Guest post - Is Risk Parity a Scam - Rcube Global Macro Research

"We have a natural right to make use of our pens as of our tongue, at our peril, risk and hazard." - Voltaire 

Courtesy of our friends at Rcube Global Macro, please find enclosed their latest publication where Paul Buigues looks at Risk Parity strategies:

(for PDF please use the following link: http://www.rcube.com/docs/Rcube_Is_Risk_Parity_a_Scam.pdf)

Risk parity strategies experienced large drawdowns between early May and late June due to a combination of rising government yields and falling equities.

Note: The original and largest fund in the sector (Bridgewater All Weather Fund) does not publish daily NAVs.

This rather significant correction raised quite a few eyebrows, particularly because risk parity strategies are often marketed as being able to withstand a wide range of economic environments (and, unlike 2008, today’s environment is rather benign).

Although it would be preposterous to disparage a strategy based on two months of negative returns, this drawback gave us the impetus to express our thoughts on risk parity as an investment strategy, as it emerged from relative obscurity just a few years ago, only recently becoming fairly popular among investors.

Like other passive asset allocation strategies,1 the basic premise of risk parity is that asset returns are unpredictable, at least in the short] and medium]term. Consequently, investors should only attempt to capture risk premia, without wasting their time and energy trying to forecast the behavior of specific asset classes.

According to the Modern Portfolio Theory (which is, itself, based on a dozen theoretical assumptions), the only rational choice for an investor is consequently to own the gmarket portfolioh which contains every asset available in the market, weighed according to its relative size. Because this is difficult to implement in practice, investors often settle for a (generally more granular) version of the 60/40 allocation between equity and fixed income.

Risk parity is a different viewpoint on how not to exert judgment on any asset class. According to risk

parity proponents, investors should try to own all major investable asset classes on an equal risk basis.

Supposedly, this results in portfolios that have better risk/reward characteristics than traditional asset allocations. Moreover, as mentioned above, some argue that risk parity portfolios can generate quasi-absolute performances, even in the face of stormy markets.

Before going any further, it is worth stating that implementing a portfolio that contains all assets on

an equal-risk basis is even more challenging to implement than implementing the "market portfolio".

This explains the existence of many different variants of risk parity.2

Recap: Portfolios that express a neutral view on future asset class returns

After selecting a specific variant of risk parity, many implementation choices need to be made:

‐ What universe of assets should be used, and how should they be regrouped them in asset classes?

‐ Should asset class correlations be taken into account? And if so, how?

- How should we define risk? In our understanding, most risk parity implementations use volatility,

which obviously exists in many different varieties (historical, implied, predicted, GARCH, etc.) and

calculation horizons.

- What leverage should be applied to the portfolio for it to reach an acceptable rate of return? (Risk

parity generally involves leverage.)

- What frequency should be used for portfolio rebalancing and volatility calibration?

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1 Although risk parity strategies have to be managed actively (if only to equalize risk levels on a regular basis), we consider them to be passive, in the sense that they are not based on trying to forecast future asset returns.

2 Here are just a few implementations of risk parity: the “All weather” portfolio, classical risk parity, cluster risk parity, risk factor parity, and equal risk contribution.

To our understanding, the “All weather” strategy is not risk parity in the strict sense. From the way it has been described in various papers, it basically consists in choosing a set of asset classes, and in leveraging each of them to obtain a common expected return (generally the expected return of equities). In that sense, this strategy should be called return parity, rather than risk parity. Unless we expect all asset classes to have the same Sharpe ratio, these two approaches are not equivalent.

Due to this large number of degrees of freedom and parameters, this paper will present risk parity from a generic viewpoint. It will contain case studies and thought experiments rather than backtests (as we will see, backtests are generally biased towards risk parity strategies).

Although the term “risk parity” was only introduced in 2005, we can trace the origins of the concept

to a strategy that Ray Dalio (3) started using in 1996 to manage his family trust. Despite Bridgewater’s success in generating sizeable alpha for their clients, Dalio wanted to create an investment process that would not depend on his own ability to manage funds or to select managers (as he wouldn’t be able to do so after his death).

The strategy (named the “All Weather portfolio”) also had to deliver returns, regardless of economic

conditions. Dalio therefore concluded that the portfolio should maintain 25% of the portfolio’s risk in

each of the four following quadrants:

This is clearly an excessively simplified portrayal of a strategy that now has $70Bn under management and that has generated an annualized performance of around 8.5% with a volatility of around 10% since 1996, inspiring many fund managers and institutional investors to run the same type of strategies in-house.

However, despite its commercial and financial success, many observers consider risk parity to be an

investment scam. Finding a strategy that might dominate the classical 60/40 portfolio is one thing. Pretending that this strategy is able to produce stable returns (without attempting to predict those returns) sounds a lot like a "get rich steadily and without effort" scheme.

Even though wefre not into passive asset allocation strategies (otherwise, we would look for another

line of work), we will try to contribute to the debate. We will organize our thoughts by looking at

three intertwined dimensions of risk parity: diversification, returns, and risk. In each section, we will

express our opinion on the conceptual merits of risk parity, as well as its prospects in the current

environment.

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(3) Ray Dalio is Bridgewater’s founder and one of risk parity’s pioneers. Despite the criticism against risk parity expressed in this paper, Dalio is at the very top of our pantheon of financial thinkers.

1. Diversification

From a passive asset allocation standpoint, it is hard to argue against diversification, which

constitutes the core of risk parityfs philosophy.

The idea of spreading risk among different asset classes obviously precedes risk parity by a few millennia, as we can find references to it in the Talmud ("One's assets should be divided into thirds: 1/3rd in land, 1/3rd in business, 1/3rd in gold") or in the Ecclesiast ("Divide your investments among many places, for you do not know what risks might lie ahead").

In the early 1980s, Harry Browne introduced the gpermanent portfolioh, an investment strategy whose aim was to withstand all sorts of economic environments, and which was originally composed of an equally weighted portfolio of four asset classes: 25% US stocks, 25% long-term bonds, 25% cash, and 25% precious metals.

However, it is worth noting that these simple equal]weight approaches only aim at minimizing the risk of ruin from a personal wealth standpoint, which is not the modern view of how portfolios should be managed (i.e., maximizing investment returns for a given level of risk).

In terms of diversification, the major innovation of risk parity over these early approaches resides in

equally weighting risks, instead of allocations.

In that respect, risk parity proponents are indisputably right when they state that traditional 60/40 asset allocations are not truly diversified, as they have had a correlation of 0.90 with equities over the last 40 years.

That being said, we believe that placing diversification above everything else can lead to unpleasant consequences. The main advantage of a passive gmarket portfolioh approach is that, by definition, it does not disturb the market's equilibrium, as every asset class is weighted according to its relative importance in the market. On the opposite side, once it becomes popular, any other passive investment process that significantly deviates from market weights can wreak havoc in market valuations, precisely because passive investment processes entail not caring about valuations.

For example, letfs take a small exotic asset class (public Timber REITS, for instance), which would display nice diversification properties in the eyes of many different diversification]minded managers. Although each individual manager might decide not to own more than 1% of the total float, their combined buying power could very well provoke a bubble in the asset class.

A real-life example of the damage that can be caused by a blind quest for diversification can be found

in the way in which CDOs used to be managed before the credit crisis. In order to increase their contractual Moody's "diversity score", CDO managers were forced to diversify their exposures in terms of industries. As a consequence, some industries that had little outstanding debt became heavily sought after and, therefore, completely mispriced. In the end, a supposedly superior diversification did not help CDO managers, as correlations converged towards 1.00 during the 2008 credit crunch.

To a certain extent, the appeal of diversification might also explain investorsf willingness to buy TIPS

at negative yields (down to around -1% for the 10 years recently). While being a relatively small part of government debt (around 10%), TIPS' characteristics make them very attractive in the eyes of

investors who value diversification far above everything else, including valuation (in this particular

case, however, the jury is still out in determining whether we’re all “turning Japanese”).

One last word about diversification: as we will see in our next section, we’re not convinced that financial markets offer a sufficient number of uncorrelated risk premia in order to be able to reach a “true” diversification.

2. Returns

2.1. Risk premia

Like any other passive asset allocation strategies, risk parity relies on the assumption that some asset

classes should structurally outperform the risk‐free rate. Although there are theoretical justifications and ample empirical evidence for some of these risk premia, their number and their magnitude is ‐ and will always be ‐ subject to intense debate.

To us, the most convincing and economically meaningful risk premium resides in equities. Because of

the high covariance of corporate asset values with the state of the economy, equities have to compensate investors for the risk they take (no one wants to lose his job and experience portfolio losses at the same time). We can obviously only make rough estimates of the forward equity risk premium (letfs settle for 5% on a global basis), but we do have little doubt about its existence.

Even if they might offer some diversification benefits from a marked]to]market perspective, we believe that many asset classes (e.g., high yield bonds, REITS, or private equity) have a risk premium that originates from the same covariance with the state of the economy. Whether they should be considered as completely separate assets classes is, therefore, debatable. In fact, this question is specifically addressed by newer risk parity implementations, such as cluster risk parity and equal risk contribution.

For some asset classes, the very existence of a positive risk premium can be questioned. In the case

of commodities, for instance, the classical justification for a risk premium (i.e., Keynesf "normal backwardation") is nowadays dubious, as an increasing number of investors have been willing to take hedgersf opposite side. Roll yields, which had been the sole source of excess returns for commodities, have been centered on zero for the last 10 years.

For other asset classes, risk premium prospects currently look rather grim, the most obvious example

being Treasuries. If we look at 10]year Treasuries, their historical long-term return over short-term

rates has been around 1.6% since 1920. Since the early 1980s however, 10-year Treasuries have produced far higher excess returns (around 5%), as 10]year yields went from 15.8% to the current 2.5%.

Although there are only a few things about which we can be certain in finance, we can safely proclaim the mathematical impossibility of getting 5% excess returns by rolling 10-year treasuries over the next 10 years.

Therefore, because risk parity strategies always overweigh fixed income assets due to their low volatility, we can ascertain that this source of outperformance against conventional 60/40 allocations has dried up, even without invoking a gbig rotationh that would bring 10-year yields back to a theoretical long]term equilibrium value.

There are obviously many other sources of risk premia. However, most of them (liquidity‐based ones,

for instance) are the “bread and butter” of specialized hedge funds. Therefore, they are outside of the scope of risk parity, which is not a bad thing, as many of these arcane risk premia tend to display a very negative skewness.

Our main point is that, even if we consider a large universe of asset classes, it’s not as if there were dozens of investable and economically meaningful risk premia waiting to be harvested by passive investors. In the end, when we take into account the fact that many risk premia actually originate from the same basic sources, we might end up with just a few investable risk premia. Additionally, as more people reach for diversification, those few risk premia tend to become more correlated over time.

2.2. Leverage

One important point regarding returns resides in the fact that risk parity strategies generally involve

leverage—that is, unless the investor is satisfied with long‐term returns of 2 to 2.5% over the risk-free rate.

Risk parity practitioners generally characterize leverage as a mere “implementation tool”, and they

believe that their superior diversification outweighs the disadvantages of running a levered strategy.

Although a reasonable use of leverage might not be fatal to a portfolio, it can irremediably hurt its

returns. Indeed, as we will see in our section about risk, leverage introduces a path dependency issue.

We can very well imagine a “black swan” situation, in which a supposedly safe asset class experiences a price trajectory that forces a deleveraging of the portfolio and, therefore, wipes out a large chunk of it.

3. Risk

We believe that the subject of risk is the one wherein risk parity is the most open to criticism.

Indeed, to reach the gparityh in risk parity, one has to reduce the risk of an asset to a single number

one way or another (generally a specific variant of the assetfs volatility). Although it is not a very original point of view, we believe that the risk of an asset cannot be quantified in this simplistic way.

Despite the fact that there is a certain level of stickiness in an assetfs risk (or volatility), every now

and then, assets - even supposedly gsafeh ones - have the nasty habit of breaking the parameters of

the equations that are supposed to describe their behavior (especially if these equations do not take

into account skewness).

To illustrate this point with a little story, letfs imagine a situation that could very well have happened

during the last decade:

In the aftermath of the 2000s tech crash, John becomes yet another young unemployed electrical

engineer (as Taleb, the inventor of the Black Swan theory, likes to characterize most quants). He decides to start a new career by getting a masterfs degree in finance. Armed with his solid math skills, John quickly digests modern portfolio theory, basic statistics, and all varieties of volatility calculations. He finds a job at an institutional investor and quickly moves up the corporate ladder.

In 2006, John convinces his board to apply a risk parity strategy to manage the firm's portfolio. Because he has a fresh and open mind about finance, he decides to spice up the asset mix by adding an exposure to mortgage]backed securities in the form of newly-minted ABX indices.

Who could blame him, based on the information available in 2006?

- The total size of the US mortgage debt is huge ($13 trillion in 2006), comparable to US equities, and larger than government debt.

- ABX indices are highly diversified, as each index is based on 20 distinct RMBS transactions. Each RMBS containing a minimum of $500 million worth of homes, an ABX investor is exposed to more than 50,000 homeowners throughout the US. What can possibly go wrong with such a diversified pool of debtors?

- ABX products are rated by respectable institutions, such as Standard & Poorfs (1860) and Moody's (1909), and they offer a wide variety of risk levels (from AAA to BBB).

- The volatility of the underlying financial products that compose the index is minuscule (they always trade around par).

Even if John had opted to buy the safest AAA ABX tranches (with, consequently, a high allocation due to their glowh risk), he would have experienced heavy losses during the 2007-2008 crisis. Additionally, he would have been forced to drastically reduce his allocation to the asset class as the gtrueh risk (or volatility) of ABXs revealed itself, preventing it from benefiting from any subsequent recovery.

Consequently, given that he was running a leveraged portfolio, John would have been forced to crystallize his losses.

This story might sound far]fetched, but we could have invented a similar story about Georgios implementing a risk parity strategy for a Greek institutional investor by leveraging on domestic government debt.

Some might argue that both of these examples involve blatantly asymmetric assets, which could have

easily been filtered out (especially in retrospect) by an experienced risk parity practitioner.

However, we can also imagine a forward‐looking scenario that would involve one of the most respectable assets on earth ‐ US Treasuries ‐ as the main culprit of a risk parity carnage:

Let’s imagine that, a few years down the road, Bernanke’s successor has to manage another “great

recession”. This time, the Fed decides to go beyond QE by pegging long‐term rates at a very low level (let’s say 0.5% for the 10year).4

As the Treasury remains stuck at 0.5%, there is no more volatility on Treasuries.

According to the risk parity playbook, an investor should therefore increase his exposure to Treasuries alongside the Fed. In exchange for a minuscule return, the investor would, thus, face a substantial jump risk if the Fed had to apply a hurried “exit strategy” due to a surge in inflation…

From a broader perspective, we consider risk parity to be the antithesis of Minsky’s “financial instability hypothesis”. According to this view, investors increase their leverage when they believe an asset to be stable, which reinforces their belief that the asset is, indeed, stable (this is a perfect description of how risk parity investors behave in a given asset class). The cycle goes on until we reach the dreadful “Minsky moment”, where investors are forced to deleverage as the real risk of the asset reveals itself.

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 4 This solution was discussed by the Fed in late 2010, and it has already been experimented with
between 1942 and 1951.

 Conclusion

Due to the fall in government yields over the last 30 years, risk parity strategies have had an easy time compared to traditional asset allocations. We should therefore disregard all the performance]based arguments that are often put forward by the proponents of risk parity.

From a conceptual standpoint, although it might seem unfair to make generalizations about a strategy that exists in many different variants and implementations, we believe that risk parity suffers from many structural flaws:

1) Risk parity requires to make choices between many different implementation options, asset selection, calculation parameters etc. These choices necessarily contain arbitrary components and will have a significant impact on the strategyfs performance under different scenarios.

2) By placing diversification above any other consideration, risk parity portfolios can hold assets at (or even move assets toward) uneconomic prices. This problem is magnified as risk parity - or other approaches focused on diversification - become increasingly popular.

3) After all, risk parity’s quest for diversification might prove fruitless, as risk parity portfolios end up harvesting the same basic risk premia as traditional asset allocation (mostly the equity premium and the term premium), albeit at different dosages.

4) The leverage used by risk parity strategies makes them prone to deleveraging and, therefore, to crystallization of losses.

5) Risk parity’s false premise that risk can be quantified as a single number exposes it to highly 

asymmetric returns, which can happen to any asset class given the right set of circumstances.

If someone wants to run a passive asset allocation, we therefore believe that a market portfolio constitutes a better option from many perspectives: conceptual, foreseeable reward-to-risk and CYA.

For the same reasons, we strongly reject the idea that risk parity portfolios could represent an "all weather", quasi-absolute return strategy (we suspect marketing departments are the ones to blame for these outlandish claims).

There are certainly seasoned risk parity professionals out there who are able to mitigate risk parity's

numerous flaws. However, we have little doubt that when the next gblack swanh terrorizes the financial world (as seems to be the case on an increasingly frequent basis), we will witness the implosion of many risk parity strategies (those that are based on high leverage, overly simplistic assumptions on asset risks, and/or an unfortunate choice of underlying assets). Trusting risk parity to manage onefs life savings is therefore quite perilous, especially if it takes the form of a formula-based risk parity ETF - which should come out any day now.

That being said, the idea of a passive investment strategy that would be able to withstand any kind of financial weather is not unrealistic. However, its goal should be the long]term preservation of capital and not its theoretical maximization under a theoretical risk constraint. Additionally, the strategy should make very little use of leverage, and it should not make too many assumptions on the risk of a given asset (as risk becomes an unpredictable beast every now and then). In the end, we would probably end up with something quite similar to the Talmudic portfolio (N equally-weighted assets).

We realize that, without adhering completely to risk parityfs principles, many institutional investors

are implementing it as a part of their portfolio alongside other "absolute return" strategies. This approach is clearly less dangerous than an all]in commitment to risk parity. At a portfolio level, it simply results in overweighting low]volatility assets, which is obviously far-removed from the original purpose of risk parity.that is, true diversification at a portfolio level.

"Living at risk is jumping off the cliff and building your wings on the way down." - Ray Bradbury 

Stay tuned!

Credit - Something Wicked This Way Comes

"Capital as such is not evil; it is its wrong use that is evil. Capital in some form or other will always be needed."
Mahatma Gandhi

Following the passing of great American writer Ray Bradbury today, we thought our credit rambling title had to be a reference to ones of Ray Bradbury's book as a form of tribute to one of our favorite writers. The 1962 novel by Ray Bradbury is about a nightmarish traveling carnival that comes to a Midwestern town one October. Looking at the ongoing nightmarish European carnival's, which has returned earlier this year, one has to wonder if indeed something wicked is coming our way. The carnival's leader in the book is the mysterious "Mr. Dark" who bears a tattoo for each person who, lured by the offer to live out his secret fantasies (markets rumors such as using ESM funding to recapitalized peripheral banks). Each person succumbing to these fairy tales has become bound in service to this (European) carnival of "Mr. Dark".

The book by Ray Bradbury "Something Wicked" has an emphasis on the more serious side of the transition from childhood to adulthood, a point we discussed precisely in our conversation "St Elmo's fire" in relation to our "European carnival" traveling from one member to another, like dominos falling, were we argued: "Looking at the attitude of our "European Brat Pack", one has to wonder if our European Politicians will ever adjust to their respective responsibilities and embrace somewhat adulthood which would in effect determine whether our Saint Elmo's fire evolves towards a positive outcome in Ludovico Ariosto's fashion, (leading to the rise of the Dioscuri), or to the negative association of Saint Elmo's fire, namely disaster and tragedy."

As our good credit friend put it:

"The capital markets have not paid enough attention to various pieces of the global puzzle falling into places, and the true picture is a cause of concern. The overall capital structure of the current financial system is at risk. Financial institutions are in dire need of capital and bailing them out will drag sovereigns (issue of circularity) with them unless policy makers decide to follow a path they have refused so far (following Lehman Brothers bankruptcy). The no-no policy (no loss for bondholders – no loss for shareholders) advocated by Paulson when he was in charge of the Treasury is not valid anymore. Investors will have to take losses if leaders want to save their populations from disaster (Greece is the canary in the coal mine). So shareholders and subordinated debt holders should be wiped out, and senior bonds holders could become the new shareholders if there is not enough capital. How long can leaders still expose their countries to such big risks is unknown, but debt to equity swaps should make the headlines again at some point."

Indeed, it has been a recurring theme of ours in our various conversations, namely that additional pain will have to be inflicted to both bondholders and shareholders. Given the EU proposals for restructuring and managing banks in crisis, something wicked indeed is coming this way, at least towards financial bondholders and shareholders. As ECB President Mario Draghi asked clearly today, the ESM (the permanent EU bailout fund) is not currently set up to be a shareholder in banks:

"Do we want an ESM that is a shareholder in banks?"

So, in this conversation we will review the need for capital which cannot be resolved by liquidity injections alone and the recent Bank Bail-ins proposal. At some point, as our good credit friend put it, losses will have to be taken.

But before we go through this important subject, it is time for a quick credit overview.

The Itraxx CDS indices picture on Friday - source Bloomberg:

Today had a positive "short covering" tone in the credit space with Itraxx Crossover 5 year CDS index (50 European High Yield entities - High Yield credit risk gauge) tightening significantly by 27 bps on the day. The SOVx index representing the CDS gauge risk for 15 Western European countries (Cyprus replaced Greece recently in the index) remains at elevated levels around 321 bps and so does the Itraxx Financial Senior Index while tighter by 13 bps on the day, a further indication of the existing correlation between financial and sovereign risk.

Itraxx SOVx index versus Itraxx Financial Senior 5 year CDS (senior unsecured financial risk gauge) - source Bloomberg:

We presented the issue of circularity indicated by Martin Sibileau in our conversation "The Daughters of Danaus":

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

We also argued at the time:
"As far as the Danaides punishment/Circularity issues goe, the Spanish banking woes threaten to cancel out austerity benefits meaning that we will not see meaningful reduction of deficits due to this vicious circle and deflation trap Spain is victim of."

Of course, most Spanish banks are in favor of seeking European funds given neither the banking system nor the government can afford to absorb the losses. As reported by Charles Penty in  Bloomberg in his article "Spain Bankers Backing EU Aid Highlight Doubts on State Finances", according to Santiago Lopez, an analyst at Exane BNP Paribas in a May 29 report:

"Spain’s financial system may still need 45 billion euros in taxpayer money, including 30 billion euros to clean up three previously nationalized banks and 15 billion euros for other lenders."

On top of that, from the same article:
"JPMorgan’s estimate that Spain may need a bailout costing as much as 350 billion euros."

Today's price action in the European Bond Space saw Spanish yields receding towards 6.28%, remaining elevated and a cause for concern in Spain's ability to access funding which it will attempt on the 7th of June for 2016 and 2022 bond auctions. France and Germany saw their yields widen respectively by 8 bps and 12 bps - source Bloomberg:

The "Flight to quality" picture as indicated by Germany's 10 year Government bond yields (well below 1.50% yield) with 5 years Germany Sovereign CDS slightly above 100 bps - source Bloomberg:

Moving on to the subject of capital raising needs, Spanish banks which have suffered rating downgrades (Bankia and Bankinter downgraded to junk by Standard and Poor's on the 25th of May) as well as rising funding costs face a 43 billion euro funding hole according to analysts, warning that they might not be able to roll over covered bonds (secured by pools of prime loans) that mature in the next 18 months according to Bloomberg in their article 'Spanish Banks Face Covered Bond Funding Squeeze" from the 1st of June:

"The seven largest Spanish banks -- Banco Santander SA, Banco Bilbao Vizcaya Argentaria SA, Banco De Sabadell SA, Bankinter SA, Banco Popular Espanol SA and Banco Espanol De Credito SA --with a total of 171.4 billion euros ($211.5 billion) in outstanding covered bond debt, have 43 billion euros maturing over the next 18 months, according to data compiled by Bloomberg.
No benchmark-sized public covered bond from a Spanish issuer has been sold for 10 weeks, and further issuance is unlikely in the near-term, according to analysts. Issuance in the first five
months of 2012 is at 36 percent of the total for 2011, according to figures from Leef Dierks, head of covered bond strategy at Morgan Stanley."

In relation to Spanish covered bonds, the secondary markets has been on the receiving end as far as Spanish banking woes are concerned as indicated by the same article:

"The issue-weighted average price of 348 Spanish covered bonds stood at 92.15 cents on the euro on May 30. Even the strongest issuers have seen their covered bonds fall in value. Banco Santander SA’s 4.5 percent covered bond maturing in July 2016 has declined to 98.37 cents on the euro from 101.65 in May. The asset-swap spread traded up to 350 basis points over mid- swaps on May 29, a near-one percentage point increase in the month and 47 basis points higher than its previous high on Dec. 2, 2011."

But it isn't only access to the most senior part of the bank capital structure which is proving difficult for Spanish banks. The access to the senior unsecured market is as well proving more and more elusive for Spanish banks:

Still below 2011 levels as indicated by Bloomberg, but another cause for concern:

"Since recovering to above par in March, the mid-yield on senior unsecured debt for Spain's two largest banks has risen steadily. Though still below November highs, sustained elevated yields will drive up the cost of refinancing. Bloomberg data show the two banks have 28.6 billions of euro-denominated senior unsecured debt maturing by 2014."

At the same time EU Banks withdrew 37 billion dollars of Interbank Support from Spanish banks according to Bloomberg:

"EU interbank exposure to Spain's banking system fell $37 billion dollars during 4Q11. Though liquidity fears were temporarily relieved by two ECB LTRO facilities, Bankia's troubles have driven unsecured funding costs higher. Should the withdrawal of interbank capacity continue faster than Spanish banks can deleverage, significant funding problems may return." - source Bloomberg.

Something Wicked indeed...as the title goes.

If it was only Spanish banks feeling the heat of Interbank lending drying in Q4 2011...

"Global cross-border claims fell $799 billion in 4Q11, 80% driven by a drop in interbank lending. Within this, euro zone cross-border claims fell $364 billion as institutions retrenched and shrank balance sheets. Absent further stimulus or a crisis solution, this draining of interbank support may become problematic as the ECB liquidity programs expire." - source Bloomberg

As the BIS put it in their Quarterly June 2012 report:

"Three features characterise the sharp decline in cross-border claims on banks in the fourth quarter. First and foremost, internationally active banks reduced their cross-border lending to banks in the euro area. Second, they also reduced cross-border interbank lending in several other developed countries, albeit by a lesser amount. Third, they cut interbank loans much more than other instruments.

Cross-border claims on banks located in the euro area fell by $364 billion (5.9%), which is equivalent to 57% of the decline in global cross-border interbank lending during the quarter. It was the largest contraction in crossborder claims on euro area banks, in both absolute and relative terms, since the fourth quarter of 2008. Cross-border lending to banks located on the euro area periphery continued to fall significantly. Lending to banks in Italy and Spain shrank, by $57 billion (9.8%) and $46 billion (8.7%), respectively, while claims on banks in Greece, Ireland and Portugal also contracted sharply.

Nonetheless, exposures to these five countries accounted for only 39% of the reduction in cross-border interbank lending to the euro area. BIS reporters also reduced their cross-border claims on banks in Germany ($104 billion or 8.7%) and France ($55 billion or 4.2%)."

In this elevated financial risk environment as indicated by the high level of Itraxx Financial Senior 5 year CDS, no wonder some European banks are on a quest of securing funding as indicated by Fabio Benedetti-Valentini in Bloomberg on the 25th of May "SocGen Search for Crisis Funding Takes Bank to German Car Buyers":

"Societe Generale SA’s quest for funding is prompting the bank, France’s second-largest, to mine
sources not tapped before: German car loans and Dim Sum debt. Seeking shelter from Europe’s resurgent sovereign debt crisis, Societe Generale and France’s three other large, listed banks -- BNP Paribas SA, Credit Agricole SA and Natixis SA --are seeking new ways of financing their balance sheets."

Lessons learned from 2011? Maybe. From the same article:

"Burned by last year’s liquidity crunch, Societe Generale, BNP Paribas and Credit Agricole are shrinking balance sheets in most overseas markets and cutting sovereign-debt holdings. The four Paris-based banks bolstered assets in France by 11 percent last year to 3.72 trillion euros ($4.67 trillion) while cutting commitments in other European countries by about 7 percent, according to the lenders’ data compiled by Bloomberg. BNP Paribas in 2011 cut assets even in Belgium and Italy, its largest retail-banking markets outside France, by 1.6 percent and 3.8 percent respectively, its annual report shows. Societe Generale boosted French assets by 15 percent and got most of its new debt placed with investors in northern Europe."

In relation to their respective funding needs:

"To protect against a refinancing drought, France’s three largest banks have completed about three quarters of their 2012 plans to issue at least 42 billion euros of debt with maturities over one year. Societe Generale went so far as to securitize 700 million euros of German car loans from a unit representing less than 0.5 percent of its balance sheet." - source Bloomberg.

So in effect, European banks while scaling back from dollar-funded businesses such as aircraft financing, are trying to find ways to diversify their sources of long-term funding such as private placements, Dim-Sum bonds (Societe Generale sold 500 million renminbi bonds to fund its Chinese operations), and securitizing German car loans (Societe Generale at its BDK unit, representing 8% of its medium and long term issuance between January and April 23rd).
funds as the region’s deepening debt crisis makes unsecured debt
sales scarcer and more expensive.

As far as the LTROs effects are concerned and investments funds strategy, as indicated in a recent note by CreditSights entitled "Eurozone Investment Funds Use LTROs to Exit Euro" from the 4th of June, they indicated the following in relation to banks' bonds take up:

"Eurozone investment funds increased their allocation to bonds by 69 billion euros in the first quarter; the largest net purchase of bonds since the third quarter 2010.

However the vast majority of that net allocation to bonds, 57 billion euro, was to emerging markets. Indeed the allocation was the largest by investment funds on record.

Investment funds also increased their allocation to banks’ bonds by the largest amount since the third quarter 2009. But that was entirely an allocation to two-year-and-shorter dated bank bonds. Funds reduced their holdings of longer-dated bank debt by 2 billion euro."

In relation to the subject of Banks Bail-in legislation, senior unsecured creditors will indeed be facing the music to cover costs from failing banks under the European plans unveiled today, meaning an end to the era of bank bailouts, in an attempt to move towards a more unified financial supervision. Under the plan, national governments would impose annual levies to set up enough cash for a resolution fund available to a failing financial institution. As of the 1st of January 2018, outstanding senior unsecured liabilities of European Banks will be "bail-in-able", excluding short-term debt (less than 1 month).
The "unintended consequences" of such a plan have been discussed in our conversation "From Hektemoroi to Seisachtheia laws?" as indicated by Nomura:

"the sooner a bank can increase its long-term debt issuance, raise its term deposit funding, or unwind its balance sheet before its competitors do the same, the cheaper its funding costs will be and the less pressure it will face to reduce its balance sheet. In this respect, the current effective subordination of unsecured creditors of eurozone banks due to the balance sheet encumbrance issue allied to a general aversion of creditors to increase exposure to banks is particularly worrisome as this impedes the ability of banks to obtain term-funding."

Yes, "Something Wicked This Way Comes" and as CreditSights put it in their note relating to the European Bank Bail-in - "D-Day for European Bank Bail-ins":

"Bail-in allows the authorities to write down some liabilities to allow the bank to remain in business. Our view is that normal insolvency proceedings are not an effective way of dealing with failing banks and preventing systemic crises, and that a resolution regime is therefore a sensible alternative. We also agree that if governments are determined that public funds should not be used to finance bank rescues, then either banks will have to have significantly higher equity and subordinated debt, or senior creditors will potentially have to be subject to write-down or conversion into equity.

However we think regulators and politicians are in denial about the consequences for banks'funding models. This will push banks towards deposits and covered bonds as principal funding instruments, which seems to alarm some regulators. Senior unsecured debt will be more expensive - some investors will inevitably view it as contingent capital - and the universe of investors will shrink. The Commission's own impact assessment reckons that the total funding cost of banks in the EU would increase on average by a range of 5 to 15 bp, reflecting an estimated average increase in yields on bail-in-able instruments of 87 bp. We suspect this significantly underestimates the likely costs and is one reason we recently revised our recommendations on European banks to Underweight."

So, thank you "Mr Dark" for the "Bail-in" invitation to your nightmarish European carnival. But, you won't be wearing another tattoo because we will not be lured in believing in yet another "secret fantasy". In our conversation "From Hektemoroi to Seisachtheia laws?" we once again voiced our concerns Mr Dark:
"We keep repeating this, but it is still very much a game of survival of the fittest....Cash is clearly king in the Basel III framework and, as Nomura put it, will therefore could lead to a war for deposits in Europe...The British stiff resistance to the latest regulatory proposals come from the fact that banks are very large in the UK relative to their GDP."

Deposit guarantee funds preference is more negative for bondholders. The resulting structural subordination means they will rank pari-passu (classes of bonds or shares having equal rights of payment or level of seniority) with unsecured claims and it could soon be a factor for UK banks if the government follows the ICB’s recommendations...

On a final note we leave you with a Bloomberg chart, showing that Indetex SA, owner of Zara clothing chain has overtaken Banco Santander SA as Spain's second-biggest company by market value as surging profit attracts investors growing wary of banks:

"The CHART OF THE DAY shows the market capitalization of Arteixo, northern Spain-based Inditex, and that of Santander. The world’s largest clothing retailer has almost trebled since the fourth quarter of 2008 to 42.1 billion euros ($53 billion), while Spain’s biggest bank has fallen more than 50 percent since 2010 to 41.6 billion euros. Telefonica SA, Spain’s biggest phone company, is the largest stock on the IBEX 35 index, with a value of 48.4 billion euros." - source Bloomberg, 21st of May.

“Really knowing is good. Not knowing, or refusing to know, is bad, or amoral, at least. You can't act if you don't know. Acting without knowing takes you right off the cliff.” 
  ― Ray Bradbury,  Something Wicked This Way Comes

Stay tuned!