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..."
‏
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!

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!

Credit - Peripheral Banks, Kneecap Recap.

"That's the method: restructure the world we live in in some way, then see what happens." - Frederik Pohl

We already touched at length in our past credit conversations on the liability exercise management taken by many weaker peripheral banks in relation to raising capital to reach the 9% Core Tier 1 Capital target set up by the European Banking Association for June 2012 (see our conversations "Subordinated debt - Love me tender?" and "Goodwill Hunting Redux"):
"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.

In 2011 as well as very recently, bond tenders have been a recurring theme in the credit space.
As a reminder on bond tenders:
Debt tender offer:
"When a firm retires all or a portion of its debt securities by making an offer to its debt holders to repurchase a predetermined number of bonds at a specified price and during a set period of time. Firms may use a debt tender offer as a mechanism for capital restructuring or refinancing."

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).

We wrote in October 2011 relating to bond tenders and the move towards debt to equity swap:
"We expected others to follow suit and given the difficulty for the weaker players in the peripheral space to access capital at a reasonable rate, as well as needing to boost their core Tier 1 capital base, it was of no surprise to see Portuguese bank Banco Espirito Santo following French bank BPCE in tendering some of its subordinated debt on the 18th of October, but this time around, we have a debt to equity swap."

Banco Espirito Santo stock price evolution - source Bloomberg:

Survival of the fittest...On October 18 Banco Espirito Santo announced a capital increase in effect via its bond tender which meant at the time a 83.5% dilution for shareholders. This was followed by another capital increase of 1 billion euro announced mid-April, to be completed by early May (see our conversation "All Quiet on the Western Front").

According to recent note by CreditSights (Euro Financial Movers - Walking on Eggshells - 15th of April 2012):

"Unnamed major shareholders have committed to subscribe just over half of the amount (50.63%), and the remainder is underwritten by a syndicate of banks. On an FY11 pro-forma basis, this will take BES's Core Tier 1 ratio to over 10.5% and allow it to meet the EBA's end-June requirement of 9 Core Tier 1. The consolidated EBA shortfall for BES's parent, Espirito Santo Financial Group, is €1,597 mln."

All clear for Banco Espirito Santo, but definitely not for its Portuguese peer, Banco Comercial Português (BCP):
"Banco Comercial Português has yet to give details of how it will cover a shortfall of €2.1 bln identified by the EBA. There is a €12 bln government recapitalisation facility available to Portuguese banks under the bailout package." - CreditSights - Euro Bank Capital Model FY11: We Are The 9%, 2nd of May 2012.

When it comes to BCP, a debt to equity swap could be a solution if we take a look at the stock price - source Bloomberg:

Not pretty to say the least...

When it comes to Greek banks, they are in the front line (see our post "Liquidity? The IV Greek Credit Therapy").
Lack of capital follows the results of the Greek PSI, leaving them with dire needs as indicated by Marcus Bensasson, Maria Petrakis and Natalie Weeks
in their article on Bloomberg on the 20th of April - Top Greek Banks Post $37 Billion in Losses on Debt Restructuring:

Greece’s four biggest banks reported a combined loss of 27.9 billion euros ($36.9 billion) for last year after participating in the country’s debt exchange, the largest sovereign restructuring in history.

The four, including National Bank of Greece, EFG Eurobank Ergasias SA, Alpha Bank SA and Piraeus Bank SA, said they wrote down about 25 billion euros in the combined value of their Greek government bond holdings.

Prime Minister Lucas Papademos is trying to finalize a plan to recapitalize Greek banks, which wrote down more than half the face value of their government bonds and posted an increase in bad loan ratios after five years of recession. Greece’s bank-recapitalization body yesterday got 25 billion euros in a first tranche of funds, or half the total assigned for the purpose, as part of a second bailout by the European Union and International Monetary Fund."

And the Bloomberg article to add:
"National Bank, the nation’s biggest lender, had a net loss of 12.3 billion euros for 2011 after a 406 million-euro profit a year earlier, the Athens-based lender said in a statement today. The average estimate from three analysts surveyed by Bloomberg News was for a loss of 9.29 billion euros.
EFG Eurobank Ergasias SA, the second-biggest lender, had a 5.51 billion-euro loss after a 68 million-euro profit in 2010 and Alpha Bank SA, the third biggest, lost 3.81 billion euros after an 86 million-euro profit in 2010. Piraeus Bank SA, the fourth largest, had a 6.3 billion-euro loss.
National Bank took 10.8 billion euros of post-tax impairments on Greek government bond holdings after writing down their value by 75 percent. Eurobank wrote down 4.6 billion euros of government bonds after taxes and Alpha Bank 3.8 billion euros. Piraeus wrote down 5.1 billion euros."
Another nice job done by "analysts"...

So, no surprise for us to hear recently about the bond tender exercise being followed by Greek bank Alpha Group Limited:

"Alpha Group Limited (the "Offeror"), a member of the Alpha Bank A.E. group (the "Group) announced today tender offers (the "Offers")for Any and All of two Tier One Securities, one Upper Tier II Security and two Lower Tier II Securities ("Securities") with an aggregate face amount outstanding of approximately EUR 985mm."

For similar purposes as all other bond tenders we have seen so far, namely to boost Core Tier 1 Capital:

"The purpose of the Offers is to generate Core Tier One capital for the Group and to strengthen the quality of its capital base. If completed, the Offers would generate a gain for the Group and thereby increase Core Tier One capital. The Offers also provide investors with an opportunity to monetise their investments at the relevant Purchase Price."

Opportunity for the bondholders to "get to the exit while they can" and take their losses...

Alpha Bank SA offered to buy back a nominal 1.58 billion euros of outstanding securities in a bid to boost its capital. If completed, this offer would generate a gain for the group’s Core Tier 1 capital, which the bank reported at 3 percent for 2011 according to Bloomberg, when the target is 9% for June 2012 for European banks as required by the European Banking Association plan but, for Greek Banks, they have until September 2012 for achieving the 9% required. In 2011, during the last EBA stress tests for European banks, 30 billion was assigned to Greece's banking system out of the 115 billion original EU-wide bailout plan.

Alpha Bank stock price - 24th of April 2012 - source Bloomberg:

ASE - Greek stock index evolution - 24th of April - source Bloomberg:

From our conversation "Equities, there's life (and value) after default!", we know that the outstanding weight of "Financials" in the ASE Greek index, is roughly around 21.70%. We wrote at the time:

"Given the outstanding weight of financials in the Greek ASE index and knowing their current Greek debt holdings, Alpha Bank, National Bank of Greece, EFG Eurobank and Piraeus bank respective equity is probably worth zero. It should in theory equate to an additional write down of at least 16.74% of the ASE Greek index."

The same Bloomberg article also indicated the following in relation to Greek Banks Core Tier 1 ratios:

"National Bank, Eurobank and Piraeus Bank did not disclose what their Core Tier 1 ratios would be without support from the Hellenic Financial Stability Fund, the state recapitalization body. National Bank reported a Core Tier 1 capital ratio of 6.3 percent after an injection of 6.9 billion euros from the HFSF.

Agricultural Bank of Greece SA and TT Hellenic Postbank SA, two state controlled lenders, were granted extensions and will report earnings by May 31, the banks said in exchange filings.

The bank recapitalization plan includes incentives for private investment such as rights for shareholders to purchase the government’s stake and safeguards for buyers of convertible bonds, according an IMF report released March 16. The HFSF will continue to hold voting rights in the event of strategic decisions related to the banks to avert the risk of asset stripping by investment funds, according to the report."

When it comes to rising pressure in relation to the need for fresh capital, it could not be more truer given the significant rise in non-performing loans as reported by Bloomberg on the 4th of May:
"Greek banks collectively saw the level of non-performing loans rise to 17 percent of their total loan portfolio at the end of the first quarter from 14.7 percent at the end of the third quarter of 2011, Kathimerini reported.
Bad mortgages climbed to 16 percent of the total, or 12.5 billion euros ($16.4 billion), from 14 percent, the Athens-based newspaper said today, citing Greek banking officials. Bad consumer loans increased to 29 percent, or 9.6 billion euros, from 26.4 percent and bad business loans nose to 15 percent, or 18 billion euros, from 13 percent, it said." - source Bloomberg, Paul Tugwell.

So what is the plan for Greek banks? So far no plan...

"Greece’s government has yet to settle on the final terms to recapitalise the nation’s banks after a 100 billion-euro writedown of sovereign debt, said an official at the Hellenic Financial Stability Fund.

Agreement still needs to be reached on a number of different issues and this may not occur before May 6 elections, the official, who declined to be named, said after a meeting in Athens between Panayotis Thomopoulos, the head of the fund, and Prime Minister Lucas Papademos.

The official said he hoped the full 50 billion euros allocated to the fund wouldn’t need to be used and that an initial 18 billion euros had been provided to the four biggest Greek banks in the form of commitments." - source Bloomberg, Eleni Chrepa - 24th of April 2012.

The HFSF (Hellenic Financial Stability Facility) total 13 billion, 1.3 billion for Alpha Bank, 4.2 billion for EFG Eurobank, 6.9 billion for National Bank of Greece (who had the largest holding of Greek bonds on its balance sheet). According to CrediSights, these facilities allow the banks to report total capital ratios of at least 8% under the current EU Capital Adequacy Directive, which in turn makes them "officially solvent" and therefore "eligible" for ECB funding...
Looking at the outcome from the Greek elections on the 6th of May with the losses of pro-austerity parties, it spells trouble ahead for Greece and its ailing financial system, resorting to desperation tactics like
-suing Reuters News agency:
"Greek bank sues Reuters over investigative report" - Reuters, 2nd of May.

"One of Greece's biggest banks has filed a lawsuit against Reuters claiming 50 million euros ($66 million) in damages over a story that exposed a series of property deals between the bank and companies run by the family of its executive chairman."

-making desperate appeal for fresh private equity to avoid total shareholder equity wipeout:

"Apostolos Tamvakakis, chief executive of National Bank of Greece, launched a last-ditch attempt to fend off a wipeout of private shareholder control, widely considered inevitable across the banking system as lenders struggle to absorb losses on their government bond holdings and other bad debts." - Financial Times, Patrick Jenkins, Banking editor - Greek banks appeal for fresh equity.

We believe debt to equity swaps will likely happen for weaker banks as well as full nationalisation for some.
As our good credit friend said in November 2011: 
"The path will be very painful for both shareholders and bondholders."
30% of National Bank of Greece shares are in the hands of foreign investors such as Bank of New York Mellon, BlackRock, Allianz, Pictet, Prudential Financial, Aviva, AXA, HSBC and BBVA, according to Bloomberg data.

"When liberty is taken away by force it can be restored by force. When it is relinquished voluntarily by default it can never be recovered." - Dorothy Thompson

Stay Tuned!

Markets update - Credit - Schedule Chicken

"Every man prefers belief to the exercise of judgment."
Lucius Annaeus Seneca

"The practice of schedule chicken often results in contagious schedules slips due to the inner team dependencies and is difficult to identify and resolve, as it is in the best interest of each team not to be the first bearer of bad news. The psychological drivers underlining the "Schedule Chicken" behavior are related to the Hawk-Dove or Snowdrift model of conflict used by players in game theory." - source Wikipedia.

Given everyone is focused now on the results for the much awaited PSI in relation to the ongoing Greek debt resolution process, Greek CDS trigger or not, courtesy of Collective Action Clauses (knowing that the IMF assumes a 95% participation rate to the PSI...), we thought this time around, we would use an analogy relating to project management linked closely to the famous game of chicken, namely the Nash equilibrium concept. Looks like we are rambling again as usual.

In this week credit conversation, we will once again discuss the LTRO effect, and the importance of deposits levels and credit cycles,  touching on the latest Commerzbank debt to equity swap (not really a surprise to us as we hinted it would happen on the 29th of November in our conversation "The Eye of the Storm"), and the impact the PSI will have on Greek banks and more.

But as always, time for a credit overview!

The Credit Indices Itraxx overview - Source Bloomberg:

The iTraxx SOVX Western Europe Index of sovereign credit-default swaps(15 governments) although tighter by 4 basis points to 344 bps, remains elevated on the 24th of February, compared to the Itraxx Financial Senior 5 year CDS index representing European Banks and Insurance institutions.

The strength of support brought around by the previous LTRO to the Itraxx Financial Senior index is clearly indicated by the spread of the index versus the SOVx 5 year CDS index representing sovereign risk in Europe, still around the highest level reached - source Bloomberg:

"Flight to quality" picture, Germany 10 year Government bond yields remain below 2% yield and falling 5 year CDS spread for Germany - Source Bloomberg:

In our conversation the "LTRO Alakaloid", we indicated that ongoing concerns surrounding the European crisis meant that the widening potential for 10 year German government bonds was indeed somewhat capped given the demand for precautionary assets.
We indicated: "It is all about capital preservation rather than a hunt for yield".

The current European bond picture with Italy and Spain 10 year government yields falling still, given the LTRO effect is encouraging Italian and Spanish banks in buying their respective domestic debt - source Bloomberg:

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:

The ECB 3 years LTRO has had a significant effect on the three months Libor OIS spread in 2012, a clear indicator of risk in the banking sector. As Nomura indicated in their note from the 20th of February entitled - ECB 3yr LTRO: Fixing what's broken:

"Low money market rates and ample liquidity provision by the central bank went a long way towards easing funding tensions in the money markets in 2008. This is evidenced by the drop in the Euribor-OIS spread, one indicator of systemic credit risk in the banking system, after the ECB's emergency rate cuts. Euribor is the rate for 3m uncollateralised interbank lending and OIS refers to a 3m swap contract whereby one exchanges EONIA(floating leg) for the 3m OIS rate (fixed leg). Despite the fact that the volume of uncollateralised lending between banks has shrunk significantly since the global financial crisis, Euribor remains a reference rate that can be used to gauge aggregate credit risk in the banking sector."

But we have a cause for concern, namely that the LTRO is addressing liquidity issues for cut-off peripheral banks but in no way solvency issues and availability of credit to the real economy (see our post, "Money for Nothing"). In fact, we are currently witnessing a dangerous phenomenon of flight of deposits from peripheral banks to Germany as indicated by John Glover in his Bloomberg article - Bank Deposit Flows Show Money Leaking to Germany:

"Money is leaking out of banks in southern Europe as customers scoop deposits out of Greece, Spain and Italy to move cash to less indebted nations such as Germany.

Greece’s total deposits plunged 28 percent from the peak in June 2009 to 169 billion euros ($225 billion) at the end of December, according to data compiled by Bloomberg. In Spain, deposits slid 5 percent in the five months through November to 934 billion euros, the least since April 2008. Italian banks held 974 billion euros in November, the lowest in 18 months.

Deposits in Germany have climbed by almost 10 percent since May 2010, when Greece was granted its first bailout. Deposits have risen every month except five since the end of 2009, and reached 2.15 trillion euros at the end of 2011, Bloomberg data show. The deteriorating growth outlook in the euro region risks exacerbating those flows, according to Dario Perkins, an economist at Lombard Street Research in London.

“The biggest systemic risk is if people lose confidence in keeping their euros in Spain, Portugal or Italy,” Perkins said. “It makes sense to put your cash into Germany just to be safe and that’s where the real systemic danger lies. That contagion isn’t priced in, and bank deposits are the place we’d spot it.”

This flight of deposits will have a significant impact in economic growth. We agree with Nomura, from their recent report, namely that:
"Monetarist economics is back in vogue; we are watching deposit growth".

Indeed, our European Flutter's narrow money (sum of currency in circulation and overnight deposits), namely M1 growth, is displaying different speed, a leading indicator when it comes to future economic activity. While in our previous conversations, we focused on the importance of the ECB's lending surveys, it is essential, we think, to follow the flight of households deposits in Europe, which is a phenomenon, that is not only affecting peripheral countries, but Emerging Eastern Europe countries as well, such as Hungary, which has been a recurring item in our recent conversations ("Hungarian Dances"):

The ongoing shift in households funds across Europe has not only implications in relation to future economic activity, the shift from short-term to longer terms deposits, as displayed in Nomura's graph will have direct implication on consumptions levels:

"We are also seeing some movement of household funds from short-term to longer-term deposits across the euro-area banking system. This reflects banks' desire to close their funding gaps by relying more on stable, longer-term retail deposits. This shift in the composition of bank funding has implications for the short-term demand outlook. If households are increasingly locking up their assets for a longer time, the money is not accessible to spend on consumption."

It is also important to note the ongoing great competition between banks in peripheral countries, offering higher deposits rates in search for longer-term deposits. There is as well a growing divergence between deposits rates across the European banking sector, indicating a growing disconnect with money markets rate.

For more on the subject:
"Savings Wars From Italy to Portugal Drive Bank Costs Higher" - Charles Penty and Sonia Sirletti - Bloomberg
"The average interest rates on new retail deposits for up to one year have jumped almost 60 percent in Portugal and 72 percent in Italy this year (2011), a sign of how Europe’s debt crisis is driving up the cost of capturing savings."

Throughout our conversations, we have been discussing at length the importance of liquidity and bank funding, in relation to credit cycles. Availability of credit is depending, as well on the level of bank deposits.
In a recent conversation we made the following comment:

"In relation to the current situation let us use this analogy. Imagine you are driving a car called Europe, now it is winter and snow has been piling up on the roads making your driving risky and prone to an accident (liquidity issues). Then comes the LTRO (ECB grit truck) to clear the road ahead of you. Now, you think the road is clear, but, as any car owner knows, what makes your engine running smoothly is the amount of oil lubricating the engine (credit conditions)."

We also added:

"You need to track the ECB lending survey, when it comes to monitoring your oil level. Lack of oil (credit), could seriously damage your engine (growth), and therefore stall your engine (recession) and seriously damage your car (economy). Now let's suppose you drive your car to make a living, and you've borrowed money (sovereign debt) to purchase your car. How are you supposed to make the repayments if your car finally breaks down because your engine has been damaged because of your negligence in maintaining a proper oil level (credit) in your engine (economy)?"

We do agree completely with the following, "Credit growth is positively correlated with GDP growth". According to Nomura:

"Households and firms are highly dependent on the availability of bank lending in the euro area. Firms – in particular small and medium-sized firms – rely almost exclusively on bank lending as a source of external funding. Households use banks for mortgage finance and unsecured borrowing. Hence, bank lending to households and firms is a critical part of the monetary transmission mechanism.

We have empirical evidence that credit growth is positively correlated with GDP growth, especially in the euro area (see Zhu, 2011). The intuition is clear: rapid lending growth boosts economic activity as funds are available to increase consumption and investment. In contrast, times of deleveraging are usually associated with low or negative activity growth as households and firms focus on debt repayment rather than consuming and investing."

Nomura indicated as well in their recent note the following important point relating to credit cycles:

"The non-synchronised credit cycles across the euro area are problematic for the ECB: There are countries which clearly require a loose monetary policy stance to offset the deflationary impacts of deleveraging (Ireland, Portugal and Greece). But looser monetary policy may also postpone the deleveraging process which is necessary in some countries (Spain). And keeping monetary policy loose for too long may fuel excessive credit growth in other countries (Germany) leading to the build up of unsustainable private sector imbalances."

Moving on to our next item, namely the recent debt to equity swap announced by Commerzbank, as we indicated at the beginning of our conversation, it was not really a surprise to us.
Commerzbank announced, in true Banco Espirito Santo style ("Subordinated debt - Love me tender?"), a debt to equity swap. The exchange offer period starts February 23 and is expected to end on March 2nd.

The latest rise in Commerzbank share price, allows Commerzbank to benefit more from exchanging hybrid capital for equity - source Bloomberg:

Following the announcement on Thursday, the shares fell as much as 9.6% to 1.95 euros.

The announced offer to swap hybrid debt covers 3.16 billion euros worth of securities. The German government owns a minority stake of just over 25% and will participate to the operation. The operation if successful could boost its core Tier 1 capital by 1 billion euros.

"The Silence of the Lambs" or more accurately "The Silence of the Subordinated bondholders and equity holders".
The capital increase equates to a maximum of 10% minus one share of Commerzbank current subscribed capital.
Last year, Commerzbank also bought back subordinated bonds trading below face value last year to boost core Tier 1 capital. The income generated from the bond tender buoyed fourth quarter profit by 735 million euros.

Commerzbank Can' t Pay Dividend, Service Silent Participations, by Aaron Kirchfeld and Nicholas Comfort
Feb. 23 (Bloomberg) --
"Commerzbank AG said it won't pay a dividend for 2011 and can't service silent participations held by the country's Soffin bank-rescue fund after posting a loss under German HGB accounting rules.
"It remains our goal to service the silent participations of Soffin in the future and also pay a dividend again," Chief Executive Officer Martin Blessing said at a press conference in Frankfurt today, according to a copy of his speech."

Silent participation is a form of non-voting capital used in Germany that is not accepted by the European Banking Authority as core Tier 1 capital.
As a reminder from our conversation relating to bond tenders on the 25th of October:
"So, in our debt to equity swap, courtesy of the subordinated bond tender, not only the subordinated bond holder is taking a hit, but our shareholder as well. Love me tender?"

In relation to this latest bond tender, our good credit friend and we commented:
"What is happening to Commerzbank could well happen to other financial institutions: swapping debt for equity is neither good for shareholders, neither for bond holders."

On a final note, and in relation to the "Schedule Chicken", Greece in the coming days will remain firmly in the spotlight given the expectations surrounding the results of the PSI and CACs impact (CDS trigger or not a CDS trigger, that is the question...). The immediate write-down of the remaining 53.5% of principal on Greek debt equates to a net present value loss of over 70%. Given Greek banks have the largest exposure to their domestic debt, you can expect a lot more of additional pain for the likes of National Bank of Greece. Taking a 75% coverage on their Greek bond portfolio (12.9 billion euros as of June 2011) implies an additional pre-tax charge of just over 8 billion euros, or around 6.5 billion euros allowing for a tax credit according to CreditSights. National Bank of Greece's core tier one capital was only 6.3 billion euros in September 2011. The 30 billion euros capital shortfall derived from the EBA (European Banking Association) exercise in 2011, was based on 50% private sector value loss. An impairment of 70 to 75% loss would equate to an additional 45 billion euros worth of aggregate recapitalisation for the Greek banking system. Oh dear...

Greek debt ownership - source Bloomberg:

"Schedule Chicken" - source Bloomberg:
Feb. 27: Germany’s Bundestag will vote to approve the Greek
bailout package.
Estonia’s parliament will vote to approve the package no later than this date, according to Taavi Roivas, the head of the legislature’s European Union affairs committee.

Feb. 28: Finland’s parliament will vote on the second Greek rescue program at 2 p.m. local time, according to Seppo Tiitinen, the Helsinki-based legislature’s Secretary General.

March 1: The Dutch parliament will have voted on the Greek bailout package by this date, according to Finance Minister Jan Kees de Jager.
The Greek parliament will also have approved the implementation law.

March 1-2: European Union leaders will hold a summit meeting in Brussels. They will discuss a possible increase in Europe’s so- called firewall, including possible concurrent operation of the temporary European Financial Stability Facility and the permanent European Stability Mechanism.

March 9: Bids for private creditors’ swap transactions are expected to close.

March 11: Private creditors’ swap transactions will take place by this date.

March 12-13: EU finance ministers will meet in Brussels.

March 20: Greece is scheduled to pay off 14.5 billion euros of maturing debt.

April 20-22: The IMF will hold a meeting in Washington.

"When people are taken out of their depths they lose their heads, no matter how charming a bluff they may put up."
F. Scott Fitzgerald

Stay tuned!