Credit - Sting like a bee - The European fight of the Century

"Boxing is the only sport you can get your brain shook, your money took and your name in the undertaker book." - Joe Frazier

"And the first thing that came to mind was something that people said many years ago and then stopped saying it: The euro is like a bumblebee. This is a mystery of nature because it shouldn’t fly but instead it does. So the euro was a bumblebee that flew very well for several years. And now – and I think people ask “how come?” – probably there was something in the atmosphere, in the air, that made the bumblebee fly. Now something must have changed in the air, and we know what after the financial crisis. The bumblebee would have to graduate to a real bee. And that’s what it’s doing.

The first message I would like to send, is that the euro is much, much stronger, the euro area is much, much stronger than people acknowledge today. Not only if you look over the last 10 years but also if you look at it now, you see that as far as inflation, employment, productivity, the euro area has done either like or better than US or Japan.

Then the comparison becomes even more dramatic when we come to deficit and debt. The euro area has much lower deficit, much lower debt than these two countries. And also not less important, it has a balanced current account, no deficits, but it also has a degree of social cohesion that you wouldn’t find either in the other two countries.

That is a very important ingredient for undertaking all the structural reforms that will actually graduate the bumblebee into a real bee."- Speech by Mario Draghi, President of the European Central Bank at the Global Investment Conference in London, 26 July 2012.

Sting like a bee! - When words speak louder than action - “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro,” and “believe me, it will be enough.” - Mario Draghi

"The CHART OF THE DAY shows the implied interest payments on Spain’s debt burden over the next four years tumbled between July 25 and July 30 after Draghi’s comments fueled speculation the Frankfurt-based central bank will buy government bonds. Spanish 10-year yields fell almost one percentage point after the comments, cutting the nation’s future funding needs, according to Rabobank calculations." - source Bloomberg

Given Mario Draghi's bee reference to the need for Europe to evolve from bumblebee to bee and how markets reacted on the back of Thursday's monetary decision and conference, we could not resist to use as a reference for our title Muhammad Ali's "Sting like a bee" boxing quote. We initiated our post using a quote from Mohammed Ali's arch-rival Joe Frazier because we wanted to make a reference to the Fight of the Century, which occurred on March 8 1971, and was the promotional nickname to the first boxing match between champion Joe Frazier and Muhammad Ali which led to Ali's first defeat. In similar fashion, to our chess reference -  "The Game of The Century", there is indeed some rumble going on in the European jungle with Bloomberg editors expressing their views recently using as well a boxing analogy on the 1st of August - The One-Two Punch That Could Put Europe Back on Its Feet:

"What’s needed is a one-two punch, in which the ECB continues its bond buying, supplemented with purchases by the European Union’s temporary bailout fund, the European Financial Stability Facility, and its permanent successor, the European Stability Mechanism. The twin actions would help make borrowing affordable again for Italy and Spain. This would also solve a structural flaw in the euro area’s design: The ECB can’t intervene in primary bond markets, where governments finance themselves by selling bonds to banks and investment firms, and where borrowing costs are determined. The EU’s bailout funds, however, can step in -- they can buy government debt in the primary market and impose conditions on the countries that borrow." - source Bloomberg

But what looked initially as a boxing game, is fast evolving into a "mixed martial arts"  (MMA) contest as indicated by Bloomberg on the 2nd of August, in relation to the Draghi (ECB) - Weidmann (Bundesbank) stand-off - Gloves Off in Draghi-Weidmann Standoff over ECB Bond-Buying Plan:

"When Mario Draghi took the helm of the European Central Bank nine months ago, he took care not to alienate Bundesbank President Jens Weidmann. Now the gloves are coming off. Draghi yesterday announced the ECB is working on a plan to re-enter bond markets and took the unusual step of naming Weidmann as the only policy maker to object to the proposal."

And in this Bloomberg article, Weidmann  recently declared in relation to the Bundesbank (being ECB's Joe Frazier):

"“We are the largest and most important central bank in the Eurosystem and we have a greater say than many other central banks in the Eurosystem,” Weidmann said in an interview published by the Bundesbank on Aug. 1. The ECB’s independence “requires it to respect and not overstep its own mandate,” he said."

In facts it appears to us that Mario Draghi's mixed martial skills seem to involve submission grappling, the ground fighting tactic consisting of taking his opponent to the ground using a takedown or throw and then applying a submission hold, forcing the opponent to submit according to the same article:

"While Draghi’s comments suggest Weidmann has lost the support of traditional allies on the council such as the Netherlands, Luxembourg and Finland, the Bundesbank president may have German public opinion behind him. The country’s mass-selling Bild tabloid yesterday protested the bond-purchase plan, saying “no more German money for bankrupt states, Herr Draghi!”"

Looks like we have indeed The European fight of the Century on our hands, but in these days and era, it is more akin to mixed martial arts rather than "traditional" boxing...

As far as Spain is concern, it looks increasingly more and more obvious to us that the ECB, by putting on hold bond purchases until further "notice", and, by focusing on the short end of the Eurozone periphery curves, will be forcing Spanish Prime minister Rajoy to "tap out" submission and ask for support sooner rather than later.  He declared on Friday in Madrid during a conference the following: “I will do what I always do, act in the best interest of Spaniards”.

When asked whether he would consider a request, he said he needed to see more details on what the European Central Bank is planning in terms of bond buying and non-conventional measures before taking any decision on seeking support.

The ECB's MMA grappling technique courtesy of Prime minister Rajoy: “What do they plan to buy in the secondary market? Six-month bills or 10-, 5-, 7-year bonds? Obviously it’s not the same,” he said. “Which mechanism will be used? The ESM that doesn’t exist? What are the methods that Mr. Draghi said yesterday they would announce? We don’t know.”

From  Andrew Davis and Angeline Benoit in their Bloomberg from the 3rd of August - Rajoy Will Consider Bond Buying Request to Protect Spain:

“The fact that Mr Rajoy is paying attention to those details shows that the Spanish government might not be that far from requesting additional support,” Ricardo Santos, a European economist at BNP Paribas SA in London, said by e-mail. “Given that the biggest liquidity needs for Spain will come later in October, the Spanish government feels that it has some time on its side before requesting for support.” Spain has 29 billion euros ($36 billion) of debt redemptions in October, according to data from the Treasury. It has 16 billion euros of bills coming due and no bond redemptions before then."

Looks like our European jungle is ready to rumble. This time around we would like to focus our attention to what we think might be analyzed from the ECB's conference as well as an important point relating to the withdrawal of funding by core European banks from their peripheral branches to make them less reliant from the parent company. We always try to reflexionate like a behavioral therapist would, in the sense that, we tend to focus more on the process rather than on the content. But first our credit overview!

The Itraxx CDS indices picture, a tale of great volatility on Thursday and Friday following the ECB conference and the Nonfarm payrolls, tighter, wider, tighter  - source Bloomberg:

The magnitude of the sell-off on Thursday was significant, with higher volumes traded than normal in a significantly volatile market context. For instance, Itraxx Financial Senior 5 year index (risk gauge for financial senior unsecured bonds) went from 240 bps offered to 270 bps in a matter of seconds given the initial market reaction of disappointment to the ECB's conference. Friday was a different trading day which saw a significant tightening move, with the Itraxx Crossover 5 year index (representing 50 mostly high yield European companies)  falling the most in 9 months by 52 bps to around 597 bps on the close, implying a significant improvement in investor sentiment which was boosted as well by the results from the latest Nonfarm payrolls in the US. The 5 year Sovereign CDS for Spain fell as well by 32 bps to around 539 bps, breaking three days of uninterrupted surge on Friday, on expectations of short-dated bond purchases by the ECB.

But, do not be fooled by the latest rally in the credit space in the Itraxx Financial 5 year CDS index (tighter by 29 bps on the day and the SOVx (representing 15 Western Europe sovereign CDS including Cyprus). Severing the Sovereign risk / Financial risk link remain to be seen as indicated by the difference in spreads between the Itraxx SOVx 5 year CDS index and the Itraxx Financial Senior 5 year index which remains broadly flat - source Bloomberg:

As far as "Yield Famine" is concerned  in relation to investment grade cash bonds from quality issuers, as  market maker rightfully commented are heavily sought:
"The grab for bonds is still on. The imbalance between supply and demand is huge at the moment. Consequently liquidity in the secondary market has declined and it feels street inventory is at multi year lows. So most low beta names grind tighter day by day amid low volume or spreads are just marked tighter without volume. Technicals clearly rule the market for now. Apart from some special situations low beta names remain well bid."

In our "Yield Famine" conversation on the 19th of July we argued the following: "While everyone is happily jumping on the credit bandwagon in this "yield famine" environment, we would advise caution given liquidity, as we discussed on numerous occasions (and liquidity mattered a lot in 2011...), is an important factor to consider in relation to investor confidence and market stability."

Our cautiousness has been validated by Lisa Abramovicz Bloomberg article from the 3rd of August - Bond Trading Least Since 2008 as Dealers Retreat:
"Investors are stockpiling corporate debt rather than trading as banks retreat from bond brokering,
with daily trading volumes in the U.S. slumping to the slowest July in four years even as offerings reached a record. Volumes averaged $9.97 billion last month, 8 percent below July 2011 and the lowest for the period since two months before Lehman Brothers Holdings Inc.’s failure ignited the credit crisis, according to Financial Industry Regulatory Authority data. Investment-grade sales rose 58 percent from the same month last year to $80.5 billion, data compiled by Bloomberg show.
Fund managers are struggling to pry loose bonds in the secondary market as new regulations to curb risk fuel an 82 percent decline in corporate-bond inventories at primary dealers since 2007. Issuance is failing to satiate investors who have plowed $63.5 billion into investment-grade bond funds this year, seeking alternatives to government debt as the Federal Reserve holds benchmark interest rates near zero through at least 2014. “There’s such an imbalance between supply and demand right now, investors aren’t willing to part with what they own,” said Jonathan Fine, Goldman Sachs Group Inc.’s head of investment-grade syndicate for the Americas in New York. “They’re just focused on getting new product through the door.” - source Bloomberg.

"Yield Famine" in conjunction with very poor liquidity, which will continue to deteriorate given market makers are continuing to reduce risk to meet capital-ratio goals (as recently announced by Deutsche Bank), could potentially be a very lethal combination indeed should the market experience a severe sell-off, so, "Mind the Gap" and do be too complacent about the prevailing situation.
"The 21 primary dealers that trade directly with the Fed have curbed trading of company bonds in the U.S. by 61 percent to an average volume of $107.9 billion in the week ended July 25 from the peak of $278.6 billion in June 2007, according to Fed data. Their holdings of the debt plunged to $37.5 billion as of July 11, the least since March 2002." - source Bloomberg - Bond Trading Least Since 2008 as Dealers Retreat.

Euro Investment Grade Issuance at a glance - source Barclays:

"The last two weeks of July saw a flurry of supply, with several issuers accessing the market post their results and ahead of the Olympics. Despite volatile market conditions, non-financial issuance of €16.0bn was more than twice the €7.3bn issued last July. In part this reflects the strong demand-technical in the market, with investors seemingly willing to invest in the “right” corporates even in periods of stress. Significant investor cash balances, combined with heightened risk aversion, have deepened the divide between the “haves” and the “have-nots” when it comes to primary market access." - source Barclays - Euro/Sterling High Grade Supply Update July 2012.

Mario Draghi's lack of intervention to support Spanish yields on Thursday, led to them rising significantly again above 7% on Thursday before receding significantly on Friday as displayed in our  European bond picture while German government yields rose back towards higher levels around 1.40% on the close  - source Bloomberg:

Leading to our "Flight to quality" picture displaying an unconvincing medium term "Risk-On" environment with Germany's 10 year Government bond yields rising again towards 1.40% and the 5 year CDS spread for Germany well below 100 bps in the process - graph below, source Bloomberg:

We say unconvincing medium term "Risk-On" because another indicator we have been monitoring has been the 120 days correlation between the German Bund and its American equivalent, namely the US 10 year Treasury notes - source Bloomberg:

We first mentioned this medium term indicator in our conversation River of "No Returns" on the 2nd of June:
"While touching again on our recent subject of asset correlation (see our post "Risk-Off Correlations - When Opposites attract"), in "Risk Off" periods we have noticed that the 120 days correlation has been close to 1 in 2010, 2011 and 2012, whereas in "Risk On" periods, the correlation was falling to significantly lower level. The correlation between both the German Bund and US 10 year note is rising very fast, now above 70%. The above graph was our reasoning behind our 30th of March call:
"One has to ask oneself if the time has not come to start taking a few chips off the table." - Macronomics - "Spanish Denial"."

Considering the lack of liquidity in the credit space and the very high correlation between asset classes driven by the European politicians, the coming weeks could see another significant spike in volatility in the European space so watch out for that "sucker punch". Both the Eurostoxx and German 10 year Government yields seems to be moving in synch for now in what seems to be a short burst of "Risk-On", with rising German Bund yields and a higher Eurostoxx 50 index courtesy of the Nonfarm payrolls number on Friday. - Top Graph Eurostoxx 50 (SX5E), Itraxx Financial Senior 5 year CDS index, German Bund (10 year Government bond, GDBR10), bottom graph Eurostoxx 6 month Implied volatility. - source Bloomberg:

Watch out for political "sucker punches" during this summer "lull" because they do sting like a bee!  Thursday "sucker punch" on EUR/USD as displayed by the significant intraday move - source Bloomberg:

Moving on to what we think might be analyzed from the ECB's conference but also the Fed's stand-by decision, we agree with our good credit friend namely that:
"The markets were waiting for the Central Banks to deliver something...One could argue they deliver nothing, our understanding is more mixed as we think the message had been crystal clear for a while. Of course, some sentences from Mario Draghi or Ben Bernanke taken out of context have created in the past days a situation similar to the situation experienced by parents trying to motivate a 5 years old child to do something he does not want.
Let us explain:
1- The FED met and did not modify anything to its monetary policy, just declaring that it remains ready to act should the economy weaken or face exogenous shocks. Basically, nothing new there.
2- The ECB met and did not modify anything to its monetary policy. Mario Draghi delivered a speech which underlines a lot of possibilities in term of outright interventions. But all the suggestions were assorted to conditionality. Here some extracts: "ECB may take measure to ensure policy transmission, Investor concerns on seniority will be addressed, ECB may undertake outright open market operations, Governments must stand ready to activate EFSF, High yields are unacceptable, Euro irreversible, and left the door open to many possibilities, ECB discussed possible interest rate cut today, ECB will focus on shorter part of the yield curve,..."
Basically, the news are not that negative! Mr Draghi just tempered markets in their expectations, but left the door open to the re-opening of the SMP bond buying program on the front end of the curve, but only within its mandate. He also left the door open to non-sterilized interventions, which is an indication that talks are going on and that such a possibility could take place should deflation materialize."

To summarize, a rate cut is in the cards, bond buying is in the cards if Spain ask for it (tap out in true MMA fashion), and unsterilized outright open interventions are a possibility:
“You shouldn’t assume that we will not sterilize or sterilize” - Mario Draghi.

The markets were too optimistic and do not seem to understand the European decision process, hence the importance, we think of focusing on the process and not the content in true behavioral therapist fashion. Investors should know by now that it takes some time for the ECB to change its policy as its main contributor, namely the Bundesbank, has a different concept of what a sound monetary policy is compared to other central banks.

But more importantly, one must understand that Central Banks ammunitions are scarce and precious, and that their ability to fight a balance sheet recession is limited, and that important decisions are in the hand of the politicians which is also what CreditSights point out in their recent report of interest – ECB Bond Buying and ESM Bank - Talk without Trousers:
"The proposal to grant the ESM the ability, as a bank, to access ECB liquidity facilities to underpin its own financing requirements could be an important step towards providing more breathing room for distressed sovereigns while a longer-term solution to the crisis can be worked out. As yet, however, there is no sign that German politicians have changed their opposition to the idea. Ultimately the decision to grant the ESM a banking license and whether to expand its lending capacity meaningfully will be taken by politicians.
Similarly the prospect of the ECB restarting its bond purchase programme will certainly be enough to give speculators pause. But no one believes that the ECB is currently willing to purchase bonds in perpetuity. The ECB views this is a crisis that requires Eurozone politicians to take difficult decisions about how much Eurozone governments are willing to share common funding and spending arrangements.
The comments of Nowotny, Draghi and also Juncker – who suggested that activation of the ESM’s bond purchases may be imminent – illustrate the extent to which brief periods of stability in stressed-Eurozone country government bonds can be achieved with statement of support and ECB liquidity. The result is that while financial markets repeatedly expect this crisis to reach some kind of conclusion within a timescale of days, weeks or months, the ability of the Eurozone policymakers to stretch this crisis out further seems to be practically inexhaustible." - source CreditSights

Many pundits have been arguing that by focusing on the short end of the peripheral countries curves, the ECB via Mario Draghi, is in fact steepening the curve for both Italy and Spain  which is apparently the opposite effect one needs to help these economies. We think these pundits are focusing too much  on the content in their analysis and should be focusing on the process which are the basis for good understanding of Behaviorism. Basically in true MMA grappling/submission analogy, we think that implicitly, the Bundesbank (Weidmann with the support of Merkel) has conceded to bond purchases by the ECB, in order to keep a tight leash on both Italian and Spanish politicians to keep up with the pace of structural reforms. It seems to us, that Germany has learn from the Greek "experiment" in the sense that buying indiscriminately bonds on the whole term structure not only put the ECB's balance sheet under great risk, but, it also alleviates significantly the pressure from politicians to make good on their commitments which they made in order to garner financial support. In fact we think the ECB has set up the stage for an operant conditioning chamber  (also known as the Skinner box):"When the subject correctly performs the behavior, the chamber mechanism delivers food or another reward. In some cases, the mechanism delivers a punishment for incorrect or missing responses. With this apparatus, experimenters perform studies in conditioning and training through reward/punishment mechanisms." - source Wikipedia

“We should not forget, and some of the statements tend to forget, that everything – the ESM recapitalisation, the stepping-in of the EFSF or the ESM in the primary or secondary markets – is subject to conditionality. There is nothing without conditionality. Conditionality is what gives credibility to these measures.” - Mario Draghi.

 By targeting the short end of peripheral yield curves. It will permit the ECB to study behavior conditioning (training) by teaching Italy and Spain to perform certain structural reforms in response to specific stimuli/bond purchases. Truth is cognitive–behavioral therapy has demonstrable utility in treating certain pathologies such as "motivating a 5 years old child" or a European politician (but we ramble again...).

In continuation of our conversation "The Game of The Century", we still think "that, after all Angela Merkel, could be one of the greatest chess players around and has just used "castling"."  The biggest winner from the last European summit was indeed Angela Merkel:

"When both sides have two rooks and pawns, the stronger side usually has more winning chances than if each had only one rook". Bobby Fischer had one rook at the end of the game and 5 pawns...

By managing to keep Germany’s liabilities unchanged Angela Merkel appears to us as the winner of the latest European summit (number 19...)."

Angela Merkel already made some "material" sacrifices in our European Chess/Boxing/MMA contest:
Jürgen Stark left on the 9 September 2011. It was reported that Stark left the ECB due to disagreement with the bank's controversial bond-buying programme.

Make no mistake; Dr Angela Merkel (she obtained a thesis on quantum chemistry) appears to us as a highly intelligent political player. Angela Merkel was named Secretary-General of the CDU, a male-dominated, socially conservative party with strongholds in western and southern Germany, and the Bavarian sister party, the CSU, has deep Catholic roots. Being a Protestant woman, originating from predominantly Protestant northern Germany, it would be very foolish to underestimate her capacity in outmaneuvering/outplaying her European counterparts - Mario Monti, François Hollande, Mariano Rajoy.

In relation to the important point relating to the withdrawal of funding by core European banks from their peripheral branches to make them less reliant from the parent company (which we discussed with our good credit friend), please note that BNP Paribas announced that it is cutting funding to its Italian subsidiary BNL through securitization. BNL will resume debt issuances under its own name. The reason was that “new rules triggered change in funding Italian unit".
The lesson from Emporiki and Credit Agricole seem to reach other banks. A kind of “balkanization” of the European financial system seem to be under way, even though Mr Draghi denied it (but he cannot acknowledge it, it would not be politically correct!).
As reported by Fabio Benedetti-Valentini in Bloomberg, BNP Joins Credit Agricole to Seek Escape From Euro-Exit Risk:
"France’s biggest banks are rushing to cut the more than 140 billion euros ($171 billion) they provide their operations in Europe’s troubled economies, seeking to protect themselves against a possible breakup of the euro. In a retreat, French banks, especially BNP Paribas SA and Credit Agricole SA -- the largest by assets -- are trying to make their businesses in Italy, Spain, Greece, Portugal and Ireland less reliant on funds from the parent company. In the decade after the creation of the euro, French banks were among the region’s most ambitious and acquisitive, investing about $36 billion in the five countries, lured by the prospect of growth in those markets. Their pullback now reflects the banks’ attempt to defend themselves against the risk, however remote, of an exit from the euro of any of the countries. “It’s an unhealthy sign,” said Philippe Bodereau, the London-based head of research for financial firms at Pacific Investment Management Co., the world’s largest bond investor. “It’s like shifting sands, with European banks protecting against invisible currency risks within the euro zone.”
Like other financial institutions in Europe, French banks are trying to match assets and liabilities on a national level to minimize risk. Reducing assets in the five countries to limit cross-border exposure may erode BNP Paribas’s after-tax earnings by 4.7 percent and Credit Agricole’s by 7.2 percent, estimates Benoit Petrarque, a Kepler Capital Markets analyst in Paris".

This will accentuate even more future funding problems for weaker peripheral branches, which are already strained by falling time deposits (see our last conversation where we discussed the Spanish structural funding issues with the example of Santander):

"June data show that total deposits held by Spanish monetary financial institutions fell more than 60 billion euros yoy, with 90% of this drop in time deposits. While banks have found alternative funding sources including repo and ECB loans, this growing mismatch may create future problems as banks move to comply with the net stable funding ratio." - source Bloomberg.

Looking at the recent financial results from various European banks, it looks to us increasingly evident that more "Goodwill impairments" are coming and will definitely  be back on the agenda in Q3 in similar fashion to our November 2011 conversation "Goodwill Hunting Redux":

"European banks carry 185 billion euros of goodwill, having written down more than 30 billion in 2011. Societe Generale's 2Q write-down of 250 million euros for its Russia subsidiary and 200 million on its TCW U.S. fund manager refer to slower momentum and market conditions as rationale. Further impairments across the sector are likely, given ongoing market difficulties." - source Bloomberg.

"It's less about the physical training, in the end, than it is about the mental preparation: boxing is a chess game. You have to be skilled enough and have trained hard enough to know how many different ways you can counterattack in any situation, at any moment." - Jimmy Smits

Stay tuned!

Credit - Europe - The Game of The Century

"You have to learn the rules of the game. And then you have to play better than anyone else."
- Albert Einstein

We could have used the title "The Scientific Cardplayer" in a continuation to the theme of Great Classic Movies. In fact, we hesitated, given that, in similar fashion to the latest European summit with Germany opposing France, Italy and Spain, in this 1972's masterpiece from film director Luigi Comencini, there is a regular showdown between a rich American widow (Bette Davis) and an impoverished Italian couple (Alberto Sordi and Silvana Mangano) over the card game scopa. The widow provides them with the stakes to play, as well as a chance to gain a small fortune. But she always wins, not returning until the same time the following year. It continues that way until Cleopatra (Antonella Demaggi), the couple’s daughter, steps in to gain a measure of revenge against the sadistic old woman...

In respect to the recent European summit, if European countries such as Italy, Spain and France gang up on Germany and ask for material changes in the rules and treaties of the "chess game" being played, we believe that "the only possible Nash equilibrium for Germany will be to defect":

-with the help of the German Constitutional Court

-with rising tensions in the German economists world - President of the Ifo Institute of Economic Research in Munich, Hans-Werner Sinn is convinced that bailing out European countries in difficulty is against Germany’s interests, and has organised a petition signed by 170 economists who urge their “fellow citizens” and the country’s parliament to put a stop to a “dangerous” policy and avoid a banking union.

 Angela Merkel is getting some more solace/help in defecting this on-going prisoner's dilemma which we recently discussed.

So why our chosen title? Many pundits have been arguing about Merkel being the big loser of the latest European summit (number 19...). It might be that, after all Angela Merkel, could be one of the greatest chess players around and has just used "castling". Many of the greatest chess players throughout history have considered the endgame to be of paramount importance because endgame theory is finite. So are Europe's possibilities in escaping the demise of its fragile construct.

In relation to our endgame chess analogy and the current European situation:

"Rook endings are probably the deepest and most well studied endgames. They are a common type of endgame in practice, occurring in about 10 percent of all games (including ones that do not reach an endgame) (Emms 2008:7). These endgames occur frequently because rooks are often the last pieces to be exchanged. The ability to play these endgames well is a major factor distinguishing masters from amateurs (Nunn 2007:125). When both sides have two rooks and pawns, the stronger side usually has more winning chances than if each had only one rook." - source Wikipedia.

In what was labeled "The Game of the Century" and in reference to our chosen title (in the end, we had to make a choice), Bobby Fischer 13 years old at the time, won the game by making material sacrifices:

"Material sacrifices are likely to be effective against a king still in the middle and an open central file."

We would therefore be inclined to agree with Wolfgang Munchau in the FT on the second of July, namely that after all the biggest winner from the last European summit was indeed Angela Merkel:
"One of the lessons from the history of financial crises is that bazookas must be big to be effective. This one is not. Nor was the now defunct securities markets programme of the ECB. It did not stem the crisis because the ECB’s commitment was strictly limited – and contested by members of its governing council. The ECB still spent more than €200bn on this programme, and yet it did not work. The ESM’s budget for bond purchases will probably be lower. Mr Monti may have secured the right kind of deal politically but to solve the ESM’s size problem he really should have insisted on a banking licence. With that, the ESM could have leveraged its lending ceiling to a more realistic level. It will not be able to do this now. This is why I believe the real winner of last week’s summit was not Mr Monti but Ms Merkel after all. She managed to keep Germany’s liabilities unchanged. Someone will have to explain to me how we can have no change to Germany’s overall liabilities, nor of ECB policies, and yet Italy and Spain can now be safe when they were not safe a week ago.
The deal on Spain was marginally better – on paper. But it, too, is not what it seems."

"Usually in the endgame, the stronger side should try to exchange pieces (knights, bishops, rooks, and queens), while avoiding the exchange of pawns." - source Wikipedia.

This exactly what Angela Merkel has done and what Bobby Fischer did on that 17th of October 1956 game against Donald Byrne which led to his victory...

"When both sides have two rooks and pawns, the stronger side usually has more winning chances than if each had only one rook". Bobby Fischer had one rook at the end of the game and 5 pawns...

By managing to keep Germany’s liabilities unchanged Angela Merkel appears to us as the winner of the latest European summit (number 19...). Question being for us now, can Europe survive in the current form (number of countries) without making material sacrifices in true Bobby Fischer fashion? One has to wonder.

In our credit conversation we would like to discuss the latest European summit focusing on the European Banking Union proposal as well as the latest decision of the ECB to cut the deposit rates to zero (meanwhile Denmark has taken the bold step of going negative). But first our credit overview.

The Itraxx CDS indices picture, a tale of ongoing volatility - source Bloomberg:

Once again the rally courtesy of the European Summit in Brussels was short lived as the markets where disappointed by the latest ECB rate decisions. The ECB on Thursday cut its main refinancing rate to a record low of 0.75% from 1% and cut its deposit rate to zero. Non-standard tools such as the SMP (Securities Market Programme) was not re-activated leading to a significant rise in Spanish government yields in the process. In that context the Itraxx Crossover (High Yield CDS risk indicator - 50 European high yield credit entities) rose significantly towards the 700 bps level, closing around 682 bps, widening by 18 bps on the day. Both the Itraxx Financial Senior 5 year index (25 banks and insurers) as well as the Itraxx Financial Subordinated 5 year index rose significantly in the process, respectively by 14 bps and 24 bps, erasing the gains registered courtesy of the European summit.

Italy's 5 year Sovereign CDS versus Spain 5 year Sovereign CDS with Spain under pressure - source Bloomberg:

The spread differential between both countries is rising close to the record levels registered in March with a spread differential between both Sovereign CDS at around 63 bps.

The current European bond picture with Friday's rise of Spanish and Italian yields, with Spain moving back towards the 7% level while German government yields closing back to lower levels around 1.32% (1.60% last week) - source Bloomberg:

Moving back to "Risk-Off" in our "Flight to quality" picture, Germany's 10 year Government bond yields fell towards 1.32% and the 5 year CDS spread for Germany has remained below 100 bps in the process for now - graph below, source Bloomberg:

Disappointing jobs report in the US (Nonfarm payrolls at 80K) in conjunction with anxiety surrounding the global economic outlook led to the flight into safety assets, pushing down core benchmarks such as the German bund in the process.

"The Gap is back": Now both the Eurostoxx and German 10 year Government yields seems to be moving out of synch, with falling German Bund yields and a higher Eurostoxx 50 index. - Top Graph Eurostoxx 50 (SX5E), Itraxx Financial Senior 5 year CDS index, German Bund (10 year Government bond, GDBR10), bottom graph Eurostoxx 6 month Implied volatility. - source Bloomberg:

It is still the "D" world (Deflation - Deleveraging) - 2 year German Notes going negative making again a new record versus 2 year Japanese Notes - source Bloomberg:

In this deflationary environment, it has long been our position that the two LTROs operations would not lead to lending to the real economy and amounted to "Money for Nothing". The latest money multiplier clearly indicates that provisions of credit remains weak at best - source Bloomberg:

"While the ECB cited a lack of direction from the June EC summit, it is clear that the ECB liquidity earmarked to kick-start the banks' provision of loans to the real economy has so far failed.
The money multiplier, broadly the expansion of money supply in the economy as a result of bank lending, remains very weak and further measures will be likely." - source Bloomberg.

Although the ECB has reduced its deposit facility rate to zero in an effort to encourage banks that have parked their LTRO cash back with the ECB, we do not believe it will be successful even, if it goes into negative territory, like Denmark just did. The central bank in Copenhagen cut the rate it offers on certificates of deposit yesterday by a quarter of a percentage point to minus 0.2 percent. Central bank Governor Nils Bernstein declared: “I hadn’t expected that. It’s the first time in this institution’s nearly 200-year history, so obviously I hadn’t expected it.”

"After the two LTRO ECB loan facilities, recipient banks of more than 700 billion euros of cheap liquidity redeposited more than 500 billion back on deposit at the ECB. Initially paying 1% for
the loan and receiving 0.25% interest on deposit, it is unlikely that a drop to 0% will offset the benefits to the banks of liquidity access." - source Bloomberg

Moving to our subject of the need for European Banking Union, in a recent note from Cheuvreux from the 6th of July, Nicolas Doisy argued the following:
"The banking union is essential as it will maintain a longterm link between the Eurozone's core and periphery.
Indeed, politically speaking, the banking issue is the one most pressing common problem to solve, due to the inter-connectedness of the Eurozone financial system. A fortunate side effect of this inter-connectedness is that it imposes a de facto duty of solidarity. Otherwise the Eurozone's banks would start collapsing one after the other in a series of bankruptcies, just like US (and later European) banks did back in the 1930s.
The Eurozone is thus making do with the need to collectively repair its banking sector, whose side effect is to make for (the very premise of) a political (union) project. In a sense, thus starting with shaping the indispensable banking union is like creating the European Coal and Steel Community in 1951, which opened the way to the European Union in 1957. This seemingly unassuming approach will hopefully obtain the same result.
In this respect, the finalisation of the plan to rescue the Spanish banking sector will be key in using the bank resolution scheme to maintain a core-periphery link. Indeed, one particularly central issue is no longer hanging up in the air: the Eurozone financial aid for Spanish banks will go directly to banks (and not via the Spanish government). Given the deadlock on the federalisation of the Eurozone, this is a breakthrough."

We "agree to disagree" with Nicolas Doisy in that respect. What remains concerning, as we argued in our conversation "St Elmo's fire" on the 26th of May, is that the SOVx index representing the CDS risk gauge risk for 15 Western European countries (Cyprus replaced Greece in March in the index) remains at elevated levels and so does the Itraxx Financial Senior Index, a further indication of the existing strong correlation between financial and sovereign risk - source Bloomberg:

Both indices remain at the same level. In respect to the subject of a European Banking Union, we agree with Nomura's take on the subject in their recent note - The EU Summit - Why the rally, from the 29th of June:
"Either way the creation of a single banking regulator may be useful, but is not a solution to the bank/sovereign crisis. Likewise the creation of a bank deposit guarantee scheme may be useful, but we think it is more likely a distraction from resolving the root cause of the current banking crisis – the sovereign-banks link, impaired assets and deficient capital and recapitalisation structures.
-The German Bundestag could require further sign-off of a direct recap agreement. The German Bundestag (lower house) could further complicate utilising the ESM for direct banking recaps by requiring parliamentary agreement of the new measures. Norbet Barthle argued that this represents a new aid instrument of the ESM to which the plenary of the German Bundestag must first agree.
-Bailouts are unlikely to encourage lending. The strict conditions put on banks that have requested aid are likely to make them less willing to lend. With an unstable economy the extension of credit is unlikely to rise particularly if there is a risk that further losses could lead to a bailout and the constraints being imposed.
-A combination of solutions is required to stabilise the banking system. In general, though, for any bank bailout to work one needs to create a stable environment on both the asset and liability side of the balance sheet. To create stable assets ECB QE and haircut reduction on collateral assets would likely be required. Further to this a bad asset manager should be created to take impaired assets off bank balance sheets."

The issue of circularity will not be broken by a European Banking Union. In our conversation "The Daughters of Danaus" we reminded ourselves of the issue of circularity namely the Danaides punishment which we also discussed in October last year. The issue of circularity we mentioned last year could not be clearer than the two  graphs below, one from Martin Sibileau in his post - "The EU must not recapitalize banks":

The other one from a Morgan Stanley note:

We might be sounding like a broken record but once again is all about Stocks versus Flows. In our Danaids analogy and their never ending task of filling the tub because, we posited the following in various conversations:"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."

From the same Nomura note from the 29th of June, the stocks versus flows issue, (hence the difference between the FED and the ECB) will not be resolved by a European Banking Union. This will not break the correlation between the sovereign and the banks:
"With regards to the marginal buyer of Spanish sovereign debt, over the past six months this has tended to be the banks. However, this appears to have come to a dead stop. Banks marginally decreased sovereign debt holdings in May according the ECB. A move in deposits to the larger banks would explain this to a degree as it would reduce the ability of smaller banks to buy sovereign debt. At the same time the bigger banks, BBVA and Santander, announced in April that they had reached their risk concentration limits on sovereign debt and could not purchase any more.
Spain's banks and sovereign are mutually infectious, but in the short run banks will continue to weaken perception of the sovereign, in our view. The knock-on effect could be that Spain weakens Italy at a sovereign level, but in Italy a weakening of the sovereign would then weaken the banks because of their holdings of BTPs. Indeed, Monte de Paschi's this week said that its capital shortfall was partly due to the loss in value on its BTP holdings."

The vicious cycle of banks and sovereigns cannot be solved only by a European Banking Union:

"The opening line of the EC's release that set markets racing stated that it must break the increasingly interconnected nature of some euro zone banks and their respective sovereign. ECB data show that Italy's banks have recorded positive inflows of sovereign debt every month in 2012 totaling 89 billion euros, a situation which should reverse in the near term." - source Bloomberg.

Even as the ECB helped boost Italian bond returns in the first quarter, the country’s budget deficit increased. Italian yields climbed in the second quarter as Spain was forced to request as much as 100 billion euros ($125 billion) to help recapitalize its banks. The extra yield investors demanded to hold Italy’s 10-year debt over similar-maturity German bunds surged to as much as 490 basis points, or 4.9 percentage points, in June, up about 200 basis points from their March low. It was at 469 basis points on Friday. Italy is now heading for a deeper and more protracted recession even after approving a deeper set of spending cuts, expected to reduce state expenditure by 4.5 billion euros in 2012, 10.5 billion in 2013 and 11 billion in 2014. These planned fiscal tightening followed those implemented in July, September and December 2011 which amounted to a cumulative 49 billion in 2012, 76 billion in 2013 and 81 billion in 2014.

In our Danaus conversation we argued:
"Until we see a clear reduction in deficits, (which we might never see in true Danaides punishment or fashion), the ECB liabilities will indeed depreciate." - Macronomics - 30th of May 2012.

It is therefore not a surprise to start seeing "Mutiny on the Euro Bounty":
-Mutiny in Germany with the head of IFO supported by 170 economists rejecting a European Banking Union.
-Mutiny in Italy with Monti’s popularity with investors damaged after he passed watered-down labor-market legislation on June 27 and was forced to temper proposals to revive Italy’s economy by making it easier for distressed companies to fire workers after Italy’s biggest union called a general strike and a key political ally vowed to oppose the bill and widespread public opposition to paying property tax, raising risks of structural tax slippage meaning Italy will miss its 2012 budget forecast.
-Mutiny in Finland and Holland, rejecting ESM bond buying. There exists no unanimous agreement on the bond purchases because Finland and the Netherlands reject the model, the Finnish government said in a report dated June 29 and presented yesterday by Prime Minister Jyrki Katainen to the parliament’s Grand Committee in Helsinki. The government reiterated its opposition today, citing the rescue funds’ limited resources and the shown “ineffectiveness” of bond purchases according to Bloomberg.

No wonder Angela Merkel in this "Game of Century", while only appearing to be making material sacrifices, she has managed to keep Germany's liabilities unchanged.
As indicated by Nomura in their recent note - Italy, Tacking into the headwinds from the 5th of July, in our European game chess of the century, we think Germany still has the upper hand: "Hence, we doubt that Ms Merkel and her allies in northern Europe are ready to cross the proverbial Rubicon by mutualising Italy's debts to a paradigm-shifting extent. That said, Italian domestic politics could be a continuing threat to the survival of the euro area."
We could not agree more. With general elections looming in Italy, the probability of survival of the Monti administration is in fact falling. The risk of the Monti administration not surviving the "electoral cut" after May 2013 should not be underestimated.

On a final note if Europe is a story of growing divergence, from a sovereign-credit rating's point of view, the East-West rating gap clearly indicates convergence - source Bloomberg:

"The CHART OF THE DAY shows the average credit rating of seven emerging and eight developed European countries from Moody’s Investors Service. Each nation’s rating is weighted for the size of its economy. The average in the east has improved to Baa1, the third-lowest investment grade, from Ba3, the third-highest junk rating, in 2000. For western Europe, it’s fallen to Aa2, the third-highest investment grade, from Aa1." - source Bloomberg.

The European Union’s seven former communist members outside the common currency will have
an average budget shortfall of 2.6 percent of gross domestic product and an average debt load of 44.7 percent of GDP this year, the European Commission estimates. That compares with 3.2 percent and 91.8 percent for the euro region according to Bloomberg. No wonder Germany, frustrated in the West, is increasingly looking more and more to the East:
"Russia is important for German companies. In 2011, there was a 30 per cent increase in trade between Germany and Russia, with a total volume of 75 billion euros. German economic representatives have been talking about the huge potential of the Russian economy for many years, and it is seen as advantageous that Russia is nearly as important for trade as Poland. In 2011, Russia ranked 12th in German exports behind Poland (10th) and before the Czech Republic (13th)."
"Russia is Germany’s biggest supplier of gas and oil, providing around 40 per cent of its gas and 34 per cent of its oil supply in 2011. With the government’s decision to stop producing nuclear energy by 2022, German demand for gas will increase in the short and medium term." - Source An Alienated Partnership - Vestnik Kazkaza - 7th of July 2012.

As we indicated in our conversation "Eastern promises" on the 9th of June:
"We think the breakup of the European Union could be triggered by Germany, in similar fashion to the demise of the 15 State-Ruble zone in 1994 which was triggered by Russia, its most powerful member which could lead to a smaller European zone. It has been our thoughts which we previously expressed."

"The human element, the human flaw and the human nobility - those are the reasons that chess matches are won or lost."
Viktor Korchnoi - oldest active grandmaster professional chess player.

Stay tuned!

Markets update - Credit - The Hungarian dances

"Learn from yesterday, live for today, hope for tomorrow. The important thing is not to stop questioning."
Albert Einstein

In a continuation of our previous analogy to the European flutter, as we enter 2012, the recent evolutions of the situation in Hungary which we discussed in our post "Mind the Gap...", warrant us this time around to ramble around how reminiscent the collapse of the Austro-Hungarian dual monarchy and empire (1867–1918) is with our European flutter. Could Hungary be the trigger in 2012? Before we enter yet another long credit conversation, for a change this time around, before our market overview, it is of importance to highlight the current situation in Hungary and contagion to Central Eastern Europe.

Back in October in our post "Long hope - Short faith" we discussed the worrisome Hungarian situation, which was also the main subject of our conversation "Leda and the (Greek) Swan and why Europe matters more for Emerging Markets".

We previously quoted an article by Geoffrey T. Smith from the Wall Street Journal on the subject and as we move into 2012, it will be paramount to monitor the risk of wholesale capital flight with the ongoing buildup of tensions in Hungary - "Austria Has a Déjà Vu Moment":

"the biggest threat to Austrian banks is still what it was in 2009—wholesale capital flight from emerging Europe."

On the 4th of January, Hungary's 5 year sovereign CDS widened by 65 bps, quoted 690-730 bps in the market, with limited liquidity and the CDS curve inverting in the process, meaning short dated protection is becoming more expensive than the 5 year point. We have seen this happening before with Greece, Portugal and others. The situation warrants caution as the Hungarian effect is spreading to other countries according to a market maker, spreading to Poland and Czech sovereign CDS, both trading wider in the process, Poland around 290 bps for the 5 year CDS and around 180 bps for Czech CDS 5 year.

As indicated by Simon Foxman in Business Insider article - Hungary's Currency Hits New Lows Amid More Signs Of Upheaval:
"The Hungarian forint weakened to its lowest value against the euro since last month—near its lowest level ever—at 319.4 amid worries that the political situation there is becoming untenable. Increasing attention is being paid to the small Eastern European country, at the center of Europe's other debt crisis.

The Hungarian government is running short on cash after it passed a law last week that could compromise the independence of its central bank. That law flaunted guidance from the European Union and the International Monetary Fund, who provided the troubled country with €20 billion ($26 billion) a bailout back in 2008. Hungary is paying through the nose to borrow even short-term funding, and the cost of insuring Hungarian debt via credit default swaps hit a new record, at 655 basis points according to Bloomberg. It paid yields of 7.67% to borrow for a three-month term and raise 45 billion forint ($190 million) yesterday.

Domestic turbulence is complicating matters, with protestors taking to the street to protest the government's new constitution (which includes that controversial central bank law). According to the BBC, protests are focusing on three major issues:

·A clause that defends the "intellectual and spiritual unity of the nation," which opponents argue could result in repression of intellectual freedoms

·Inclusion of social issues like the right of the unborn child and the definition of marriage as a union between a man and a woman

·Changes to the electoral system which could empower the leading Fidesz party at the expense of the opposition

Popular support for the Fidesz party hit 18% in a December opinion poll cited by the BBC, although it still leads other parties. If the Hungarian government were unable to pay its bills, it could wreck the Austrian banking system, which has an estimated $226 billion in exposure to Eastern Europe and €1.14 trillion ($1.6 trillion) of assets held in the region. 10-year yields on Austrian government bonds—and indicator of stress on the country—are moving sharply higher this morning. They rose to 3.20%, the highest level since before a central bank stilled their rise earlier in the year."

At the time of our November conversation "Mind the Gap...", we reminded the new legislation which passed by the Hungarian government in relation to the ill-fated currency mortgages which burden Hungarian households:
"Under the new legislation borrowers can repay their mortgage in a single installment at a HUF/CHF rate of 180 or a HUF/EUR rate of 250. Current FX rates are around 239 for HUF/CHF and HUF/EUR is around 297, a 25% and 16% discount according to CreditSights."
In November we commented:
HUF/EUR rate was 297 at the time, and is now much higher (315), meaning losses for European banks and in particular the likes of Austrian Erste Bank exposed to these mortgages will be significantly higher - source Bloomberg. Given HUF/EUR is reaching new highs, Austrian banks exposed to these mortgages face significant additional losses. So yes, contagion to EM, and in particular Central Eastern Europe, which was highlighted as a key risk for 2011, is indeed starting to materialise early in 2012.

But before we delve more into the Hungarian dances (as a reference to the 21 lively Hungarian dance tunes by Johannes Brahms), and discuss some of our previous call for concerns, it is time for a quick market overview.

The 36 months LTRO set up on the 21st of December by the ECB is far from having the expected results in relation to alleviating concerns that banks will use the cheap funding provided to generate generous positive carry by buying peripheral bonds. 455 billion euros are deposited at the ECB earning a paltry 0.50% of interest for now - The liquidity picture in four charts. ECB Overnight Facility, Euro 3 months Libor OIS spread, Itraxx Financial Senior 5 year index, Euro-USD basis swaps level - source Bloomberg:

The Credit Indices Itraxx overview - Source Bloomberg:

Most credit indices remain in the "concern" area, with Itraxx Financial Subordinate 5 year CDS index around 530 bps, still indicating the unsecured subordinated financial market is shut down, while Itraxx Financial Senior 5 year CDS index is rising again towards the 300 bps in a very thin market. As indicated by a market maker, so far both clients and dealers are on the sidelines. The Itraxx SOVx index tied to 15 European Government sovereign CDS is on the rise as well getting closer towards its 385 record set up on the 25th of November. Similar story to what we wrote in January 2010, "European problems not going away in 2011", and not going away in 2012.

The current European bond picture, a story of ongoing volatility, with Spain now rising as well with Italy following recent news of regional funding issues in Spain (Valencia) - source Bloomberg:

So what about our CPDO EFSF? It seems French yields are now rising faster as we start a new year, Investors demanded a yield of 3.29% on the 3.25% OAT due in October 2021, last auction on 1st of December was 3.18% - source Bloomberg:

German 10 year government yield falling (flight to quality) while German 5 years sovereign CDS rising - source Bloomberg:

In relation to the deflation story still playing out in Europe, here is an update on 30 year Swiss bond yields now below 1%, nearly 100 bps lower than Japan 30 year bond yields - source Bloomberg:

But back to our main story, namely the Hungarian situation and contagion to Emerging Markets (EMEA).

During various credit conversations, we argued that the name of the game is survival of the fittest in the race to raise much needed capital. It seems Deutsche Bank is sharing our views as indicated in their Emerging Markets special publications published on the 6th of December entitled amusingly "Survival of the fittest":
EMEA dominates our list of the most vulnerable countries. Five countries (Hungary, Ukraine, Romania, Poland, and Egypt) show up as highly vulnerable, though for different reasons. Egypt’s underlying vulnerabilities, for example, are fiscal first and external second. Ukraine’s risks are mostly external. Hungary’s vulnerability reflects a combination of risks in all four areas."

According to Deutsche Bank, for 2012, EMEA countries will be facing many difficulties and will need IMF support:

"Current account balances have improved in the last few years and central banks have been able to build bigger buffers of foreign reserves. But the large stock of external debt accumulated during the middle of the last decade still leaves the region with large external burden. Much of this borrowing took place in foreign currencies – Swiss franc mortgages in Hungary (20% of GDP) being just one example – the local currency burden of which is now being inflated as those currencies come under pressure. With these debts needing to be serviced on an ongoing basis, many countries still face large external financing needs even as their current account positions have improved. This is particularly true of Hungary and Ukraine, which have gross external financing needs of 30% of GDP or above in 2012 despite a moderate current account deficit in Ukraine and a small surplus in Hungary."

IMF support?

"Three of these countries (Hungary, Ukraine and Egypt) may well need to tap the IMF for financial support next year. Ukraine already has an IMF program (of which USD 12bn or 6.5% of GDP is potentially still available) but is currently looking first to Russia for cheaper gas prices to reduce its external financing needs. Hungary is seeking the reassurance of a precautionary IMF program although negotiation on the policy condition has not yet started and could well be difficult. Egypt had reached agreement in principle on a USD 3bn (1.2% of GDP) arrangement with the IMF but has yet to proceed with the deal for political reasons."

In our conversation "Leda and the (Greek) Swan and why Europe matters more for Emerging Markets", we already discussed at length the Western Europe banking deleveraging impact will have on Emerging Markets and in particular Central Eastern Europe. In their December note, Deutsche Bank also commented:

"The buildup of foreign currency debt was probably largely a reflection of relatively high and volatile inflation in some cases, leading to a large spread between domestic and foreign interest rates. But the availability of foreign currency loans was also facilitated by the rapid expansion of western European banks throughout much of the region. This has left many countries exposed to deleveraging by foreign banks as they seek to meet additional capital requirements imposed by the European Banking Authority. These requirements are largest for Greek, Italian, and Spanish banks, which may be a concern for Romania and Hungary (as well as Croatia, Serbia, and Bulgaria outside our sample) where Greek and Italian banks are most active. But other banks may also be reluctant to maintain their exposures in the region. Germany’s Commerzbank, for example, has indicated that it will temporarily suspend new lending outside of Germany and Poland. Austria’s central bank has also imposed limits on new lending in CEE by the subsidiaries of Austrian banks. And countries without strong parent-subsidiary ownership linkages are also unlikely to be immune. Turkish banks, for example, have substantially increased their short term external borrowing in the last couple of years (from foreign banks) and may face some difficulties in rolling these loans."

As indicated by Deutsche Bank, given Hungary exports to the euro area account for 40% of GDP, Hungary is arguably more exposed to a recession in Europe. The recent failed Hungarian auction and additional pressure on the Forint is definitely not helping.

And my good credit friend to comment on the 5th of January:

"The Hungarian Forint is under pressure again (EurHuf @ 321.50), and the country had problem raising 1 year T-Bills this morning (35 billion HUF instead of the 45 billion planned, the average yield rose to 9.96% versus 7.91% for the same kind of maturity on December 22nd). The cost of insuring Hungary’s debt through CDS reached an all-time high at 750 bps!

Basically, the country is now in a worst situation than Portugal, and without the IMF and EU assistance, the risk of a hard default is rising very quickly. Consequences for European banks exposed to this country are difficult to assess, but Erste Bank, Raiffeisen and some other players should suffer…"

And suffer they already have, not only with the legislation capping the exchange rate on currency mortgages provided to Hungarian households (putting them in a difficult situation) we mentioned above but, also in relation to Goodwill impairments (which we discussed in our conversation "Goodwill Hunting Redux").
As a reminder:

"Erste Bank in fact, wrote down the value of its Hungarian and Romanian units by a combined 939 million euros in October."

"UniCredit wrote down goodwill on assets in its home market, eastern Europe and former Soviet Union countries in its third-quarter earnings report in November (8.7 billion-euro impairment charge)".

It wasn't therefore a big surprise to us and our good credit friend to see a decline of 37% of UniCredit shares in three days following its 7.5 billion right issues priced with a 43% discount (selling shares for 1.943 euros each...).

Back in November in our Goodwill conversation we made the following warning:
"Tip for “banks’ friends”: First came dividends cuts, then bonds haircuts. Next, we will see some massive write-off (Goodwill ?). UniCredit started, others will follow. The path will be very painful for both shareholders and bondholders."


Given we already know that UniCredit made 60 billion USD worth of acquisition between 2005 and 2008, tracking goodwill impairments will indeed be a necessary exercise in 2012 as they can take a real chunk out of bank earnings in the process.

In relation to current bank exposure to Hungary, Deutsche Bank in their latest Hungarian sovereign risk review published on the 6th of December indicated the following:

"During the past days the Hungarian sovereign risk exposure has increased
significantly, taking the development of CDS prices as an indicator. Austrian banks have material exposure to Hungary, both via sovereign bonds and through loans. Erste Group has a total of EUR11bn in assets invested in Hungary (some EUR8bn in loans, some EUR3bn in sovereign exposure) while Raiffeisen Bank International has a total of EUR8bn in Hungarian assets (some EUR6bn in loans, some EUR2bn in sovereign exposure.
According to latest EBA data, as of 30 Sept 2011 the largest European banks have a total sovereign exposure of EUR31bn vis-a-vis Hungary. The data indicates the largest absolute exposures (combined net trading and banking book) are held by KBC with EUR6.9bn (of which EUR2.6bn was due within 3 months, so might have left the balance sheet by now), OTP with EUR4.2bn, Erste Group with EUR3.3bn, BayernLB with EUR2.2bn, Commerzbank with EUR2.0bn, Intesa with EUR1.7bn, ING with EUR1.7bn, RBI with EUR1.6bn. In some cases the maturity profile in the EBA spreadsheet was biased to short-term exposures, in some cases biased towards long-term exposures.
In relation to current market cap, high ratios result for KBC (c.220%), Erste Group (c.70%), RBI (c.40%) and Commerzbank (c.30%). A haircut on Hungarian sovereign exposure therefore would have meaningful implications for these institutions."

Continuing on the same Hungarian theme in Deutsche Bank EMEA Daily Compass published on the 6th of December, we have to agree with their assessment of the situation for Hungary:
"The failure of yesterday’s a12M bill auction has ignited fears that the situation in Hungary may spiral into a solvency crisis triggered by an inability to roll-over upcoming LOCAL debt maturities.
From a medium term perspective, a useful rule of thumb for assessing debt sustainability is to compare the marginal real yield required to roll-over the existing stock of debt and the real growth rate of the economy Over the past 10 years, real growth has averaged 2.4% y/y while yearly inflation stood on average at 5.9%, which suggests that at the current blended (local and external) marginal rate of refinancing (10.5%), a consistent fiscal primary surplus of 2.2% would be required to maintain current public debt levels stable. It is clear to us that such a theoretical outcome is not credible for the market, i.e. paradoxically yields have reached a level that is too high to motivate buyers to participate in the financing of an issuer that is running an unsustainable debt position."

Deutsche Bank to conclude their note making the following point:
"As a conclusion, we expect events to unfold rather quickly in Hungary. It may come down to a choice between a partial loss of sovereignty in economic management or of a debt restructuring, to be made at the highest political level."

And has clearly indicated by Bloomberg's Chart of the day of the 4th of January, we have seen this movie before...

"Hungary’s failure to secure an international bailout has pushed the cost of insuring its debt against default above that of Ireland for the first time since September 2010.
The CHART OF THE DAY shows that credit-default swaps on Hungary rose to 720 basis points in London on the 3rd of January, compared with 709 for Ireland, according to CMA, which is owned by CME Group Inc. and compiles prices quoted by dealers in the privately negotiated market.

Hungary’s default swaps surged to the highest on record on the third of January and the forint weakened to an all-time low versus the euro after Citigroup Inc. said an International Monetary Fund deal is unlikely in the next six months and European Commission spokesman Olivier Bailly said the European Union has no plans to resume aid talks."

"When there's uncertainty they always think there's another shoe to fall. There is no other shoe to fall."
Kenneth Lay - CEO and chairman of Enron from 1985 until his resignation on January 23, 2002.

Stay tuned!

Markets update - Credit - The Generous Gambler

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

While we already referred to Baudelaire's "Generous Gambler" in our post "Complacency" in conjunction with Verbal Kint's adapted quote from the Usual Suspects, the latest European summit and ECB statements inspired us, this time around, to refer to this great text from Charles Baudelaire.

But before we delve ourselves in another long credit conversation, it is time for a usual quick credit market overview.

The Credit Indices Itraxx overview - Source Bloomberg:

Sovereign CDS 5 year index (15 European countries sovereign CDS) led the widening on the back of the European summit, reaching around 366 bps, a weekly advance of more than 40 bps (the most since July according to Bloomberg), with Italy breaking ranks yet again, rising 20 bps to 545 bps, with ECB buying 10 year bonds at 6.54% yield.

The interesting point is that the SOVx Western Europe index on the 5 year is again wider than its Central Europe and Middle East counterpart, namely SOVx CE as per the below graph - source Bloomberg:

Itraxx Financial Senior 5 year index (linked to senior debt of 25 banks and insurers) and Itraxx Financial Subordinate 5 year index remains stubbornly elevated - Source Bloomberg:

The current European bond picture, a story of poor liquidity and volatility - source Bloomberg:

German 10 year government yield rising in lockstep with German 5 year sovereign CDS on ongoing European issues - source Bloomberg:

Our flight to quality indicator, the spread between 10 year Swedish government yields and German 10 year government yields. It looks like this relationship is breaking up again - source Bloomberg:

The liquidity picture in four charts. ECB Overnight Facility, Euro 3 months Libor OIS spread, Itraxx Financial Senior 5 year index, Euro-USD basis swaps level - source Bloomberg:

The new reserve period for deposits at the ECB will start on the 14th of December and last 35 days.
The ECB awarded a significant extension of its liquidity facilities for Eurozone Banks from 13 months to 3 years, so that they could somewhat provide credit to the real economy. The European credit crunch has already started given the European Banking Association planned 9% Core Tier 1 by June 2012, means deleveraging on a massive scale. The EBA is also indicated banks need to raise 114.7 billion euros in new capital when it was only 9 billion needed following the July European banks "stress" test...
Broader collateral has been allowed for Asset Backed Securities, a looser rule, from AAA paper, now single A paper allowed.
25 bps rate cute given deteriorating growth prospects.

Our CPDO/EFSF yield on the rise again, courtesy of Standard and Poor's negative watch on the fund, following the agency's decision to put all 15 European countries (of our SOVX CDS 5 year index) on review for downgrade - source Bloomberg:

European Council President Herman Van Rompuy announced on Friday the EFSF would be rapidly deployed.
Fact: The EFSF has only raised 16 billion euros from four bonds this year and looking at the amount that needs to be raised in 2012, the prospect of raising more money is looking slimmer by the day.
We already discussed the flawed EFSF in our conversation "EFSF - If you are in trouble - double". Recent developments relating to the European summit were interesting, namely because the latest proposal seems to have the "transitional" EFSF rescue fund and the "permanent" rescue fund the European Stability Mechanism (ESM due to start in July 2012) running alongside each other.
In our previous October conversation this is what my good credit friend had to say about the proposed combine structure as a reminder:

"Main talks were about E.U. combining the EFSF and the ESM by mid-2012 to create 1 Fund with 940 billion euro (1.3 trillion US $) firepower.
Well, obviously there are a number of issues about such a conclusion….
The 500 billion Euro ‘permanent” bailout fund (ESM) was slated to replace the 440 billion "Temporary" European Financial Stability Facility (EFSF) fund. Well, the latest proposal that has the stock markets excited is to merge the two funds…. But there is a bias; it is double counting the money.
The total overall cap is 500 billion euros, of which 160 billion have already been committed or spend to help Greece. Therefore there is only 340 billion left! So how can you get 940 billion euros? This would raise the permanent fund above the agreed upon amount…. And the German Supreme Court has stated this cannot be done without a popular vote (referendum) !!! Also bear in mind that the German Supreme Court has ruled there should not be a permanent bailout fund at all…. Which add to the already constitutional issue."

Germany still remains against combining both structures.
On the latest headlines relating to the ESM, here is what my good credit friend had to say:

"The ESM is to be implemented as soon as July 2012, and the EFSF running in parallel for 1 year (please note that the combined firepower of the ESM/EFSF 500 billion euros only that might be revised in March 2012. Which means it will not be over 500 billion euros!"

We also had the agreement from European politicians to lend 200 billion euros to the International Monetary Fund via national central banks to be used for loans to troubled states and limiting so-called private-sector involvement (PSI) to the terms accepted in IMF bailouts was part of the package. The PSI was a major blunder which led to the questioning of "risk-free" status which we discussed in "The curious case of the disappearance of the risk-free interest rate and impact on Modern Portfolio Theory".

As a reminder, this is what Arnaud Marès, from Morgan Stanley in his publication of the 31st of August -Sovereign Subjects had to say about the PSI:
"'Private sector involvement' in the restructuring of Greek debt was in our view a major policy error, which has changed in a quasi-irreversible way the perception of sovereign debt in advanced economies as risk-free and therefore as safe haven assets. This has broadened the channels of contagion across Europe.
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.

Pandora’s Box has been opened. Only fiscal integration accompanied by centralised financing of governments can bring about full stabilisation of the market in Europe, in our view. The alternative could eventually be a resumption of the run on governments and a wave of public and private defaults.
The ECB can provide protection against a run, temporarily. While the ECB has the capacity to act as a lender of last resort, doing so exacerbates political tensions and is not a lasting solution, we think."

In relation to the IMF bilateral loans agreement, my good credit friend added:
"Provision of additional resources to the IMF of up to 200 billion, in the form of bilateral loans, to ensure the IMF has adequate resources to deal with crisis. Very interesting indeed! If the EU has 200 billion euros to spend, why not using them to increase the size of the ESM? Why do they need the IMF?"

As we pointed it out in our credit conversation "The European issue of circularity", "Nothing is more frequently overlooked than the obvious" (Thomas Temple Hoyne). The latest European agreements do not resolve the European issues!

As a follow up on our "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."

A Tale of Two Central Banks - according to Martin Sibileau:
“…The Fed was financing what we call in Economics a “stock”, i.e.( mortgages) “…a variable that is measured at one specific time, and represents a quantity existing at that point in time, which may have accumulated in the past…”
"The ECB is financing “flows”, deficits, or “…a variable that is measured over an interval of time…” Therefore, by definition, we cannot know that variable until the interval of time ends…When will deficits end? Exactly!! Nobody knows! Thus, it is naïve to ask more clarity on this issue from the ECB. The only thing that is clear here is that the Euro, i.e. the liabilities of the ECB will necessarily have to depreciate as long as that interval of time exists, until a clear reduction in the deficits is seen…”.

My good credit friend and I came to the following conclusion:

"We remain fundamentally negative on European markets for 2 reasons: a) the negative impact on the European economies from austerity measures which will be implemented by the governments, and b) the financial institutions’ deleveraging which will drastically reduce the funds available to the various agents of European economies. In addition to this, the sovereigns 2012 massive funding needs will result in a deadly competition between the protagonists to raise whatever money is available, resulting in much higher funding costs and the collapse of those with weaker balance sheets."

In relation to the deflation story playing out in Europe, here is an update on 30 year Swiss bond yields compared to Japan 30 years yield - source Bloomberg:

On a final note, I give you Bloomberg Chart of the day, showing bank US treasury holdings surging in echo of Japan:

"The CHART OF THE DAY shows bank ownership of U.S. Treasury and agency debt climbed to a record $1.71 trillion in the two weeks through Nov. 23, the latest period for which Federal Reserve data are available. It also tracks deposits at banks rising to the most ever. The lower panel charts an index of Treasuries maturing in 10 years and more.
Investors are snapping up Treasuries after Europe’s debt crisis slows global growth, helping send benchmark U.S. 10-year yields to a record low of 1.67 percent on Sept. 23. The trend echoes developments in Japan, where demand from lenders helped keep rates on 10-year government bonds, so called JGBs, at 2 percent or less since 1999."
Treasure treasuries?

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

Stay tuned!