Credit - The Week That Changed The CDS World

"One must change one's tactics every ten years if one wishes to maintain one's superiority." - Napoleon Bonaparte 

Looking at the epic compression in recent weeks of the Itraxx CDS financial subordinated index versus the Itraxx Senior Financial CDS 5 year index, tied up to the recent ISDA proposals to include Bail-In Credit Event, we decided our reference this week ought to be a shorthand for describing surprising and uncharacteristic actions in similar fashion to Kissinger's 1971 secret trip to China. This secret trip laid the groundwork for the historic visit of Nixon to China that followed in 1972. 

Given the upcoming clean up of ISDA's 2003 Credit Derivatives Credit Event definitions which were in dire need of a brush up following the recent Dutch banks SNS subordinated debt saga, as per our Napoleon Bonaparte quote goes, arguably, one indeed must change tactics every ten years if ones wishes to maintains one's superiority. It could not be more truer than for the viability of the CDS market. What happened this week in the CDS world, with the proposed introduction of a new credit event for financial CDS in the case of a bail-in triggered by a government agency and the change in deliverability rules, made this week an important one from a credit perspective.

We already discussed the implications of the SNS case in our previous conversation "House of pain and House of cards":
"The SNS case this week has had some major significant risks to the "House of pain" in the European banking sector that warrants additional close attention for the remaining subordinated bondholders.
If the recovery rate for SNS LT2 subordinated bonds is zero, the significance for the European subordinated CDS market is not neutral given the assumed recovery rate factored in to calculate the value of the CDS spread is assumed to be 20% for single name subordinated CDS and 40% for senior financial CDS. On top of that, a nationalization, such as SNS case, is not by itself a credit event trigger. Appointing an insolvency official is.
As far as delivery of LT2 underlying subordinated bonds referenced in any CDS contract referencing SNS, you would have to ask the Dutch state for delivery (if the subordinated bonds are not simply cancelled or converted into equity...).
So what's the value of your subordinated single name CDS on SNS? Could it mean single name subordinated CDS are a "House of cards"? We wonder. Oh well..."

So in this week's conversation we will look at the wider implications for the financial CDS market on the proposed ISDA Credit Events revamp on the 10 year anniversary of the ISDA 2003 Credit event definitions because the validity of the CDS market as a hedge had been put in jeopardy quite significantly by the SNS case. We will also look at debt disturbances and price-level disturbances, revisiting the wisdom of Irving Fisher in the process.

The CDS compression story in one chart - Itraxx Financial Senior index versus Itraxx Financial Subordinated 5 year index - source Bloomberg:

From the above chart one can see the severity and rapidity of the move in the subordinated financial CDS space.  

So is the move justified?

Here is BNP Paribas take on the move from their 23rd of May entitled  "ISDA Proposes Bail-in Credit Event:

"Is the Sub CDS move since last Friday justified?

Sub CDS has collapsed by more than 40bp since 16 May and the Sub/Sen ratio is now just below 1.4x, after having been at a mean of around 1.7x for a long time. The timing surprised us, as the new definitions are not finalised nor implemented yet. In addition, the market could have already reacted more than it did after the SNS news. Therefore, while we were proponents of the general Sub/Sen compression theme, we were surprised both in terms of timing and severity of the market move.

How do we explain the move then? The rapid compression of Sub vs. Sen over just a few trading sessions was probably due to the realisation that existing financial CDS contracts will over time be replaced by the new ones, making the old contracts less valuable from a long protection perspective. Thin market conditions due to European holidays may have exacerbated the move.

Other possible explanations of the significant move are the general bull market and search for yield, the gradual acceptance and pricing in of senior bail-in and the possibility of depositor preference over senior. Finally, investors may expect that, with the arrival of a new CDS contract, authorities would be less careful about legacy CDS (i.e. about making sure that there are deliverables, as the Irish authorities had ensured). That said, the change of definitions had been mentioned for a while and the implications clear, i.e. the new contracts should trade at a wider level. The old contracts can still be useful, especially as we believe that bail-in will trigger a restructuring event (as was the case with SNS), but the existence of sub deliverables is uncertain and therefore they are less valuable to a protection buyer than the new one. This information was previously available but the market reacted last Friday.

Can the magnitude of the move be justified by relative recovery expectations between senior and sub contracts? Chart 1 shows the implied Sub/Sen ratio (for the existing contracts) as a function of the senior expected recovery rate for different sub recovery rate assumptions. In most cases the sub recovery rate has been in the 0-20% range. At current market pricing, this corresponds to a senior recovery rate of 30-40%. This does not strike us as too low, especially when we consider that (i) the Moody’s average historical senior corporate recovery rate is around 38%; (ii) further developments towards resolution regimes and senior bail-in should increase the senior credit event probability relative to the sub probability; (iii) depositor preference, if forthcoming, would reduce the senior expected recovery rate; and (iv) the recent SNS event highlights a growing likelihood of events with a significantly higher sub recovery rate (for the existing contracts) than 0-20%." - source BNP Paribas.

We disagree with BNP Paribas on the implied recovery rate of 30-40%. It is not too low, it is not low enough at least on the "old contracts" because it relies on Moody's average historical senior recovery so this analysis is backward looking. The senior expected recovery rate due to the evolution of resolution regimes and senior bail-in implies lower recovery rates and wider spread levels in the new contract.

Why the new contracts should trade at a wider level you might rightly ask? 

We have touched on that subject previously in February 2013 in our conversation "Promissory Hope":

From EDHEC-Risk Institute in their January 2012 note entitled "The Link between Eurozone Sovereign Debt and CDS Prices" provides us with some insight on the aforementioned impact:
"To examine the difference between these spread measures, we priced a 5-year bond with a 5% coupon in an environment where the default-free yield curve is assumed flat at 3% and the Libor risk-free curve is also assumed to be flat at 3.5%. We considered two cases - first an expected recovery rate of 40% and second an expected recovery of 0%. We then varied the 5-year survival probability assuming a flat term structure of default rates11 and calculated the implied bond price and spread measures. In all cases we assumed k = 1.

Figure 2 Comparison of the model-implied CDS, bond yield-spread and par asset swap spread measures as a function of the full price of a 5-year bond with a 6% coupon. We show this for an expected recovery of 40% (above) and 0% (below).":

"The results are presented in Figure 2. When the expected recovery rate is 40% we find that as the 

bond price falls (and it cannot fall below 40), the CDS spread grows and asymptotically tends to infinity while the yield-spread and asset swap spread tend to different large but finite numbers. However, if we set the expected recovery rate to zero then the yield-spread also tends to infinity and is very close in value to the CDS spread as the bond price falls to zero." - source EDHEC-Risk

As we repeatedly pointed out, the importance of liquidity is paramount, particularly in the credit space, given the low level of inventories on dealers' book that can accommodate large selling movements. The lack of liquidity in the financial CDS space without a revamp of the 2003 ISDA Credit Events definitions would exacerbate potentially the movements in financial bonds. 

The liquidity in credit is already impacted by the poor liquidity in the secondary space, in this low yield, and yield hunting environment as described in a recent presentation made by Wells Fargo Credit Strategy team:

"Anecdotal evidence from our trading desk suggests the performance of secondary bonds is lagging that of new-issues. In addition, trading flows point toward more investors buying new-issues “on switch” rather than outright from cash. This is particularly true at the long end of the curve and for frequent borrowers." - source Wells Fargo

Since January the price action has been more volatile in the Investment Grade than in the US High Yield ETF space, which has mirrored much more the price action of equities, namely the S&P 500. Investment Grade is therefore a more volatility sensitive asset, whereas High Yield is a more default sensitive asset, as indicated in  by the price movement of the the iShares iBoxx $ Investment Grade Corporate Bond Fund ETF (AMEX: LQD) versus the US High Yield ETF HYG and the S&P 500- source Bloomberg:

Looking at the latest minutes from the FOMC and the discussions surrounding the Fed's QE stance and the possibility of a reduction in bond purchases in coming quarters provided an improvement in the employment data, it does make Investment Grade corporate bonds highly more volatile to interest movements in this "Japonification" of the credit markets courtesy of global ZIRP.

As per a recent Wells Fargo credit presentation, we agree with them in relation to the key risks for Q2 2013 given that:

"Lower coupons and longer maturities increase a portfolio’s duration/interest-rate sensitivity. The duration of the entire HG corporate bond market has extended 1.0 year to 7.0 years over the past five years. In maturities of greater than 10 years, duration has extended 2.0 years to 13.6. With the Fed signaling a potential shift in policy this year, long-duration corporate bond prices could be at risk of falling sharply and quickly." - source Wells Fargo Credit Strategy.

We are not surprised that the price of "stability" courtesy of massive liquidity injections from global central banks has come at a cost of increased "instability" as per Hyman Minsky's definition:

"A Minsky moment is the point in a credit cycle or business cycle when investors have cash flow problems due to spiraling debt they have incurred in order to finance speculative investments. At this point, a major selloff begins due to the fact that no counterparty can be found to bid at the high asking prices previously quoted, leading to a sudden and precipitous collapse in market clearing asset prices and a sharp drop in market liquidity." - source Wikipedia.

You might want to read again, Irving Fisher's book "The Debt-Deflation Theory of the Great Depression" published in 1933. Because in this book Irving Fisher dealt extensively with "business cycle theory".

For Irving Fisher, the two big bad actors in great booms and depressions are debt disturbances and price-level disturbances. We have both...but that's us ranting:

"Debt Starters

Easy money is the great cause of over-borrowing. When an investor thinks he can make over 100 per cent per annum by borrowing at 6 per cent, he will be tempted to borrow, and to invest or speculate with borrowed money. This was the prime cause leading to the over indebtedness of 1929." - Irving Fisher

Just a fact:

Investors borrowed $384.4 billion in April, a 1.3% gain from the previous month which was at $379.5 billion and conveniently the second highest in the history of the NYSE going back to 1959. The April surge was a 29% rise from the same month last year. The highest level was $381.4 billion recorded in July 2007.  We have an all-time record for margin debt and it exceeds the previous high mark. 

And what else did Irving Fisher wrote in his 1933 book?

"When the starter consists of new opportunities to make unusually profitable investments, the bubble of debt tends to be blown bigger and faster than when the starter is great misfortune causing merely non-productive debts."

So no "speculation" going on, it is all going well...

As far as credit is concerned, the rapidity in the tightening movements in credit spreads is reminiscent of the warnings given in 1933 by the wise Irving Fisher. 

A recent note from Societe Generale on the 22nd of May is clearly indicative of the rapidity of how this time around the credit bubble is being blown by our "omnipotent" central bankers:

"When the music stops, we pause and then just add another chair. It's usually the slightest of breathers and the market isn't waiting too long before that relentless grind and lifting of paper resumes. Clips, blocks of paper and new issues are managing to get taken down without much fuss, and we're not seeing any contagion from the volatile stocks impacting the cash market. We're well poised here. Of course there's plenty of apprehension and it is understandable that we all need a little convincing that still adding risk at these levels is the right thing to do. It is. In the meantime, the low/high beta compression continues and was clearly evident from yesterday's deal from Plastic Omnium. The unrated - but implied non-IG - French borrower managed to raise €500m for seven years, paying just 3% for the privilege. Add in a premium for being unrated and one has to concede that the level is a funding coup for the borrower! For the broader market, the iBoxx cash index closed below B+133bp yesterday and will be lower again today after the tightening seen in today's session for corporate spreads. Even taking into account the massive February/March wobble (when the index widened 22bp), credit is tightening faster than even we - the most bullish of observers - would have expected. Hitting our original 2013 target of B+120bp is now a case of when not if, and we can only expect investor nervousness to rise even more as a result. As long as money continues to come into the asset class and supply remains at these (low) levels given the size of the demand, then the current tightening/compression dynamics will stay in place. Position for it." - source Societe Generale.

Moving back to the subject of the evolution ISDA Credit Events and the impact of expected changes recovery rates on financials, the impact of the new CDS contracts would make the CDS market in the financial space more relevant as per a note from Societe Generale from the 24th of May on the subject:
"Event: 
CDS protection may be more valuable should reported proposals for amending credit derivative definitions be accepted. The proposal is to amend credit derivative definitions for banks and comprises three main points. First, it adds a credit event to capture government enforced bail-in. Second, it expands the list of deliverables in the new credit event and keeps current deliverables available for old events, despite their potential loss-absorption ability in the future. And third, it improves successor provisions to keep CDS protection attached to the debt. Taken together, these may help to avoid a repeat of the CDS insurance failure of SNS while capturing the increased tool-kit available for governments to restructure banks out of bankruptcy. We do not expect these provisions to be retrospectively applied to existing contracts; however the amendments suggest much less value in outstanding sub contracts.
Assessment: 
ISDA’s proposed changes would make CDS protection more robust and, therefore, valuable. First, a new ‘hard’ credit event would capture government-enforced bail-in. This would be broadly defined as an action taken by government authorities that alters creditor rights under bank restructuring and resolution laws. By our understanding, this does not include the institution triggering Tier 2 contingent capital (CoCo) clauses, as this is an action undertaken by the entity itself, but it would capture Bankia-type events. If the new credit event trigger is a write-down, the event would not occur until the write-down is permanent or there is nonpayment under prior contract terms. A ‘hard’ event eliminates the maturity buckets of restructuring events. Second, deliverables in the new credit event auction may include the written-down or conversion/exchange proceeds. Again, this is Bankia-event type protection. In the event of complete write-off, à la SNS, par payment would be received by the protection buyer. In addition, deliverables under a current or new credit event could include Tier 2 or more senior securities with write-down provisions as mandated by legislation, provided they are not yet written down. This would enable most Lower Tier 2 debt to be deliverable even if it is loss absorbing Basel III-compliant via legislation. CoCos could be delivered in the new credit event provided they have not yet triggered. This captures many bail-in eventualities. Third, successor provisions would track the debt, enabling subordinated and senior CDS to succeed to different entities. This would keep CDS viable in a good bank/bad bank situation. Also, importantly, the new credit event could occur on subordinated CDS without triggering senior CDS. This may have implications for sub/snr trading levels once the new amendments are in place." - source Societe Generale

On a final note, the US equities market is increasingly being boosted by buybacks, yet another artificial jab in the on-going liquidity induced rally as indicated by Bloomberg's chart, great for CEOs and stock options and their shareholders but probably less so for the health of the balance sheet:

"Repurchases are becoming a bigger source of demand for U.S. stocks, and shares of the companies that carry them out may have an easier time beating benchmark indexes if history is any guide.
As the CHART OF THE DAY shows, the Nasdaq Buyback Achievers Index has more than tripled in the current bull market and has left the Standard & Poor’s 500 Index behind. The Nasdaq gauge consists of companies that repurchased at least 5 percent of their shares in the previous 12 months.
“Corporations have been aggressively buying back shares,” Jeffrey Kleintop, chief market strategist at LPL Financial Holdings Inc., wrote two days ago in a report. He added that the repurchases are largely designed “to boost earnings per share as revenue growth slows.” - source Bloomberg

"The public psychology of going into debt for gain passes through several more or less distinc phases: (a) the lure of big prospective dividends or gains in income in the remote future; (b) the hope of reckless promotions, taking advantage of the habituation of the public to great expectations; (d) the development of downright fraud, imposing on a public which had grown credulous and gullible". - Irving Fisher.

At some point the Fed will have to normalize, probably not now, but the more they delay the adjustment, the more painful it is going to end up.

Stay tuned!

Credit - The year of the empty hand

"Men occasionally stumble over the truth, but most of them pick themselves up and hurry off as if nothing had happened." - Winston Churchill

"This is the year of the empty hand 
Oh you hold on to what you can 
And charity is a coat you wear twice a year 

These are the days of the guilty man 
Your television takes a stand 
And you find that what was over there is over here"
George Michael - Praying For Time

"emp·ty-hand·ed (mpt-hndd) adj.
1. Bearing nothing.
2. Having received or gained nothing."
source the American Heritage Dictionary

While we recently looked into Spain's record surge in Nonperforming loans making a comparison with storm surges and Hurricane Sandy versus the 1991 "Perfect Storm", and looking at the epic performance in credit pointing towards a record year in similar fashion to 2009 (performance now close to 11% in Total Return), we thought this week we would be using part of the lyrics from George Michael's 1990's single hit "Praying for Time" for our title. James Hunter of Rolling Stone magazine described the song as "a distraught look at the world's astounding woundedness".We think our title is appropriate given the astounding woundedness caused by Balance Sheet Recessions (BSR). Looking back at the level of support provided in Europe to the financial system in conjunction with drastic austerity measures for some, the performance in the financial credit space has been epic while yielding no benefits to the real economy. The irony of our chosen title lies in the extraordinary returns for credit in 2012 with admittedly a very clear disconnect with valuations and fundamentals which we discussed last week and as indicated by the below graph from BNP Paribas:

Expensive credit markets you think? You bet!

But, given the on-going "Yield Famine" in the credit space, the theme in the cash market remains the same. Investors are underinvested and full of cash, and with the latest pause in issuance in the corporate space, there is technically no natural supply. As a market maker commented recently on this market context:

"So bonds remain bid and it is difficult to buy bonds even as corporate cash looks expensive. CDS remains quiet but generally feels a little weak in low beta."

In this week conversation, we will look at how to play credit in a deleveraging environment, as well as the upcoming pain for Spanish junior subordinated bondholders and we will finish with the future for credit returns after a record year for the asset class.

In a world facing "Yield Famine" and "River of No Returns" courtesy of a deleveraging environment, what is the investment recipe one should follow?

"All real-world investors face funding constraints such as leverage constraints and margin requirements, and these constraints influence investors’ required returns across securities and over time. Consistent with the idea that investors prefer unleveraged risky assets to leveraged safe assets, which goes back to Black (1972), we find empirically that portfolios of high-beta assets have lower alphas and Sharpe ratios than portfolios of low-beta assets. The security market line is not only flatter than predicted by the standard CAPM for U.S. equities (as reported by Black, Jensen, and Scholes (1972)), but we also find this relative flatness in 18 of 19 international equity markets, in Treasury markets, for corporate bonds sorted by maturity and by rating, and in futures markets." - source Betting Against Beta, Andrea Frazzini and Lasse H. Pedersen - October 9, 2011.

"These are the days of the beggars and the choosers" - George Michael - Praying For Time

The BAB factor (Betting Against Beta) explain the returns of some investors such as Warren Buffett:

"Leveraged buyout funds and Warren Buffett’s firm Berkshire Hathaway, both of whom have access to leverage, buy stocks with betas below 1 on average, another prediction of the model (BAB). Hence, these investors may be taking advantage of the BAB effect by applying leverage to safe assets and being compensated by investors facing borrowing constraints who take the other side. Buffett bets against beta as Fisher Black believed one should". - source Betting Against Beta, Andrea Frazzini and Lasse H. Pedersen - October 9, 2011.

The on-going forced deleveraging for large parts of the European financial system, which have been "begging" for liquidity and provided vast amounts of it, courtesy of our "Generous Gambler" aka Mario Draghi, is no doubt a golden opportunity for cash rich "choosers".

"And you find that what was over there is over here" - George Michael - Praying For Time

Europe is indeed finding out that the deleveraging (which has started earlier in the US) is accelerating over here in Europe hence the tremendous deflationary forces at play and the traumatic effect on the real economy with the EBA (European Banking Association) forcing banks to reach a target of 9% of Core Tier 1 capital in June 2012 in conjunction with austerity measures and unrealistic deficit targets but we ramble again...

As we reminded ourselves in our previous conversation Chadburn, on Full Ahead?:
"One of the most important indicator we think in relation to our Credit Chadburn and the growth divergence between the US and Europe is the evolution of the Loans-to-Deposit ratio progress."

The growing divergence between US and European PMI indexes - source Bloomberg:

US PMI versus Europe PMI from 2008 onwards.

Which as we pointed out recently, this growth difference can be seen in the credit prices between the USA and Europe. The divergence of growth between the US economy and the European economy is reflected in credit prices such as the US leveraged loan cash price index versus its European peer - source Bloomberg:

For Europe, the deflationary forces at play are tremendous. When looking at Spain, one can see the correlation of rising unemployment and rising nonperforming loans - source Bloomberg:

We could go even further by looking at the evolution of the Spanish misery index (inflation + unemployment) in conjunction with nonperforming loans- source Bloomberg:

As far as the Spanish hurricane is concerned, the amount of funding needed for 2013 is significant - source Bloomberg:

One could as well posit that our title could be a veiled reference to a game of high stake poker being played out in Europe. The beggars are indeed not the choosers when it comes to our chosen title and Europe. Pushing the analogy further, we would like to quote Dr Jochen Felsenheimer from his latest credit letter for November 2012 from credit asset management house "assénagon" :
"There are two games in particular whose mechanism is closed to that of capital market: Poker and chess. The development of recent years sadly suggest that the former has gained the upper hand. The central banks have shown their aces of spades, the European Union is using the Spanish Opening to fight for the center of the euro, investors are checking if they don't have anything in their hand after the flop, and the markets are using the Queen's gambit to bet on the same gameplay being repeated again and again. But there is also the possibility that it will be different this time. The financial markets are facing changes which might change the rules of the game for ever. Traditional investment approaches are about to be superseded and long decades of valid mechanisms will be influenced by new developments."

While the political game being played is a game of Chess (see our conversation "The Game of the Century"), we agree with Dr Jochen Felsenheimer's assertion relating to financial markets being currently a game of high stake poker:
"Having the ace and the king as your hole cards is somewhat disparingly know in Texas hold'em as an "Anna Kournikova" - "looks great but never wins". That describes the current situation in the markets extremely aptly. The markets' first reaction to the concerted action by the ECB (Draghi effect) in combination with the political developments (Spanish banks, ESM, etc.) was, of course, positive. The imminent breaking up has been averted for now, even if the fundamental problems are far from solved. The thin line between austerity and growth will continue to dominate the political discussions in Europe and regulatory measures are limited to a few segments and are seamlessly merging into the tradition of combating the symptoms, while the causes largely persist. The European monetary union's basic problem is due to nothing more than the heterogeneity of the member states. This is just what is causing the current problems - the necessity of transfer payments which are currently reflected in the massive TARGET2 balances. The close ties between the banking sector and governments are not solved by Basel III and a banking union - but only raised to another (European) level. And ultimately the economic environment will continue to represent the greatest challenge, as this makes the elegant escape of "growing out of the crisis" seem highly unlikely. Necessary structural reforms (which are known to take time) and the long-drawn-out reconstruction of the European architecture confirm us in our assumption that we are currently on the "Japanese path". And this is more similar to the Way of St. James than a walk in the park."

Indeed, European politicians have been praying for time, we think, and so is the Spanish financial  system!

The Spanish bad bank SAREB will have between 45 billion euros and 90 billion euros in assets. The estimated of assets to be transferred to SAREB taking into account Group 1 of banks (BFA-Bankia, Catalunya Banc, Novagalicia Banco and Banco de Valencia) is 45 billion euro. The average haircut for the transferred assets is between 46% and 63% based on Oliver Wyman's baseline scenario plus an additional discount. What amounts, we think, into wishful thinking from the Spanish government is that it ambitions to keep its stake in the structure below the 50% threshold so that SAREB stays private and Spain's public accounts are not affected and to avoid taking a hit on its public debt level. What caught our attention is that the Spanish government is already facing "mutiny" in the sense that BBVA has already balked at investing into the bad bank. Angelo Cano, BBVA's CEO has already voiced is concern and said last Wednesday he had no interest in investing in the bad bank in true Banker's algorithm fashion:
"When the system receives a request for resources, it runs the Banker's algorithm to determine if it is safe to grant the request. The algorithm is fairly straight forward once the distinction between safe and unsafe states is understood."
Request denied...from BBVA. "We have no real obligation"  - Angelo Cano, BBVA CEO.

Supposedly most of the funding for the SAREB is to come from private investors (8% equity) with an expected ROE of 14-15% (according to FROB). Three main sources of funding are envisaged:

-State-guaranteed senior debt

-Perpetual subordinated debt

-Common equity

Both the perpetual debt and the common equity will be subscribed in part by the restructuring Spanish fund FROB (Fund for the Orderly Restructuring of the Banking Sector) but with a majority subscribed supposedly by private investors.

Why has the request has been denied by BBVA, simply because of pending provisions to comply with the two RDLs (Royal Decrees relating to real-estate provisioning for banks) as displayed in the Exane BNP Paribas table below from their recent report on the Spanish Bad Bank SAREB from the 30th of October:

Only 31% of provisions have already been booked by BBVA, hence the rejection...

As far as losses are projected in relation to real estates exposure (all credit - performing or not - + foreclosed) - RD1 + RD2 versus Oliver Wyman's adverse scenario versus the Bad Bank Sareb and Deutsche Bank estimates versus NAMA, the below table from Deutsche Bank indicate the expected losses:

"Hanging on to hope when there is no hope to speak of" - George Michael - Praying For Time

Hanging on hope is exactly what Banco Popular Espanol junior subordinated boundholders are hanging onto. They are counting on being rescued by the Spanish lender's equity investors from avoiding being wiped out on 6.4 billion USD of junior debt as reported by Estaban Duarte from Bloomberg on the 1st of November in his article -  Popular Bond Wipe-Out in Shareholder Hands:
"The bank wants to raise as much as 2.5 billion euros ($3.2 billion) in shares to avoid seeking state aid that would trigger losses on subordinated bonds under European Union rules. Popular’s 5.702 percent junior notes due 2019 rose 15.8 percent in the past month to 7O cents on the euro, according to Bloomberg prices, compared with an average 1.93 percent increase for securities in the Bank of America Merrill Lynch Euro Financial Subordinated & Lower Tier-2 Index. Failure to raise funds through a share sale could mean Popular having to conduct a restructuring under the eyes of regulators, cap salaries and dispose of assets. The lender is a victim of Spain’s real estate collapse, failing the latest government stress tests which revealed the Madrid-based lender has a 3.22 billion-euro capital shortfall. “The share sale is the last hope for Popular subordinated bondholders since a failure would mean that the state would have to step in,” said Ignacio Victoriano, head of fixed-income at Renta 4 SGIIC, which manages 1.5 billion euros of assets including some Popular subordinated bonds. “We are confident that they will get the deal done.”" - source Bloomberg.

We " agree" to disagree", with the above statement from Ignacio Victoriano and we would rather side with the comment from Jean-Luc Lepreux, senior bank analyst at Societe Generale SA in Paris from the same Bloomberg article:
"Raising 2.5 billion euros when your market capitalization is 2.6 billion euros will be hard without running the extra mile,” Lepreux said in an interview. “Subordinated debt holders should be prepared to face high haircuts for banks needing public funds, up to 100 percent for fully nationalized institutions."

Banco Popular Espanol share price evolution since 1989- source Bloomberg:

"Popular wants its customers to buy 60 percent of the new shares being offered because Chief Financial Officer Jacobo Gonzalez-Robatto said Oct. 1 that “the bank has enormous goodwill of its customers.” The stock was at 1.20 euros today and has slumped 29 percent since the day before the share-sale announcement on Oct. 1, valuing the lender at 2.6 billion euros.
Bankia followed the same strategy in July last year when it tapped about 347,000 individual investors as it was seeking to boost capital. Bankia stock has fallen almost 70 percent since then.
Popular’s third-quarter profit fell to 75.6 million euros from 98.6 million euros in the same period a year earlier, the lender said Oct. 26. That surpassed the 42 million-euro median estimate in a Bloomberg survey of nine analysts." - source Popular Bond Wipe-Out in Shareholder Hands, Bloomberg.

As far as asset quality is concerned for Banco Popular in general, and Banco Popular's shareholders in particular, Banco Popular has still some significant provisions to book based on the two RDLs (4.9 billion euro) as reported by Nomura on their recent note on Banco Popular:

"Popular still has significant provisions to book based on the new legislation introduced this year of c.EUR 4.9bn. These provisions, plus additional ones highlighted by management, making a total of EUR 9.3bn will be booked following the upcoming rights issue." - source Nomura

This is exactly how our story is unfolding for junior subordinated bondholders:
"At some point, as we argued recently (Peripheral Banks, Kneecap Recap), losses will have to be taken."

We correctly foresaw this process for weaker peripheral banks.

"First bond tenders, then we will probably see debt to equity swaps for weaker peripheral banks with no access to term funding, leading to significant losses for subordinate bondholders as well as dilution for shareholders in the process." - Macronomics - 20th of November 2011.

"Oh, you hold on to what you can" - George Michael - Praying For Time

Moving on the subject of future returns for credit, it is indeed a question of holding on what you can.

Nomura in their recent Quantitative Strategies update from the 31st of October ask the following important question:
"Will future credit returns be a trick or a treat?"

Following up on the concept of "Betting on Beta" earlier in our conversation, one has to remember these fundamentals concepts when approaching credit as indicated by Nomura's note:
"Many investors understand that what they get from credit exposure depends on how high credit spreads are when they buy.
But relatively few grasp just how high credit spreads have to be to earn decent risk-adjusted returns. Only top-quartile spreads will do- "above-average" -is not good enough as shown below:

Spreads in 2009 were in the top decile, and credit has performed well since then. Spreads today are above-average but not top quartile. Adjusted for regulatory changes, they would probably be even lower.
The trick: average credit returns (stripping out funding and duration) are mediocre, as spreads barely cover the cost of fallen angels or defaults.
The treat: credit returns are semi-predictable, due to their links with trends in corporate fundamentals, rating actions, and business cycles. This makes credit a good fit for systematic long/short strategies.
Balancing carry, momentum and value investment styles to position long/short in credit indices outperforms, with a Sharpe ratio of 1.01." - source Nomura

Is buying and holding an issue in credit? Nomura indicates these empirical elements:
"Long-only credit returns have been poor over time 
In Figure 2 we show the cumulative duration-adjusted excess returns of US corporate bonds since 1997 and the bonds‘ average OAS":

"A long-only investor would have received very little additional return for the extra risk they were taking in this 15-year period. In our paper Making credit beta work for real we show how credit spreads tend not to compensate investors for the costs of fallen angels and defaults – investors sell bonds as they are removed from indices at a substantial loss to par. Even a small number of fallen angels or defaults can wipe out the positive carry from performing names. While there are periods where excess returns are positive, these tend to follow periods of spread widening."

Finally how does one generate future credit returns going forward? Combining long/short strategies makes credit perform as indicated by Nomura:

"A styles-based strategy combining carry, momentum and value to position in a basket of CDS Indices delivers solid returns since 2006. The index has a Sharpe of 1.01, Calmar of 0.92 and skew of 0.86 (vs. long-only Sharpe of 0.36, Calmar of 0.13 and skew of -0.7)." - source Nomura


"Nothing is enough for the man to whom enough is too little." - Epicurus 

Stay tuned!

Credit - Yield Famine

"Hunger knows no friend but its feeder." - Aristophanes

Looking at the recent price action in the credit space with continuous appetite for investment grade credit, with struggling money markets, with high quality issuers spread making new lows, negative core government bonds for some and unquenchable appetite for yield, we decided to step away from literary analogies, and historical references this time around. Last week we saw high quality corporate Nestle issuing 500 million euro worth of a 7 year bond at Mid-Swap +30 bps, then revising its guidance at Mid-swap +15 bps (that means a 1.50% coupon) because there was such a BIG DEMAND for the new issue (there was 6 billion euros plus worth of orders in the book). When you hear that money markets fund in euros are suspending new subscriptions courtesy of ECB cutting deposit rate to zero, it can only mean one thing: it means the “japonification” of the credit markets with dwindling liquidity as well, hence our title "Yield Famine".

Credit is increasingly becoming a crowded trade, forcing yield hungry investors to get out of their comfort zone and reaching out for High Yield as well as Emerging Markets in the process. In that context of falling yields and falling volatility, we do agree with the recent comments our good cross asset-friend made in our recent post "European Credit versus volatility looks increasingly appealing":

"Long 1 year atm (At the Money) volatility on Equity Indexes versus long credit via short CDS Indexes positions looks increasingly appealing on current levels.

Following the Greek Elections and the European Summit, implied volatilities levels on equity indexes have corrected dramatically while other risk measures are clearly not validating any “blue-sky” scenario (Spain/Italian sov spreads, bund yield, credit spreads…). On current relative valuations long credit vs long equity volatility positions look particularly interesting.

On the credit side you benefit from the relative backing of huge flows from institutional investors hungry for yield, while still enjoying relatively solid balance sheets from a corporate universe that has consistently been rolling over debt maturities.

On the equity side you are paying reasonable volatility levels, almost in line with the recent subdued realized levels with a large upside should any stress materialize in coming months."

The relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge) - source Bloomberg:

In our credit conversation, before our credit overview where we will discuss default risk in low yield environments in a deflationary world and revisiting our calls on upcoming financial bonds haircuts, we would like to highlight once more, the complacency prevailing in the credit space with dwindling liquidity pressuring even more quality issuers yields, causing famine in the process.

Truth is nothing has really changed, when it comes to the outlook in the credit space. While demand for Core European bonds remain very strong, pushing more and more core government spread towards negative yields, peripheral names continue to be shunned with atrocious liquidity given inventory levels for market makers remain at record low level. Therefore activity levels in the secondary space remain more or less subdued in terms of flows. We are witnessing indeed some sort of "japonification" in the credit space (a theme we previously wanted to approach). In a June note UBS indicated the following worrying trend in credit:
"A troubling ongoing development for the credit market is the significant decline in trading liquidity (which has been accentuated by European concerns). A challenging liquidity environment is not conducive to a healthy marketplace and is incorporated into overall risk premiums. Coping
with the logistics of trading realities has led to rational decisions from market participants that have influenced the ongoing decline in liquidity.
Unfortunately, this liquidity dynamic is unlikely to see a meaningfully reversal anytime soon given global uncertainties, constrained risk appetites, and the shifting regulatory backdrop." - source UBS - Macro Keys, 7th of June 2012

- source UBS - Macro Keys, 7th of June 2012

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.

Pick your poison:

- source UBS - Macro Keys, 7th of June 2012

Deleveraging for banks means a significant reduction in RWA (Risk Weighted Assets) leading to dwindling liquidity for cash rich investors as dealers play close to home.

Courtesy of "improved" bank regulations, banks have been piling up Treasuries, agency, and MBS securities as indicated by UBS:

"The result for the credit market is a more cautious stance from market makers whose reluctance to
be aggressive in a less liquid marketplace is in turn hindering market liquidity." - source UBS - Macro Keys, 7th of June 2012.

Using a baseball analogy from our Americans friends, investors and dealers alike do not want to try stealing third base in this market environment:

"The credit market appears caught in an adverse cycle where both liquidity providers (dealers) and liquidity users (investors) are reluctant to be aggressive, preferring to stick with close-to-home risk positions of light balance sheets for dealers and near-benchmark exposures for investors." - source UBS - Macro Keys, 7th of June 2012.

The Itraxx CDS indices picture, with indices tightening with rising equities and falling core government bond spreads - source Bloomberg:

In that context the Itraxx Crossover (High Yield CDS risk indicator - 50 European high yield credit entities) fell significantly towards the 650 bps level, tighter by 14 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 fell significantly in the process, respectively by 10 bps and 15 bps.

While we have been monitoring closely the relationship between Itraxx Financial Senior 5 year index and the SOVx index representing the CDS risk gauge risk for 15 Western European countries (Cyprus replaced Greece in March in the index), the discussions of a Banking Union during the last European summit, has led to the SOVx index trading very marginally tighter (nearly 7 bps apart) than the Itraxx Financial Senior index - source Bloomberg:

The sovereign-bank link as indicated by the above credit indices touched recently a low of 18 bps, the bank-sovereign crisis has yet to be resolved meaningfully.

Given the decision of the German Constitutional court to postpone its ruling by three months on the ESM, it leaves the EFSF as sole agent in the recapitalization process of the ailing Spanish banking system.

The current European bond picture with today's rise of Spanish yields back towards the 7% level while German government yields closing back to lower levels around 1.20% (1.32% last week) with other European core bonds (France, Netherlands) making new lows in this "yield famine" environment - source Bloomberg:

As far as our "Flight to quality" picture is concerned, Germany's 10 year Government bond yields are falling again towards record low levels and the 5 year CDS spread for Germany has fallen recently well below 100 bps in the process for now - graph below, source Bloomberg:

Italy's 5 year Sovereign CDS versus Spain 5 year Sovereign CDS with Spain coming again under pressure on the back of Sovereign government yields - source Bloomberg:

As far as credit is concerned, we like to repeat our cautious stance in this unquenchable appetite for yield environment. In that context we do agree with Citi's recent Credit Strategy Cheat Sheet from the 13th of July:
"The net result is that we are near the tights with few obvious positive catalysts, but a long way from the wides. In effect, we believe that the upside / downside ratios for at least some segments of the market are not overly compelling at this stage."

In fact we are reminding ourselves we have seen similar "complacency" before. Back in November 2011, we posited the following in our conversation:
"In a low yield environment, defaults tend to spike. Deflation is still the name of the game and it should be your concern credit wise (in relation to upcoming defaults), not inflation."

"Low inflation environments, like the one we’ve had for the past 25 years, tend to be ones where defaults can spike." - Morgan Stanley - "Understanding Credit in a Low Yield World.

We already touched in depth the European car market deflationary environment in our April conversation "The European Clunker - European car sales, a clear indicator of deflation", where we discussed as well French car manufacturer Peugeot (PSA) European woes. To illustrate the point we mentioned above, risk of defaults can indeed rise suddenly. As our good cross-asset friend pointed out recently, Peugeot is indeed a good case study in the sense that the basis between cash and CDS was around 200 - 220 bps, on the 13th of July, in a single day the credit curve repriced by around 150 bps to 200 bps, with the CDS not moving much - source Bloomberg, anonymous dealer cash run:

The last column on the right indicates the change in spread for Peugeot cash bonds rising suddenly ("COD" = "Change On Day"). This clearly indicates that the CDS market had indeed sent out much earlier a warning signal on Peugeot bond prices, which eventually led to a repricing of the cash market for Peugeot. Peugeot announced on the 12th of July that it would shed 14,000 jobs. Its equity price touched its lowest level today at 5.864 euros. Peugeot is currently burning 200 million euros per month and is rated Ba1 by Moody's.
In similar fashion to our conversations involving shipping (Shipping is a leading deflationary indicator) and air traffic (Air Traffic is a leading deflationary indicator), the auto industry is as well facing a game of survival of the fittest in this current deflationary environment.

It was therefore not a surprise to see Peugeot's  5 year CDS jumping above 800 bps, which amounts to a cumulative probability of default above 50%. Peugeot's CDS has risen by 27.42% last month and by 244% in 2011 according to Thomson Reuters and Markit. Peugeot SA 5 year CDS touched 838 bps on the 16th of July according to CDS Data provider CMA, a 9.73% change on the day and a 74 bps move.

Moving to our pet subject of upcoming financial bond haircuts and debt to equity swap, for those who follow us, we have been sounding the alarm for a while:
"At some point, as we argued recently (Peripheral Banks, Kneecap Recap), losses will have to be taken.

We correctly foresaw this process for weaker peripheral banks.

"First bond tenders, then we will probably see debt to equity swaps for weaker peripheral banks with no access to term funding, leading to significant losses for subordinate bondholders as well as dilution for shareholders in the process." - Macronomics - 20th of November 2011.

"The CHART OF THE DAY shows that the Markit iTraxx Subordinated Financial Index is underperforming the Markit iTraxx SovX Western Europe Index by the most since 2010, when
Ireland forced lower-ranking bondholders to share the cost of saving its banking system. The gauge of credit-default swaps on 25 banks and insurers now exceeds the sovereign benchmark by 1.67 times, up from a ratio of one to one in March. Bank debt risk is rising at a faster pace than that for governments after Spain said it will require burden sharing measures from holders of junior debt in lenders receiving public funds. The move minimizes the cost to taxpayers and was required as a condition for international aid." - source Bloomberg.

As indicated by John Glover in his Bloomberg article - Senior Bondholder Immunity to Losses Begins to Fade on the 17th of July:
"The shelter available to bondholders in senior bank debt is starting to fracture as the escalating
cost of reinforcing Europe’s financial institutions prompts policy makers to seek to share the burden more widely. Bank bonds that rank ahead of subordinated and junior debt for payment have been almost unscathed by the debt crisis. Bankia SA, Spain’s third-biggest lender, has seen the value of its 4.625 percent undated subordinated bonds plummet to 27 percent of face value, while its 4.25 percent senior securities repayable in May 2013 trade at about 92 cents per euro."

It has long been a shared position with our good credit friend that subordinated bondholders as well as bank shareholders, would be facing the music at some point:
"EU will give Euro 100 billion to Spain in order for the country to recapitalize its banks. Meanwhile, Finland has asked for and got collateral for its loans to Spain. As we all wait for these funds to be delivered to Spain, subordinated debt holders will pay a nice contribution. Translation: the Iberian barber will make a nice haircut "à la Irish". The European funds will be lent by the EFSF as the ESM is still non-existent and may remain until September when the German Constitutional Court will give its assessment."

The new Subordinated Liability Exercises (SLEs), to be introduced with new legislation by the end of August by Spain, will allow banks to enforce mandatory exchanges if "liability management offers fail" on a "voluntary basis" – similar to what happened in Ireland a couple of years ago which led to significant losses for subordinated bondholders (30% of which were retail investors versus 60% in Spain...). Translation: "Tender your bonds or else...".
Subordinated debt - Love me tender? We wonder...

On top of that, according to Bloomberg on the 16th of July:
"The European Central Bank would no longer oppose the forcing of losses on senior bondholders of euro-area banks, said two officials with knowledge of the ECB’s thinking.
A key condition to imposing losses is if the bank in question is being wound down, one of the officials said. The ECB supported imposing losses on senior bondholders of ailing Spanish banks at a meeting of euro-area finance ministers in Brussels on July 9, though the proposal didn’t get much traction, the other official said. Both of them spoke on condition of anonymity as the talks are confidential."
On that very subject of losses on senior bondholders, CreditSights in a recent note entitled "What if the Bail-Out Had Been a Bail-in?" made the following key points:
"Bankia is a current example of a big taxpayer bail-out, which provides a good case study for how things might have turned out if proposed bail-in, mechanisms had already been in force.
Their scenarios are hypothetical, and they do not expect senior bail-in mechanisms to be invoked at this stage in Spain or elsewhere in the EU, although subordinated debt is already under threat.
They walked through a revaluation of Bankia’s balance sheet to reflect the write-downs that led to the recapitalisation request, as well as an exercise in segregating out the bank’s encumbered assets and collateralised liabilities, including substantial covered bond issuance and ECB repos.
In future, resolutions authorities might go through a similar sort of exercise to justify the haircuts that they impose on senior debt in a bail-in.
Their estimate is that haircuts of up to 22% could have been justified if Bankia’s senior unsecured liabilities had been the subject to bail-in, based on its end-2011 balance sheet and a recapitalisation need of 12 billion euro. This is predicated on an asset segregation scenario, whereas a full liquidation scenario would imply a higher loss rate."

An interesting exercise indeed, we think.

On a final note many pundits are discussing the need for an additional round of QE by the Fed, Bloomberg Chart of The Day indicates that Fed easing may do little to lift bank lending:

"As the CHART OF THE DAY illustrates, banks reduced the amount of reserves held at the Fed’s regional banks and made more money available to businesses in the past 12 months. The shifts took place even though the central bank’s total assets were little changed, according to Michael Shaoul, Oscar Gruss & Son Inc.’s chief executive officer wrote two days ago in a report. "“This point is sadly missed by those looking for a new round of quantitative easing,” the report said. Between 2008 and last year, the Fed bought $2.3 trillion of debt securities in two rounds of easing to support economic expansion.
Bolstering reserves through a third round of purchases “will not increase the supply of or demand for credit,” the New York-based analyst wrote.
Reserves for the week ended July 4 were $179.2 billion lower than their peak last July, according to data compiled by the Fed. The decline coincided with a $171.2 billion increase in commercial and industrial loans, based on central-bank data. “This is precisely how monetary policy can affect domestic activity,” wrote Shaoul, who also helps oversee more than $2 billion as Marketfield Asset Management LLC’s chairman. “What it cannot do is magically increase employment.” - source Bloomberg.
As far as the ECB is concerned, we should know very soon the true impact of the cut in the deposit rate:

"The CHART OF THE DAY shows financial institutions may meet reserve requirements at the ECB as early as today, three weeks early, if they increase their current-account deposits at the rate of the past few days. Once they reach that level, they won’t earn any more interest and might seek alternative investment opportunities, Klaus Baader, an economist at Societe Generale in Hong Kong, said. “Banks will have to choose what to do with the excess reserves: accept zero return, buy safe and liquid assets that do yield an acceptable return -- not many of those these days -- or, of course, reduce the amount of reserves,” he said. “The best of all worlds, of course, would be if banks started to lend to each other again, but the chances of that happening are remote.” Banks have shifted money from the deposit facility, where funds no longer earn interest, into reserve accounts, parking about five times as much per day as they need to on average. The ECB remunerates these holdings with interest equivalent to its benchmark rate, currently at 0.75 percent, until requirements are met." - source Bloomberg.

"From the gut comes the strut, and where hunger reigns, strength abstains." - Francois Rabelais

It will be interesting to monitor where this "yield famine" will lead us to.
Stay tuned!

Credit - Agree to Disagree

"Politics is the art of postponing decisions until they are no longer relevant."
Henri Queuille

Looking at the growing spat between Germany and France in relation to the on-going European saga, we thought this time around we would use the term "Agree to Disagree", given that the term "agree to disagree" or "agreeing to disagree" is referring to the resolution of a conflict (usually a debate or quarrel) whereby all parties tolerate but do not accept the opposing positions:

"It generally occurs when all sides recognise that further conflict would be unnecessary, ineffective or otherwise undesirable. They may also remain on amicable terms while continuing to disagree about the unresolved issues." - source Wikipedia.

While our European politicians continue to be irrational/irresponsible in their behavior, and "agree" to continue to "disagree" for now; as indicated by Wikipedia, investors can as well follow a similar path:

"Economist Frank J. Fabozzi argues that it is not rational for investors to agree to disagree; they must work toward consensus, even if they have different information. For financial investments, Fabozzi posits that an investor's overconfidence in his abilities (irrationality) can lead to "agreeing to disagree"—the investor thinks he is smarter than others."

When looking at the growing divergence between US stocks and US Bond yields, and softening US economic data, one can wonder our long US investors can "agree" to "disagree" - source Bloomberg:

"Any multiyear rally in U.S. stocks may depend on a signal that the bond market has yet to send, according to Michael Hartnett, Bank of America Corp.’s chief global equity strategist.
Bond yields have to reach “an inflection point” before shares can move into what’s known as a secular bull market if history is any guide, Hartnett wrote in a June 12 report.
The CHART OF THE DAY compares the Dow Jones Industrial Average and the yield on 10-year Treasury notes since 1900, as Hartnett did in his report. The yield figures were compiled by Yale University Professor Robert J. Shiller and obtained from his website.
Hartnett highlighted three inflection points in the past century, as shown in the chart. They foreshadowed stock-market booms during the 1920s, after World War II, and throughout most
of the 1980s and 1990s.
A comparable surge in share prices is unlikely, he wrote, “until Treasury yields rise in response to stronger growth and a healthier global economy.” The 10-year yield fell to a record 1.4387 percent this month.
Even so, lower yields are giving investors more incentive to shift into stocks from bonds, the New York-based strategist wrote. He estimated that it will take a 0.6 percent yield for the 10-year’s return in the next 12 months to match stocks’ 20th-century average of 10.5 percent a year." - source David Wilson, Bloomberg, 15th of June 2012.

"Mind the Gap" we indicated on the 8th of May in relation to the European space. European investors had agreed to disagree, we thought at the time, for too long, and now it looks like the gap has been closing. - 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:

So, as we go through a credit overview, this time around we will focus our attention on the future of Europe, given that our European politicians, in true "Henri Queuille fashion" are once again playing the "can kicking game". Unfortunately for them, with Spanish yields at 7%, crumbling Spanish Cajas and Greek elections on top of weak economic data, it is decision time.

Henri Queuille was the epitome for "professional politician": he served three times as Prime Minister and was 21 times minister in a French government under the IIIrd and IVth French Republic. He was the symbol of the inefficiency and the failure of the French IVth Republic, but we ramble again (do we really?). Time for our credit overview touching again on our pet subject of "subordinated bond holders" ("Peripheral Banks, Kneecap Recap"), Spanish bondholders are starting to experience similar pain than Irish and Portuguese subordinated bond holders. "Liability" exercises are already leading to some interesting debt-to-equity swaps.

The current European bond picture with the recent rise in Spanish and Italian yields - source Bloomberg:

While Spanish bonds breached 7% on Thursday, Spanish bonds eased 6 bps on Friday to close at 6.90% while Italian yields receded to around 6%, falling 15 bps. Some of the intra-day relief in Italian and Spanish debt was due to short covering.

Indeed Spanish bond yields have reached "intervention" level for the ECB, with Prime Minister Rajoy pleading for additional support, although the SMP (Securities Market Programme) has been on hold since March, after reaching 219.5 billion euros - source Bloomberg:

"The CHART OF THE DAY shows Spain’s 10-year yields climbed to the highest rate since the start of the euro yesterday, reaching 6.998 percent, on the brink of the 7 percent threshold that helped trigger bailouts for Greece, Ireland and Portugal. Yields are rising even as Spain requested as much as 100 billion euros ($126 billion) in aid for its banks on June 9." - source Bloomberg

As far as Credit Markets were concerned on Friday, it was short covering time, as a European credit market maker put it:

"Market caught between fears over the Greek elections and prospect of a new QE on both sides of the pond. Generally speaking spreads closed somewhat better today in low beta probably fueled by tightening swap spreads. Flow was balanced and trading remains very technical."

The Credit Indices Itraxx overview - Source Bloomberg:

Indeed, short covering it is, in both government bonds market and credit markets as investors and traders alike do not want to be short risk with the looming Greek elections. No surprise to see Itraxx Crossover 5 year index ((High Yield risk gauge, 50 European entities) receding therefore by  more than 20 bps towards the close. Same applies to Itraxx Financial Senior 5 year index and Itraxx Financial Subordinated 5 year index, receding as well in similar pattern. The Iraxx Europe index, (which comprises 125 high-grade borrowers, 25 of which are banks and insurers), was at 175 bps, five basis point tighter from Thursday's close.

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 correlation between financial and sovereign risk:

In fact the rising spread between Financial risk and Sovereign risk to 38 bps is indicative of the growing solvency fears of some sovereigns which received additional pressure this week with both Cyprus and Moody's seeing their sovereign rating downgrade, with both countries requesting support for their ailing financial system.

-Moody’s downgraded Spain 3 notches from A3 to Baa3 on the 13th of June, and placed Spain on review for further downgrade, following Spain’s announcement that it may seek up to 100 billion euros from the EFSF/ESM to recapitalise its banking system (twice Moody’s previous base case estimate and in-line with its adverse scenario).  FROB was also downgraded from A3 to Baa3 accordingly.  Moody’s is further concerned about Spain’s limited access to markets and its dependence on domestic banks, who in turn rely on the ECB, to support new issues.  Moody’s added it would conclude its review within three months as it awaits clarity on the size/terms of the recap, additional estimates from Wyman/Berger, further euro-area initiatives on a fiscal or banking union, and the impact of the recap package to restore market confidence.

-Moody’s downgraded Cyprus as well by two notches from Ba1 to Ba3, on review for further downgrade, due to a material increase in the likelihood of a Greek exit and its impact on the level of support needed by Cypriot banks.  Moody’s  previously estimated Cypriot banks would need support in the range of 5-10% of GDP but now expects it could be materially higher, with Cyprus Popular Bank alone probably accounting for 10% of GDP.

As we indicated in our conversation "The Spread Also Rises" on the 24th of March following the credit indices rebalancing:
"Replacing Greece by Cyprus is the SOVx series 7 index might not be enough to preserve the 15 member's number status. On the 13th of March, Moody's rating agency joined its peer Standard and Poor's in slashing Cyprus to junk status on heightened concerns over its banking sector’s exposure to Greece. Only Fitch rating agency has maintained its rating for Cyprus one notch above junk."

On the back of Spain's downgrade, Moody's downgraded 12 Spanish Sub-Sovereigns, 2 Gov-Related Entities on Friday.

In relation  to our Flight to quality" picture, Germany's 10 year Government bond yields have been recently rising towards 1.50% and the 5 year CDS spread for Germany has remained firmly above 100 bps in the process. In the recently quoted 24th of March conversation "The Spread Also Rises" we also wondered if the rise in German 5 year CDS was an ominous signs of upcoming stress in the markets, which in retrospect was a good sign - graph below, source Bloomberg

While some "agree to disagree", we, on the other hand "agree to agree" with Nomura in relation to their lower forecasts relating to 10 year German yields. In their 14th of June note they added:

"We are bullish Bunds and in recent months have had a series of lower forecasts for 10yr yields - 1.50%, then 1.25% and currently 1.0%. In all cases, we referred to our forecasts as interim, which reflected our view that as the eurozone crisis nears its denouement, yields could fall far below 1.0% as Bunds came to be traded less as yield instruments and more as collateral instruments with a sizable embedded FX option.

 Such bullishness can be somewhat uncomfortable when the asset you recommend experiences a pronounced sell-off. 10 year Bund yields have risen from 1.127% on 1 June to 1.49% currently! Does this sell-off represent the pricing in of new information or does it provide an opportunity for investors who missed the Bund move to establish fresh longs? We think the latter. Two factors have driven the Bund move, and we do not expect either to persist:

1) Bund “Risk” has been reduced ahead of Greek elections. This could increase the market impact of a “bad” election result, while we fear that even a market-positive election outcome would entail an uncertain period while a coalition was formed. More importantly, the Greek election matters less than it did even a fortnight ago. Then, many investors viewed Greece as a catalyst for the latest market down-leg. But in our view Greece was always a symptom of a European policy mix that is undermining growth, fiscal stability and bank solvency. These broader trends have already led to Spain’s need to request bail-out funds and fuel the growing risk that the country loses market access. A positive Greek election will not assuage these risks.

2) Fears of a fiscal union. Hopes have increased that we will see a European Redemption Fund (ERF) or European Banking Union. However, we do not expect meaningful progress towards fiscal union in a timeframe relevant to the current crisis. Of the various Eurobond proposals, the only one which we believe could generate any period of optimism would be the ERF, but even then only until the market analysed the proposal in detail and concluded – as we do – that it is not a solution and may increase the scale of the crisis. Meanwhile, progress in creating a European TARP would be positive but of limited use unless it was combined with talk of turning the ESM into a bank to allow it to fund the recapitalisation via the ECB. (It is difficult to see another source of sufficient funding for the ESM.)

There is also the risk that the escalation of the crisis means that a truly proportional policy response may be more than can be delivered. After all, the response needs to restart rather than just maintain investment flows from core to non-core countries. While we still expect the ECB to initiate QE in Q3, this may now need to combine with an ECB funded TARP. Even then, we assume that the crisis needs to escalate far further before the ECB/ Germany agree to such options. Given these risks, 10yr Bunds around 1.50% seem attractive."

No wonder in the current European context, there is such a difference between the Spanish and German sovereign yield curve  with a much more flatter German curve - source Bloomberg:

Moving on to the core subject of the future for Europe as we are reaching the end for this extended game of "can kicking", we have been wondering what could make us "agree to agree" rather than continue to "disagree" in relation to our European saga. We think Exane BNP Paribas did a good work in summarizing what is needed to review our negative stance, in their recent note "Crunch time is still not with us" from the 14th of June:

"What policies would we regard as sufficiently radical to upgrade?

Any solution to the Euro area debt crisis is going to have to involve one of three unpalatable policies: a) large scale default, b) mutualisation or c) monetisation.

At present, mutualisation appears to be the most likely solution, with the European Redemption Fund (ERF) under discussion in the German parliament; however aggressive monetary action by the ECB remains a possibility."

In relation to the ongoing issue of circularity, which we discussed in our conversation "Eastern Promises", it means that correlation between Sovereign risk and Financial risk is different between countries since January 2010 - Spain versus Germany:

"Spain 5 year Sovereign CDS versus Santander 5 year Senior CDS, correlation is at 0.92. In Germany, the second graph, since January 2010, Germany's Sovereign 5 year CDS correlation with Deutsche Bank Senior 5 year CDS has only been 0.76.

From the above, one can clearly conclude that the more stress you get on a country's sovereign debt, the higher the correlation with the financial sector."

Exane BNP Paribas in their note added in relation to the 100 billion euros plan for the Spanish banking sector added:

"We do not believe that the Spanish programme will materially alter perceptions of that part of the tail risk which related to the danger of a break-up of the Euro. Furthermore, although, as noted above, the benefits from clearing up the financing issues are considerable, and the difference between the market and official interest rates represents a benefit to Spain, all that has really been done here is to move a liability from the banking sector to the sovereign, in the process potentially introducing a layer of subordination to private sector sovereign creditors. Since it is the sovereign credit which is the driver at present (most major bank CDS have tightened markedly relative to their domestic sovereigns), increasing the sovereign indebtedness in order to recapitalise marginal banks does not necessarily benefit that part of the banking sector which is not directly being assisted."

We have long argued that subordination would lead to insubordination, leading to a buyers strike in the European bond markets which is exactly what has happened courtesy of European politicians meddling.

So what could be the possible solutions for the Eurocrisis? These are the possible outcomes according to Exane BNP Paribas:

"In our opinion, unless one of these major bottlenecks is tackled with a plausible solution, any policy initiative, whether actually implemented or merely suggested, is either a non-solution or simply an exercise in buying time. A number of potential solutions are currently circulating in the policy community, along with a distressingly high number of non-solutions." - source Exane BNP Paribas.

In order to "agree to agree" with Exane BNP Paribas, we think the possible solution for the Eurocrisis goes through mutualisation, default and Official sector involvement:

"Finally, there is the option of default (in a general sense of the word "default", taken to include bail-ins, quasi-voluntary debt tenders, negotiated writedowns and similar operations as well as formal defaults within the meaning of CDS contracts). Sufficiently large debt reduction by official sector creditors is simply another means of mutualisation; more chaotic than Eurobonds, less transparent, setting fewer precedents and in nearly every way less satisfactory, but achieving largely the same goal. As long as the eventual defaults, when they happen, involve a majority of official sector creditors (and/or local banks with similarly few international creditors), the potential for contagion to the wider financial markets could be limited." - source Exane BNP Paribas.

Make no mistake, at some point, as our good credit friend put it, losses will have to be taken.

In relation to the recent European political talks relating to Banking Union, "The road to hell is paved with good intentions", we agree with Exane BNP Paribas that it is a "non-solution":
"Europe needs a short term solution before it can consider a long-term one, and the current nature of the short term problem facing Europe is not necessarily one that is addressed by a banking union."

Indeed, looking at the continuous deposits outflows from Greece, European politicians, while continuously agreeing to disagreeing, are once again utterly and completely behind the curve:

"The problem is that the "failure mode" for Euro exit is most likely to be triggered by a banking system collapse in a peripheral economy such as Greece. And the main stress on the Greek deposit base is not coming from bank-specific concerns related to the credit-worthiness of individual banks, or even related to the ability of individual sovereigns to back up their deposit guarantee schemes in the event of systemic bank failure. Put simply, depositors are worried about getting their savings back in drachma rather than in euros. For this reason, the only guarantee scheme that could persuade them to keep money in the local banking system would be a guarantee of the EUR value of their deposits, which would be payable even in the event of euro exit." - source Exane BNP Paribas.

If our European politicians had studied carefully what had happened in Argentina before their default in 2002, they would not be pressing for a "Banking Union" but should rather be more concerned about a deposit guarantee scheme if they are "really serious" about keeping Greece in the Euro. Back in March we argued the following in our conversation "Modicum of Relief":
"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."

In relation to the similarity of Greece in relation to the Argentina crisis of 2001 leading to its 2002 default, we related to a CreditSights article written at the time of the crisis (CreditSights, 31st of July 2001 paper "Defining the Default Path") :
"the most puzzling aspect of the crisis so far is the relative complacency of the public. This is starting to be tested. The term structure of deposits doesn't bode particularly well, especially as the government has tried to force the banks out longer on the curve than is ideal given deposit withdrawals. We estimate that almost 2/3 of deposits are eligible to be withdrawn in the next 30-60 days and we would be surprised if those deposits that extend in the system were put in time deposits. In addition to the obvious potential of a run on the banks, the lack of liquidity in the system has forced the central banks to provide unprecedented level of repos to the system and also relax reserve requirements. The problem is that this is very unclear whether that additional liquidity is funding anything but capital flight at this point."

As far as Spain is concerned, deposits flights have not yet materially happened:

"There was little evidence from aggregate data that the Spanish banking sector was under any particular funding pressure; aggregate domestic deposit balances have declined by 1.3% since the start of the year, which is broadly in line with loan contraction and is therefore likely to reflect overall deleveraging rather than capital flight. Although there were press rumours of a deposit run on Bankia on 11 May (El Mundo), these were not followed up and the official denials appear to have been largely correct in asserting that the deposit flows were seasonal. The large TARGET2 negative balance of the Bank of Spain in the Eurosystem accounts seems to indicate mainly that the liquidity provided in the ECB's monetary operations over the last year has facilitated an orderly withdrawal from Spain by foreign portfolio investors." - source Exane BNP Paribas.

Following on our pet subject of bond tenders, and pain for bondholders as well as shareholders, we have long been expecting such a pain to materialise:
"First bond tenders, then we will probably see debt to equity swaps for weaker peripheral banks with no access to term funding, leading to significant losses for subordinate bondholders as well as dilution for shareholders in the process." - Macronomics - 20th of November 2011.

Banco Sabadell on the 14th of June offered to buy back 1.6 billion euros worth of preferred shares and subordinated debt issued by CAM, a former savings bank  which was acquired by Sabadell in 2011. Sabadell offered to buy back 1.3 billion euros of preference shares issued by CAM and 321 million euros worth of subordinated debt which will be re-invested by investors in newly issued Sabadell shares. Most of these "preferred" shares had been issued to retail clients...

"We believe additional debt to equity swaps will have to happen for weaker peripheral banks, similar to what we witnessed with Banco Espirito Santo in October 2011, as well as for German bank Commerzbank ("Schedule Chicken" - 25th of February 2012)." - Macronomics - Peripheral Banks, Kneecap Recap.

Spain has yet to apply the full extent of the Irish recipe which we discussed "The road to hell is paved with good intentions":"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..."
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Looking at the recent Sabadell "liability" exercise, it looks like Spanish retail investors are bound to be inflicted additional pain. As indicated by Bloomberg in a recent article - "Irish Tell Spain to Imagine the Worst and Burn Bank Bondholders":
"In all, subordinated bondholders suffered about 15 billion euros of losses in Ireland, helped by the direct or threatened use of the new laws, due to expire this year.
Spain may be reluctant to impose losses on holders of junior debt. Bankia Group is among Spanish lenders that sold 22.4 billion euros of preferred stock to individual investors through retail branches, according to data compiled by CNMV, the financial markets supervisor.
Because of capital structure rules, these investors should be wiped out before losses are imposed on junior debt holders, a move Spanish Prime Minister Mariano Rajoy’s government may shy away from unless he introduces laws to protect them."

Unless our European politicians rapidly introduce European laws guaranteeing depositors money ("insurance for depositors against the risk of euro exit" is qualitatively different from "deposit insurance"), capital flight might start in Spain as it has already in Greece.
"It should also be noted that for the ECB to guarantee the Euro deposit base against redenomination risk is not necessarily as radical a policy as it might seem; really, all it amounts to is a guarantee that the Euro will function as a currency union. This can be seen through a thought experiment." - Exane BNP Paribas

CreditSights in their article relating to Argentina clearly indicated the dangers of deposit outflows. While complacency is prevailing so far in relation to Spanish deposits, it cannot be taken for granted, as shown by the situation in Argentina which quickly spiraled out of control and led to its default in 2002:
"the most puzzling aspect of the crisis so far is the relative complacency of the public. This is starting to be tested." - CreditSights, 31st of July 2001 paper "Defining the Default Path".

Clearly while our European politicians are continuing to "Agree to Disagree" the clock is ticking on the Doomsday European device. As Exane BNP Paribas put it, our European politicians need to come fast with the defusal kit:
"How to defuse a nuclear bomb:
Managing such a crisis would require the ECB to carry out policies which differ by orders of magnitude from anything it has attempted so far. As we noted in an earlier section, a deposit insurance scheme cannot guarantee the entire deposit base against redenomination risk; this is another example of the general principle that a basically fiscal entity cannot do the work of a monetary authority. Furthermore, in a case of a run motivated by fears of euro exit, the guarantee required could not realistically be restricted to the insured deposit base. Even for Greece, the total deposits (domestic NFCs and households) total EUR160bn; for Spain the liability would be EUR714bn and for Italy EUR1trn. Clearly, the only body that could credibly backstop a guarantee to pay depositors the Euro value of their euro-denominated deposits would be the ECB."

On a final note, as indicated by Bloomberg Italy could rapidly come back in the spotlight, should European politicians fail to stabilise Spanish woes: "Italian corporate and household bad debt, totaling a combined 107.6 billion euros, is more than 65% higher yoy while remaining stable ytd. Spain's reported bad debts total 148 billion and have risen 6% in 2012, driven by construction and real estate. Italian corporate and consumer bad debt will likely rise should contagion fears spread."

"Even as Spain requested up to 100 billion euros to bail out its banks, yields on Italian and Spanish sovereigns rose 20 bps to 30 bps. Respective sovereign CDS have also tracked each other closely, although Italian banks outperformed Spanish peers since mid-2011, as Spain's real estate troubles worsened. This may reverse if contagion fears spread." - source Bloomberg

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

"There is no problem urgent enough in politics that an absence of decision cannot resolve."
Henri Queuille

Stay tuned!