Markets update - Credit - The law of unintended consequences

"It is easy to dodge our responsibilities, but we cannot dodge the consequences of dodging our responsibilities."
Josiah Stamp

"The law of unintended consequences has come to be used as an adage or idiomatic warning that an intervention in a complex system tends to create unanticipated and often undesirable outcomes." - source Wikipedia

According to Robert Merton Senior there are five causes of unanticipated consequences:
"1.Ignorance (It is impossible to anticipate everything, thereby leading to incomplete analysis)
2.Error (Incorrect analysis of the problem or following habits that worked in the past but may not apply to the current situation)
3.Immediate interest, which may override long-term interests
4.Basic values may require or prohibit certain actions even if the long-term result might be unfavorable (these long-term consequences may eventually cause changes in basic values)
5.Self-defeating prophecy (Fear of some consequence drives people to find solutions before the problem occurs, thus the non-occurrence of the problem is unanticipated.)" - source Wikipedia.

So in this latest post, the latest FOMC's decision has brought to our attention another analogy, the law of unintended consequences. In this credit conversation, while going through our usual credit overview, we will be revisiting some of our calls with some additional subordinated bond haircuts (Unicredit this time around) creating more pain for subordinated bondholders, Portugal in the headlights (which does not come to us as a surprise), and we will attempt to analyse the latest FOMC's decision relative to the existing swap lines agreement between the Fed and the ECB and the consequences that come to our mind.

Time for our Credit overview.

The Credit Indices Itraxx overview - Source Bloomberg:

Not much has changed since our previous post, the Markit Itraxx SovX Western Europe 5 year CDS index (representing 15 countries)  is marginally tighter, around 332 bps points whereas both Itraxx Financial Senior 5 year index and Subordinated index are wider by a couple of basis points. Not a lot of volatility going on.

In relation to the liquidity picture, it is more of the same as well, 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 current European bond picture with Italy starting to widen again slightly in conjunction with Spain - source Bloomberg

Some change in "Flight to quality" picture, with wider Germany 10 year Government bond flirting again with the 2% yield level  and falling 5 year CDS spread for Germany - Source Bloomberg:

 The 10 year German Bund and the Eurostoxx seem to reconnect at least from a directional point of view - source Bloomberg:










It is of no surprise to us to see Portugal taking center stage, following on current Greek negotiations with private bondholders (PSI). In fact we first noticed the decoupling between Ireland and Portugal in August last year in our post "Ireland June trade surplus - A glimmer of hope?":
"But, we are starting to see divergence between Portugal and Ireland, not only in the CDS 5 year space, but also in the 10 year government bond space:
Ireland 5 year CDS versus Portugal 5 year CDS, correlation was one and breaking since a couple of weeks."
Ireland 5 year sovereign CDS versus Portugal 5 year sovereign CDS spread.

Portugal 5 year Sovereign CDS has reached a new record level at 1312 bps, representing a cumulated probability of default of over 67% according to CDS data provider CMA.
The LTRO sparked rally on both financial stocks and senior bonds so far this year. But in relation to Portugal Sovereign CDS versus Portuguese banks financial CDS there is indeed an interesting dislocation as highlighted by a credit trader. Banco Espirito Santo senior 5 year CDS trades around 865 bps, 200 bps tighter year to date, whereas Portugal Sovereign CDS is around 240 bps wider year to date.   This is indeed the direct consequences of the ECB intervention as highlighted by Bank of America Merrill Lynch in our previous conversation, mainly due to the fall in correlation between the banks and the sovereign spreads. This dislocation is only a function of the outlook for peripheral sovereign debt given current banks'exposure to the periphery. While banks have indeed inherited from unconditional support from the ECB courtesy of the three years LTRO, as indicated in Nomura's recent note from the 24th of January entitled "36-month LTROs: A pyrrhic victory?", sovereign so far have not received unconditional support:

"Through these operations the ECB is providing an interim solution to the liability side of bank balance sheets; it is not intended to resolve the significant impairment on the asset side. Although there has been a large repricing of the front-end of sovereign curves into and since the operation, we do not think this demand will persist as the ECB’s operation is not about adjusting the dynamics of the stock or flow demand problems faced by European sovereigns."

We mentioned the problem of stocks and flows and the difference between the ECB and the Fed in our conversation "The European issue of circularity", given that while the Fed has been financing "stocks" (mortgages), while the ECB is financing "flows" (deficits). We do not know when European deficits will end, until a clear reduction of the deficits is seen, therefore the ECB liabilities of the ECB will have to depreciate. It is therefore not a surprise to see the ECB's current reluctance in getting a haircut on their Greek holdings in relation to the ongoing negotiations revolving around the Greek PSI.

But back to the title of our conversation, the law of unintended consequences, given Nomura in their report indicated the following:

"In light of the LTRO-spurred rally, we analyse whether the LTRO has indeed
formed a sea-change in the eurozone debt crisis. We conclude that:
The 3yr LTRO significantly reduced the tail-risk of a liquidity-driven
collapse by a European bank...
...but that the ECB liquidity will have adverse unintended consequences
for private sector financing of banks...
...and that it is more expensive funding than commonly viewed…
...which provides an effective floor to front-end rates as driven by ECB liquidity...
...both of which will limit the size of next month's LTRO...
...as such, without non-bank investor demand, we do not think the LTRO will lead to a durable flow of liquidity into Europe's non-core bond markets...
...meaning that we retain our bearish strategic view on non-core European bond markets."

Nomura also adding:

"LTROs are increasingly punitive and lead to subordination of senior unsecured bank debt. The haircut structure and increased asset usage effectively means that further ECB liquidity is increasingly punitive, utilising ever more balance sheet. The more the facility is used the greater the degree of subordination to senior creditors, which previously would have partially relied on the assets, now pledged to the ECB, as security against senior debt. This problem is particularly pertinent given that banks have already been using the covered bond markets to raise funds, which require over-collateralisation in order to achieve higher ratings and to meet the criteria laid down by the ECB in order to be deemed eligible collateral for operations."

Meaning dwindling quality collateral to pledge in the process, the law of unintended consequences...which we thing will of course lead the ECB to lower again its collateral standards in the near future.

Which brings us to the most recent subordinated bond tender offer by Unicredit and this is what our good credit friend had to say:
"Unicredit announced this morning a tender offer on Tier 1 and Upper Tier 2 bonds for a total of 3 billion euro. Prices range from 50% to 86% depending on the securities...Which is a nice haircut for subordinated bondholders!

At the same time, the Italian bank plans euro 25 billion covered bond issue (which reminds me of what happened with the Irish Banks covered bonds)."

Nomura expects the second round of LTRO in February to be not only smaller but to have the following effect:

"In aggregate we think that the total level of funds taken down through the ECB operation will be less than the previous round. In our estimation this is likely to be in the €200-300bn range.

If the size is bigger than this, perhaps in the range of €500bn or greater, the effect on bank balance sheets in Europe will be distinctly negative in our view, and would make future wholesale and term funding from private sector sources significantly more difficult."

For more on the subject Joseph Cotterill in FT Alphaville goes into more details about the impact of the LTRO in his post - "Margin call, the LTRO movie"

In "A Tale of Two Central Banks" we argued:

"You cannot ask the ECB to suddenly morph into a Fed. This process will undoubtedly take time and a due process, but a larger involvement of the ECB is so far conditional to stricter fiscal discipline."

This leads us to the latest FOMC's decision in relation to the existing swap lines agreement between the Fed and the ECB and the unintended consequences that come to our thoughts as indicated by Martin Sibileau:

"The institutional weakness of the Euro zone, having failed (back in March 2011) the move towards a unified bond and fiscal integration, triggered the jurisdictional arbitrage of deposits (Euro funding). Deposits were taken from banks in the periphery (Greece, Portugal, Spain, Ireland, Italy) and shifted to the core (Germany, France, Netherlands). This situation generated a funding squeeze that was and continues to be addressed by long-term refinancing operations (“LTROs”) by the ECB. In these operations, the ECB extends collateralized Euros to EU banks. These are loans, assets to the ECB, and liabilities to the EU banks. Since its inception, the ECB has steadily been decreasing the minimum quality of acceptable collateral and increasing the tenor of the financing. Most of these funds have been returning to the ECB as excess reserves, a disturbing fact. But at one point, the repression by the political apparatus and the temptation to use these cheap funds to buy high yielding EU sovereign debt is too strong and we start seeing the use of these funds to monetize (i.e. purchase sovereign bonds in the primary market) EU fiscal deficits."

Hence the difference between the FED and the ECB, with the ECB financing flows (deficits).

Unintended Consequences according to Martin Sibileau:

"With the Fed swaps, as we pointed out on September 12th, the Euro is still artificially stronger than without the swaps, which makes the EU less competitive. Finally, the institutional uncertainty of the EU zone remains unaddressed. All these factors only contribute to prolong the recession and a high unemployment rate."

Given today's decision of the FOMC to maintain US rates low until late 2014, it seems to us that the European recession can only be prolonged as indicated by Rcube Global Macro research in our previous conversation, increasing the likelihood of a Euro Breakup.

Again, like any cognitive behavioral therapist, we tend to watch the process rather than focus solely on the content.

Does the FOMC's latest decision put a floor to the drop of the euro versus the dollar? Are the FED's swap lines and latest FOMC decision delaying a painful adjustment in Europe? We wonder.

"Logical consequences are the scarecrows of fools and the beacons of wise men."
Thomas Huxley

Stay tuned!

Macro and Markets update - No test, no stress, no stress, no test...

All is in the title, as clearly Mr Market has not bought into the latest results for the European banking sector stress test. EBA's assumption of a 15% loss on Greek bonds and a 1 to 2 percent "haircut" on Irish and Portuguese debt, cannot be deemed serious.

Eight European banks failed the European Banking Authority's stress test: five from Spain, two from Greece and one from Austria.
Most were smaller banks. The aggregate shortfall was measured at 2.5 bln euro, but the EBA points indicated that the system raised 50 billion euro of capital between January and April this year, for the positive side.
16 banks have a projected Core Tier 1 between 5% and 6% at end-2012. Raising the threshold to 6% would mean a shortfall of over 10 billion euro.

Stress test puts banks' euro zone debt in spotlight

"The EBA data showed banks held 98.2 billion euros of Greek bonds (67% held by domestic banks), 52.7 billion euros of Irish sovereign debt (61% held domestically) and 43.2 billion to Portugal (63% at home). Applying more realistic losses of 40% on Greek bonds and 25% on Portuguese and Irish debt would add over 45 billion euros to capital needs."

Here is the picture for Italy in the CDS space as seen on Friday:


Update on Spanish Sovereign 5 year CDS as of the 18th:

France still leading the pack of Core Sovereign CDS 5 year movement:

France is now trading above 120 bps, as I previously posted, France is now at the same level Italy was in April 2011.

Portuguese 5 year banks CDS, following the results, well as expected, wider:

As well some Italian banks in the mix:

Swaps on Spanish and Italian banks led the rise in financial debt risk, with Banco Popular Espanol SA soaring 72.5 basis points to 648 and Mediobanca SpA up 22 at 238, both records.

For the SOVx 5 year index, here is the picture of the widening we have seen so far:

As a reminder, 1/15th of the Index is made of Greece, same applies for Portugal and Ireland.

Government bonds update, the 2 year picture - it ain't pretty for some...

Greece 2 year at 31.7%, Portugal at 18.24%, Ireland at 21.5%.

And here is the 10 year Government bonds morning snapshot:

Italy 10 year now closed to 6% (highest level since 1999, new week, new record), Spain at 6.249%. Greece, at 17.2%, Portugal at 11.87% and Ireland at 13.49%.

Italy approaching 7% would be a cause of concern. The 7% mark prompted its smaller euro partners to seek bailouts, namely Ireland, Portugal and Spain and Italy's economy is three times larger than the combined three. The extra yield investors demand to hold Italian 10 year debt over German bunds widened to 3.48 percentage points last week, the most since September 1996.

The overall Itraxx indices picture this morning was wider as well:

• The iTraxx Financial Index linked to senior debt of 25 banks and insurers increased 5 basis points to 194 and the subordinated index climbed 8.5 to 338, both the highest since January.
• The Markit iTraxx Crossover Index of 40 companies with mostly high-yield credit ratings increased 10 basis points to 470, the highest since the second of December 2010.
• The Markit iTraxx Europe Index of 125 companies with investment-grade ratings rose 3.5 basis points to 126.25 basis points, the highest in more than a year.

That's the latest and I haven't even mention the action on the equity space. Nasty as well.

On a final note, Bloomberg's chart of the day today was an update on the Misery index:

 A 28 year high according to ZeroHedge.

"The CHART OF THE DAY shows the correlation between the U.S.
Misery Index, or the sum of the unemployment and inflation
rates, and measures of consumer confidence."

And it is only Monday...ouch...

To be continued...unfortunately...

Europe - The end of the Halcyon days

"Hi, I'm a _______ (add country) and I'm addicted to credit."

Greece, Ireland, now Portugal:
Banco Comercial Portugues SA (SUB) 5 Year CDS:
1472 bps +194 bps on the 6th of December +15%
Banco Espirito Santo SA (SUB) 5 Year CDS:
1467 bps +137 bps wider on the 6th of December +10.36%

These were the levels we had on the 22nd of November as published in the post Dominos in Europe:

From the 22nd of November until the 6th of December, Banco Comercial Portugues SA (SUB) 5 Year CDS has moved from 974 bps to 1472 bps, a mighty 51% increase. Banco Espirito Santo SA (SUB) 5 Year CDS, has moved from 974 bps as well to 1467, similar widening of 51% of the spread.

Any similarity with what has happened with Irish Banks Sub CDS 5 Year, which jumped above 1000 bps in September, would be of course be purely fortuitous...

Italian Financials SUB Cds are widening as seen on the 8th of December:

By accepting too early to guarantee its banking system, Ireland sealed its fate and part of its Sovereignty to Europe and the IMF. Private debt from the dodgy Irish banks have been in fact transferred to the Irish taxpayers. The Black Hole in the Irish banking system is too strong to resolve the outstanding issues as I pointed out back in November (The Irish Black Hole).
According to Dr Constantin Gurdgiev in his last post, the bailout package won't be enough to save both the Irish budget and the Irish banks. Something will have to give:
Economics 6/12/10: IMF stress tests for Irish banks
"It appears that the IMF was either not given the full realistic picture of the Irish banks balance sheets, or it is seriously underestimating the demand for future losses cover in the banks."

"Either way, the numbers continue to suggest that the €67 billion package of loans will not be enough to provide simultaneously a cover for Exchequer deficits and the funds required to underwrite losses and capital requirements of the banks. Somehow, the Irish Exchequer will have to make up for this shortfall."

Either bondholders of Irish banks debt agree take a haircut on both the sub and senior debt, or the Irish Goverment will have to cut more spending, which means more austerity for the Irish people.

On the 9th of December Fitch downgraded Ireland to BBB+ from A+, which automatically means a downgrade for Irish banks as well.

The Dominos keeps falling in Europe and France will also have to face the music at some point.
"France 'next' in Euro debt
firing line" by Hysni Kaso, 6th of December.

"The country's deficit is much, much higher than anyone realises. My view is that the markets are not prepared to finance it any more unless there is serious, structural reform. No one, not even France, can hide anymore."

These were the comments made by Xavier Rolet, CEO of the LSE. Mr Rolet is right, Germany has made great stride in implementing structural reforms which are today paying off (GDP growth, lower unemployment) whereas France has postponed structural reforms for too long. Time is running out.
France is a difficult country to reform. We have recently witnessed the difficulty, with the strikes and demonstrations relating to the increase in the retirement age from 60 to 62 then 67, when, it had already been set at 67 in many European countries.

France, like many other European countries has kicked the can down the road for to long, and now is running out of road. Structural reforms are needed, but given the looming presidential elections coming in 2012, don't expect any radical reforms in France anytime soon.
The solution for Europe is binary, it is either further integration or disintegration.

Peripheral Europe which is now the politically correct term for PIIGS, represents 17% of Pan-European GDP. Core European banks have 900 Billions USD in peripheral Europe. The ECB now owns or repo 350 Billions Euros of peripheral bonds. A nice transfer from the private hands to the public hands.

Although peripheral Europe is still sinking, macro fundamentals are very good for the likes of Sweden, Germany and Norway, to name a few.

The German economy expanded 3.90 percent in the third quarter of 2010:

The Swedish economy expanded 6.9 percent in the third quarter of 2010.

The major difficulties of the ongoing crisis is due to the characteristic of this recession being a balance sheet recession. In the post "Honey I shrunk the balance sheet", I indicated that in a balance sheet recession, and due to the amount of excess, the deleveraging process is a slow and painful and the road to repair households balance sheet is indeed a very long one. In previous recoveries, the GDP growth following a recession had been much more pronounced. Due to the nature of this particular nasty recession linked to the housing bubble, the recovery is at a much smaller pace as we can see in GDP growth figures in many countries.
What is making the crisis as well more acute in Spain, Portugal and Ireland is the high private sector leverage to GDP compared to other countries: Above 150% for Portugal, around 220% for Spain and close to 300% for Ireland.

The Euro can survive provided there is stronger integration and a tougher approaches to structural issues. France and Germany led the European project from the start. Germany seems to be left on its own to drive the project forward, given the lack of progress of reforms so far in France.

Jean-Claude Juncker and Giulio Tremonti's proposal was an interesting one.
So far both Germany and France are refusing the idea of issuing Euro-bonds.
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 their is a haircut on the existing peripheral debt. Unfortunately the game of kicking the can down the road is still well alive with French and German politicians. At some point restructuring of the debt for some peripheral countries will have to happen.

Owed to Germany:

Countries Cross-border bank exposure: