Japan, where credit is leading equities...

"It is better to meet danger than to wait for it. He that is on a lee shore, and foresees a hurricane, stands out to sea and encounters a storm to avoid a shipwreck." - Charles Caleb Colton 

Back in our conversation "Saint-Elmo's fire", our good cross asset friend indicated to us an interesting correlation between the Japan Nikkei index and Japan's Itraxx 5 year CDS since the beginning of March. The index had been falling whereas at the same time, Japan's Itraxx CDS had been rising. The bottom graph indicates so far a fairly muted volatility for the Nikkei index:

As one can see from the above, the Japanese Itraxx CDS has been rising steadily (inverted in the graph for comparison purposes with the Nikkei index) while volatility has remained so far muted on the Nikkei index.

Itraxx Japan CDS climbing - source Bloomberg:

As a reminder from our conversation "Ecce Creditor" from March from Cheuvreux analyst Jolyon-Charles Montague his note "Atlas shrugged" on the 7th of March:

"Japan provides two important lessons for European investors: first, a case study of the perils of failing to achieve structural reform; second, how to invest in and trade a 20-year bear market. We conclude that for the current rally to continue beyond 2012 structural reform must be implemented, deflation averted and regulatory forbearance reversed: no small feat. It is often underappreciated that in 1989 Japan's net public debt to GDP was just 14.4% and the major driver for its explosion was a lack of tax revenue not fiscal largesse. Europe arguably is in a worse position than Japan as it has little room to raise taxes. Furthermore, Japan's government spending excluding social security and interest payments is among the lowest in the world. Given an aging population, Europe is on the verge of experiencing the same surge in social security spending."

Also in our conversation "Structural Instability" we looked at correlations between credit and equities and Japan stood out in particular. Monitoring levels of correlation in the short-term is fundamental if you are looking at adding relative value positions or if you would like using historical signals to position yourself on either credit or equities.

We believe once again credit is a leading indicator particularly when looking at Japanese equities.

Chart Volatility 6 months ATM Nikkei vs CDS ITRAXX JAPAN (50 entities versus 225 names) - source Bloomberg:

The recent Itraxx Japan roll impact on the widening of the Itraxx Japan index amounted to 20 bps of the widening move.

According to our good cross-asset friend, the correlation between the Nikkei volatility and credit spreads represented by the Itraxx Japan index has not been recently materially significant but, the widening of Japanese credit spreads cannot be ignored. In a very bullish credit environment, Japan is the only region (apart from peripheral Europe) where credit spreads are closer to the higher levels reached during the crisis of 2008/2009. This on-going weakness reflects deteriorating fundamentals for Japanese corporate companies such as Utilities suffering since Fukushima, struggling exporters courtesy of a very strong currency with private households hoarding cash, and specific companies facing difficulties such as Sharp and Sony. 

- source CMA cds data provider.

Therefore we believe this relationship warrants close monitoring. A very important point to make is that Japanese structured products (Uridashi) are totally driving the Nikkei's volatility as long as we are in a range 8,000 / 10,000 on the Nikkei index. Also please note Itraxx Japan has 50 names versus 225 names for the Nikkei index, further investigation in the components in sectorials bias would be needed in our exercise.

The Tokyo Stock Price Index commonly known as TOPIX is tracking all domestic companies of the exchanges First Section (1669 domestic companies). We find there is no opposition between Nikkei and Topix spot prices versus credit.

From the below, and following a similar exercise / analysis, we can find a similar relationship with credit, namely a high correlation in spot prices but not in volatility.

CDX Japan / TOPIX:

Correlation at -82.24%

CDX Japan / 12 months ATM TOPIX Volatility:

Correlation at 18.94%

We can therefore conclude that our Japanese "uneasiness" or discomfort courtesy of many years of "easiness" is indicative of the growing deterioration of some Japanese corporates, namely the ones being quoted in the CDS market. Globally, Japanese corporates remain "cash" rich but nevertheless the cracks are beginning to show in relation to Japan. Japanese output fell by 1.3% in July and Japan is headed for contraction this quarter.

Japanese Sovereign CDS 5 year evolution since 2004 - source Bloomberg:

The Japanese fight against deflation goes on...

On a final note in the latest spat between China and Japan, trade wise, China looks to have the upper hand:

"Japan’s increased dependence on China for export sales gives officials in Beijing the upper hand in a territorial dispute that triggered street protests and forced Chinese units of Japanese companies to close plants. The CHART OF THE DAY compares Japan’s exports to China, the European Union and the U.S. measured in billions of yen, showing sales to China more than doubling between 2002 and 2011 as the nation became the No.1 market. Exports to America dropped by almost one third and EU demand was little changed. The lower panel tracks nominal gross domestic product of the Asian countries, with China surpassing its neighbor as the world’s second-largest economy in 2010 in dollar terms, data compiled by Bloomberg show. China’s share of Japanese exports doubled over the decade to 20 percent. By contrast, the U.S. bought about 15 percent of Japan’s exports last year, half the proportion in 2002. The shift underscores China’s clout in a fracas over control of islands called Diaoyu in Chinese and Senkaku in Japanese."  - source Bloomberg

"Every government has as much of a duty to avoid war as a ship's captain has to avoid a shipwreck." - Guy de Maupassant 

Stay tuned!

Credit - Zemblanity

"Insanity: doing the same thing over and over again and expecting different results." - Albert Einstein

Last week, we ventured towards the diminishing returns QE in the US would have on the real economy. While you might be puzzled by our latest choice of title, we ought to give you, dear readers, some rational explanation in this week title selection. William Boyd, the novelist and screenwriter (who wrote the latest James Bond novel), used the term "zemblanity" to mean somewhat the opposite of "serendipity": "making unhappy, unlucky and expected discoveries occurring by design", which is exactly what central banks over the world will eventually discover with their latest merry go rounds of quantitative easing. So in our long credit conversation, we will investigate further the potential for disappointment from this latest round of "easing" from our "Generous Gamblers" which have been flooding the markets recently with even more liquidity.

Definition of Zemblanity - "The inexorable discovery of what we don't want to know".

While serendipity means a "happy accident" or "pleasant surprise"; specifically, the accident of finding something good or useful while not specifically searching for it, zemblanity is the opposite. Robert K. Merton  in Social Theory and Social Structure (1949) referred to the "serendipity pattern" as a fairly common experience of observing an "unanticipated, anomalous and strategic datum which becomes the occasion for developing a new theory or for extending an existing theory" as indicated by Wikipedia.

What we found most interesting is the "relationship" between US Velocity M2 index and US labor participation rate over the years. Back in July 1997, velocity peaked at 2.13 and so did the US labor participation rate at 67.3%. Now at 63.5% the US is back to 1981 and velocity is still cratering (1.58), back to 1965 level - source Bloomberg:

Back to the Future? So although in the movie Dr Emmet "Doc" Brown was trying to find a way to return to 1985 from 1955, we have "Doc" Ben Bernanke expecting QE3 will be successful in increasing the labor participation rate and velocity back to 1997 and successful in reducing the unemployment burden on the US economy. It will not happen.
President Ronald Reagan, was a fan of the film "Back to the Future" and referred to the movie in his 1986 State of the Union Address when he said, "Never has there been a more exciting time to be alive, a time of rousing wonder and heroic achievement. As they said in the film Back to the Future, 'Where we're going, we don't need roads.'" Unfortunately this is not 1986 in terms of economic outlook.

So what "Doc" Bernanke is telling us now is that "Where we're going, we need jobs" basically. Nice wishful thinking.
MV=PT as per Irving Fisher's equation. Unfortunately, it looks like the increase in M with a falling V, is not leading to a rise in T nor in a rise in the US labor participation rate for "Doc" Bernanke. Velocity and US labor participation rate from 2005 onwards - source Bloomberg:

Milton Friedman was convinced he could rebuke Keynes theory by showing that the velocity of money was relatively fixed and thus that the relationship between the money supply and national income could therefore fall apart if Friedman's assumption was indeed correct. It wasn't. Velocity is not constant and Friedman admitted on the 19th of August 2003 he was wrong:
"Prior to the 1980s, the Fed got into trouble because it generated wide fluctuations in monetary growth per unit of output. Far from promoting price stability, it was itself a major source of instability. Yet since the mid '80s, it has managed to control the money supply in such a way as to offset changes not only in output but also in velocity. This sounds easy but it is not -- because of the long time lag between changes in money and in prices. It takes something like two years for a change in monetary growth to affect significantly the behavior of prices. The improvement in performance is all the more remarkable because velocity behaved atypically, rising sharply from 1990 to 1997 and then declining sharply -- a veritable bubble in velocity. Chart 2 shows what happened. Velocity peaked in 1997 at nearly 20% above its trend value and then fell sharply, returning to its trend value in the second quarter of 2003."

But Keynes was also wrong. For Keynes the quantity of money did not matter, what mattered were autonomous spending and the multiplier. By keeping interest low to promote investment, like the Fed is currently doing, full employment would therefore be "attainable". For Keynes, the velocity of money would move together with the level of economic activity (and the interest rate).

We think the above charts indicating M2 and the US labor participation rate are indicative of the failure for both theories. Both theories failed in essence because central banks have not kept an eye on asset bubbles and the growth of credit and do not seem to fully grasp the core concept of "stocks" versus "flows".

Our core thought process relating to credit and economic growth is solely based around the very important concept namely the accounting principles of "stocks" versus "flows":
"We mentioned the problem of stocks and flows and the difference between the ECB and the Fed in our conversation "The European issue of circularity", given that while the Fed has been financing "stocks" (mortgages), while the ECB is financing "flows" (deficits). We do not know when European deficits will end, until a clear reduction of the deficits is seen, therefore the ECB liabilities will have to depreciate."

We encountered through our weekly blog reading an essential post dealing with our core concept of "stocks versus "flows" from Mr Michael Biggs and Mr Thomas Mayer on voxeu.org entitled - How central banks contributed to the financial crisis which explains precisely why both Friedman, Keynes and the central banks have been behind the curve in preventing the previous financial crisis and potentially the next one: "We have argued at some length in the past that because credit growth is a stock variable and domestic demand is a flow variable, the conventional approach of comparing credit growth with demand growth is flawed (see for example Biggs et al. 2010a, 2010b). 
 To see this, assume that all spending is credit financed. Then total spending in a year would be equal to total new borrowing. Debt in any year changes by the amount of new borrowing, which means that spending is equal to the change in debt. And if spending is equal to the change in debt, then the change in spending is equal to the change in the change in debt (i.e. the second derivative of the development of debt). Spending growth, in other words, should be related not to credit growth, but rather the change in credit growth. 
We have called the change in debt (or the change in credit growth) the 'credit impulse'. The credit impulse is effectively the private sector equivalent of the fiscal impulse, and the analogy might make the reasoning clearer. The measure of fiscal policy used to estimate the impact on spending growth is not new borrowing (the budget deficit), but rather the change in new borrowing (the fiscal impulse). We argue that this is equally true for private sector credit."

We therefore wonder in relation to the latest bout of global quantitative easings the following:
"Does the end (lowering unemployment levels) justify the means (increasing M) or do the means justify the end (deflationary bust)?"

So can someone please demonstrate to us how "this time it is going to be different" in terms of outcome for the US labor market given the "paradox of thrift" with bank reserves sitting idle at the Fed like we indicated in our previous conversation, with a broken transmission to the US economy, and questions surrounding fiscal stimulus which could potentially alleviate the situation (tax breaks for small companies anyone...)?

We came across this comment from a participant on a macro research forum from a prominent global research firm and we did find it very appropriate in relation to our title analogy, namely "Zemblanity" and thought we had to share it:
"Isn't QE3 in one sense a blow to the essence of America's prosperity, free markets and with that efficient capital allocation? Setting a target for unemployment rate by running the printing press sounds a lot like a planned economy. It might get us to the target (if not the drop in participation rate eventually will) but with that the economy risk be even more similar to Japan? Have we become so short sighted and spoiled that we can't face the hard facts of our previous reckless childish behavior? I can't think of any time in history when avoiding the truth ever was a sustainable choice. Only history will tell but FED, ECB, BOJ and BOE (soon BOC?) all being in the same boat makes you worried about unintended consequences.... I'm 100% long risk for the moment but long term I think this takes us further from a sustainable world."

"we can't face the hard facts of our previous reckless childish behavior" - No, we clearly cannot.
Definition of Zemblanity - "The inexorable discovery of what we don't want to know".

"It might get us to the target (if not the drop in participation rate eventually will) but with that the economy risk be even more similar to Japan?"
Of course it will! The Bank of Japan is already losing out to Yen-hoarding households! - source Bloomberg:

"The Bank of Japan’s efforts to weaken the yen are being undermined as households hoard the most currency in 14 years, according to Mizuho Corporate Bank Ltd. The CHART OF THE DAY tracks the yen’s rally versus the dollar and the deposit-assets and currency holdings of domestic savers. Also shown is the start of central bank monetary easing through the asset purchase program set up in October 2010, which has had limited impact on the currency. The yen rose the past two days even after the BOJ’s surprise Sept. 19 announcement of more asset buying, contrasting with stimulus efforts in February that helped weaken the currency for five weeks. BOJ quarterly flow of funds data yesterday showed individual investors, often referred to as “Mrs. Watanabe” because many are housewives, increased yen deposits and cash to 844.1 trillion yen ($10.8 trillion) in the three months ended June 30. That’s the most since at least December 1997 and double the annual output of Japan’s economy, the world’s third largest." - source Bloomberg

Back in early September in our conversation "Structural Instability", we indicated that the overall underperformance of Japanese credit spreads as illustrated from the below graph on some selected Japanese companies (source CMA) which continue to weaken in conjunction with their Sovereign CDS (Japan's sovereign CDS wider by  20 bps in one month) is at present the only notable disconnect between credit spreads and spot equities.

The Japanese relationship between equities and credit warrants monitoring and could be played by selling CDS and buying Nikkei Put Options we indicated in early September courtesy of our good cross-asset friend. Nikkei Put Options benefit from absolute low volatility levels. Nikkei Index - 3 Month 100% Moneyness Implied Vol versus Japan 5 year CDS since March 2010 until the 21st of September 2012 - source Bloomberg:

In similar fashion to the current Japanese plight, the Fed will eventually discover soon that company debt sales will counter its bond buying plan - source Bloomberg:

"Increased borrowing by companies may blunt the economic effects of the Federal Reserve’s third round of bond purchases, according to Michael Shaoul, chairman of Marketfield Asset Management LLC. As the CHART OF THE DAY shows, U.S. companies have already sold more than $1 trillion of dollar-denominated debt this year, according to data compiled by Bloomberg. The year-to-date total is 22 percent above the average for the previous five years. “Corporate debt should act to absorb the cash” generated by the Fed’s quantitative easing, Shaoul wrote yesterday in an e-mail. The central bank will buy $40 billion of mortgage-backed securities a month in an effort to stimulate economic growth and reduce unemployment. Borrowing costs for companies were unusually low before Fed policy makers reached their decision last week. Yields on Baa rated corporate bonds are less than 5 percent, according to a Moody’s Investors Service index. They fell below the threshold this year for the first time in more than a quarter century. As more companies take advantage of the relatively cheap funding, they may overwhelm any growth in bond demand that stems from the Fed’s buying and related bond investments, Shaoul wrote in the e-mail “Our greatest concern regarding QE3 was that it was not only unnecessary, but may in the end prove to be positively harmful,” he wrote yesterday in a report highlighting this year’s increase in corporate borrowing. He said the risk arises because bonds will be unable to match their gains in the past few years “unless we truly face an ‘end of the world’ type depression.”." source Bloomberg.

We ended up last week's conversation by indicating:
"The fight against deflation goes on..."

Bank of America Merrill Lynch report from the 11th September entitled "Bernanke and Draghi's deflationary bubbles wrote the following in relation to the on-going deflationary forces at play we mentioned on a regular basis: "Bubbles forming in the Three Wise Themes Some of the assets tied to the Three Wise Themes of Yield, Growth and Quality are exhibiting bubble-like characteristics (see chart below). But these deflationary bubbles are just beginning to form. The ECB has now joined the Fed in using liquidity injections in the war against deflation. Consequently, the prices of assets tied to the Three Wise Themes are likely to inflate further until central banks can normalize monetary policy. The RIC therefore remains overweight large-cap US Growth, preferred stocks, EM stocks, investment grade and high yield bonds and significantly overweight international bonds. We remain underweight US Treasuries, small-cap stocks and Value stocks."

Indeed it is going on. Richard Koo, the chief economist at Nomura Research Institute wrote in his 19th of September note entitled - Excitement over new policies that may have only limited impact:
"Borrowers, not lenders, are in short supply during balance sheet recessions I used the term “unnecessary” to describe recent central bank actions because balance sheet recessions are characterized by a massive surplus of private savings. In noneurozone countries, these funds have nowhere to go but the government bond market, since the government is the last borrower standing. That is why government bond yields fall steadily, as they did in Japan even prior to 2001. In other words, it is borrowers that are in short supply when the private sector is saving money and paying down debt in spite of zero interest rates. Under such circumstances it is difficult to see what economic benefit could arise from adding the central bank as a lender when the bottleneck of the economy is elsewhere."

Exactly! This even more the case when you factor in the demographic impact the "Baby Boomers Generation" has had and will have on US treasury markets (74 million to retire in the next 20 years) as we posited in our last conversation "Pareto Efficiency" and so was the impact on yields from Japan's aging population on JGB's yields.  In a Pareto efficient economic allocation, no one can be made better off without making at least one individual worse off, it is that simple, and the losers today being unfortunately the younger generation in "developed" countries. Therefore, we believe that, from an allocation point of view, investing in Fixed Income Emerging Markets countries, having both favorable demographic trends (young population) and decent current account balances, makes a lot of sense from a long term investment perspective, but we ramble a lot. Time for a credit overview!

The Itraxx CDS indices picture is displaying a different picture from last week given the 20th of September saw a change in the composition of the Itraxx family of credit indices - source Bloomberg:

While overall the Itraxx credit indices reflecting credit risk in various components of the credit markets ended up Friday flat following the week, we think it is interesting to note the following changes in terms of risk structure in relation to the composition of the new series of Itraxx Credit indices (series 18). While credit risk, has overall decreased in the last six months mostly for non-financial investment grade credit (Itraxx Main Europe 5 year index back to March level of around 120 bps) by courtesy of the various central banks interventions, the latest iteration of the Itraxx Main Europe investment grade index has seen various peripheral names dropping out such as Spanish Repsol (negative outlook by Moody's and Fitch), Italian bank Banca Monte Paschi dei Siena (550 bps cost for 5 year Senior CDS) and Spanish Bank BBVA (325 bps cost for 5 year Senior CDS). Both peripheral banks in the Investment grade index have been replaced by Dutch bank ING (172 bps on 5 year Senior CDS) and UK bank Standard Chartered (120 bps on 5 year Senior CDS). Therefore the new names being added to the Investment Grade index have lower default risk and lower volatility than the ones removed. Only 11 names of the new 125 entities making the new Itraxx Main Europe index come from Italy and Spain (none from Portugal, Ireland or Greece).
But more importantly the changes in the Itraxx Crossover series 18 (which references the 50 most liquid European High Yield and low triple B rated credits) have seen the arrival of Spanish giant Repsol as a result of the rating actions in conjunction with the negative outlook. 14 members of the 50 names of the Itraxx Crossover index now come from peripheral strained countries.

While rolling from the old Series 17 to the new series 18 (selling series 17 and buying series 18) cost you around 5 bps for the Itraxx Main Europe (investment grade risk gauge), a similar roll for the Itraxx Crossover cost you around 65 bps on Thursday. Whereas the roll for the Itraxx Financial Senior index and Itraxx Financial Subordinated index was around -11 bps for Senior and -20 bps for Subordinated, reflecting the improvement in quality of the index with the addition of ING and Standard Chartered and the removal of BBVA and Monte Paschi dei Siena (MPS).

One can expect that going forward, the series 18 should be more volatile for the Itraxx Crossover whereas the Itraxx Main Europe, Itraxx Financial Senior and Subordinated index should be less volatile given the substitutions of the entities making up these various indices.

Looking at the below graph, one could argue that severing of the link between Sovereign risk / Financial risk is somewhat happening given the significant drop of the spread between the Itraxx Financial 5 year Senior index reflecting financial risk and the SOVx 5 year index representing Sovereign CDS risk in Western Europe. It is deceptive given that the new series 18 for the Itraxx SOVx index which comprised previously 15 entities, has seen Cyprus falling out of the index because of lack of trading in CDS linked to Cyprus's debt - source Bloomberg:

We expected Cyprus to drop as we indicated on the 24th of March 2012 in our post "The Spread Also Rises": "Replacing Greece by Cyprus is the SOVx series 17 index might not be enough to preserve the 15 member's number status. On the 13th of March, Moody's rating agency joined its peer Standard and Poor's in slashing Cyprus to junk status on heightened concerns over its banking sector’s exposure to Greece. Only Fitch rating agency has maintained its rating for Cyprus one notch above junk."

The main concern of European authorities has been trying to break the close relationship between sovereign risk from financial risk. Many European politicians are expecting that the European Banking Union will finally break this relationship. But in fact, the ECB's two LTRO operations so far have not only increased the link but made it in effect more acute as indicated by a graph realized by global macro research house Gavekal:

In relation to the European bond picture, this week Spanish 10 year yields closed around 5.80% but flirted again with the 6% as the pressure is building for Spanish Prime Minister Rajoy in seeking official support whereas Italian 10 year yields still well below 6% around 5.00% whereas German government yields receding towards the 1.60% levels with other core European bonds yields rising as well in the process - source Bloomberg:

Clearly our "Generous Gambler" Mario Draghi's effect is fading as indicated by Bloomberg:

"European Central Bank President Mario Draghi’s pledge to buy short-dated government bonds may not be enough to end investor concern that Spain’s debt is unsustainable and the country will need a sovereign bailout. The CHART OF THE DAY shows that Spanish 10-year bond yields climbed past 6 percent today for the first time since Sept. 7, the day after Draghi gave details of the central bank’s asset-purchase plan. Since falling to a five-month low of 5.55 percent on Sept. 10, the yield jumped as much as 46 basis points to a high of 6.01 percent today. The yield reached a euro-era record 7.75 percent on July 25, before Draghi pledged the next day to do “whatever it takes” to safeguard the monetary union." - source Bloomberg.

On a side note we were quite amused to read Bundesbank President Jens Weidmann's reference to Faust, in reference to Mario Draghi's bond-buying programme "OMT" in similar fashion to our  "Generous Gambler"  analogy: "If a central bank can potentially create unlimited money from nothing, how can it ensure that money is sufficiently scarce to retain its value?" and added: "Yes, this temptation certainly exists, and many in monetary history have succumbed to it".

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

Weidmann intended his speech and his reference to "Mephistopheles" and the money printing to point towards the risk of creating rampant inflation.

But as far as credit is concerned, spread wise, the process is more akin to "Japanification" rather than rampant inflation for the time being. In Societe Generale's Market Wrap-Up from the 17th of September they made the following interesting points:
"The light we see at the end of the tunnel isn't that of sustained economic recovery, nor is it that of the eurozone's issue being resolved or the US fiscal cliff issues ameliorated. It's that we are switching overnight to a pragmatic view of the world. We have decided that with all the liquidity sloshing around and the additional recent central bank actions, peripheral sovereign downgrades to junk (Spain to come?) should be no barrier to buying peripheral corporate risk. The freed up money needs to go somewhere and blue chip, national champions from the periphery are deemed as being unlikely medium-term defaulters - should the euro remain intact. In the past couple of sessions alone, Spanish and Italian corporate risk has rallied by between 50-75bp (and by some 150-200bp since the beginning of August). So all that liquidity finds itself pressing on corporate bond yields and the ‘herd’ is in thunderous form, heading in the same direction - hopefully it's not towards the precipice. 
Which means that corporate credit spreads are going into Japanification mode. The unlikely triumvirate of low growth, low rates and low yields have become the corporate bond market’s friend. And we're now ratcheting tighter, led by higher yielding financials where T1 and LT2 prices lead, although most high beta risk is in vogue. The iBoxx cash corporate is now at B+196bp and has tightened 164bp this year. We now target B+165bp for year-end. Returns for IG are close to 19%, HY at 17% and, even if we hold here at worst, this will still finish as the second best year ever for corporate credit. We might still - likely will - get some jitters along the way. Spain's expected downgrade might see some (temporary) weakness; a Greek flare up might too; and, political event risk elsewhere is quite possible. Otherwise, the ECB taking govvies out of the market is keeping liquidity plentiful and it needs a home. Some of it keeps rolling into credit, helping the supply to get mopped up, keeping confidence at elevated levels. 
Non-financial issuance YTD is now close to €130bn which is the long-term annual average; and we are now looking at somewhere well over €150bn for the full year. That's more than double what we had forecast at the beginning of the year. The €22bn for September alone is massive and we still have two weeks to go. And nearly half of the issuance has come from the periphery. Furthermore, if we can get past €26bn by the end of the month, we'll be looking at September in the context of it being the fifth best month for non-financial supply - ever. We can't get enough financial risk either. Senior paper is tightening fairly consistently amid poor secondary market liquidity. Almost €95bn has been printed YTD which is close to our €100bn forecast for the year. And the way the technicals of the market are playing out, we're in the mood to absorb much more issuance and see banks raise funds at ever decreasing costs. €125bn looks like the next stop."

As far as credit is concern, it still "Risk-On" for now, but we are definitely moving more and more in expensive territory which is not supported by a favorable economic outlook based on the latest economic releases (European PMIs). Both the Itraxx Main Europe 5 year index and Itraxx Financial Senior 5 year index are converging, indicative of falling risk aversion - source Bloomberg:

But as we posited before when quoting Bastiat around our liquidity concerns, there is what you see and what you don't see (from our conversation "The Unbearable Lightness of Credit": "That Which is Seen, and That Which is Not Seen").
As a reminder, back in January 2012 in our conversation "Bayesian thoughts" we quoted Dr. Constantin Gurdgiev, from his post entitled "Great Moderation or Great Delusion":
"when investors "infer the persistence of low volatility from empirical evidence" (in other words when knowledge is imperfect and there is a probabilistic scenario under which the moderation can be permanent, then "Bayesian learning can deliver a strong rise in asset prices by up to 80%. Moreover, the end of the low volatility period leads to a strong and sudden crash in prices."

In a recent article by Mary Childs in Bloomberg entitled "Swap Traders Scrape Bottom in Fed's New World from the 21st of September we read the following that made us chuckle in a 2007ish way:
"With the global speculative-grade default rate holding at 3% in August, below the average of 4.8 percent as measured by Moody’s Investors Service in data since 1983, investors see less of a need to hedge against losses, according to Bonnie Baha, head of global developed credit at Los Angeles-based DoubleLine Capital LP that oversees $45 billion of assets. “CDS is so yesterday,” she said in a telephone interview. “The will to buy default protection is diminished because you figure you don’t need it.”
We disagree with the above.

Back in August in our conversation "The Unbearable Lightness of Credit" we argued:
"Yes, in this "unbearable lightness of credit / low yield" environment default will indeed spike at some point even for banks, consequence of the gradual disappearance of IGs (Implicit Guarantees). One can also argue that the advantage of explicit guarantees is that markets tend to "function" better under them. To quote again Dr Jochen Felsenheimer from his recent monthly letter:
"The advantage of explicit guarantees is that the market can value them and that the guarantee can be taken up - even in a crisis! For this reason, we can quote the "last man standing" at this point, the president of the German Federal Constitutional Court, Andreas Vosskuhle:"The constitution also applies during the crisis". That is a hard guarantee, both for politicians and for investors!"

We also indicated at the time:
"The unintended consequences of banks deleveraging and increased regulations means banks are in risk reduction mode leading to lower inventories provided to the market place which are at the lowest levels since 2002. Traders are as well jumping ship towards Hedge Funds. We already touched in liquidity issues in our conversation "Yield Famine".

In credit markets, liquidity can fast become a problem. Should the credit market experience a consequent sell-off, losses will be fast and furious. One should polish its "Bayesian learning" once in a while or take the great risk of becoming a victim of some "irrational exuberance" or "euphoria".

From the same Bloomberg article: "Investors have funneled $55.9 billion into high-yield bond funds globally this year through Sept. 12, breaking the previous record set in 2009 by $24.1 billion, according to data compiled by Cambridge, Massachusets-based EPFR Global."

This latest credit market "euphoria" has been marked by the significant return of Covenant lite issuance. Back in May 2012, we specifically discussed this return in our conversation "The return of Cov-Lite loans and all that Jazz...". Covenant-lite financing amounts to corporate credit on lax terms, where most covenants such as maintaining a certain level of profits are waived by deal-hungry lenders and were previously used to finance before the 2008 crisis big leveraged buyouts. Corporate loans typically include provisions, or what we call covenants. They can trigger a "default" if finances deteriorate, even if the borrower is still paying interest. This forces the company to negotiate with the bank lenders, often allowing to force a restructuring. Covenants also act as early warning system when the credit metrics of a company start to deteriorate.

In true Zemblanity fashion and credit market insanity as we posited at the time:
"Any statistician will tell you, a good outcome for a bad risk doesn't mean the risk wasn't bad; it just means you happened to get lucky".

In 2008-2010, less than 10 billion USD worth of covenant lite loans were issued. This anemic issuance period combined less than the 535 billion issuance of 2007. In 2011, 40 billion of covenant lite loans were issued and the leveraged loan volume was 373 billion USD. Refinancing was the purpose of 2011 borrowings for 54% while LBOs only represented 14%. There was a low default rate in 2011, less than 0.5%. Loans have been much "juicier in terms of yield than 10 year treasuries with B rated loans offering Libor +520 bps and BB- offering L+411 bps. Back in May 2012, 31 billion USD of leveraged loans were issued in the first two weeks hence our previous post. While European borrowers cannot easily get covenant lite in Europe, they come to the US. The default rate is higher in Europe in 2011 was higher than in the US at 4.1%.
- source Covenant-Lite Loans - Emerging Trend in the Syndicated Loan Market.

We do agree with some of the conclusions from the presentation quoted above:
"-He who has the gold, does not always make the rules.
-The market does not learn for long.
-Human nature does not change."

It looks to us we are indeed on the path towards "Zemblanity", with a difference discovery outcome as one could expect from "Serendipity".

On a final note we give you Bloomberg Chart of the day indicating that the Yen may climb to a record as the Bank of Japan lags the behind the Fed in all this Zemblanity experience:

"Yen printing by the Bank of Japan is trailing money creation by the Federal Reserve and European Central Bank, boosting risks the Asian nation’s currency will rise to record levels, according to Mizuho Securities Co. The CHART OF THE DAY shows that Japan’s monetary base, a measure of money in circulation, has grown more slowly than those of the U.S. and the euro area since September 2008 when the collapse of Lehman Brothers Holdings Inc. prompted central banks to buy bonds in a bid to stem a global crisis. The lower panel shows the yen has risen 27 percent over the same period, as measured by Bloomberg Correlation-Weighted Indexes, while both the dollar and the euro slid. The yen strengthened to a seven-month high of 77.13 per dollar on Sept. 13, nearing the post-World War II record of 75.35, when the Fed announced its plan to buy $40 billion a month of mortgage debt in a third round of so-called quantitative easing. The ECB unveiled its own unlimited bond-purchase program a week earlier." - source Bloomberg.


"Insanity in individuals is something rare - but in groups, parties, nations and epochs, it is the rule."
Friedrich Nietzsche

Stay tuned!

Credit - European Derecho

"Derecho comes from the Spanish word for "straight" (cf. "direct") in contrast with a tornado which is a "twisted" wind. The word was first used in the American Meteorological Journal in 1888 by Gustavus Detlef Hinrichs in a paper describing the phenomenon and based on a significant derecho event that crossed Iowa on 31 July 1877." - source Wikipedia

"A derecho  is a widespread, long-lived, straight-line windstorm that is associated with a fast-moving band of severe thunderstorms. Generally, derechos are convection-induced and take on a bow echo form of squall line, forming in an area of wind divergence in the upper levels of the troposphere, within a region of low-level warm air advection and rich low-level moisture. They travel quickly in the direction of movement of their associated storms, similar to an outflow boundary (gust front), except that the wind is sustained and increases in strength behind the front, generally exceeding hurricane-force. A warm-weather phenomenon, derechos occur mostly in summer, especially during June and July in the Northern Hemisphere, within areas of moderately strong instability and moderately strong vertical wind shear. They may occur at any time of the year and occur as frequently at night as during the daylight hours." - source Wikipedia

Looking at the recent storms which have recently unfortunately hit our American friends, and given the sudden rise in Spanish yields to record levels, touching a euro record high of 7.56%, we thought this time around, our "Derecho" analogy would be appropriate. Although these "Derechos" storms most commonly occur in North America, "Derechos" can occur elsewhere in the world, hence our recurring theme of severe weather patterns (Plain sailing until a White Squall? - 18th of March, The Tempest - 8th of May, St Elmo's fire - 26th of May). After all, "Derechos" in North America form predominantly from May to August and the “Sell in May and go away” has persisted as a profitable market-timing strategy for stock investors. Could it be in similar patterns to "Derechos"? We ramble again:

"The CHART OF THE DAY shows the average percentage-point gaps in stock performance between the six months ended in April and the next six months, as presented in the study. The figures cover MSCI Inc.’s local-currency indexes of 23 developed markets for November 1998 through April 2012.
Every index did better in the November-April period, led by MSCI Ireland, which had a differential of 17.9 points. Fourteen emerging-market indexes were included in the research, and all of them showed the same tendency. “The Sell in May effect occupies a special place among seasonal anomalies,” University of Miami Assistant Professor Sandro C. Andrade and two of his colleagues wrote in the study, posted yesterday on the Social Science Research Network. That’s because it only takes two trades a year to make money, unlike other patterns that require more frequent buying and selling. The research by Andrade, Vidhi Chhaochharia and Michael E. Fuerst followed up on a study published in 2002 by the American Economic Review, an academic journal. The earlier work tracked the disparities in the 37 MSCI indexes from their inception, as early as 1970, through October 1998.
In the earlier period, the gap averaged 8.7 points. The differential climbed to 10.5 points after excluding Argentina and Brazil, which experienced hyperinflation. The overall average in the new study was 9.7 points." - source Bloomberg.

 

 

So in our long credit conversation, given the interesting turn of events of the week, with some very important legal evolution, we think, in the subordinated bond space relating to "Bail-ins" and exit consents challenge (h/t FT Alphaville Joseph Cotterill for pointing this out), we will take a look at implied recovery in bank credit and credit events. This recent interesting legal challenge has indeed significant implication for recovery rates in the subordinated bond space, particularly for Spanish subordinated bondholders (facing the music of haircuts, coercive or not, in true Irish fashion). But first our credit overview.

The Itraxx CDS indices picture, with indices tightening on the back of Mario Draghi's declarations  - source Bloomberg:

The Itraxx Crossover (High Yield CDS risk indicator - 50 European high yield credit entities) tightened by 22bps to 642 bps level. Both the Itraxx Financial Senior 5 year index (25 banks and insurers) as well as the Itraxx Financial Subordinated 5 year index fell significantly in the process, respectively by 12.5 bps and 21 bps. Truth is, during this summer lull, with poor liquidity, market makers are not seeing big sellers of protection (going long credit, being "Risk-On" that is), and are scrambling to bid for protection with no offer available and remain wary of this market movement akin to short covering. We have seen this movie before...

Although French President Francois Hollande and German Chancellor Angela Merkel said Friday their nations are “bound by the deepest duty” to keep the currency bloc intact, following on the commitment made Thursday by ECB President Mario Draghi, we remain deeply concern by the economic situation in the peripheral space with Spain registering a new unemployment record at 24.6% from 24.4% in the prior three months, the most since at least 1976, the year of the democratic transition.

We have indeed reached intervention time given Spanish yields and rising NPLs have as well reached new record highs:

"Spain's ability to fund itself at the shorter end suffered a severe blow as two-year yields breached 6.5% on fears that regional governments beyond Valencia would seek aid, rendering the 18 billion euro bailout fund insufficient. Beyond funding difficulties, bank bad debt will deteriorate faster as debt rollover costs continue to rise." - source Bloomberg.

 

 

While Europe’s success in severing the link between Sovereign Risk and Financial risk remain to be seen as indicated by the difference in spreads between the Itraxx SOVx 5 year CDS index (representing 15 Western Europe sovereign CDS including Cyprus) and the Itraxx Financial Senior 5 year index which remains broadly flat - source Bloomberg:

“We have got to cut the fatal loop between sovereigns and banks, which will otherwise bring the euro-zone project as it exists now down,” Adair Turner, chairman of the U.K. Financial Services Authority, said in a London speech as reported by Bloomberg (wishful thinking). The Commission is working against a "self-imposed" September deadline to carve out plans that would give oversight of banks to the ECB as the first step in a campaign to break a cycle of banks and sovereigns fuelling each other's solvency risk.

Truth is time is running out for Spain, probably the reason why Mario Draghi felt compelled to "buy" some time in order to give sufficient time to the market to calm down before the September deadline:

"The CHART OF THE DAY shows the difference in yield between the two securities narrowed this month before flipping on the 26th of July. The five-year note yield surged to as much as 7.785 percent, the most since the euro was created in 1999, and more than three basis points higher than the 10-year rate, which reached 7.751 percent. The selloff also pushed yields on Spain’s two-year securities to more than 7 percent for the first time since September 1996. The bonds subsequently rebounded and the five year rate dropped below 10-year yields amid speculation Spain’s fiscal predicament will convince the European Central Bank to augment the firepower of the region’s bailout fund." - source Bloomberg.

With Mario Draghi's timely intervention, no wonder Spanish yields receded very significantly by more than 100 bps in our European bond picture while German government yields rose back towards higher levels around 1.40% on the close (1.16% on the 20th) with other European core bonds (France, Netherlands) rising as well in conjunction with German yields - source Bloomberg:

Spain's 10-year yield fell 52 bps this week to 6.74%, the biggest weekly drop since the period ended December 2nd according to Bloomberg.

While Spanish banks have been busy lowering their sovereign holdings for a third straight month:

"Euro zone financial institutions increased sovereign debt holdings by more than 145 billion euros during 1Q, as ECB cash was put to work. Spanish banks, having purchased 78 billion euros of sovereign in the four months to end-March, lowered their exposure for a third month in June. A euro-zone wide, sustainable solution is required to stem the crisis." - source Bloomberg.

Looking at Santander 1H deposit mix, Spanish structural funding issues are very clear for these institutions:

"While Santander's total customer deposits grew 3% yoy to 1H, its time deposits fell 22 billion euros. The key delta was growth of more than 38 billion euros in non-resident "other" deposits. As Spain's troubles continue, a shortening of liability duration and withdrawal of mutual and pension fund support will likely continue across banks, pressuring funding costs further." -  source Bloomberg.

Hungary has been long been our pet subject (Hungarian Borscht, Hungarian Dances) in relation to the study of systemic risk diagnosis (Modicum of relief):
"The reason behind our choice is that it appears to us as very good case study for systemic risk diagnosis from a macroeconomic point view (after all our blog is called Macronomics)."
We argued at the time:
"A liquidity crisis happens when banks cannot access funding (LTRO helped a lot in preventing a collapse). A solvency crisis can still happen when the loans banks have made turn sour, which implies more capital injections to avoid default (hence the flurry of subordinated bond tenders we have seen). Rising non-performing loans is a cause for concern as well as rising loan-to-deposit ratios. "
It was not really a surprise therefore to see Hungary Yields dropping below Spain for the first time this week:

"Hungary’s borrowing costs dropped below Spain’s for the first time as the European Union’s most
indebted eastern member held talks on an international bailout and Spain’s regions requested aid. The CHART OF THE DAY shows investors this week demanded lower yields to hold Hungary’s debt than Spain’s after Hungary began talks for an International Monetary Fund credit line and Spain’s Valencia region sought financial assistance. Hungary’s 10-year bond yields were at 7.39 percent on July 23, compared with 7.49 percent for similar-maturity Spanish debt. “The primary reason why Hungarian bonds have been doing well is because anticipation has been building up that the country is moving toward an IMF program,” Arko Sen, a strategist at Bank of America Corp. in London, said in a phone interview yesterday. Hungarian yields were as high as 10.8 percent after Prime Minister Viktor Orban’s government passed legislation the IMF and the EU said threatened the central bank’s independence in December, obstructing talks on aid. Hungarian yields were as much as 539 basis points above Spain’s in January." - source Bloomberg.

Looking at Mario Draghi's speech we could not resist to reminding ourselves our previous December 11th post "The Generous Gambler" where we quoted the wonderful poem by French poet Baudelaire which inspired Verbal Kint in The Usual Suspects:

"The greatest trick the devil ever pulled was to convince the world he didn't exist"

Roger "Verbal" Kint- The Usual Suspects

"My dear brothers, never forget, when you hear the progress of enlightenment vaunted, that the devil's best trick is to persuade you that he doesn't exist!" - Charles Baudelaire, French poet, "Le Joueur généreux," pub. February 7, 1864

"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

People are trading on hope: "Please make Mario Draghi keep his word", we could posit in similar fashion to what we commented in our September 2011 conversation "The curious case of the disappearance of the risk-free interest rate and impact on Modern Portfolio Theory and more!"

"So far the devil's best trick has been to persuade us that risk-free interest rates did exist. It ain't working anymore and that is a big cause of concern." - Macronomics.

We could not resist but we chuckled when we read the following comment from a credit desk:
"Equities = Hope, Credit = Reality, unfortunately, Reality follows Hope until the Hope dies, then Reality settles in."

As a reminder from our "Generous Gambler" conversation this is what Arnaud Marès, from Morgan Stanley in his publication of the 31st of August 2011 -Sovereign Subjects had to say:

"Does it matter that sovereign debt is risk-free? It very much does. If sovereign debt is no longer a safe haven, then the ability of governments to implement counter-cyclical policies is impaired. Fiscal policy is becoming at best neutral, at worst pro-cyclical. At a time when growth is rapidly slowing, the economic cost may be high.
Weakening the quality of government credit means weakening the fiscal backstop from which banks benefit. This risks resulting in an accelerated de-leveraging of bank balance sheets, with equally costly economic consequences."

This is exactly what has happened so far with the ill-fated EBA June 2012 request of asking European banks to reach a Core Tier 1 ratio which precipitated the deleveraging as well as the withdrawal of credit, bond tenders and other liability management exercises, hitting hard in the process the real economy in European countries. This withdrawal of credit has also been confirmed by the latest results from British bank Barclays as indicated by Bloomberg:
"The exodus from debt-ridden peripheral Europe continues, with Barclays detailing reduced sovereign exposure of 22% and 5% lower retail lending in 1H. Plagued by liquidity shortages, EU Banks have also rushed to reduce local funding mismatches: Barclays took additional Spanish deposits since 2011 year-end, while taking 8.2 billion euros from the ECB's LTRO in Spain and Portugal." - source Bloomberg.

As we pointed in a "Tale of Two Central banks", we would like to repeat Martin Sibileau's view we indicated back in October when discussing circularity issues:

"What would be a solution for the EU? We have repeatedly said it: Either full fiscal union or monetization of the sovereign debts. Anything in between is an intellectual exercise of dubious utility."

We would like to take the opportunity of debunking further the "efficient market theory" (if there are any believers left out there...) in relation to Draghi's intervention. We agree with a recent note from French broker Aurel, namely that this "theory" has taken yet another blow. The markets did not react to Mario Draghi's declarations  made in an interview last Saturday in French newspaper Le Monde but "only" reacted strongly on Thursday when similar declarations were displayed in bold red on Bloomberg: « Believe me, it will be enough ».
Oh well...

In relation to our recent theme of "Yield Famine",  Unibail has sold this week EUR750m of bonds at 2.25% maturing on 1st August 2018 (6 years). The issue was 4 times oversubscribed with the order book reaching over EUR 3bn in less than 1.5 hours...We saw similar action this week on numerous new high quality issues coming to the market.
The rush for yield and strong appetite for credit is cause for concern and caution particularly in the High Yield space where risk is lurking.
"unintended consequences" of this low yield environment will have to corporate balance sheets, to some extent, it tends to explain, why defaults tend to spike in a low rate deflationary environment such as today", we argued last week.

High Yield is indeed becoming very expensive as indicated by Lisa Abramovicz in her Bloomberg article - BofA Cools on Junk Priciest to Stocks Since ’93:
"Junk bonds are losing their sheen after becoming about the most expensive relative to stocks in at least two decades, prompting firms from Bank of America Corp. to Loomis Sayles & Co. to warn that gains on the debt may wane. Junk bonds are returning less than the highest-rated corporate notes for the fourth straight week, the longest stretch since the period ended Nov. 27, Bloomberg data show".

Time to reduce duration and favor short term High Yield if you are "starving" for yield and can stomach the volatility risk we think.

Moving on to the very important subject of the legal evolution in the subordinated bond space relating to "Bail-ins" and exit consents challenge,  this recent interesting legal challenge has indeed significant implication for recovery rates in the subordinated bond space, particularly for Spanish subordinated bondholders.
 As indicated on the FT Alphaville comment section, Claudio Borghi Aquilini made some very valid comments:
"This is an extremely important ruling. Basically it (rightfully) denies the very concept of forced burden sharing at the basis of the eurodebt disaster. Either you let the bank fail or if you decide to save it you may not kill bondholders (albeit subordinated) ad random. Reducing the burden for taxpayers might seem a good reason to do silly things but debt is based on rules, if you create doubts and "special situations" no wonder if funding costs skyrocket (and if a judge tells you that you can not play with contracts). "

We could not agree more. Debt is based on rules. The capital structure is there for a reason when it comes to bank debt and the difference between junior debt from senior debt as well as the recovery values and credit events triggering CDS contracts relating to the capital structure. Looking at the recent discussions relating to "Bail-in" proposals (a subject we discussed in "Something Wicked This Way Comes"),  Morgan Stanly in their Credit Strategy review from the 27th of July entitled - Implied Recovery in Bank Credit, argued the following:
"One hears every possible argument in the debate over whether senior bank debt in Europe should bear losses. There is the moral (better that bondholders pay for bank rescues than ordinary taxpayers). The practical (senior bonds are a small slice of the capital structure, burning them saves relatively little money). The game theory (country that imposes losses saves money, everywhere else suffers). The theoretical (if the institution’s insolvent, of course its lenders should bear loss). The psychological (debt haircuts will scar funding markets for years to come). The list goes on. We believe that the costs of haircutting senior bank debt in Europe vastly outweigh its rewards."
On that matter, we "Agree to Disagree" with Morgan Stanley, given that, as we posited in "Long hope - Short faith, Hungary and Bank Recapitalization", the study realised by Stanford University Anat R. Admati (Why Bank Equity is Not Expensive) shows that banks have fought bitterly against increasing equity buffers which is the cheapest and easiest way to recapitalize banks. Why? because allowing high payouts to shareholders, namely bank employees in many cases, allows financial institutions to raise their leverage: "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." - Anat R. Admati.

The latest legal spat as reported by FT Alphaville (link above) involving credit asset manager Assénagon and Anglo Irish, is a relative important matter given the latest European Bail-in resolution and, because, as indicated by Morgan Stanley in their research piece:
"Fixing the recovery of subordinated debt and taking the spreads on senior and sub debt observed in the market, it becomes possible to solve for a recovery rate on senior."

"The eight banks in the top of the table provide observations of actual loss severity. Why do we focus on CDS? Our approach provides a simple way to solve for implied recovery, but only if the probability of default between two instruments is similar. This isn’t strictly the case with bank bonds, as the restructuring of Lower Tier 2 bonds in the Irish banks bound holders to a large loss, but left senior debt unscathed. CDS, in contrast, triggers at the entity level, meaning that senior and sub CDS are much more likely to take loss at the same time" - source Morgan Stanley.

In terms of market observations, Morgan Stanley also indicates:
"Although senior bank bondholders have generally been protected in Europe, it has been more common for sellers of senior CDS to face losses when contracts are triggered by restructurings. Recoveries in such events have been generally high, at around 50%.
The range of pricing, however, has been enormous – senior CDS on Bradford and Bingley recovered at 95c, CDS on Landsbanki recovered at 1c – especially with regards to the ratio of loss (or the implied ratio of loss).
Across current banks in Greece, Portugal and Spain, pricing also remains highly disperse." - source Morgan Stanley.

"What’s notable? For most banks, implied senior recovery is surprisingly ‘average’ relative to the last seven years, despite all the recent rhetoric. The range of implied recovery is also very narrow (35% to 57%), in direct contrast with the large variation in senior recovery under stress seen in previous table, although we acknowledge that the banks above are for the most part higher-quality than the names in that data-set.
Per our framework, the UK banks (e.g., Lloyds, RBS, Barclays) as well as Commerzbank enjoy the highest implied senior recoveries (i.e., sub debt trades the widest to senior). This is somewhat odd, given that both the UK and Germany have resolution regimes in place whereby subordinated and
senior bondholders could potentially take losses. One explanation could be that investors feel more comfortable in UK and‘core’ European bank senior debt, yet more cautious on subordinated debt, given the resolution regimes. We’re generally happy to lean against this, and would note that the wide senior/sub differential is consistent with our generic preference for UK LT2 and certain Commerzbank subordinated debt structures.
In contrast, Spain and Italy have among the lowest implied recovery rates. Consistent with what we note on UK and German banks, we suspect that this relates to the high degree of sovereign stress which has pushed out senior spreads to very wide levels. Equally, the potential risks of some form of burden-sharing spreading up the capital structure to even include senior debt are also a source of concern for investors, even if a low-risk tail event, in our view." - source Morgan Stanley - 27th of July 2012.

Using Santander as a proxy in determining "Implied Recovery and Default Rates:

For SANTAN, subordinated CDS spreads are ~1.5x senior, implying 1.5x higher loss severity for the same probability of default. Fixing the potential loss on Lower Tier 2 at 90% (10% recovery), this gives an implied loss on senior debt of 59% (90%/1.5x), for an implied recovery of 41% (1-59%).
Similar to the story in the broader index, implied recovery is only marginally lower than its historical average, while spreads now suggest a near-record probability of default over five years (32%). Stress on the Spanish sovereign has led to an increase in the risk of default, but not a decline in perceived recovery." source Morgan Stanley, 27th of July.

Forced burden sharing and coercive action in similar fashion to the Anglo Irish situation, would indeed, lead lower perceived recovery for Spanish  banks bonds, hence the importance of this legal ruling relating to Anglo Irish.
Morgan Stanley in their note Senior and Sub Financials - Credit Derivatives Insights on the 27th of July point to the following:
"What are the historical examples of senior and sub CDS triggers in Europe?
We now have a few precedents for bank CDS triggers in Europe (see table below): The Icelandic banks, Bradford & Bingley (UK) and now Irish banks are the financials credit events for CDS in Europe in the last five years. The above can be sorted into three groups: i) banks that were not backstopped and allowed to default (Icelandics); ii) banks that had an extremely credible backstop (Bradford& Bingley) and a well-supported senior; and iii) banks that were perceived to have a backstop for seniors but not fully robust (Irish banks)."

"We think the Anglo Irish example is good template for how bank restructurings could evolve from a CDS perspective and how auctions could work. Anglo Irish Bank announced a tender offer following equity injections, offering to exchange all the three existing LT2 bond issues into new 1yr government guaranteed senior FRNs (Euribor +375bp) equivalent to 20c of existing face value. In addition to the exchange offer, the Bank convened meetings to approve the inclusion of a right to redeem all (but not some only) of the existing notes at practically zero to encourage acceptance. This series of events triggered a restructuring credit event for Anglo Irish CDS. The requirements in determining a restructuring credit event were fairly straightforward to establish in the case of Anglo Irish: a loss of principal for a multiple holder obligation, made binding on all holders and which resulted directly from deterioration in credit quality.
While all thee LT2 bonds were restructured ultimately, the timeline was in a staggered fashion in order to avoid a lack of LT2 deliverables if all were restructured in one go. Thus, the auction was conducted in an accelerated timeframe, after the first bond was restructured and triggered CDS, but before the other bonds was restructured." - source Morgan Stanley.

The recent legal ruling for Anglo Irish versus Assénagon (rightfully) denies the very concept of forced burden sharing which has been used in the determination of the recovery during the restructuring credit event for the CDS auction process and the results, a process which will inevitably occur for weaker Spanish and Italian institutions at some point:

"While the recoveries for the senior CDS of different buckets were largely in line with each other, sub CDS had very different recoveries for the 2.5yr bucket (74.5) vs. for the other two buckets (around 18). In practice the recovery for different buckets of senior CDS could also vary considerably, as the dollar prices of a 2.5yr bond could be very different from a 7.5yr bond in a restructuring scenario." - source Morgan Stanley.

As indicated by FT Alphaville in their post,  IFR reports that IBRC, the successor to Anglo Irish, is considering an appeal. The awarding of any damages is yet to come. A truly interesting legal development in the banking space.

On a final note, a weakening of the Euro is likely to be reflected in HSBC, Santander, BBVA 2nd Quarter results as shown by Deutsche Bank's recent profit warning:

"As Deutsche Bank's profit warning demonstrated, the ongoing weakness of the euro can negatively affect results where there is a  mismatch between costs and revenue, or material parts of the business earn and report in different currencies. Euro zone revenue contributions are likely to shrink at HSBC, which has significant euro operations and reports in dollars." - source Bloomberg.
Given Deutsche Bank AG recently announced it would reduce risk to meet a 2013 capital-ratio goal after second quarter profit missed analysts' estimates on expenses tied to a weaker euro (net income fell to 700 million euros), reduced risk will lead to reduced liquidity and inventories provided to the market place. Yet another story of de-risking, deleveraging. No wonder traders are leaving the banking industry for Hedge Funds in this process.

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

"Politics is the art of looking for trouble, finding it everywhere, diagnosing it incorrectly and applying the wrong remedies."  - Groucho Marx

Stay tuned!