Credit - The Doubt in the Shadow‏

"Truth is beautiful, without doubt; but so are lies." - Ralph Waldo Emerson, American poet.

Looking at the deposit-levy fallout in Cyprus and the rising concerns about the sanctity of European deposits as whole, we thought this week that our title analogy should be on two levels.

Our title is first and foremost a veiled reference to the 1943 Alfred Hitchcock movie "Shadow of a Doubt".

Let us explain our "twisted" analogy. In the movie, Charlotte "Charlie" Newton always complained that nothing seemed to be happening in her life until her uncle Charlie Oakley paid her a visit (the European Troika). Charlie Oakley, in the movie is suspected of being a serial killer known as the "Merry Widow Murderer", who seduces, steals from, and murders wealthy widows. At first young Charlie refused to even consider the police's claims that her uncle is the man they are looking for. Her suspicion grows, and her uncle finally spilled the beans and admitted to her that he was the man the police were looking for aka the serial killer. He begged her for help and she resigned herself to keep the horrible scandal secret in order to avoid her family being destroyed (the European Union). Uncle Charlie is delighted in the movie to be off the hook, but, knowing that young Charlie knows all his secrets, he decided to get rid of her. In Hitchcock's movie, Uncle Charlie failed the assassination attempt on his niece and died. But, young Charlie ended up resolved to keep her uncle's crimes secret in the end.

Of course, the first level of our analogy with the deposit-levy and capital control imposed in Cyprus by the European Troika visit is purely fortuitous, but, the second level of this week's title analogy resides in the doubts we have in shadow banking in general, and banks' capital in particular, in continuation of last week's conversation "Dumb Buffers".

We have regularly indicated that, like any good behavioral therapist, we always prefer to focus on the process rather than the content. 

In relation to the Cyprus outrage on the deposit-levy, we think it is entirely "misdirected". What the outrage should be all about is that, as we posited last week, (and in agreement with Bloomberg editors views, Simon Johnson, the MIT professor and Stanford University professor Anat R. Admati), the lack of sufficient equity buffers in banks, means no doubt, that banks are indeed the "serial economic killers" of this world, or "Merry Widow Murderers". As indicated by Ben Moshinsky in his Bloomberg article "Big Banks had $269.2 Billion Basel III Shortfall in Mid-2012":

"The largest global banks would have needed an extra 208.2 billion euros ($269.2 billion) in their core reserves to meet so-called Basel III capital rules had the standards been enforced in June 2012, increasing capital levels by about 166 billion euros from the end of the previous year.

Global banks also had an average leverage ratio of 3.8 percent versus a target of 3 percent ratio for banks’ equity to debt, the Basel Committee on Banking Supervision said today in a statement on its website. The Basel measures are scheduled to be phased in by 2019.“The Committee appreciates the significant efforts

contributed by both banks and national supervisors to this ongoing data collection exercise,” the Basel group said.

Global regulators have clashed with lenders over the severity of the capital and liquidity rules, which were set out in 2010 as part of an overhaul of banking regulation in the wake of the financial crisis that followed the collapse of Lehman Brothers Holdings Inc. The Basel III measures will more than triple the core capital that lenders must hold to at least 7 percent of their assets, weighted for risk.

The biggest lenders in Europe would have needed a combined 112.4 billion euros to reach the core tier one capital target of 7 percent, the European Banking Authority said in a separate statement today.

Both the EU and the U.S. missed a January 2013 deadline to begin phasing in the standards, and have said they will seek to apply them from next year.

The lenders surveyed also needed a combined 2.4 trillion euros to meet another liquidity rule set by the Basel committee, which would force banks to back long-term lending with funds that are unlikely to dry up in a crisis.

Banks can address shortfalls in meeting capital requirements by either boosting their reserves or by reducing their assets weighed for risk. "

And, in similar fashion to Uncle Charlie in Hitchcock's movie, the Charlie Oakleys of this world, namely  banks, have indeed been let off the proverbial hook.

This week we will again focus our attention on the banking sector in particular. 

In October 2011, we argued that the markets were long hope and short faith, we also looked at bank recapitalization and in particular professor Anat R. Admati's work. 

On numerous occasions she voiced her opinion on the lack of equity buffer for banks. Specifically she wrote a column in Bloomberg on the 25th of February 2011 on that very subject entitled - "Fed Runs Scared With Boost to Bank Dividends: Anat R. Admati":

"While equity is used extensively to fund productive business, bankers hate to use it. With more equity, banks have to “own” not only the upside but also more of the downside of the risks they take. They have to provide a cushion at their own expense to reduce the risk of default, rather than rely on insurers and eventually taxpayers to protect them and their creditors if things don’t work out.

Fixation with return on equity also contributes to bankers’ love of leverage because higher leverage mechanically increases ROE, whether or not true value is generated. This is because higher leverage increases the risk of equity, and thus its required return. Focus on ROE is also a reason bankers find hybrid securities, such as debt that converts to equity under some conditions, more attractive than equity."

Truth is bank debt is indeed a much larger universe than equity, no question there in the capital structure in the banking space:

"However, bank shareholders’ equity represents typically just around 5% of total balance sheet and c. 25% of investable liabilities. Other main investable liabilities include Basel 3 compliant Alternative Tier 1 (eg, including some contingent convertibles (Cocos)), Basel 3 compliant Tier 2 (including some former hybrids), non-Basel 3-qualifying subordinated debt (some former hybrids that counted as Tier 1 or upper/lower Tier 2 (LT2) debt under Basel 2.5), senior unsecured debt and covered bonds. Future resolution legislation could lead to the creation of new classes of ‘bail-inable’ debt." - source Nomura, European Banks - Navigating the liabilities - 30th of November 2012.

Anat Admati concluded her Bloomberg column of 2011 by adding:

"The muddled debate on capital regulation has left us with only minor tweaks to flawed regulations, even after banks’ catastrophic failure in the crisis and the lasting consequences for the economy. The proposed solutions that regulators in the U.S. are focused on, such as resolution mechanisms, bail-ins, contingent capital and living wills, are based on false hopes. They can’t be relied on to prevent a crisis. Increasing equity funding is simpler and better than these pie-in-the-sky ideas."

In addition to the delays in implementing much needed regulations, banks have been using CDS to lower their capital requirements, as indicated by Jim Brundsen in a Bloomberg article from the 22nd of March entitled - Banks' Use of CDS to Lower Capital Targeted by Basel Regulators:

"Global regulators are planning to crack down on banks that underestimate their capital requirements because of the way they use credit-default swaps and other instruments to lower the amount of risk on their books.

The Basel Committee on Banking Supervision said today that it would seek to stop banks from lowering capital charges by buying instruments such as CDS to insure themselves against losses, while failing to recognize the large liabilities they incur from what they pay for this protection, the group said in a statement on its website.

“The proposed changes are intended to ensure that the costs, and not just the benefits of purchased credit protection are appropriately recognized in regulatory capital,” the Basel, Switzerland-based group of international regulators said in a statement. There exists a “potential for capital arbitrage” as banks can book the benefits of these deals without also booking the associated costs, the group said.

The measure is one of many developed by global regulators to bolster banks’ solvency after the financial crisis. For banks, such credit-protection transactions offer a way to redeploy capital more profitably while meeting the stiffer requirements of the latest round of Basel rules.

Critics say the practice doesn’t make the lenders any safer and pushes the lending risk into the unregulated shadow-banking industry.

Blackstone Group LP, the world’s largest private-equity firm, last year insured Citigroup Inc. against any initial losses on a $1.2 billion pool of shipping loans. The regulatory capital trade, Blackstone’s first, let Citigroup cut how much it sets aside to cover defaults by as much as 96 percent, while keeping the loans on its balance sheet, according to two people with knowledge of the transaction." - source Bloomberg

On top of the use of CDS to massage "capital requirements", the 2012 losses from JP Morgan CIO office also shows the inefficiency of the enforcement of the 2010 Dodd-Frank Act derivatives rule given the lack of transparency and clarity of the information received by the CFTC (Commodity and Futures Trading Commission) from the repositories such as the DTCC (Depository Trust and Clearing Corp) as reported by Silla Brush on the 19th of March in Bloomberg - Dodd-Frank Swap Data Fails to Catch JPMorgan Whale, O’Malia Says:

"Swap-trade data the agency has been receiving since the end of last year from repositories including the Depository Trust and Clearing Corp. is inadequate to identify large positions and have overwhelmed government computer systems, O’Malia said in a speech prepared for a Securities Industry and Financial Markets Association conference in Phoenix.

The data “is not usable in its current form,” said O’Malia, 45, one of the agency’s five commissioners. “The problem is so bad that staff have indicated that they currently cannot find the London Whale in the current data files.” JP Morgan, regarded on Wall Street as one of the best- managed banks in the world, lost more than $6.2 billion last year in a derivatives bet on companies’ creditworthiness that reached a net notional value of $157 billion.

Dodd-Frank was enacted in part to give regulators better oversight of the $639 trillion global swaps market after largely unregulated trades help fuel the 2008 credit crisis. The CFTC and Securities and Exchange Commission were granted authority to write rules requiring trade information to be reported to so-called swap data repositories that function as central record keepers." - source Bloomberg

O'Malia also added in the same article:

"“It means that for each category of swap identified by the 70-plus reporting swap dealers, those swaps will be reported in 70-plus different data formats because each swap dealer has its own proprietary data format it uses in its internal systems,” he said. “The permutations of data language are staggering. Doesn’t that sound like a reporting nightmare?” The CFTC’s computer systems are failing to handle the incoming data. “None of our computer programs load this data without crashing,” O’Malia said."

Hence our "doubt in the shadow" reference in our title. Oh well...

One of our recurring themes in our numerous conversations has been around the "accounting tricks" which have been played by banks in relation to capital requirements. The June 2011 Basel 3 monitoring exercise by the EBA showed that large European banks were short of EUR 242 billion of capital to meet CET1 requirements including the G-SIB surcharge (The regulations require a further 1.5% of ‘Additional Tier 1’ plus a further 2.0% of Tier 2, for Global Systemically Important Banks).

Of course reaching the overly ambitious targets for June 2012 have meant credit contraction in peripheral countries such as Portugal where Portuguese banks are still on "IV" (Intravenous therapy) support from the ECB as reported by Anabela Reis in Bloomberg on March 20 - Portuguese Banks Stay Hooked on ECB Feeding Cash:

"ECB lending slipped to 49.51 billion euros ($64 billion) last month, down 0.4 percent from January, the Bank of Portugal said on March 12. While that was the least in a year, ECB money still accounts for a larger proportion of the financial industry’s assets in Portugal than Ireland, the epicenter of the euro region’s worst banking crisis to date. The ECB’s credit line to Portuguese banks in January was 49.7 billion euros, or 9 percent of their total assets, according to central bank data compiled by Bloomberg. Spain relies on the funding for 9.9 percent of its assets, with the figure 6.1 percent in Ireland."

The ECB provided 841 billion euros of emergency funding to periphery banks at the end of January, according to the latest central bank data available. That’s down from a peak of 977 billion euros in August as reported by Bloomberg.

The on-going deleveraging - source Morgan Stanley Research:

European banks are indeed trying to clean up their balance sheets, spreading, no doubt the cost across shareholders (debt-to-equity swaps, or right issues such as the recent one announced by the second largest German bank Commerzbank with its equity share tanking by 17% in the process), bondholders (bond tenders or junior subordinated debt wipe-outs such as SNS) and now even with depositors (Cyprus).

As a reminder, here are a few illustrations of some of these accounting tricks enabling either boosting capital requirements or boosting earnings which we have discussed in the past.

Liability management:

Banks may have an incentive to buy back non-compliant Basel 2.5 hybrids that do not qualify as regulatory capital under Basel 3. To the extent that such "liability management exercises" can result in debt being repurchased at a discount to par (well below a cash price of 100), banks are able to generate common equity Tier 1 (CET1) gains. On that subject see our October 2011 conversation "Subordinated debt-love me tender?".

Recently Spanish banking giant Santander has been trying to get junior bondholders to contribute to the balance sheet clean-up of its liability structure but not encountering the same level of success it had in 2012. We illustrated the game played by Santander in our August 2012 conversation "Banker's algorithm":

"Credit wise, while in our last conversation "Desperado" on the 21st of August  we touched on Santander 2 year senior unsecured 2 billion euro new issue, which had been the first Spanish bank to issue since mid-march, we were taken aback by the latest "liability management" exercise which Santander followed immediately after its new issuer with. Banco Santander and Santander Financial Exchanges (each an Offeror and jointly the Offerors) inviting holders of certain Tier 1, Upper Tier 2 and Lower Tier 2 securities to tender such securities for purchase for cash at prices to be determined pursuant to an Unmodified Dutch Auction Procedure (as such term is defined in this Tender Offer Memorandum). The maximum aggregate principal amount of Securities that the Offerors intend to accept for purchase jointly pursuant to the Offers, will be an amount equivalent to €2,000,000,000." - source Macronomics

While bond tenders for Santander were so "2012ish", it ain't so much in 2013 given that the acceptance level of the recent proposed "hair cut" on the main GBP/Eur part of the bond tender offer was only 7% in aggregate with sterling bond holders more eager to get the "shaving" treatment with 30% accepting the proposed terms according to CreditSights in their recent Euro Financial Movers report from the 17th of March 2013 - The Week Before Cyprus.

Goodwill write-downs and the beauty of tax credits:

Back in 2012 we indicated that BBVA took a Goodwill impairment charge of 1.5 billion euros in January 2012, which according to CreditSights counter-intuitively helps improved its regulatory capital by generating an immediate tax credit:

"The 400 million Euros tax credit is offset against current taxation and relates to a gross goodwill impairment charge of about 1.5 billion euros rather than 1.1 billion euros, because of rounding differences. 400 million euros equates to an increase in retained earnings flowing into Core Tier One versus the retained earnings that would have been achieved without the goodwill impairment of the tax credit. This is because the gross impairment of 1.5 billion euros does not affect Core Tier 1, since all outstanding goodwill is already discounted in the regulatory number, even though in accounting terms, shareholders'equity will be negatively affected on the balance sheet. The benefit in ratio terms is 14-15 bps worth of Core Tier 1(which stood at euros 25,979 million at 30 September under the EBA Criteria).

Our understanding is that BBVA will be able to offset this against tax payable for the whole of 2011. Although a tax charge is accrued quarterly in the P&L, it is actually paid on an annual basis, so the lack of sufficient pre-tax earnings in the fourth quarter alone should not prevent the group from offsetting the 400 millions euros against the tax that will be payable on the full-year 2011 earnings."

While it was a Spanish trick in 2012, in 2013 it is an interesting Italian trick. Unicredit in its 4Q12 earnings statement reported losses at -€553m vs. -€173m company's gathered consensus it could have been much worse:

"Goodwill tax redemption (DTAs) saves the day:

The results were marked by a very high credit loss charge at €4.6bn which was however partly offset by c. €2bn goodwill tax redemption. Lower yoy costs were a positive but management guided to a flattish 12-13 cost line. In 4Q12 revenues dropped a significant 6% yoy and qoq (NII >€200m lower qoq)" - source Bank of America Merrill Lynch - Alberto Cordara - The Cost of deleveraging - 18th of March 2013

So, no earnings mean no Goodwill impairment impact on earnings and a "convenient tax credit" in conjunction with an improved regulatory capital:

"Losses at -€553m were worse than expectations but capital impact was contained with a B3 fully phased common equity at 9.2% (9.3% in 3Q12) while B2.5 core tier I was slightly higher. UCG was able to offset a high credit charge at -€4.6bn with DTA generated by the goodwill tax redemption (€2bn = €3.9bn – €1.9bn substitute tax).

Capital position:

Basel 2.5 core Tier 1 improved to 10.84% despite a negative earnings impact (-17bps) thanks to lower RWA (+24bps) and other actions at 10bps. The bank stated to be at 9.2% fully-phased Basle 3 lower than in 3Q12 (9.3%) probably on account of higher DTA deductions. " - source Bank of America Merrill Lynch - Alberto Cordara - The Cost of deleveraging - 18th of March 2013

For more on goodwill, see our post from November 2011 - Goodwill Hunting Redux.

Earnings boosting techniques - FAS 159:
In July 2010 we commented on the above: "Statement 159 - Debt Valuation Adjustments - Déjà Vu 2008"

"Statement 159, adopted by the Financial Accounting Standards Board in 2007 allows banks to book profits when the value of their bonds falls from par. This rule expanded the daily marking of banks’ trading assets to their liabilities, under the theory that a profit would be realized if the debt were bought back at a discount."

And  we wrote more on the subject in October 2011 - For whom the vol tolls and the return of FAS 159.

Bank Profits Depend on Debt-Writedown ‘Abomination’ in Forecast - Bloomberg July 2010:
"To the extent that the earnings power is less, the banks would not generate as much capital, so there’s less capital available to absorb future losses." - Credit Agricole Securities USA analyst Michael Mayo
Any similarities to today's situation are of course purely fortuitous. As a reminder from David Hendler, Senior Analyst from CreditSights did sum it up nicely in the same Bloomberg article around FAS 159:

"When the prevailing winds of credit spreads tighten, they make a lot of money, and when spreads widen, they can’t make as much." 

Of course the on-going discussions surrounding the most recent tool in liability management being deposits, the risk of letting the genie out of the bottle is raising fears of contagion across Portugal and Spain as indicated by Bloomberg:

"A controversial bank-deposit levy to raise 5.8 billion euros ($7.5 billion) of a 10 billion euro Cypriot rescue package raised fears of bank runs across Southern euro zone nations. While the proposed 6.75% levy on deposits of 100,000 euros or less may be amended to shift a greater burden to larger accounts, it could still prompt deposit runs in Portugal or Spain. That would drive CDS levels higher, raising funding costs for both sovereigns and banks." -source Bloomberg.

A total of 378 billion euros was pulled from banks in so-called peripheral countries -- Ireland, Spain, Portugal, Greece and Italy -- in the 13 months through August, according to data compiled by Bloomberg. 

But the Cyprus situation is not unique: 

"In 2011, Denmark became the first EU nation to bail-in bank depositors when it forced some Amagerbanken A/S savers and senior creditors to share losses. While the move affected only depositors holding more than the EU insurance limit, it left its mark on Danish banks by increasing borrowing costs.Outside the EU, Iceland decided to pay domestic depositors only after the country allowed its banks to fail, leaving out about $5 billion of deposits collected in the U.K. and the Netherlands. The British and Dutch governments made depositors in those countries whole and demanded payment from Iceland.

The almost blanket protection of depositors has been one reason withdrawals from banks in the periphery haven’t soared. Another is higher interest rates paid on deposits. Lenders in those countries and Cyprus are paying customers 3 percent to 5 percent interest on savings, compared with about 1 percent by German banks and 0.5 percent in Belgium, according to ECB data." - source Bloomberg - EU Getting Closer to Bank Union Fails to Help Cyprus Crisis.

Talking about regulations and banks, being "serial economic killers" in true Charlie Oakley fashion, although Denmark was the first EU nation to imposed bail-in, the lack of equity buffers in banks are indeed a serious threat even for Denmark given Danish borrowers are starting to struggle on their interest-only mortgages with a deepening property slump as reported by Frances Schwartzkopff on the 19th of March in Bloomberg - Denmark Races to Prevent Foreclosures as Home Prices Sink:

"The Association of Danish Mortgage Banks and the Mortgage Bankers’ Federation are due to start talks with Business Minister Annette Vilhelmsen to decide how to treat borrowers who won’t be able to afford the interest-only loans they took out a decade ago once amortization requirements kick in this year.

Borrowers are also struggling as a deepening property slump drives house prices down to 2005 levels.

“Eighty percent of homeowners under 35 years of age are under water. That’s a lot,” Curt Liliegreen, head of the Center for Housing Economics in Copenhagen, said yesterday in a telephone interview. “This is a problem that threatens the Danish economy.”

Denmark’s housing crisis, which started when the nation’s property bubble burst in 2008, is showing signs of deepening. Prices sank 2.8 percent last quarter from a year earlier, the two mortgage groups said yesterday. More than 100,000 households will need to have special terms negotiated if they are to meet their loan obligations, according to a February study by the University of Southern Denmark." - source Bloomberg.

We have argued in a 2011 conversation that the policy of achieving a high home ownership rate is the biggest threat to an economy:

"The issue with enticing a high home ownership rate is the level of household debt it generates. It can be argued that the most toxic of all bubbles is a housing/property bubble. They also always generate a financial crisis when they burst due to the leverage at play. How the risk can be mitigated? By forcing players to have more skin in the game.

Recently Sweden passed a law limitating the maximum Loan to Value (LTV) to 85%. In effect, Swedish people will need to put down a minimum of 15% of deposits to borrow 85% of the remainder."

More recently the prudent Swedish Central bank has entered into a direct confrontation with the Swedish bank regulators over macro-prudential supervision as indicated in a Bloomberg article on the 22nd - Swedish Banks Find Ally in FSA Warning Against Risk-Weight Race: 

"Sweden’s financial watchdog cautioned against a central bank proposal to consider raising risk weights from levels announced less than half a year ago.

Riksbank Governor Stefan Ingves said earlier this week Sweden should consider increasing risk weights on mortgage assets to more than the 15 percent proposed by the regulator in November. The Financial Supervisory Authority’s target, which is three times existing levels, is due to become effective later this year.“We don’t today see any reason to immediately touch these,” Martin Andersson, director-general at the FSA, said in an interview in Stockholm. “To make lots of changes and then make changes to the changes before anyone has had a chance to evaluate them and before we’ve even had time to implement these I think is to run a bit too fast.” The watchdog, which has argued against proposals to hand over macro-prudential supervision to the central bank, has defended stricter bank capital standards than those set elsewhere as Sweden tries to shield taxpayers from the risk of losses. The biggest Swedish banks, whose combined assets are four times the size of the economy, must set aside at least 12 percent core Tier 1 capital of their risk-weighted assets by 2015.

The FSA in 2010 reacted to signs of excessive credit growth by imposing an 85 percent cap on loan-to-value ratios. The regulator has also warned it is ready to do more should the need arise. Measures to date have started to work and credit growth slowed to 4.5 percent in January, compared with a peak of 13.2 percent in March 2006. " - source Bloomberg

In our 2011 conversation relating to housing we also said:

"One could argue, that home ownership should not be recklessly encouraged by politicians as it does appear to be a "Weapon of Economic Destruction" (WED). If people are struggling to raise large deposits required to secure a mortage, should the government encourage them to leverage too far in the first place? The recent credit bubble burst in the US and the subprime debacle, highlights the dangerous results in the incestual relationship between politicians and banks, and the promotion of the "American Dream" at all cost."

The housing bubble in Europe - source Nomura - EU Banks Macro Hedging, March 11th 2013

In relation to Sweden's housing market, and the previously quoted Bloomberg article:

"Though the real estate market has cooled in the past two  years, property prices have soared about 25 percent since 2006. That has fanned speculation the market may be overstretched, making households vulnerable to interest rate increases. Ingves signaled last month his bank may start raising rates next year. Swedish home prices could fall by as much as 10 percent in the next 18 to 24 months, Jens Hallen, director for financial institutions at Fitch Ratings, said last month.

Ingves has also discussed introducing other measures to cool the housing market, including requiring borrowers to amortize their mortgages. A March report by the FSA showed that the average Swedish household needs 140 years to pay down its home loan." - source Bloomberg

Lessons learned?

Quite frankly no, when one looks at the latest proposal from the United Kingdom Chancellor of the Exchequer George Osborne as reported by Bloomberg on the 21st of March - Cameron Unsettled by Housing in Austerity Offers Aid: Mortgages:

"Osborne yesterday pledged 3.5 billion pounds ($5.3 billion) to help buyers of new homes with loans of as much as 20 percent of the property’s value, broadening an existing program beyond first-time purchasers. He also announced a plan to guarantee as much as 130 billion pounds of new mortgages to fuel demand from purchasers with limited cash for a deposit."

From the same Bloomberg article:

"Osborne’s Help to Buy program will provide potential buyers equity loans for newly built homes worth up to 600,000 pounds starting in April. The program lasts three years. It also offers guarantees to support 130 billion pounds of mortgages for existing and newly built homes. Under the program, which starts in 2014 and runs for three years, lenders can buy a state guarantee that compensates part of their losses in the event of foreclosure, and the government will charge a fee for the assurance."

This is pure madness and will end up in tears. 

We completely agree with a recent Gavekal note on this subject from Anatole Kaletsky: 

"This is akin to creating a British equivalent to Fannie Mae mortgages to offer equivalent sub-prime loans. The government whose excessive prudence has discouraged banks from offering mortgages worth more than 75% of a home’s value, will now guarantee borrowers who have a 5% deposit the additional 20% loans they need to qualify. In doing this, the Treasury will expose itself to any falls in house prices beyond 5%—and this exposure will not be included in national debt statistics. In short, Britain will imitate the off-balance sheet financing of Fannie Mae that helped to trigger the 2008 crisis, and will use this mechanism to “support £130 billion of high loan-to-value mortgages over three years”that are much more leveraged than Fannie Mae’s “conforming” loans. (In relation to GDP, the US equivalent of £130bn would be roughly $1.5 trillion)." - source Gavekal.

On a final note and in relation to our recent computational analogy "Winner-take-all", should a deposit flight occur in Europe, depositors will no doubt seek a German bank sanctuary - source Bloomberg:

"German lenders could be the beneficiaries of renewed peripheral Europe depositor-outflow fears after the Cypriot bailout, as savers seek a haven in the euro zone's strongest economy. German banks have been awash with deposits since the onset of the sovereign debt crisis, with inflows from retail and corporate clients accelerating in the aftermath of the political gridlock following Greek elections in mid-2012." - source Bloomberg

"Doubt grows with knowledge." - Johann Wolfgang von Goethe 

Stay tuned!

Credit - The Donk bet

"There are three roads to ruin; women, gambling and technicians. The most pleasant is with women, the quickest is with gambling, but the surest is with technicians." - Georges Pompidou, former French president (1969-1974)

While watching the much anticipated LTROs refund on Friday, as well as the economic data during the week  with the rebound of the European PMI which we had anticipated (France being an outlier, but, our readers  know it doesn't come to us as a surprise), Spain's Economy Minister Luis de Guindos took center stage for us on Friday by declaring on Bloomberg TV: "Spain doesn't need any sort of bailout", adding that the target for the budget shortfall this year is "achievable" and concluding his remarks by "The perception of the Spanish economy has improved and will continue to do so over the next weeks and months". 

Given last week's title analogy referred to poker games in general and the art of bluffing in particular, we thought we had to use yet another poker game reference in our title namely the "Donk bet".

 The "Donk bet" being:

1. A bet made by a donk, i.e. one that is generally considered weak or to demonstrate inexperience or lack of understanding of strategy.
2. A bet made in early position by a player who didn't take initiative in the previous betting round. It was named because this move is often considered indicative of a weak player (since it is more often reasonable to expect a continuation bet). - source Wikipedia

It seems to us that Spain's Economy Minister has not fully demonstrated his understanding of the "Fabian Strategy" of Mario Draghi. Our "Generous Gambler" has been trying to "call the clock" (using another poker game reference) on Spain  namely trying to discourage them to take a long time to act.

We would therefore "agree to disagree" with Mr de Guindos given Spain pose the biggest threat to the survival of the Euro. In fact the Spanish Misery index has beaten Greece as the crisis bites and unemployment has reached 26.60% as indicated by Bloomberg:

The European Commission prediction for Spain’s budget shortfall last year is already wider than the EU’s goal of 6.3 % of gross domestic product. The target for 2013 is 4.5 %...

We quoted in our conversation "Agree to Disagree" Henry Queuille. Henri Queuille was the epitome for "professional politician": he served three times as Prime Minister and was 21 times minister in a French government under the IIIrd and IVth French Republic. He was the symbol of the inefficiency and the failure of the French IVth Republic:

"Politics is not the art of solving problems, but to silence those who ask." - Henri Queuille

It appears to us that Mr de Guindos is indeed a true disciple of Henri Queuille when we listened to his latest Bloomberg interview. As a matter of Spanish "quote" comparison, BBVA's Chief Operating Officer Angel Cano said in April 2010 that asset quality was probably going to be "stable from now on". Looking how "stable nonperforming loans have in been in Spain, one can wonder whether or not a Henri Queuille award should be set up in Europe for the best delusional political quote, but, we ramble again...

So in true poker fashion, one can posit "there's indeed plenty of action in this game". In this week's conversation we will therefore look at what lies ahead for the Spanish banking sector in general and Spain's real economy in particular in conjunction with the LTRO impact of the early refund. But first a quick credit overview.

US PMI versus Europe PMI - source Bloomberg

"Short term, we do expect a minor reduction in the divergence as reflected in credit prices such as the US leveraged loan cash price index versus its European peer." - Macronomics, The Fabian Strategy, 5th of January 2013

We explained the divergence in our conversation "Growth divergence between the USA and Europe" and we indicated early January that this divergence should persist in 2013. 

The uncanning similarity of the US leveraged loan cash price index versus its European peer with the above PMI graph - source Bloomberg:

"Loan prices have risen to 97.72 cents on the dollar, the highest since July 2007, from 59 cents in December 2008, as concern eases that the world’s largest economy will slide back into recession. Leveraged loans and high-yield, high-risk bonds are rated below Baa3 at Moody’s Investors Service and lower than BBB- at S&P." - source Bloomberg.

The current European bond picture with the continuing fall in Spanish and Italian yields with rising Core European yields - source Bloomberg:

In relation to our "Flight to quality" picture, Germany's 10 year Government bond yields have been recently rising above 1.60% and the 5 year CDS spread for Germany has been rising in tandem in the process - source Bloomberg:

2 year German bond yields versus 2 year Japanese yields, yet another "sucker punch" courtesy of the LTRO's refund anticipations. From 0% yield to 0.23% in January 2013 - source Bloomberg:

Credit and volatility wise, the Itraxx Crossover index (representing the credit risk gauge for 50 European high yield entities) have as well falling in tandem but with volatility (a subject we recently touched on) breaking through important levels similar to the regime of 2004-2007 - source Bloomberg.

Credit wise, what really caught our attention was not only the "new regime" in volatility (or should we say Central Banks' dictatorship via "financial repression"), but, the US High Yield space, where Tenet Healthcare has issued a 7 year bond with a single "B" rating with a coupon of 4.25%, which is an "all time low" level for a primary yield level on a single "B" credit on a 7 year bond.  

As we have discussed in our first credit conversation of the year "The Fabian Strategy", we don't believe the hype in credit and as we argued in our conversation "Hooke's law" previously the "credit mouse-trap" has been set by Central Banks. Well done...

We also recently reflexionate around the return of mega leveraged buyout transactions such as DELL inc  in our recent conversation "The return of LBOs - For whom the Dell tolls".  Record low borrowing costs in the market for junk bonds (high yield) where LBOs are financed is creating the ideal set up for a leverage buyout   buying spree: "There will be about $135 billion in LBO volume this year, compared with an average of $100 billion during the past two years, and below the $600 billion annual peak of 2006 and 2007, he said. Credit-default swaps typically surge on LBO speculation because the debt added to a company’s balance sheet to fund the takeover erodes its credit quality and leads to ratings downgrades. 
“As the recent experience with Dell illustrates, the risk of LBOs has a particularly large impact” on Markit’s investment-grade benchmark, pushing it a net 2 basis points wider, Bank of America’s Mikkelsen and Yuriy Shchuchinov wrote in a Jan. 23 note. Their model shows 14 percent of the index’s underlying credits are feasible LBO candidates. 
 Credit-default swaps on Quest Diagnostics have climbed 38.5 basis points to a mid-price of 123 basis points since Bloomberg News first reported Dell’s buyout discussions with private- equity firms, according to data provider CMA, which is owned by McGraw-Hill Cos. and compiles prices quoted by dealers in the privately negotiated market. 
Buying Protection:   
That was “precipitated by investors’ buying protection on names that have traditionally been considered LBO candidates,” following the Dell news, according to a note dated Jan. 23 from Barclays Plc analysts led by Shubhomoy Mukherjee. Credit-default swaps tied to Nabors surged 42 basis points to 191, the highest since July, and contracts on Avnet Inc.’s debt climbed as high as 254 basis points on Jan. 14 before falling to 178 basis points yesterday, CMA data show. Those on Falls Church, Virginia-based Computer Sciences Corp. added 40.5 basis points since Jan. 11 to 193 yesterday. Buyout firms announced a record $1.6 trillion of acquisitions from 2005 to 2007. The end of that era was “quite painful for many overleveraged deals and many PE firms and their investors have continued their long wait to reach that point where they can exit and take their gains,” CreditSights Inc. analysts Glenn Reynolds and Ping Zhao wrote in a note."  - source Bloomberg - Dell Lifts Default Risk on Next Buyout Targets: Credit Markets.

Could that be another indication of a "Donk bet" taking place in the credit space? We wonder...

As we have argued last week's Dell LBO conversation:
"One thing for sure with which we clearly agree on with CreditSights, is that the yield curve management policies of the Fed is clearly pushing investors into higher risk assets to reach for return in this "Yield Famine" induced environment of "Financial Repression" (probably out of their comfort zone too...)."

Moving on to the Spanish "Donk bet", no disrespect to Mr de Guindos and Mr Cano but we will have to agree with Citi's recent note on Spanish Banks - Iberoamerican Big Picture from the 21st of January:
"A change in the latest asset quality deterioration trend is needed for the sustainability of the banking system. If at a system level we maintain the loan contraction and the NPL growth during the next 5 quarters, the NPL ratio for the corporate segment would increase to 29.1% in 4Q13E from 16.6% in 3Q12. As expected the key drivers of the NPL growth will be the construction and the real estate sectors" - source Citi

"Just as an example, if we maintain the yoy loan contraction and the NPL growth during the next 5 quarters, the NPL ratio for the corporate segment would go from 16.6% in 3Q12 to 29.1% in 4Q13E. Just keeping the contraction deleverage pace stable pace with the stock of NPLs, the NPL ratio would increase to 18%." - source CITI

So much for "stability Mr Cano. So much for "improvement Mr de Guindos.

In last week's conversation "Cool Hand" we discussed the Bank of Spain's recent willingness in stemming the  war for deposits taking place in Spain:
"By trying to put an end to the deposit wars, the Bank of Spain ambitions to reduce the pressure on banks' earnings and profitability which would reduce the capital shortfall for some Spanish banks and the level of capital injunctions needed. It is once again a "Fabian strategy", buying time that is."

Citi's recent note on that matter is as follows:
"On 8 January 2012, the Spanish press reported that the Bank of Spain had “recommended” the largest banks in Spain to limit the yield of saving products. Other banks followed shortly. The measure apparently would also affect guaranteed funds and commercial paper products. The penalty for high yield deposits would consist of higher capital requirements, which would not affect foreign banks operating in the country (ie Banco Espirito Santo, ING). 

The press sources differ in the way the penalty is going to work, given the lack of official statements from Bank of Spain, the interpretation of the law can vary significantly. We expect a law to regulate this “recommendation” shortly. The Bank of Spain has taken this measure in order to reduce the cost of funding for the banks, which are expected to transfer part of this reduction to lower lending rates. We have to take into account that, according to the 3Q12 results, banks are already reducing the yield of loans after the repricing cycle during 2012. 

How do we understand the new recommendation? It will apply to the new savings production from banks — 85% of the new production of the banks won’t be able to exceed the yield limits set in the table below (Figure 4). The banks exceeding this limit will need to comply with higher core capital requirements, according to the press up to 125bps more from the current 9.0% requirement. The latest reports point out that the deposits above €10 million won’t be affected by the new requirement, supporting big corporate and public deposit accounts." - source CITI

The larger than expected EUR 137.2 billion initial repayment from the first three year LTRO (consensus was for 84 billion), we will have to wait until mid-march to get the geographical breakdown from National Central Banks in order to assess the complete picture for European countries.

But some Spanish banks such as Banco Sabadell indicated on the 11th of January, that the bank was planning to repay EUR 4.8 billion of LTRO funding (20% of the total requested) according to Citi's note.

As far as profitability for Spanish banks is concerned, as indicated by Citi's note:
"Given that the last LTRO was already announced in February 2012, it should be fully included in analysts’ estimates, reducing revenues expectations for 2015. Below we can find the revenue consensus estimates of our coverage universe. It is not only that revenues seem high, in our view, it is also that consensus seems to be missing the LTRO effect in 2015 revenue estimates, as they are expected to grow by 7% on average (ex Santander and BBVA)." - source Citi

An interesting analysis from Citi, while there are not missing out on the LTRO impact on earnings, we think they are lacking some essential points in relation to Spanish banks.

-First missing point - the issue of puttable bonds which we discussed in our conversation "When causation implies correlation":
"Banco Santander SA, Spain’s biggest lender, is placing its trust in bondholders by issuing 4.4 billion euros ($5.7 billion) of fixed-income securities that investors are able to redeem before maturity.
Bonds with put options make up 36 percent of Santander’s debt funding this year, compared with 9 percent in 2011, according to data compiled by Bloomberg. While the bonds have lower interest rates, they leave the bank vulnerable to a potential 7 percent increase in the 33.4 billion euros it must repay next year. Investors have already demanded early repayment on 1 billion euros of the notes." - source Bloomberg
Puttable bonds are indeed a typical instrument used by financial institutions under stress. For us, a big red flag." - source Macronomics, When causation implies correlation, 27th of October 2012

-Second missing point - the issue of the dwindling capacity in absorbing potential losses at the parent bank due to partial IPOs discussed in the same October conversation:
Another red flag we think for Santander, comes from its dwindling capacity in absorbing potential losses at the parent bank by its increasing policy of partial IPOs such as the one done in Mexico as indicated by CreditSights in their report Spanish Banks - The Value of Empires from the 22nd of October:
"In Santander's case especially, the capacity of equity in its foreign subsidiaries to absorb potential losses at the parent bank is being reduced by its policy of partial IPOs(the goal being to list all the most significant subsidiaries within five years – see Santander: Partial IPO in Mexico). The erosion of loss absorbing capacity that this implies at parent or group level is reflected in the Basel 3 reform that will ultimately prevent banks from including in consolidated CET1 capital any surplus equity contributed by minorities in excess of the subsidiaries' minimum regulatory requirements." - source CreditSights" 

-Third missing point being one of Macronomics's favourite namely the importance of "Goodwill" (see our conversation from November 2011 - "Goodwill Hunting Redux"):
"Large Goodwill Impairments increase the debt to equity ratio.
It is therefore paramount to track goodwill impairments in relation to future banks earnings."

Goodwill:
"Goodwill is an accounting convention that represents the amount paid for an acquisition over and above its book value. Under the accounting rules European banks use, the International Financial Reporting Standards, companies have to write down goodwill on their balance sheets if the underlying assets have permanently deteriorated in value."

In December 2010 ("Goodwill Hunting - The rise in Goodwill impairments on Banks Balance Sheet"), this is what we discussed as a reminder:

"When a bank acquires another one, goodwill as intangible asset goes on its balance sheet. When a medium bank acquires a smaller one, goodwill is created onto the balance sheet. But, when the medium bank is acquired by a larger one, there is a compounding effect given that the larger bank will also create some more goodwill of its own and therefore inflates its balance sheet.

As the process goes on and on, for banks on the acquisition war path, you find more and more goodwill making up the capital."

We also indicated at the time:

"Looking at non-cash intangible assets (i.e., goodwill) can be a good indicator and used as a proxy to determine the health of banks.

The significance of the write-downs on Goodwill is often presaged as rough waters ahead. These losses often take a real bite out of corporate earnings. It is therefore very important to track the level of these write-downs to gauge the risk in earnings reported for banks."

When one looks at European banks, Spanish bank Santander, Credit Agricole and Italian bank Intesa are carrying the most "Goodwill" as indicated in the table below from Bloomberg:

"A mere 5% of the 800 billion euros of outstanding goodwill was impaired in 2011, with about 19.2 billion (2.4%) relating to financial services, according to an analysis of 235 public European companies by the European Securities and Markets Authority. The top 24 European banks' combined goodwill fell to 173 billion euros at FY07, from a 2007 peak of 233 billion euros, with further impairments likely." - source Bloomberg.

In relation to the "real economy" in Spain and the on-going "Donk bet", Spanish recession has deepened in the last quarter of 2012 with GDP contracting 0.6% from the previous 6 months when it slipped 0.3%. So while Spanish Economy Minister Mr de Guindos is seeing an improvement in the perception of the Spanish economy, there is a difference between perception and reality. Even the European Commission on the 22nd of January indicated Spain would miss its 2012 deficit target. with a GDP contraction forecast of 1.4%, taking the deficit to 6% for 2013, not the "ambitious" 4.5% Mr de Guindos seems so sure of.

What matters is loan growth for economic growth to resume in Spain. We do not see it happening in 2013 for the "real economy" - graph below source Citi:

As indicated in the article from Charles Penty in Bloomberg from the 21st of January 2013 entitled - "Spain Banks selling debt still won't cut loan costs:
"The prospect of diminishing competition for retail deposits may boost lending margins. Reports that the Bank of Spain wants lenders to cap the yields they offer on deposits are positive for banks because it would provide relief for their funding costs and bolster margins, Sergio Gamez, an analyst at Bank of America Merrill Lynch, wrote in a Jan. 10 note to clients. Bank behavior may make it hard for Spain to rejuvenate an economy mired in a five-year slump and headed for a further contraction this year, said Tobias Blattner, an economist at Daiwa Capital Markets in London. Spain’s economy will shrink 1.5 percent this year after contracting 1.4 percent in 2012, according to the median forecast of 38 analysts surveyed by Bloomberg. “The interest rates that banks are charging to lend to companies aren’t going down and that’s a big worry,” Blattner said. “There are no signs yet of a pass-through by banks of their lower funding costs to the real economy.”" - source Bloomberg

We hate sounding like a broken record but, no credit, no loan growth, no loan growth, no economic growth and no reduction of aforementioned budget deficits:
"So austerity measures in conjunction with loan book contractions will lead unfortunately to a credit crunch in peripheral countries, seriously putting in jeopardy their economic growth plan and deficit reduction plans."- "Subordinated debt - Love me tender?" - Macronomics, October 2011

From the same Bloomberg article: 
“If they’re using wholesale debt that costs 3 to 4 percent to replace ECB funding that costs 0.75 percent, that means substantial pressure on margins,” Creelan-Sandford said. Banks are trying to wring more revenue from loan books as they seek to absorb the rising cost of a clean-up of 180 billion euros of real estate assets ordered by the government last year, he said. Banks in other nations have dropped their lending rates, ECB data show. German rates declined to 2.9 percent from 3.9 percent a year earlier, while French companies pay 2.2 percent, down from 3.2 percent. In Portugal, the cost of a loan for as much as 1 million euros fell to 6.7 percent from 7.6 percent, while Irish banks charge 4.6 percent, compared with 5.3 percent. Spanish companies are petitioning Prime Minister Mariano Rajoy, who says one of his priorities in government is to create conditions for credit to recover in Spain. The Spanish Confederation of Small and Medium-Sized Companies said in a Jan. 17 statement that it didn’t see “normal” financing conditions returning until 2016 at the earliest and that the lack of funding put firms in a “situation of extreme weakness.” - source Bloomberg

It is deflation in Europe and Spain is still mired in a deflationary spiral. 

On a final note the VIX volatility index passed the 5 year level as Bank CDS fall further as indicated in the Bloomberg chart from the 21st of January:

"The VIX Index, a widely-used measure of market risk often called the investor fear gauge, fell to its lowest level in more than five years as macroeconomic concerns, including those regarding the U.S. fiscal cliff, recede. Certain bank revenue streams remain correlated to volatility, with lower volatility increasing demand for risky assets, pressuring prices higher, and vice versa." - source Bloomberg

"There is no gambling like politics." -   Benjamin Disraeli, British statesman

Stay tuned!

Credit - When causation implies correlation

"All human actions have one or more of these seven causes: chance, nature, compulsions, habit, reason, passion, desire." - Aristotle 

Looking at the dismal economic figures coming out of Europe as of late (PMI, consumer confidence, unemployment in Spain, IFO, etc.), we could not resist using in our title a veil reference to the phrase used in science and statistics "Correlation does not imply causation". Admittedly, a correlation between two variables does not necessary imply that one causes the other, but when it comes to European woes, not only did the ECB's LTROs amounted to "Money for Nothing" given the lack of transmission to the real economy as we posited in February this year, but looking back at the overzealous deficit targets set up by the European Commission which we discussed in our conversation "A Deficit Target Too Far", we are not surprised to see that the economic causation does indeed implies correlation to current European economic woes unsurprisingly due to poor loan growth as displayed by the below Bloomberg graph displaying loan growth in in the Euro Zone with the Euro Zone Money Multiplier at multi-year low:

"Third quarter bank results will shed further light on the outlook and appetite for euro zone bank lending. The money multiplier remains at multi-year lows and recent regulatory steps to soften or defer the implementation of new liquidity and capital rules underscore the pressing need for banks' loan supply to improve, release cash to the economy and support growth" - source Bloomberg.

Yes, some will counter us, by saying that the opposite assumption which we used in our title, that correlation proves causation is a questionable cause of logical fallacy also called "cum hoc ergo propter hoc" ("with this, therefore because of this"). Well, truth is, the economic contraction in Europe is a consequence of the first event sometimes describe in latin as "post hoc ergo propter hoc" (after this, therefore because of this) namely rapid credit contraction due to accelerated bank deleveraging courtesy of the EBA (European Banking Association) objective for most European banks to reach a Core Tier 1 capital of 9% by June 2012.
So dear readers, no, we do not think it is a logical fallacy, "post hoc" supposedly being a "tempting error" because the temporal sequence in Europe appears to be integral to causality namely credit contraction:
A occurred, then B occurred
Therefore, A caused B

Of course as of late, our "Generous Gambler" aka Mario Draghi, ECB's president, has defended is latest OMT (Outright Monetary Transactions) bond buying plan on the 24th of October in front of the German parliament with a warning about deflation risks:
"In our assessment, the greater risk to price stability is currently falling prices in some euro-area countries"
and added:
"In this sense, OMTs are not in contradiction to our mandate: in fact, they are essential for ensuring we can continue to achieve it."

Arguably our dexterous "Generous Gambler" has indeed been highly successful in propelling Spanish bonds gains above Germany as indicated by Bloomberg:

"Investors who held onto Spanish bonds this year as the price of the securities whipsawed amid the euro-area debt crisis stand to earn more than those who sought refuge in German bunds. The CHART OF THE DAY shows Spanish debt has handed investors a 4.2 percent return since Jan. 3, rebounding from an 8.7 percent loss in the period through July, according to data compiled by Bloomberg and the European Federation of Financial Analysts Societies. German bunds, perceived as Europe’s safest sovereign debt, have earned 2.7 percent this year. The Iberian nation’s securities have surged since the European Central Bank said it will buy bonds." - source Bloomberg

Making us reminding ourselves part of the great poem from Charles Baudelaire which we have used in numerous conversations:
"If it hadn't been for the fear of humiliating myself before such a grand assembly, I would willingly have fallen at the feet of this generous gambler, to thank him for his unheard of munificence. But little by little, after I left him, incurable mistrust returned to my breast. I no longer dared to believe in such prodigious good fortune, and, as I went to bed, saying my prayers out of the remnants of imbecilic habit, I said, half-asleep: "My God! Lord, my God! Please make the devil keep his word!"
Charles Baudelaire, French poet, "Le Joueur généreux," pub. February 7, 1864

The most recent table of monthly purchases of sovereign debt is a clear indicator of the faith many investors have put in our "Generous Gambler" - source Bloomberg:

"Euro zone banks purchased an aggregate 33.3 billion euros of sovereign debt in September, following sales of 24.9 billion euros in the preceding two months as yields fell and gains were taken. The ECB commitment to do "whatever it takes" drove the Spanish 10-year yield down to 5.5% from August highs above 7%, and recent bank purchases reflect this new-found confidence." - source Bloomberg

"The greatest trick the devil ever pulled was to convince the world he didn't exist"
Roger "Verbal" Kint- The Usual Suspects

"The greatest trick European politicians ever pulled was to convince the world that default risk didn't exist" - Macronomics.

Our generous gambler also argued the following: 
"OMTs will not lead to disguised financing of governments. All this is fully consistent with the Treaty’s prohibition on monetary financing. Moreover, they will focus on shorter maturities and leave room for market discipline."

But he also said the following:
"The ECB intervenes only in countries where the economy and public finances are on a sustainable path."

Our "Generous Gambler" is indeed kept on a tight leash for now, a German one that is, courtesy of the Banker's Algorithm.

Our "Banker's Algorithm" comes into play when you think about on-going Spanish deflationary vicious spiral given our computational reference which we touched again last week:

"The algorithm avoids deadlock by denying or postponing the request if it determines that accepting the request could put the system in an unsafe state."
So of course, our Banker's algorithm has avoided the deadlock in Europe because of Spain. Clearly by denying or postponing the request, it has determined the Spanish request could put the European system in a clear unsafe state!
For Spain, it is "request denied" courtesy of the Bankers' algorithm."

Question being now, can Europe survive in the current form (number of countries) without making material sacrifices? One has to wonder...

By managing to keep Germany’s liabilities unchanged German Chancellor Angela Merkel has been in fact the clear "winner" of the last European summit in June (number 19...) we argued in our conversation "Europe - The Game of the Century". On the 18th of October, Chancellor Merkel in her address to the German lower-house has indeed craftily defended again Germany's liabilities by declaring:
"Financial aid without conditions attached has in some cases frustrated the drive to streamline economies, and therefore joint liability is the wrong answer"

Given the IMF has cut its euro-region growth forecast for 2013 from 0.7% to 0.2% with the European economy potentially shrinking by 0.4% in 2012 instead of the "projected" 0.1% by the ECB, in this week's conversation we will look at correlations and causation on our European ship given the increasing risks of "Mutiny on the Euro Bounty" in 2013 which we have been highlighting since April this year:
"As well as Fletcher Christian and part of the crew, our European "sailors" (politicians) were attracted to the "idyllic" initial cheap funding environment provided by a single currency umbrella. The recent austerity "harsh treatments" measures imposed by the captain of the ship (European Commission) which we reviewed in our recent conversation ("The Charge of the Light Euro Brigade") seems to be clearly pushing some of the members of the crew towards mutiny. This explains somewhat, why the European ship is attempting to change tack, moving towards growth."

"Prosperity makes friends, adversity tries them." - Publilius Syrus

Unemployment figures in Germany which will be published next week and will be key. So will be economic data from Germany. In September 2011, in our conversation "Much ado about nothing" we argued:
"And given Merkel's big u-turn relating to the Japanese nuclear disaster in 2011, and that next general election in Germany are to be held in September 2013, and we know that Merkel is already committed to a third term, we would really follow closely the German economy in general and the German labour market in particular. "

There is indeed a growing rift between France and Germany in relation to the course that needs to be taken in relation to Europe due to a growing divergence in the political agenda for both France and Germany. We agree with the latest report from Nicolas Doisy - Politoscope number 10  from Cheuvreux which validates our recent analysis Merkel and our Banker's algorithm:
"Delaying the euro federal Big Bang again: the Franco-German “phoney war” (redux):
-While it should be starting, Europe's federal Big Bang is stalling again due to diverging political agendas in Germany and France with regard to the euro institutions. The disagreement is partly real (i.e. of substance) and partly fake (i.e. purely motivated by domestic politics) and likely to drag on for months… if not years.
 -Merkel has timed her agenda in 2013 with a view to the full monty (re-election and a euro to her liking) and thus intends to frame the debate to her advantage. To keep her options open, Merkel wants to have the final say on any decision regarding Spain and the euro: this is why she uses the federal agenda as a red herring.
-To secure her chances for re-election, Merkel needs to keep the Eurozone quiet during the coming year: this is why she has agreed to the ECB's OMT for Spain. For as long as she is leading the electoral polls, she is sure to keep both France and the SPD in check: this is why she is skilfully nurturing German anti-euro feelings.
-Hollande's options are limited, as he can only bank on the SPD or market pressure to break the deadlock: he thus also uses this debate to keep his own left in check. His only potential ace is to use next year's recession in the Eurozone to table his "growth" agenda again, so as to get a more lenient fiscal treatment by Germany. 
-All in all, this Franco-German divide over institutional options looks very likely to lead to a two-speed Eurozone as the periphery will continue entering its debt-deflation." - source Cheuvreux.

Moving on to France and the subject of when causation implies correlation, we noted from the same interesting note from Cheuvreux the following interesting correlation. Namely that Hollande's popularity is 100% correlated with the rise in unemployment since he has taken office: 5,000 more unemployed = 1% less popularity for Hollande, so that (theoretically), according to Cheuvreux's analysis, he should be ousted when unemployment reaches 3.2 million:

"Hollande's first option out of this diplomatic deadlock could be for the social democrats to win next year's election or the leadership of another Grand Coalition. However, after supporting France's stance very vocally on several occasions in the winter of 2011, the SPD has gone mute on the issue of Eurobonds in particular. This clearly is a sign that Merkel has so far won the battle of public opinion on the euro issue." - source Nicolas Doisy - Cheuvreux.

Following up on François Hollande's political strategy of hoping for the social democrats to win next year's election, we could not resist, (given our post title) but refer to "Mierscheid law"!
The Mierscheid law was a satirical forecast published in German magazine Vorwärts on 14 July 1983 which forecasted that the Social Democratic Party of Germany (SPD)'s share of popular based on the size of steel production in Western Germany: "The Vote share of the SPD equals the Index of the crude steel production in the western federal states - measured in millions of tonnes - in the year of the federal election".

"The last corroboration of the law was in the 2002 election, where the West German crude steel production was 38.6 million tonnes, and the vote share of the SPD 38.5%. For the early election in 2005 the vote share was 38.4%, with a mean crude steel value of 40.0 million tonnes. Over the last ten elections, the two values were within two units nine times, and within one unit seven times." - source Wikipedia

- source - the full Wiki.

With German confidence falling to the lowest level in more than two and half years and Europe's composite PMI falling to 45.8 from 46.1 in September, the IFO institute's business climate index unexpectedly dropped to 100.0 from 101.4 in September, indeed accelerated deleveraging and generalized austerity is increasing the causation of economic woes and the correlation with worsening economic outlook. We feel comfortable with our recent call of growing divergence between the growth differential between USA and Europe as indicated by the recent PMI.

We also believe that as economic woes weight on both Germany and France in 2013, so will increasing political rifts arise in the process. We do agree with Nicolas Doisy's take from Cheuvreux, namely that there is indeed a new "phoney war" evolving between both countries:
"This (peaceful) remake of the Franco-German phoney war obeys a purely political logic and forces the Eurozone to continue walking along the abyss for another year. Unfortunately, it can only add to the uncertainty surrounding the fate of the Eurozone by leaving deflationary Spain very much on the hook: there is no clear prospect of Eurobonds any time soon, be it to recapitalise Spanish banks or help Spain's government. Beyond, this phoney war could well turn into another "battle of Stalingrad" when the actual size of the Spanish problem is fully revealed, right after the German election (if not before). It is thus to be hoped that another Grand Coalition wins in Germany, as seems to be the preference of the German electorate. Such an outcome would have the advantage of creating the conditions of a de facto national unity government in Germany. In any event, this Franco-German great divide over institutional options looks very much apt at leading to a two-speed Eurozone of sorts in the not-so-distant future. Indeed, it appears clearly from this debate that the core issue is what to make of the periphery. This amounts to raising the question: (where and how) does the periphery belong in the Eurozone? While still implicit, this theme will surely rise to the front in near future." - source Cheuvreux - Nicolas Doisy

Indeed, what to make of the periphery in general and Spain in particular given the recent Spanish banks earnings which clearly indicate that Oliver Wyman's nightmare scenario could as well play out which therefore clearly justify the retention in the allocation process of our European Banker's algorithm?
Caixabank, the third biggest bank saw its profit fall 42% as it accelerated loss recognition tied up to real estate with 4.41 billion euros of provisions in the first nine months to fully cover the required 2.44 billion euros from the first RDL (Royal Decree Law) and 600 million of the 2.1 billion euros in charges needed from RDL2 passed in May. Bad loans jumped to 8.42% in September from 5.58% in June and 4.9% in December 2011.
It was a similar story for Spanish giant Santander, with third quarter profit felling 94% due to the necessary purge in real estate exposure needed with net income falling to 100 millions euros from 1.8 billion euro a year earlier. Bad loans as a proportion of total lending rose to 4.33% from 4.11% in June. The bad-loan ratio across the Spanish business climbed to 6.38% from 5.98% in June and 5.15% a year earlier.

The rise in bad loans are all a reflection of the rise from bad loans in the construction sector as reported by Bloomberg:

"September's Spanish stress test projected aggregate losses of 270 billion euros for the banks under its adverse scenario, with a 43% loss on real estate developers, identical to Santander's 3Q real estate non-performing loan ratio. Spain's construction and real estate bad debt topped 100 billion euros at 1H and may rise faster and further than stress estimates." - source Bloomberg

No wonder the Banker's algorithm is reluctant in allocating "resources". In that context, the bad bank SAREB which need to be in place by December, will have as much as 90 billion euros of asset based on their transfer price, initially comprising land, developer loans and residential units that went bad according to Bloomberg article "Spain Bad Bank Seen Too Big to Work With $117 Billion: Mortgages" by Sharon Smyth from the 25th of October.
"The Bank of Spain has yet to fix transfer valuations for the assets based on the stress tests of Spanish lenders carried out by management consultants Oliver Wyman and published on Sept. 28. The 90 billion euro number is based on transfer prices, so the original value of the assets is likely to be higher.
In comparison, Ireland’s National Asset Management Agency, set up in 2009, spent 32 billion euros on mortgages with a face value of 74 billion euros to cleanse its banking system.
Lenders that take state aid will have to transfer to the bad bank foreclosed property of more than 100,000 euros, real estate and builder loans of more than 250,000 euros and controlling stakes in property firms, according to the Economy Ministry official. A decree to regulate the entity should be passed on Nov. 16. It may be amplified in the future to include loans to consumers, small and medium enterprises and retail mortgages." - source Bloomberg.

In relation to Bankia, we argued in May 2012 in our conversation "The Tempest the following" with our good credit friend:
"A better solution would be to force a conversion of debt to equity (In a debt-for-equity swap, a company's creditors generally agree to cancel some or all of the debt in exchange for equity in the company). Doing so will not require 7 to 10 billion funds, but would of course dilute shareholders and destroy bond holders (haircut)."

The ECB is now pushing for inflicting losses on junior debtholders as reported by Emma Ross-Thomas, Esteban Duarte and Ben Sills from Bloomberg on October 25 - ECB is Said to Push Bankia Losses as Spain Purges Assets:
"The European Central Bank and European Commission want investors including preference shareholders to swap their securities for new shares to reduce the cost to the taxpayer, according to two people who asked not to be named because the discussions are private. Profit at Banco Santander SA, Spain’s biggest lender, slumped in the first nine months as it took a 14.5 billion-euro charge on real estate losses.
Confronting the toxic legacy of Spain’s 10-year building boom is imposing political costs on Prime Minister Mariano Rajoy as he faces a separatist challenge in Catalonia, protests on the streets of Madrid and a battle to avoid a full bailout." - source Bloomberg.

Back in our May conversation we indicated:
"Transparency in asset valuations would finally help in discovering the extent of the problems plaguing the Spanish Financial sector. The set-up of a "Bad Bank" in similar fashion to Ireland's NAMA, would indeed force price discovery and true valuations provided a third party assessor is drafted."

and we added:
"Without credit growth resuming, the ambitious target deficits will not be met in Spain. The conditions for growth needs credit growth to resume, as shown by the recent credit growth in the US (see our conversation - "Growth divergence between US and Europe? It's the credit conditions stupid..."). Spain has to go through resolving the Spanish banking encumbered balance sheets."

When causation implies correlation...

Credit wise, for Spanish banks, the rise in the issuance for "Puttable bonds" is a cause for concern we think. Puttable bonds are fixed-income securities which investors are able to redeem before maturity. It is a very dangerous option given the funding shock it could create should investors decide in concert to exercise their option. As reported by Bloomberg by Esteban Duarte and John Glover on the 25th of October in their article "Santander Seeks Salvation in Puttable Bonds":
"Banco Santander SA, Spain’s biggest lender, is placing its trust in bondholders by issuing 4.4 billion euros ($5.7 billion) of fixed-income securities that investors are able to redeem before maturity.
Bonds with put options make up 36 percent of Santander’s debt funding this year, compared with 9 percent in 2011, according to data compiled by Bloomberg. While the bonds have lower interest rates, they leave the bank vulnerable to a potential 7 percent increase in the 33.4 billion euros it must repay next year. Investors have already demanded early repayment on 1 billion euros of the notes." - source Bloomberg

Puttable bonds are indeed a typical instrument used by financial institutions under stress. For us, a big red flag.

Another red flag we think for Santander, comes from its dwindling capacity in absorbing potential losses at the parent bank by its increasing policy of partial IPOs such as the one done in Mexico as indicated by CreditSights in their report Spanish Banks - The Value of Empires from the 22nd of October:
"In Santander's case especially, the capacity of equity in its foreign subsidiaries to absorb potential losses at the parent bank is being reduced by its policy of partial IPOs (the goal being to list all the most significant subsidiaries within five years – see Santander: Partial IPO in Mexico). The erosion of loss absorbing capacity that this implies at parent or group level is reflected in the Basel 3 reform that will ultimately prevent banks from including in consolidated CET1 capital any surplus equity contributed by minorities in excess of the subsidiaries' minimum regulatory requirements." - source CreditSights

On a final note, looking at the our "Flight to quality" picture as indicated by Germany's 10 year Government bond yields (well below 2% yield), falling again towards 1.55% versus 5 year Germany Sovereign CDS which has cratered below 25 bps, by avoiding increasing so far Germany's liabilities, Chancellor Merkel has in effect alleviated concerns on Germany's exposure to European woes we think - source Bloomberg:

It's deflation (デフレ) in Europe.

"Correlation is not causation but it is sure a hint" - Edward Tufte - professor emeritus of political science, statistics and computer science at Yale University.

 Stay tuned!