed by early May (see our conversation "All Quiet on the Western Front").

According to recent note by CreditSights (Euro Financial Movers - Walking on Eggshells - 15th of April 2012):

"Unnamed major shareholders have committed to subscribe just over half of the amount (50.63%), and the remainder is underwritten by a syndicate of banks. On an FY11 pro-forma basis, this will take BES's Core Tier 1 ratio to over 10.5% and allow it to meet the EBA's end-June requirement of 9 Core Tier 1. The consolidated EBA shortfall for BES's parent, Espirito Santo Financial Group, is €1,597 mln."

All clear for Banco Espirito Santo, but definitely not for its Portuguese peer, Banco Comercial Português (BCP):
"Banco Comercial Português has yet to give details of how it will cover a shortfall of €2.1 bln identified by the EBA. There is a €12 bln government recapitalisation facility available to Portuguese banks under the bailout package." - CreditSights - Euro Bank Capital Model FY11: We Are The 9%, 2nd of May 2012.

When it comes to BCP, a debt to equity swap could be a solution if we take a look at the stock price - source Bloomberg:

Not pretty to say the least...

When it comes to Greek banks, they are in the front line (see our post "Liquidity? The IV Greek Credit Therapy").
Lack of capital follows the results of the Greek PSI, leaving them with dire needs as indicated by Marcus Bensasson, Maria Petrakis and Natalie Weeks
in their article on Bloomberg on the 20th of April - Top Greek Banks Post $37 Billion in Losses on Debt Restructuring:

Greece’s four biggest banks reported a combined loss of 27.9 billion euros ($36.9 billion) for last year after participating in the country’s debt exchange, the largest sovereign restructuring in history.

The four, including National Bank of Greece, EFG Eurobank Ergasias SA, Alpha Bank SA and Piraeus Bank SA, said they wrote down about 25 billion euros in the combined value of their Greek government bond holdings.

Prime Minister Lucas Papademos is trying to finalize a plan to recapitalize Greek banks, which wrote down more than half the face value of their government bonds and posted an increase in bad loan ratios after five years of recession. Greece’s bank-recapitalization body yesterday got 25 billion euros in a first tranche of funds, or half the total assigned for the purpose, as part of a second bailout by the European Union and International Monetary Fund."

And the Bloomberg article to add:
"National Bank, the nation’s biggest lender, had a net loss of 12.3 billion euros for 2011 after a 406 million-euro profit a year earlier, the Athens-based lender said in a statement today. The average estimate from three analysts surveyed by Bloomberg News was for a loss of 9.29 billion euros.
EFG Eurobank Ergasias SA, the second-biggest lender, had a 5.51 billion-euro loss after a 68 million-euro profit in 2010 and Alpha Bank SA, the third biggest, lost 3.81 billion euros after an 86 million-euro profit in 2010. Piraeus Bank SA, the fourth largest, had a 6.3 billion-euro loss.
National Bank took 10.8 billion euros of post-tax impairments on Greek government bond holdings after writing down their value by 75 percent. Eurobank wrote down 4.6 billion euros of government bonds after taxes and Alpha Bank 3.8 billion euros. Piraeus wrote down 5.1 billion euros."
Another nice job done by "analysts"...

So, no surprise for us to hear recently about the bond tender exercise being followed by Greek bank Alpha Group Limited:

"Alpha Group Limited (the "Offeror"), a member of the Alpha Bank A.E. group (the "Group) announced today tender offers (the "Offers")for Any and All of two Tier One Securities, one Upper Tier II Security and two Lower Tier II Securities ("Securities") with an aggregate face amount outstanding of approximately EUR 985mm."

For similar purposes as all other bond tenders we have seen so far, namely to boost Core Tier 1 Capital:

"The purpose of the Offers is to generate Core Tier One capital for the Group and to strengthen the quality of its capital base. If completed, the Offers would generate a gain for the Group and thereby increase Core Tier One capital. The Offers also provide investors with an opportunity to monetise their investments at the relevant Purchase Price."

Opportunity for the bondholders to "get to the exit while they can" and take their losses...

Alpha Bank SA offered to buy back a nominal 1.58 billion euros of outstanding securities in a bid to boost its capital. If completed, this offer would generate a gain for the group’s Core Tier 1 capital, which the bank reported at 3 percent for 2011 according to Bloomberg, when the target is 9% for June 2012 for European banks as required by the European Banking Association plan but, for Greek Banks, they have until September 2012 for achieving the 9% required. In 2011, during the last EBA stress tests for European banks, 30 billion was assigned to Greece's banking system out of the 115 billion original EU-wide bailout plan.

Alpha Bank stock price - 24th of April 2012 - source Bloomberg:

ASE - Greek stock index evolution - 24th of April - source Bloomberg:

From our conversation "Equities, there's life (and value) after default!", we know that the outstanding weight of "Financials" in the ASE Greek index, is roughly around 21.70%. We wrote at the time:

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

The same Bloomberg article also indicated the following in relation to Greek Banks Core Tier 1 ratios:

"National Bank, Eurobank and Piraeus Bank did not disclose what their Core Tier 1 ratios would be without support from the Hellenic Financial Stability Fund, the state recapitalization body. National Bank reported a Core Tier 1 capital ratio of 6.3 percent after an injection of 6.9 billion euros from the HFSF.

Agricultural Bank of Greece SA and TT Hellenic Postbank SA, two state controlled lenders, were granted extensions and will report earnings by May 31, the banks said in exchange filings.

The bank recapitalization plan includes incentives for private investment such as rights for shareholders to purchase the government’s stake and safeguards for buyers of convertible bonds, according an IMF report released March 16. The HFSF will continue to hold voting rights in the event of strategic decisions related to the banks to avert the risk of asset stripping by investment funds, according to the report."

When it comes to rising pressure in relation to the need for fresh capital, it could not be more truer given the significant rise in non-performing loans as reported by Bloomberg on the 4th of May:
"Greek banks collectively saw the level of non-performing loans rise to 17 percent of their total loan portfolio at the end of the first quarter from 14.7 percent at the end of the third quarter of 2011, Kathimerini reported.
Bad mortgages climbed to 16 percent of the total, or 12.5 billion euros ($16.4 billion), from 14 percent, the Athens-based newspaper said today, citing Greek banking officials. Bad consumer loans increased to 29 percent, or 9.6 billion euros, from 26.4 percent and bad business loans nose to 15 percent, or 18 billion euros, from 13 percent, it said." - source Bloomberg, Paul Tugwell.

So what is the plan for Greek banks? So far no plan...

"Greece’s government has yet to settle on the final terms to recapitalise the nation’s banks after a 100 billion-euro writedown of sovereign debt, said an official at the Hellenic Financial Stability Fund.

Agreement still needs to be reached on a number of different issues and this may not occur before May 6 elections, the official, who declined to be named, said after a meeting in Athens between Panayotis Thomopoulos, the head of the fund, and Prime Minister Lucas Papademos.

The official said he hoped the full 50 billion euros allocated to the fund wouldn’t need to be used and that an initial 18 billion euros had been provided to the four biggest Greek banks in the form of commitments." - source Bloomberg, Eleni Chrepa - 24th of April 2012.

The HFSF (Hellenic Financial Stability Facility) total 13 billion, 1.3 billion for Alpha Bank, 4.2 billion for EFG Eurobank, 6.9 billion for National Bank of Greece (who had the largest holding of Greek bonds on its balance sheet). According to CrediSights, these facilities allow the banks to report total capital ratios of at least 8% under the current EU Capital Adequacy Directive, which in turn makes them "officially solvent" and therefore "eligible" for ECB funding...
Looking at the outcome from the Greek elections on the 6th of May with the losses of pro-austerity parties, it spells trouble ahead for Greece and its ailing financial system, resorting to desperation tactics like
-suing Reuters News agency:
"Greek bank sues Reuters over investigative report" - Reuters, 2nd of May.

"One of Greece's biggest banks has filed a lawsuit against Reuters claiming 50 million euros ($66 million) in damages over a story that exposed a series of property deals between the bank and companies run by the family of its executive chairman."

-making desperate appeal for fresh private equity to avoid total shareholder equity wipeout:

"Apostolos Tamvakakis, chief executive of National Bank of Greece, launched a last-ditch attempt to fend off a wipeout of private shareholder control, widely considered inevitable across the banking system as lenders struggle to absorb losses on their government bond holdings and other bad debts." - Financial Times, Patrick Jenkins, Banking editor - Greek banks appeal for fresh equity.

We believe debt to equity swaps will likely happen for weaker banks as well as full nationalisation for some.
As our good credit friend said in November 2011: 
"The path will be very painful for both shareholders and bondholders."
30% of National Bank of Greece shares are in the hands of foreign investors such as Bank of New York Mellon, BlackRock, Allianz, Pictet, Prudential Financial, Aviva, AXA, HSBC and BBVA, according to Bloomberg data.

"When liberty is taken away by force it can be restored by force. When it is relinquished voluntarily by default it can never be recovered." - Dorothy Thompson

Stay Tuned!

Markets update - Credit - Schedule Chicken

"Every man prefers belief to the exercise of judgment."
Lucius Annaeus Seneca

"The practice of schedule chicken often results in contagious schedules slips due to the inner team dependencies and is difficult to identify and resolve, as it is in the best interest of each team not to be the first bearer of bad news. The psychological drivers underlining the "Schedule Chicken" behavior are related to the Hawk-Dove or Snowdrift model of conflict used by players in game theory." - source Wikipedia.

Given everyone is focused now on the results for the much awaited PSI in relation to the ongoing Greek debt resolution process, Greek CDS trigger or not, courtesy of Collective Action Clauses (knowing that the IMF assumes a 95% participation rate to the PSI...), we thought this time around, we would use an analogy relating to project management linked closely to the famous game of chicken, namely the Nash equilibrium concept. Looks like we are rambling again as usual.

In this week credit conversation, we will once again discuss the LTRO effect, and the importance of deposits levels and credit cycles,  touching on the latest Commerzbank debt to equity swap (not really a surprise to us as we hinted it would happen on the 29th of November in our conversation "The Eye of the Storm"), and the impact the PSI will have on Greek banks and more.

But as always, time for a credit overview!

The Credit Indices Itraxx overview - Source Bloomberg:

The iTraxx SOVX Western Europe Index of sovereign credit-default swaps(15 governments) although tighter by 4 basis points to 344 bps, remains elevated on the 24th of February, compared to the Itraxx Financial Senior 5 year CDS index representing European Banks and Insurance institutions.

The strength of support brought around by the previous LTRO to the Itraxx Financial Senior index is clearly indicated by the spread of the index versus the SOVx 5 year CDS index representing sovereign risk in Europe, still around the highest level reached - source Bloomberg:

"Flight to quality" picture, Germany 10 year Government bond yields remain below 2% yield and falling 5 year CDS spread for Germany - Source Bloomberg:

In our conversation the "LTRO Alakaloid", we indicated that ongoing concerns surrounding the European crisis meant that the widening potential for 10 year German government bonds was indeed somewhat capped given the demand for precautionary assets.
We indicated: "It is all about capital preservation rather than a hunt for yield".

The current European bond picture with Italy and Spain 10 year government yields falling still, given the LTRO effect is encouraging Italian and Spanish banks in buying their respective domestic debt - source Bloomberg:

The liquidity picture, as per our 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 ECB 3 years LTRO has had a significant effect on the three months Libor OIS spread in 2012, a clear indicator of risk in the banking sector. As Nomura indicated in their note from the 20th of February entitled - ECB 3yr LTRO: Fixing what's broken:

"Low money market rates and ample liquidity provision by the central bank went a long way towards easing funding tensions in the money markets in 2008. This is evidenced by the drop in the Euribor-OIS spread, one indicator of systemic credit risk in the banking system, after the ECB's emergency rate cuts. Euribor is the rate for 3m uncollateralised interbank lending and OIS refers to a 3m swap contract whereby one exchanges EONIA(floating leg) for the 3m OIS rate (fixed leg). Despite the fact that the volume of uncollateralised lending between banks has shrunk significantly since the global financial crisis, Euribor remains a reference rate that can be used to gauge aggregate credit risk in the banking sector."

But we have a cause for concern, namely that the LTRO is addressing liquidity issues for cut-off peripheral banks but in no way solvency issues and availability of credit to the real economy (see our post, "Money for Nothing"). In fact, we are currently witnessing a dangerous phenomenon of flight of deposits from peripheral banks to Germany as indicated by John Glover in his Bloomberg article - Bank Deposit Flows Show Money Leaking to Germany:

"Money is leaking out of banks in southern Europe as customers scoop deposits out of Greece, Spain and Italy to move cash to less indebted nations such as Germany.

Greece’s total deposits plunged 28 percent from the peak in June 2009 to 169 billion euros ($225 billion) at the end of December, according to data compiled by Bloomberg. In Spain, deposits slid 5 percent in the five months through November to 934 billion euros, the least since April 2008. Italian banks held 974 billion euros in November, the lowest in 18 months.

Deposits in Germany have climbed by almost 10 percent since May 2010, when Greece was granted its first bailout. Deposits have risen every month except five since the end of 2009, and reached 2.15 trillion euros at the end of 2011, Bloomberg data show. The deteriorating growth outlook in the euro region risks exacerbating those flows, according to Dario Perkins, an economist at Lombard Street Research in London.

“The biggest systemic risk is if people lose confidence in keeping their euros in Spain, Portugal or Italy,” Perkins said. “It makes sense to put your cash into Germany just to be safe and that’s where the real systemic danger lies. That contagion isn’t priced in, and bank deposits are the place we’d spot it.”

This flight of deposits will have a significant impact in economic growth. We agree with Nomura, from their recent report, namely that:
"Monetarist economics is back in vogue; we are watching deposit growth".

Indeed, our European Flutter's narrow money (sum of currency in circulation and overnight deposits), namely M1 growth, is displaying different speed, a leading indicator when it comes to future economic activity. While in our previous conversations, we focused on the importance of the ECB's lending surveys, it is essential, we think, to follow the flight of households deposits in Europe, which is a phenomenon, that is not only affecting peripheral countries, but Emerging Eastern Europe countries as well, such as Hungary, which has been a recurring item in our recent conversations ("Hungarian Dances"):

The ongoing shift in households funds across Europe has not only implications in relation to future economic activity, the shift from short-term to longer terms deposits, as displayed in Nomura's graph will have direct implication on consumptions levels:

"We are also seeing some movement of household funds from short-term to longer-term deposits across the euro-area banking system. This reflects banks' desire to close their funding gaps by relying more on stable, longer-term retail deposits. This shift in the composition of bank funding has implications for the short-term demand outlook. If households are increasingly locking up their assets for a longer time, the money is not accessible to spend on consumption."

It is also important to note the ongoing great competition between banks in peripheral countries, offering higher deposits rates in search for longer-term deposits. There is as well a growing divergence between deposits rates across the European banking sector, indicating a growing disconnect with money markets rate.

For more on the subject:
"Savings Wars From Italy to Portugal Drive Bank Costs Higher" - Charles Penty and Sonia Sirletti - Bloomberg
"The average interest rates on new retail deposits for up to one year have jumped almost 60 percent in Portugal and 72 percent in Italy this year (2011), a sign of how Europe’s debt crisis is driving up the cost of capturing savings."

Throughout our conversations, we have been discussing at length the importance of liquidity and bank funding, in relation to credit cycles. Availability of credit is depending, as well on the level of bank deposits.
In a recent conversation we made the following comment:

"In relation to the current situation let us use this analogy. Imagine you are driving a car called Europe, now it is winter and snow has been piling up on the roads making your driving risky and prone to an accident (liquidity issues). Then comes the LTRO (ECB grit truck) to clear the road ahead of you. Now, you think the road is clear, but, as any car owner knows, what makes your engine running smoothly is the amount of oil lubricating the engine (credit conditions)."

We also added:

"You need to track the ECB lending survey, when it comes to monitoring your oil level. Lack of oil (credit), could seriously damage your engine (growth), and therefore stall your engine (recession) and seriously damage your car (economy). Now let's suppose you drive your car to make a living, and you've borrowed money (sovereign debt) to purchase your car. How are you supposed to make the repayments if your car finally breaks down because your engine has been damaged because of your negligence in maintaining a proper oil level (credit) in your engine (economy)?"

We do agree completely with the following, "Credit growth is positively correlated with GDP growth". According to Nomura:

"Households and firms are highly dependent on the availability of bank lending in the euro area. Firms – in particular small and medium-sized firms – rely almost exclusively on bank lending as a source of external funding. Households use banks for mortgage finance and unsecured borrowing. Hence, bank lending to households and firms is a critical part of the monetary transmission mechanism.

We have empirical evidence that credit growth is positively correlated with GDP growth, especially in the euro area (see Zhu, 2011). The intuition is clear: rapid lending growth boosts economic activity as funds are available to increase consumption and investment. In contrast, times of deleveraging are usually associated with low or negative activity growth as households and firms focus on debt repayment rather than consuming and investing."

Nomura indicated as well in their recent note the following important point relating to credit cycles:

"The non-synchronised credit cycles across the euro area are problematic for the ECB: There are countries which clearly require a loose monetary policy stance to offset the deflationary impacts of deleveraging (Ireland, Portugal and Greece). But looser monetary policy may also postpone the deleveraging process which is necessary in some countries (Spain). And keeping monetary policy loose for too long may fuel excessive credit growth in other countries (Germany) leading to the build up of unsustainable private sector imbalances."

Moving on to our next item, namely the recent debt to equity swap announced by Commerzbank, as we indicated at the beginning of our conversation, it was not really a surprise to us.
Commerzbank announced, in true Banco Espirito Santo style ("Subordinated debt - Love me tender?"), a debt to equity swap. The exchange offer period starts February 23 and is expected to end on March 2nd.

The latest rise in Commerzbank share price, allows Commerzbank to benefit more from exchanging hybrid capital for equity - source Bloomberg:

Following the announcement on Thursday, the shares fell as much as 9.6% to 1.95 euros.

The announced offer to swap hybrid debt covers 3.16 billion euros worth of securities. The German government owns a minority stake of just over 25% and will participate to the operation. The operation if successful could boost its core Tier 1 capital by 1 billion euros.

"The Silence of the Lambs" or more accurately "The Silence of the Subordinated bondholders and equity holders".
The capital increase equates to a maximum of 10% minus one share of Commerzbank current subscribed capital.
Last year, Commerzbank also bought back subordinated bonds trading below face value last year to boost core Tier 1 capital. The income generated from the bond tender buoyed fourth quarter profit by 735 million euros.

Commerzbank Can' t Pay Dividend, Service Silent Participations, by Aaron Kirchfeld and Nicholas Comfort
Feb. 23 (Bloomberg) --
"Commerzbank AG said it won't pay a dividend for 2011 and can't service silent participations held by the country's Soffin bank-rescue fund after posting a loss under German HGB accounting rules.
"It remains our goal to service the silent participations of Soffin in the future and also pay a dividend again," Chief Executive Officer Martin Blessing said at a press conference in Frankfurt today, according to a copy of his speech."

Silent participation is a form of non-voting capital used in Germany that is not accepted by the European Banking Authority as core Tier 1 capital.
As a reminder from our conversation relating to bond tenders on the 25th of October:
"So, in our debt to equity swap, courtesy of the subordinated bond tender, not only the subordinated bond holder is taking a hit, but our shareholder as well. Love me tender?"

In relation to this latest bond tender, our good credit friend and we commented:
"What is happening to Commerzbank could well happen to other financial institutions: swapping debt for equity is neither good for shareholders, neither for bond holders."

On a final note, and in relation to the "Schedule Chicken", Greece in the coming days will remain firmly in the spotlight given the expectations surrounding the results of the PSI and CACs impact (CDS trigger or not a CDS trigger, that is the question...). The immediate write-down of the remaining 53.5% of principal on Greek debt equates to a net present value loss of over 70%. Given Greek banks have the largest exposure to their domestic debt, you can expect a lot more of additional pain for the likes of National Bank of Greece. Taking a 75% coverage on their Greek bond portfolio (12.9 billion euros as of June 2011) implies an additional pre-tax charge of just over 8 billion euros, or around 6.5 billion euros allowing for a tax credit according to CreditSights. National Bank of Greece's core tier one capital was only 6.3 billion euros in September 2011. The 30 billion euros capital shortfall derived from the EBA (European Banking Association) exercise in 2011, was based on 50% private sector value loss. An impairment of 70 to 75% loss would equate to an additional 45 billion euros worth of aggregate recapitalisation for the Greek banking system. Oh dear...

Greek debt ownership - source Bloomberg:

"Schedule Chicken" - source Bloomberg:
Feb. 27: Germany’s Bundestag will vote to approve the Greek
bailout package.
Estonia’s parliament will vote to approve the package no later than this date, according to Taavi Roivas, the head of the legislature’s European Union affairs committee.

Feb. 28: Finland’s parliament will vote on the second Greek rescue program at 2 p.m. local time, according to Seppo Tiitinen, the Helsinki-based legislature’s Secretary General.

March 1: The Dutch parliament will have voted on the Greek bailout package by this date, according to Finance Minister Jan Kees de Jager.
The Greek parliament will also have approved the implementation law.

March 1-2: European Union leaders will hold a summit meeting in Brussels. They will discuss a possible increase in Europe’s so- called firewall, including possible concurrent operation of the temporary European Financial Stability Facility and the permanent European Stability Mechanism.

March 9: Bids for private creditors’ swap transactions are expected to close.

March 11: Private creditors’ swap transactions will take place by this date.

March 12-13: EU finance ministers will meet in Brussels.

March 20: Greece is scheduled to pay off 14.5 billion euros of maturing debt.

April 20-22: The IMF will hold a meeting in Washington.

"When people are taken out of their depths they lose their heads, no matter how charming a bluff they may put up."
F. Scott Fitzgerald

Stay tuned!