Credit - The road to hell is paved with good intentions‏

"The meaning of the phrase is that individuals may do bad things even though they intend the results to be good. An example is the economic policies of the 1920s and 1930s. These were intended to be a prudent response to the economic turmoil following World War I and the Wall Street Crash respectively, but they were one of the causes of the Great Depression and World War II in which millions of people suffered and died." - source Wikipedia

Back in January in our conversation "The European Overdiagnosis", our friends at Rcube Global Macro Research pointed out the inherent flaws of the European currency construct when discussing "The likelihood of a Euro Breakup": "By eliminating currency crises, which were common until the mid-1990s (and at the same time preventing evil “speculators” from making billions on them), the Euro built an economic crisis of far larger proportions. Once again, economics provides a good illustration of the old proverb “the road to hell is paved with good intentions”.

Indeed, while today's price action marked somewhat a respite in the recent sell-off, the unintended consequences of the numerous mistakes made during the ongoing European crisis have yet to be really understand by our European politicians, still struggling to address the many issues of our "European flutter". In our credit conversation we will therefore look at the direct consequences of their actions, as well as looking at the potential outcome for Spanish subordinated bond holders in relation to the necessary exercise of capital increases that will need to take place for the Spanish banking system. But first our credit overview.

The Credit Indices Itraxx overview - Source Bloomberg:

The Itraxx Crossover 5 year CDS index (50 European High Yield companies - High Yield credit risk gauge) was tighter by 33 bps, moving back towards the 700 bps level. It touched 790 bps on Friday. While most indices were overall tighter including Itraxx Financial Senior 5 year CDS index (cost of insuring the senior debt of 25 European banks against default) and Itraxx Financial Subordinated 5 year CDS index, the price action is akin to short covering.

Itraxx Financial Senior index fell to a low of 181 bps in March and has been widening since, reaching 309 bps on the 18th of May, the highest level since the 19th of December - 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:

"Mind the Gap" we indicated on the 8th of May - 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:

While volatility has somewhat receded slightly in relation to the V2X Eurostoxx, the German 10 year Bund remains tightly below the 1.50% level indicating the "flight to quality" mode experienced so far.

The "Flight to quality" picture as indicated by Germany's 10 year Government bond yields (well below 2% yield),  with 5 year Germany Sovereign CDS above 100 bps. Back in November last year, when Germany's sovereign 5 year CDS went above the 100 bps level, the Bund experienced an impressive widening move above the 2% following the "failed" German auction. Could it be different this time? - source Bloomberg:

The current European bond picture, a story of ongoing volatility for Italy and Spain, with Spain 10 year yields receding towards the 6% level - source Bloomberg:

Truth is, the rising exposure of peripheral banks to government bonds has indeed boosted Sovereign Risk - source Bloomberg:

"While ECB cash injections significantly improved bank liquidity conditions, more than 300 billion euros of announced austerity measures have pressured the budgets of central and local governments. Total euro-zone bank lending to governments has grown 135 billion euros since 2009, tying banks' fates increasingly closely with their sovereigns." - source Bloomberg.

No wonder both the SOVx index (representing the sovereign risk of 15 Western European countries with Cyprus replacing Greece in the index) and the Itraxx Financial Senior 5 year index have moved in synch - source Bloomberg:

The ECB so far has been providing much needed support via LTRO operations to the European Financial sector, avoiding so far direct support of countries and suspending secondary government bonds buying via the Securities Market Programme (SMP). According to Fitch Ratings as reported by Gavin Finch in Bloomberg, a third LTRO operation could take place:

“If a third Longer Term Refinancing Operation is needed, we believe it will be provided,” James Longsdon, a managing director at Fitch’s financial institutions group in London, wrote in a report today. The timing is “unlikely to be imminent without a further significant shock, such as a Greek exit from the euro.”

It could be a possibility given that for weaker peripheral financial institutions, the ECB remains the ONLY source of funding for ailing institutions. The recent downgrades of both Spanish and Italian banks undertaken by rating agency Moody's means that many banks still face funding issues due to the over reliance of many European banks to wholesale funding.  According to Credit Suisse "Q2 issuance has been remarkably light so far, initially driven by earnings blackout periods, but since hampered by volatile market conditions. This lack of supply has been particularly acute for financials.":

"For senior unsecured benchmark deals, we have experienced negative net issuance of approximately EUR94bn since April 2011." - source Credit Suisse

Moody's downgrades of Italian banks were centered on the unsecured Italian Bank Maturities that needs to be replaced:

"Moody's Italian bank downgrade focused on poor wholesale funding access. In 2012 it suggests that only 20% of unsecured maturities will be replaced by new unsecured issues. A structural reliance on market funds poses "one of the biggest challenges for many banks," as Unicredit's 22.5 billion euros of 2012 maturities highlights." - source Bloomberg.

And with soaring Italian bad debt, increasing to 108 billion euros, shadowing Spain, the survival of the weaker players is conditioned by the willingness of the ECB in providing support:

"Moody's cited deteriorating conditions and risk of increasing bad debt in its downgrades of the Spanish and Italian banks. Italy's bad debt has risen 65 billion euros since the start of 2009, close behind Spain's 75 billion increase. Corporate bad debt now represents two-thirds of Italy's total and will likely rise should sovereign yields remain elevated." - source Bloomberg.

In relation to Spain, rising unemployment, rising Non-performing loans and increasing fears of deposit flights (in relation to deposits flight, Greece’s banking system lost 9 billion euros of deposits this year and has seen outflows of 73 billion euros since the 2009 peak according to Bloomberg), reducing therefore the ability for banks in providing credit to support economic growth to the Spanish real economy, doesn't bode well for the its recovery prospects and overly ambitious budget deficits targets. As shown by Bloomberg chart below, Spain's 148 billion euros worth of NPLs dwarf austerity cuts:

"While Spain's bad debt ratio of 8.37% remains below its February 1994 high of 9.15%, its current bad debt outstanding is more than 6x the 1994 equivalent. With provision requirements increasing and a fourth bank clean up underway, further real estate deterioration will materially offset 37 billion of announced austerity cuts". - source Bloomberg.

Many pundits expect that Spain's ability in restoring investor confidence will be determined by the results of the audit of the banks' balance sheets which will be undertaken by Roland Berger Strategy Consultants and Oliver Wyman. While this operation is laudable, we think it is more akin to an operation of damage control and we do not believe it will change investor's willingness in investing in Europe given the growing foreign buyers strike plaguing the European Government market courtesy of "unintended consequences". The Greek PSI created de facto subordination of private sector creditors while protecting both the interests of the ECB and EIB (goodbye "pari passu" - "The European Opprobrium",  classes of bonds or shares having equal rights of payment or level of seniority).

In retrospect, we think our title is uncannily accurate, in relation to Spanish woes, caught in a vicious deflationary spiral: the road to hell is indeed paved with good intentions. We will not comment further on the overly ambitious deficit targets set up by the European Commission as we have been through this exercise previously ("A Deficit Target Too Far"). But, as the explanation goes, in relation to the colloquial expression used in our title, many mistakes were made leading to a flurry of unintended consequences. These errors are forcing our European politicians to try to change tack aboard the "European Bounty" and calling for a "Growth Compact" and asking again for Eurobonds, clearly facing rising risks of mutiny:
-upcoming Greek and Irish elections
-blunt refusal by Germany and Austria in relation to Eurobonds provided the Fiscal compact is not abided by all.

In a note published today by French broker Oddo, Bruno Cavalier indicates clearly the many mistakes taken since the Sovereign debt crisis broke out in 2010:

"The first error was the diagnosis in 2010, namely that the crisis of the euro had its main source, if not unique, in loose fiscal policies. If this point is not debatable in the case of Greece, it is not true for Ireland and Spain. Before 2008, both countries had scrupulously respected the public deficit criteria. Their current difficulties were not caused by an excessive public debt; they appeared when foreign capital financing their housing bubble ended abruptly. In fact, current problems in the euro area therefore reflect as much a fiscal crisis than a balance of payments crisis. However, the policy prescriptions are not necessarily the same in one case or another. Faced with a budget crisis, as in Greece, it is essential to run a thorough reform of the state, forcing us to rethink the tax system to make it more efficient and reduce public funds waste. Faced with a crisis of balance of payments, jeopardizing the banking system, the priority is different. There is  an urgent need to recapitalize institutions in big trouble, if any, by nationalizing them, it should be the priority in Spain. In this country, controlling public deficits cannot  obviously be ignored, but it is secondary to the need of cleaning up the banking system.
The second mistake was to try to subordinate private sector creditors in the context of public assistance programs  for peripheral countries in trouble. This is the famous "Deauville agreement" announced in October 2010 at the end of a Franco-German summit. The ECB, under Jean-Claude Trichet as president at the time, saw its decision immediately criticized. In fact, it resulted in government securities issued by euro area countries ceasing to be considered as "risk-free assets", they were previously even considered "risk-free" when they were not AAA. Risk premiums increased and the appetite for these securities declined, making it more difficult to control debt dynamics."

Of course there is an urgent need to recapitalize Spanish banks, although Spanish Economy Minister expects Bankia to only need 7 billion to 7.5 billion euro to meet provisional rule and doesn't expect Spain Mortgage defaults to rise much.  According to the IMF Spanish Banks losses could reach 260 billion euro and the sector as a whole could need help to the tune of 80 billion euro (5% of GDP). Today saw as well an acceleration in the consolidation of the Spanish banking sector with the replacement of Bancaja Chairman Olivas by Antonio Tirado, the Vice Chairman.

Moving on to our pet subject of subordinated bond holders, Spanish bond holders are likely to experience similar pain than Irish and Portuguese subordinated bond holders given that the need for capital raising will undoubtedly lead to "liability" exercises taking place. In a recent note published by Barclays comparing Spain to Ireland published on the 17th of May, they indicate the following:
"Recent developments in the Spanish banking sector have led investors to draw comparisons between the Spanish and Irish banking systems and analogies between the two are evident, in our view. Most notably, both countries are experiencing severe real estate market adjustments, as large imbalances accumulated over the decade prior to 2008 correct.
Loan losses soared in Ireland: It has been four years since the Irish lending boom came to an end, and the implied loss rate on all Irish bank loans based on the most recent provisioning data is 24%.
Eventually leading to realised losses for subordinated bondholders: The real estate related loan problems at Irish banks eventually caused subordinated bondholders to accept substantial realised losses. On average, subordinated bondholders recovered approximately 20% of par value.
Spanish banks have subordinated debt that could be used for burden sharing: In light of the similarities with Irish banks and the expected need for government capital injections into the Spanish banking system, the question of whether Spanish subordinated bondholders will eventually meet the same fate as their Irish counterparts becomes a legitimate one."

Of course we agree. We have long been warning that, there would be more pain to come for both subordinated bond holders and shareholders alike (see our recent post "Peripheral Banks, Kneecap Recap").

Barclays in their note added:

"Although bank bondholder involvement could help reduce Spain’s debt burden, authorities may avoid coercive burden-sharing because of elevated retail ownership of subordinated bank debt. Nonetheless, we acknowledge that there is downside risk to our base case loss estimates and that the risk of burden-sharing for subordinated bondholders of Spanish banks is material."

The Irish example on a subordinated bond LT2 demise - source Barclays:

"The process was incremental, beginning with the nationalisation of Anglo Irish, advancing with the creation of NAMA, and culminating with the passage of the Subordinated Liabilities Order. Ultimately, subordinated bondholders recovered approximately 20% of par value on average". - source Barclays.

Oh dear...

Ireland also took coercive actions in relation to subordinated bondholders:
"The Credit Institutions (Stabilisation) Act led to the Subordinated Liabilities Order (SLO), which was published on 14 April 2011 and was a key factor in the unfortunate fate of subordinated bondholders. The SLO enabled the State to exercise a wide range of powers over banking institutions, including modifying the terms of subordinated liabilities.
Specifically, the terms of lower-tier 2s were amended such that interest payments became optional and maturities were extended to 2035. The terms of upper-tier 2s were amended to remove all requirements to pay missed coupons. In addition, dividend stoppers were removed from both upper-tier 2 and tier 1s, eliminating the last of the structural leverage previously included in these securities." - source Barclays

In relation to Spain, Barclays indicated:
"Spanish banks have €65bn of subordinated debt outstanding, or €47bn excluding Banco Santander and BBVA. Under our base case scenario, where lifetime loan losses reach €198bn, which would exceed the current stock of provisions by €88bn, the government could be required to contribute €45-50bn to the recapitalisation of the banking sector. The need for public sector support could be reduced substantially through coercive bondholder involvement."

Given the recent outrage by individuals investors relating to the performance of Bankia's share price following its IPO in 2011, it will be interesting to watch the subordinated bond space when looking at the difference in ownership between Ireland and Spain:

One has to wonder if Spanish retail investors will be inflicted additional pain...

On a final note a chart from Bloomberg indicates US Banks CDS track Europe's higher as Spanish yields rise:

"In mid- to late-2007 European bank CDS were driven by liquidity fears and did not track yields particularly closely. As Spanish spreads rose again recently, sovereign fears have this time chased EU bank CDS levels higher. Even with limited sovereign exposure, U.S. banks' spreads are tracking Europe's closely, as fears regarding global growth heighten." - source Bloomberg.

"The safest road to hell is the gradual one - the gentle slope, soft underfoot, without sudden turnings, without milestones, without signposts."

C. S. Lewis -

Stay tuned!

Markets update - Credit - Plain sailing until a White Squall?

"It takes a real storm in the average person's life to make him realize how much worrying he has done over the squalls."
Bruce Barton

While, the rally so far this year in risky assets has been very solid, we thought this week, we would venture in our usual ramblings towards sailing analogies. Indeed, the "slush funds" courtesy of LTRO 1 and LTRO 2, have avoided what would have been a very nasty financial disaster in the making with the growing liquidity issues we witnessed in 2011. But, although, plain sailing has been so far the course in 2012, it does not mean problems in Europe have gone away, as the saying goes in true maritime style: "You may tell that to the marines, but the sailors will not believe it".

Looking at the US data so far in 2012, it appears to us that there is indeed a different "cut of jib" between the US ship and the European one.
Indeed, while, the ECB intervention via LTROs has "pushed the boat out" (Push the boat out, to, a boat work term used to imply paying for a "round of drinks" - Royal Navy Slang) and avoided many financial institutions to "walk the plank", in this week credit conversation, we will discuss the interesting disconnect between German 10 year Bond Yields and US Treasury 10 years yields, as well as some of our previous calls, namely credit flows in European peripheral countries and goodwill write-downs.

Time for our usual credit overview!

The Credit Indices Itraxx overview - Source Bloomberg:

One week on and the Markit Itraxx Crossover index (European High Yield names - 40 most liquid sub-investment grade entities) is 50 bps tighter, following on the continuous rally seen in risky assets. SOVx Western Europe is now around 224 bps (14 countries left, following Greece credit event, out of the original 15). The 20th of March will see a rebalancing of all Markit Europe Itraxx Credit indices (every 6 months), with Bouygues SA, Rolls-Royce PLC and HSBC Bank PLC all added to the larger index for Investment Grade, namely Itraxx Main Europe CDS index (125 Investment Grade and above companies). HSBC will replace Banco Popolare (BSPC) in both the Itraxx Main Europe index comprising 125 names and the Itraxx Financial Senior CDS index (25 European Financial institutions).

The trend is your friend - Itraxx Crossover falling in tandem with Eurostoxx Volatility - source Bloomberg:

Itraxx Financial Senior 5 year CDS spread falling with the Eurostoxx surging and volatility falling as well, indicating the strength of the rally so far year to date and the positive impact of the 2 LTROs on Financials in Europe - source Bloomberg:

The pain in Spain - Spain 5 year Sovereign CDS versus Italy's 5 year sovereign CDS widening to around 43 bps above Italy, (27 bps a week ago) - source Bloomberg:

Our"Flight to quality" picture. Germany's 10 year Government bond yields spiking above 2% yield and 5 year CDS spread for Germany still falling, ending somewhat the capped in the rise in yield which had prevailed since the beginning of the year - source Bloomberg:

What we have been monitoring closely has been the acceleration of the drop in the correlation between the US 10 year yield and the German 10 year bund, falling below 60%. Since the end of December 2011, the correlation has been falling significantly - source Bloomberg:

Could this disconnect be a manifestation of the reasons behind the growth difference between the US and Europe data we have been wondering recently? ("Shipping is a leading deflationary indicator").

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

Given the ECB has "pushed the boat out" with its two LTRO rounds, it is no surprise to see a much improved liquidity picture.

The current European bond picture with Spain yields rising above Italy10 year government yields - source Bloomberg:

While Total Return fund managers have enjoyed a steady rally in German bunds for the last 6 months, the latest rise in German bund might see some of them concerned about their holdings of long dated corporated  bonds. It could entice them to reduce their duration and sell some of their long dated corporate bonds exposure in the rally to ease the pressure.

While it still "Plain sailing" so far in 2012, European political uncertainties in conjunction with weak lending surveys could indeed trigger a "White Squall". As we argued in our conversation "Ecce Creditor":
"Going forward, we think you should be focusing on the ECB's monthly lending surveys, loan-to-deposit levels, deposits flights from peripheral countries as well as the rise in nonperforming loans."

Back in our conversation "Modicum of relief" we argued:
"Maintaining lending and credit flows is paramount to avoid a credit crunch which would essentially impair GDP growth in the process."

The latest quarterly BIS March 2012 report has indeed confirmed our November call ("Leda and the (Greek) Swan and why Europe matters more for Emerging Markets"), namely that the deleveraging in European banks has affected more significantly Emerging Markets in Central and Eastern Europe:

"European banks also cut lending to emerging markets. Their consolidated foreign claims on emerging Europe, Latin America and Asia had already started to fall in the third quarter of 2011. New syndicated and large bilateral loans from EU banking groups to emerging market borrowers then fell in the final quarter of the year. This was in contrast to lending to western Europe and other developed countries, which was essentially unchanged. At the same time, banks tightened terms on new loans to corporations and households in emerging markets. The more pervasive tightening in emerging Europe than elsewhere may have reflected the widespread ownership of banks in the region by EU banking groups. Reduced lending to emerging Europe may also reflect lower demand, however, as the region’s economic growth forecasts fell by more than those for any other during the final quarter of 2011."

"Emerging Europe, the region most dependent on euro area banks for foreign credit, saw the largest drop (Graph 3, bottom left-hand panel). The $35 billion (4.3%) overall decline was led by a $21 billion (4.6%) fall in interbank claims. Lending to non-banks also shrank (–$15 billion or –3.9%).
The countries most affected were Poland (–$13 billion or –8.6%), Hungary (–$5.5 billion or –7.0%) and Turkey (–$9.1 billion or –5.1%). Euro area banks account for more than 80% of all foreign credit to the first two of these countries. They are also responsible for approximately two thirds of all foreign claims on Turkey, whose susceptibility to sudden capital withdrawals is further increased by the fact that more than half of all international claims on its residents have a maturity of less than one year." - source BIS - Quarterly report, March 2012.

In our conversation "Modicum of relief", we indicated why Hungary has been our pet subject ("Hungarian dances") as a very good case study for systemic risk diagnosis:
"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."

Moving to the subject of Goodwill write-downs, one of our previous warnings came in our conversation form November 2011 in "Goodwill Hunting Redux":
"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."

Yes, UniCredit started, and it was not a surprise for us to see Italy's second largest bank Intesa posting a fourth quarter loss of Eur 10.1 billion on Goodwill write-down on the 15th of March:
Intesa Reports Fourth-Quarter Loss After Goodwill Writedown, by Sonia Sirletti and Francesca Cinelli, Bloomberg
"Intesa Sanpaolo SpA, Italy’s second-biggest bank, posted a fourth-quarter net loss because of a 10.2 billion-euro ($13.3 billion) writedown of goodwill related to mergers and acquisitions.
The net loss was 10.1 billion euros, compared with net income of 505 million euros a year earlier. Excluding one-time items, the quarterly profit was 265 million euros, the Milan-based lender said in a statement. Analysts expected profit of 633 million euros, according to the average of 10 estimates compiled by Bloomberg. The bank cut its dividend by 3 cents to 5 cents per share.
Intesa joined UniCredit SpA, the country’s biggest bank by assets, in reducing the value of intangible assets related to acquisitions. The lender’s purchases included a 29.6 billion-euro takeover of Sanpaolo IMI, merged into Banca Intesa in 2007."

Intesa's stock price evolution year on year  as of 16th of March 2012 - source Bloomberg:

Intesa took 11 billion euro from the LTRO to cover its 2012 wholesale funding needs.
Yet again "analysts" had not included the potential writedown in their forecasts (it was already the case for BBVA's writedown we discussed in our post "Money for Nothing"). Another fine job by analysts... (Analysts expected profit of 633 million euros, according to the average of 10 estimates compiled by Bloomberg).
What is concerning us in Intesa's case is that loan loss provisions more than doubled to 2 billion euros in the quarter. Rising Nonperforming loans (NPLs) will be a drag on Intesa's ability to provide support to the real economy via credit channels namely loans.

On a final note given Portugal has been on the receiving end lately in our conversations ("SOVx Western Europe - And Then There Were 14..."), we will leave you with Bloomberg's Chart of the Day from the 16th, indicating that Portuguese banks will contract credit conditions further to meet comitments made to secure the 78 billion euro aid program, providing fewer loans to the real economy (businesses) and therefore impacting economic growth in the process.

"The CHART OF THE DAY shows that a slowdown in savings growth may make it harder for banks to reduce the ratio of loans to deposits to 120 percent as pledged in the bailout. Deposits rose 0.4 percent in January, the same as the previous month and a fraction of the 1.4 percent pace in November. That’s putting pressure on banks to trim the ratio by curbing new lending.
“The pace of deposits growth seems to be stabilizing,” Andre Rodrigues, an analyst at Caixa Banco de Investimento in Lisbon. If banks are to reach the expected loans-to-deposit ratio by 2014 “it will have to be done mainly through loans.”
Portugal’s five biggest banks had a combined median loan-to-deposit ratio of about 140 percent at the end of 2011, with Banco BPI SA having the lowest at 109 percent. Banco Comercial Portugues SA, Portugal’s second biggest by market value, with the highest ratio, of 145 percent.
The loan-to-deposit goal may end up countering efforts by the European Central Bank and the Portuguese government to get banks to step up lending." - source Bloomberg

By now you can probably "Fathom out" (To ascertain something; to deduce from the facts) in true Royal Navy slang fashion, the consequences a credit crunch will have on Portugal's economy.

"I could not tread these perilous paths in safety, if I did not keep a saving sense of humor."
Horatio Nelson

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!