Credit - Dumb buffers

"When the weather changes, nobody believes the laws of physics have changed. Similarly, I don't believe that when the stock market goes into terrible gyrations its rules have changed."

- Benoit Mandelbrot 

A buffer is a part of the buffers-and-chain coupling system used on the railway systems of many countries, among them most of those in Europe, for attaching railway vehicles to one another. Buffers in the very earliest days of railways were rigid (dumb buffers). 

You might wonder where we might be going with this week's railway analogy, but, looking at the recent senate hearings following last year JP Morgan's 6 billion dollar losses, discussions surrounding banks and equity capital have resurfaced as of late. Arguably one of the most pertinent read we have come across was from Bloomberg's editors - JPMorgan’s $6 Billion Loss Shouldn’t Be a National Matter:

"To make the whole system more resilient, banks need to get a larger share of their funding in the form of equity from shareholders, as opposed to loans from depositors and other creditors. We have advocated $1 in equity for each $5 in assets, a level that would absorb a 20 percent drop in the value of a bank’s investments, compared with JPMorgan’s 3.1 percent. The latest global banking rules require only $1 in equity for each $33 in assets, and use a lenient approach for measuring the ratio.
Higher equity requirements reduce taxpayer support to banks in a different way, by making them less likely to require bailouts. The added discipline would also put natural pressure on banks to shrink: Once shareholders fully realized how poorly the largest banks perform in the absence of subsidies, they would have more incentive to demand that they be broken up into smaller, more profitable units." - source Bloomberg

Dumb buffers were the source of many staff accidents and damaged loads and vehicles. The Board of Trade required all new construction in England and Wales from 1889 to have spring buffers, but in Scotland the railway companies continued to accept new wagons with dumb buffers until 1 October 1903. From 31 December 1913 all dumb buffered vehicles were banned from the main line, but the Scottish owners gained an extension to 1915. In fact, the disruption of the Great War meant that dumb buffers persisted in Scotland until at least 1920-21. 

One can argue that the latest global banking rules requiring only $1 in equity for each $33 in assets is akin to the famous dumb buffers that plagued Scottish railways for an extended period of time, which might be leading to many "derailments" for banks in particular and for the economy in general as witnessed with the financial crisis of 2008:

The aftermath of the Gare Montparnasse accident

Similar to Bloomberg editors and Simon Johnson, MIT professor and former chief economist at the IMF, we have long advocated larger equity buffers for banks in order to reduce the systemic risk banks pose to the real economy as a whole. Back in October 2011, in relation to discussions surrounding Capital Regulation, contrary to many beliefs, we argued as well that Bank Equity is not expensive. It is a myth. A study realized by Stanford University by Anat R. Admati is a must read. a summary of the presentation made to the Bank of England by the co-author is available here:

"Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Expensive"

A summary of a presentation to the Bank of England is available below which highlights Professor's Admati's key findings.

http://www.bankofengland.co.uk/publications/events/ccbs_workshop2011/presentation_admati.pdf

Some countries such as Denmark have started asking for higher extra capital. For instance, Denmark's systematically important financial institutions will have to hold 2.5% to 5% of extra capital as recommended by Denmark's Sifi committee. Its recommendations will have to be passed into law by the Danish parliament.

While the European Union us trying to press ahead with global banks standards by March 22nd, if the measures are not in place by month end, it would mean additional delays in implementing the January 2014 target for Basel III accord, which could potentially shorten the transition period and put some additional strain on lenders to adjust by the start of 2014 or delay the implementation until January 2015.

In this week conversation, we would like to focus our attention to this very important subject of bank regulation and capital adequacy, given both the European Union and the US have struggled to agree on legislation to apply the international standards on capital, known as Basel III, which were published in 2010 in conjunction with the Dodd-Frank act, following the demise of Lehman Brothers Holdings Inc.

So far, the Basel rules negotiations also have been stalled on how much additional capital should be required for systemically important financial institutions as reported by Rebecca Christie and Caroline Connan in their Bloomberg article from the 26th of February entitled - Barnier Says EU Needs Basel Deal to Lift Uncertainty for Banks:

"Lawmakers are pushing the EU to include in the capital rules a requirement for country-by-country reports on profits, losses and taxes, according to the document. Nations have been reluctant to expand the scope of the capital rules, preferring to tackle the topic in separate accounting legislation.

The Basel Committee on Banking Supervision brings together banking regulators from 27 nations including to the U.S., U.K., and China to coordinate their prudential rule-making.

The Basel III measures, which must be written into national laws, would more than triple the core capital lenders must hold and set standards for how lenders should manage risks. Representatives of Karas and the Irish presidency in Brussels declined to comment on the paper." - source Bloomberg.

On top of that, regulators from the Basel Group have clearly put Bank's debt addiction on scrutiny this year as reported by Ben Moshinsky and Jim Brunsden in Bloomberg on the 12 th of March - Bank's Debt Addiction Said to Face Scrutiny at Basel Meetings:

"Regulators are preparing to fight lenders over the details of the so-called leverage ratio as they seek to toughen rules on the minimum amount of capital they must use to back their investments. The Basel group, which brings together supervisors from 27 nations, will meet in the Swiss city tomorrow, according to the people, who asked not to be identified because the meetings are confidential.

 Concerns over how banks calculate reserves has led U.K. bank regulator Adair Turner and U.S. Federal Deposit Insurance Corp. board member Jeremiah Norton to call for tougher leverage ratios. Global supervisors in 2010 included a draft leverage ratio in an overhaul of rules, known as Basel III, drawn up in response to the financial crisis that followed the collapse of Lehman Brothers Holdings Inc.

“Early on, banks did not see it as such a big danger, or as a priority for lobbying, because it looked less likely to be implemented in the EU than other parts of Basel III,” Philippe Lamberts, the lawmaker leading the work on the Basel III rules for the European Parliament’s Green group, said in a telephone interview.

Leverage ratios force banks to hold capital equivalent to a percentage of the value of their assets. Such measures are simpler than standard capital requirements as they don’t give banks any scope to take into account the riskiness of their investments when calculating the reserves they must hold." - source Bloomberg

Back in September 2011, we quoted Dr Jochen Felsenheimer from asset management company "assénagon" now called "XAIA", we would like to quote him again looking at the current context:

"Banks employ too much debt, because they know that they will ultimately be bailed out. Governments do exactly the same thing. 

Banks have fought bitterly against increasing equity buffers which is the cheapest and easiest way to recapitalize banks. Why? Because allowing high payouts to shareholders, namely bank employees in many cases, allows financial institutions to raise their leverage: "Focus on ROE is also a reason bankers find hybrid securities, such as debt that converts to equity under some conditions, more attractive than equity." - Anat R. Admati.

For instance, since 2009, banks have indeed been very creative in the methodology used to beef up their Core Tier 1 ratio using a new generation of Hybrids securities called CoCo (Contingent Convertible Capital). CoCos, convert to equity or are written off once an issuer’s capital ratios fall below a preset level. This market for these new securities, already amounts to +10 billion dollars. This contingent convertible security pays a higher coupon and automatically convert into equities or suffer a full or partial write-down when the bank's capital ratio falls below a pre-defined trigger. 

The beauty for the issuer is that the CoCo automatically boosts its Core Tier 1 capital ratio in times of stress rather than being forced into a dilutive right issue during difficult market conditions. Owning a CoCo, according to a recent BNP Paribas note is very similar to selling a Down-and-In put option on the issuing

bank’s shares with a knock-in barrier linked to a balance sheet capital ratio as opposed to stock price level.

The issuing bank is effectively buying skew and convexity (crash protection) from the investor, who is exposing himself to losses in stress scenarios. 

It is not a free lunch although a coupon in the region of 7% to 8% is outright appealing in this low rate / low yield environment.

The benefits of such transactions for the issuer of CoCo notes is that not only it enables the issuer to maintain a particular minimum capital level, it also pleases the regulator and allows issuers which have been previously bailed out in Europe, to continue repayment of the aid received. For instance, KBC bank issued in January 1 billion dollar worth of CoCos, allowing them to continue the repayment schedule on time and, following a stress test, the National Bank of Belgium had required an additional 2 billion euros of Core Tier 1 capital to be raised. KBC completed in December 2012 a 1.25 billion euro equity offering and 750 million euros worth of CoCos.

While Europe is falling behind in relation to the implementation of Basel III, Switzerland has started implementing it as of January 2013 as indicated in a recent note by BNP Paribas on KBC's specific CoCo from January 2013:

"It is worth pointing out that due to the implementation of Basel 3 in Switzerland starting January 2013 as planned (as opposed to the delay in Basel 3 implementation in Europe, due to delay in completion of CRD4), the relevant ratio in ascertaining the likelihood of trigger is now the Core Equity Tier 1, rather than Core Tier 1 as it was under Basel 2.5. While this comes as no surprise and should have been fully expected it does make quite a bit of difference. For instance, at its Q3 12 UBS reported Basel 2.5 Core Tier 1 ratio of 18.1%, whereas the pro-forma phased in Basel 3 CET1 ratio was 13.6%." - source BNP Paribas

The fixation bankers have with equity buffers mean that they prefer issuing hybrids securities such as CoCos rather than equity in order to maintain their leverage and generate ROE. As indicated by Dr Jochen Felsenheimer, in case of trouble, the insurer is the taxpayer. CoCos are deemed to be "capital" and automatically improve the capital ratios, pleasing regulators in the process, and avoiding an automatic dilution of existing shareholders via capital increases through right issues. They are not equivalent to "equity", they are debt instruments, paying no doubt, a higher coupon, given the risk taken by the low subordination and risk of capital wipe-out faced by the bondholders.

As a reminder, under the draft Basel III plan in 2010, banks would have to hold so-called Tier 1 capital equivalent to 3 percent of their assets, so capping a lender’s debt at no more than 33 times those reserves, which, we think is way too low.

Last week events surrounding German Bank Commerzbank's capital increase is a reminder of not only the lack of sufficient equity buffer in the banking space but is also indicative of the material impact internal models of RWA (Risks Weighted Assets) can have to boost capital ratios as highlighted again in Bloomberg's article from the 12th of March - Bank's Debt Addiction Said to Face Scrutiny at Basel Meetings:

"The temptation for banks to boost their reserves through changes to risk calculations, rather than real steps to raise capital, could be countered by a strong leverage ratio, said Lamberts, the European lawmaker. One example of this is how German lender Commerzbank AG sought to meet EU capital rules in part by adjusting its risk calculations, rather than simply raising fresh reserves, Lamberts said.

“Details that are coming to light about how banks misuse their internal models, for example when Commerzbank said it would make up half of a capital shortfall through changes to its models, show the need for this kind of rule,” he said.

Commerzbank was one of more than 60 lenders told by the European Banking Authority to hold capital equivalent to 9 percent of its risk-weighted assets." - source Bloomberg

On March 2013, Commerzbank AG, Germany's second largest bank announced it would sell 2.5 billion euros of shares to repay the government and insurer Allianz SE. Commerzbank received a 18.2 billion euros bailout in 2009 and the German government had owned 25% of the bank prior to the announcement.

Of course the 15% dilution announcement led to the share sliding 14% in Frankfurt on the 13th of March - source Bloomberg:

 The share declined 14% valuing the bank at around 7 billion euros.

Commerzbank's shares, the intraday proverbial "sucker punch" - source Bloomberg:

This news made us chuckle given that the CEO Martin Blessing, will be using the capital raised to repay 1.6 billion euros owned to the government and 750 million euros to German insurer Allianz, as well as increasing its Core Tier 1 capital to 8.6% under full Basel III capital from 7.6%. 

Why did we chuckle, you might ask? Well, because Commerzbank's largest shareholder SoFFin (Special Financial Market Stabilization Fund), converted already its silent participation in June 2012 to approximately 58.85 million Commerzbank shares,  increasing in effect the capital of Commerzbank to maintain its equity interest ratio in Commerzbank to 25% plus one share. With the 15% dilution, this participation will be now diluted to 20%, meaning in effect a loss for the German taxpayers.

Oh well...

But this painful adjustment for Commerzbank will not be the last one, given we have already established the link between credit and shipping and in particular the exposure of German's second largest bank to shipping woes back in August 2012:

"Commerzbank – the world’s second-biggest provider of ship finance, and reluctant owner of a flotilla of foreclosed ships – said it is shutting down its €20bn (£15.7bn) ship funding operations entirely to “minimise risk and capital lock-up” under tougher EU banking rules."

In April in 2011, in our conversation "Shipping is a leading credit indicator", we indicated:

"Commerzbank’s 2008 takeover of Dresdner Bank AG increased its stake in shipping lender Deutsche Schiffsbank to 92 percent, doubling the size of its maritime-loan portfolio, just before the industry entered its biggest crisis since World War II." - source Bloomberg.

One can wonder what will be the recovery value for its maritime-loan portfolio looking at the boom and bust which occurred in the shipping space - source Bloomberg:

"The marine shipping industry is highly cyclical and susceptible to periods of boom and bust. Cycles are driven by overbuilding during times of growth to take advantage of strong markets. Shipping companies do not have enough lead time to alter orders when economic activity begins to slow, which has a significant effect on freight rates." - source Bloomberg.

Not only have overbuilding occurred due to cheap credit that fuelled an epic bubble in the Baltic Dry Index, but, the on-going decline on vessel prices, will no doubt exert additional pressure on recovery values for Commerzbank's loan book:

"Prices of seaborne vessels have crashed since peaking in 4Q08 and have been steadily declining since 4Q09, as excess capacity slowed the new build backlog, along with cheaper builds in China and tight credit markets. Chinese shipbuilders have been using price in attempt to win market share. Price pressure has come on less sophisticated dry-bulk ships relative to LNG tankers." - source Bloomberg

On the subject of banks capital shortfalls and the need to deleverage, and RWAs in particular, Nomura's note from the 11th of March 2013 entitled EU banks - Reconciling weak macro with momentum made some interesting points:

"To illustrate the point on headline capital ratios, the last published EBA Basel 3 monitoring exercise showed that at end-2011, European banks required EUR 225bn of equity capital to meet the minimum CET1 requirement of 7.0% of RWAs (inclusive of GSIB buffers where required). The report implied that the risk-weighted capital ratio rather than the unweighted leverage ratio was more of a bind on banks’ capital needs (given that the bar for unweighted leverage at 3.0% is set rather low, in our view). While we do not expect an official update on the 2012 capital position before September 2013, the EBA did separately disclose that as a result of capital raised for the 2012 stress test as well as other capital measures, European banks increased their capital positions by more than EUR 200bn in 1H 2012 (mostly through measures that directly increase capital rather than reduced assets). Based on the 2011 run-rate of net profit, in 2H 2012 around another EUR 40bn could have been added to banks’ capital bases.

Given that some banks will choose to build additional capital buffers, we do not expect the next monitoring exercise to show zero capital shortfall at end-2012 (several of the large often wholesale banks such as Deutsche Bank still had a gap at end-2012). However, we expect the reported capital shortfall to be substantially reduced for end-2012.

We are aware in 2013 that regulators are looking to improve harmonisation of the measurement of RWAs, moving away from internal models. In some cases, the banks have been well prepared (such as in Sweden) while in others it will delay the timeline to full Basel 3 compliance (such as in the UK). In general, we find that it is the wholesale banks with the lowest RWA/total asset ratios that might have the most need for additional capital actions or balance sheet shrinkage to meet regulatory goals. 

However, our main concerns for the banks are less about the measurement of RWAs and more about the fact that in some economies (such as Spain), the historical cost carrying value of banks’ assets is too high compared with their market value considering the fall in real estate prices in those economies. These unrecognised bad assets (along with deteriorating GDP and rising unemployment) require banks to divert profits to loan loss reserves rather than new lending." - source Nomura.

Moving back to our discussion around bank regulation and capital adequacy, we need to ask ourselves what have been accomplished since the demise of Lehman in 2008? Not enough, as indicated by the Bloomberg editors on the 10th of March in their article - Getting the Banks Around the World to Play by the Same Rules:

"Since that 2008 pact, progress has been made on the road to convergence. One example: Starting on March 11, Wall Street’s largest banks, including Goldman Sachs Group Inc. and JPMorgan Chase & Co., must process derivatives trades through clearinghouses, an accomplishment of the 2010 Dodd-Frank financial reform law, itself part of the U.S.’s commitment to convergence. By holding collateral and standing between buyers and sellers, clearinghouses can prevent one participant’s default from infecting all the others. In another step forward, the EU decided in December to create a single bank regulator. 

In Reverse 

But the dream of convergence remains, well, a dream. Conflicting national and regional laws, regulations and accounting standards have blocked the world from getting on the same page on financial reform. This, in turn, has jeopardized the ability of regulators to work across borders to address the next crisis. Shutting down a large failing bank that, say, loses all its capital because of a trading strategy gone haywire isn’t possible without universal rules for resolving sick banks. Moreover, financial companies will be able to take advantage of regulatory arbitrage -- shifting operations to countries with the loosest rules.

What happened? Let’s take a tour.

 In the U.S., regulators have been lobbied to a standstill. They have yet to name a single nonbank financial company or industry as systemically risky, despite the immense size and vital roles played by money-market funds, hedge funds, insurers and nonbank lenders. 

The Commodity Futures Trading Commission is backing away from some of its early positions on derivatives, moves that could have broken the big-bank stranglehold over the swaps business. The agency looks likely to revoke a proposal that would have required large investors to solicit quotes from at least five dealers, as a way to promote pre-trade price transparency. 

Regulatory agencies have also stalled over the Volcker rule, named after former Federal Reserve Chairman Paul A. Volcker. The measure is supposed to limit speculative trading by federally insured banks. For more than a year, five agencies have been debating with large banks and among themselves about where to draw the line between trading and making markets for clients, which the law exempts from the Volcker rule. On Capitol Hill, meanwhile, lawmakers from both parties and both chambers want to repeal parts of Dodd-Frank, including the requirement that banks move derivatives trading to separate affiliates with their own capital. 

Nasty Split

In Europe, the situation is no more auspicious. A nasty split has opened between the Continent and the U.K. The European Parliament and national governments have moved in recent weeks to tax financial transactions and cap bankers’ bonuses. This has (rightly) rubbed the British the wrong way, as their model of finance -- the Anglo-Saxon model -- is less regulated, more centered on trading and pays bigger bonuses than its counterparts in, say, France or Germany. 

Another rift is between Europe and the U.S. -- this one over capital requirements. New rules being written in Basel, Switzerland, have been watered down after much bickering. The level is now set at 7 percent of risk-weighted assets, up from 2 percent. Still, it falls short of the 10 percent initially sought by the U.S., and way short of the 20 percent of total assets that some economists and academics recommend. France and Germany led the opposition, seeking to protect the interests of their biggest lenders, which would have needed to raise more capital than foreign competitors, Bloomberg News has reported. Not only is the global financial system no safer now than it was in 2008, it’s also clear that the project of convergence is badly stalled. Is the world really prepared to let the great convergence turn into the great divergence?" - source Bloomberg.

On a final note the principal reason for banks to hold a larger equity buffer is to be able to face risks such  as real estate bubbles. For instance both Credit Suisse and UBS have been asked to hold more capital to that effect as reported by Bloomberg:

"The 1.2 swiss-franc-to-euro cap and low interest rates have prevented the Swiss National Bank from tightening monetary policy to avert soaring real estate prices. To mitigate the risk of a property bubble, the authorities plan to curb lending growth by requiring banks to hold an extra 1% of capital on residential mortgages, starting 4Q13. UBS and Credit Suisse had 252 billion francs of mortgages outstanding at end-November." - source Bloomberg.

"What we define as a bubble is any kind of debt-fueled asset inflation where the cash flow generated by the asset itself - a rental property, office building, condo - does not cover the debt incurred to buy the asset. So you depend on a greater fool, if you will, to come in and buy at a higher price." - James Chanos 

Stay tuned!

Credit - Cool Hand

"Sometimes nothing can be a real cool hand" - Paul Newman in 1967 Cool Hand Luke.

Looking at how credit risk has receded in 2012 and continue to recede, albeit at smaller pace in 2013, we thought we could refer to one of our movie favourite of all times, 1967 drama Cool Hand Luke in our title analogy, given Luke's character deservedly earned his nickname by winning a poker game on a bluff with a worthless hand. This is exactly what our "Generous Gambler" aka Mario Draghi has done.

So, one can wonder if our "Generous Gambler" should in fact be given a new nickname such as "Cool Hand Mario" when one looks at the Spanish CDS level which has receded below mid-2011 levels with auction costs declining in the process as indicated by Bloomberg:

"Spain's CDS spread fell below mid-2011 levels, when sovereign concerns increased aggressively and funding costs spiked. Beyond easing bank funding conditions, given high wholesale and deposit funding costs pressure margins, lower CDS also benefits the cost of sovereign auctions, as evidenced by January's 1.95 billion euro placing at below 4%, vs. 6.5% in mid-2012." - Source Bloomberg

Not only does our "Generous Gambler" deserve some praise in relation to the on-going Spanish situation but he also prevented a serious financial crisis liquidity induced meltdown courtesy of his two LTROs, given European cost of dollar funding is now at the lowest level in 18 months as displayed in the below Bloomberg graph:

"As CDS spreads on banks and sovereigns continue to narrow, the cost of accessing dollar funding for European financial institutions (euro-basis swap) has fallen to its lowest level in more than 18 months. Simultaneously, U.S. money-market funding to non-U.S. financials has risen 12% since the start of 2013, providing further confirmation of easing bank liquidity conditions." - source Bloomberg

As we posited in regular posts in 2012 these liquidity induced measures that were the LTROs amounted to "Money for Nothing" given the real economy did not benefit from the ECB's "Cool Hand". Weak monetary expansion and weak credit growth have meant weaker economic growth prospect for Europe as displayed in the Below Bloomberg table of Euro Area Monetary Aggregates:

"A shrinking ECB balance sheet, lower yields and CDS spreads coupled with capital inflows and lower redemptions were all cited by Mario Draghi as evidence of the gradual repair of euro zone fragmentation in a Jan. 10 address. These positive developments have as yet failed to reach the real economy, as reflected in weak monetary expansion and credit growth."  - source Bloomberg

In this week conversation we will focus on the possible outcome relating to the market's anticipation of the much awaited early repayment of the LTROs first tranches which are due at the end of the month for 523 banks, given analysts are divided between how much money will be repaid from the 1 trillion euros provided with estimates ranging from 10% to 20%. But first, a quick market overview.

The indicator we have been monitoring in relation to "Risk-On" and "Risk-Off" phases, has been the 120 days correlation between the German Bund and its American equivalent, namely the US 10 year Treasury notes - source Bloomberg:

Back in our conversation "River of No Returns" in June 2012, we indicated that in "Risk Off" periods we had noticed that the 120 days correlation has been close to 1 in 2010, 2011 and 2012, whereas in "Risk On" periods, the correlation is falling to significantly lower level. The correlation between both the German Bund and US 10 year note is falling towards 70%, indicative of a continuous "Risk-On" phase for now.

Nota Bene: ("Risk On" refers to a period of time in which investors are putting money into risky assets such as stocks, commodities, etc. "Risk Off" meaning the exact opposite with investors putting money into safe haven assets such as cash and treasuries or German Bund).

The "Fabian Strategy" at play - European bond picture, the fall was dramatic for peripheral bonds in the second half of 2012 thanks to Mario Draghi's intervention with Spanish 10 year yields falling towards 5.00%, whereas Italian 10 year yields are now well below 5% around 4.16% and German government yields rising towards 1.60% levels with other core European bonds yields rising as well in the process - source Bloomberg:

While all seem fine and dandy, for Spain and other peripherals, Spanish Minister Mariano Rajoy did manage by stealth to add to off-balance sheet debt in the closing hours of 2012 by adding more than 3 billion euros to the Spanish debt load according to Ben Sille and Esteban Duarte, as reported in their Bloomberg article - Rajoy Stealth Order Adds to Off-Balance Sheet Debt on the 8th of January:
"Spanish Prime Minister Mariano Rajoy added more than 3 billion euros ($3.9 billion) to his debt load in the closing hours of 2012 with a New Year’s Eve order removing a cap on utilities’ government-guaranteed losses. The decision, announced in the official gazette, added to the snowballing power-tariff debt, which isn’t included in the public accounts. The shortfall exceeded 20 billion euros at year end, according to government filings. Spain’s government-controlled electricity system has raised less revenue from consumers than it pays to power companies for most of the past decade. Officials have covered the difference selling bonds through the so-called FADE program, which is not reflected in public accounts." - source Bloomberg.

We would like to use again a reference to Bastiat in relation to Spain and this "off-balance" sheet issue (a quote we used in our conversation "The Unbearable Lightness of Credit"): "That Which is Seen, and That Which is Not Seen" as indicated in the same Bloomberg article:
"Behind the political spat over whether the electricity- system losses wind up on the government’s balance sheet lies the structural challenge of reining in the cost of powering the Spanish economy. The ECB’s intervention has enabled Spanish officials to push the liabilities down the road. Public debt jumped 17 percentage points to 85 percent of gross domestic product last year. Power Debt Without action, the power debt would reach about 50 billion euros by 2015, Soria said last year. The 2012 deficit equates to about 70 percent of the profits of Spain’s four biggest power companies. The burden poses a problem of the same order as the toxic real estate assets that forced Rajoy to request 39 billion euros of bank aid from Europe last year, according to Cesar Molinas, former head of European fixed income at Merrill Lynch now a partner at CRB Inverbio private-equity fund. “It’s on the scale of the bank rescue,” Molinas said in a telephone interview. “That’s what we are heading for.”" - source Bloomberg

Yes, no doubt that our "Cool Hand Mario" won 2012's poker game with the bond vigilantes on a bluff. But, as we posited above, in true Bastiat, fashion, problems in Europe in general and Spain in particular have not been resolved, they have just been postponed.

We do agree with Ben Sills and Angeline Benoit in their Bloomberg article published on the 14th of January entitled "Draghi's Bond Rally Masks Debt Loop Trapping Spain's Rajoy", as we believe Spain is in a deflationary trap:
"The bond rally that has sent Spanish borrowing costs to 10-month lows has distracted attention from the nation’s growing debt pile. Spain’s budget deficit probably exceeded 9 percent for a fourth year in 2012 as Europe’s highest unemployment rate, a third recession in four years and the cost of bailing out its banks offset almost all of the government’s 62 billion euros ($83 billion) of spending cuts and tax increases, according to economists at Societe Generale SA, Lombard Street Research and the Madrid-based Applied Economic Research Foundation. Total debt will reach 97 percent of gross domestic product this year, the International Monetary Fund forecasts. “This is a classic example of the doom loop,” Societe Generale’s London-based chief European economist, James Nixon, said in a Jan. 10 telephone interview. “They just aren’t making any progress.” The last time Spanish debt was trading at this level, with 10-year yields around 5 percent, was early March 2012 after European Central Bank President Mario Draghi flooded the banking system with more than a trillion euros. Spanish Prime Minister Mariano Rajoy shattered that calm when he surprised EU leaders March 2 by rejecting the country’s deficit target just hours after signing a treaty on budget discipline." - source Bloomberg.

From the same Bloomberg article:
“The market is ignoring unresolved macro issues,” Alberto Gallo, head of European macro credit research at Royal Bank of Scotland Group Plc in London, said in an interview last week.“Spain is not sustainable.”

On top of that you have Italy looking for at least 9 billion euros in additional budget measures in 2013 to meet its deficit targets as a worsening recession is no doubt hurting tax revenues and hindered by surging unemployment costs.

Credit wise, the Markit Itraxx Europe index of 125 companies with investment-grade ratings is now only 15 bps above the CDX IG, its US equivalent, representing the smallest gap in 19 months between both indices -  source Bloomberg:

At the same time European High Yield yields less than US High Yield, the first time since 2010 at 1.24% less on average than US speculative-grade securities according to Bloomberg, after being 3.90% more at the end  of 2011.

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

Volatility in Europe as clearly reached lower levels courtesy of the "illusory" disappearance of systemic risk provided by Central Banks intervention.

So, as we indicated in our recent conversation "Fabian Strategy", short term, we do expect a minor reduction in the divergence between the PMI in Europe and the US PMI as reflected in credit prices such as the US leveraged loan cash price index versus its European peer which have shown a recent uptick in prices - source Bloomberg:

In next week's PMI releases in Europe, we therefore we think we could see a slight improvement in the data in Europe.

Moving on the on-going debate surrounding the implications of an early repayment of the first tranche of the LTRO at the end of January, the speculation has had its effect last Thursday, and delivered yet another proverbial intraday "sucker punch" as indicated in the rise in core European bonds such as the German five year bond yield - source Bloomberg:

The uncertainty surrounding the amount of repayments link to the first tranche of the LTRO is dividing a lot of analysts.

Gareth Gore from the IFR review in his article "Early LTRO repayments far from certain" on the 18th of January made the following important points on that subject:

"Analysts are divided over how much of the €1trn will be paid back, with estimates ranging from 10% to 20%. Banks in northern Europe, which generally have better access to capital markets and cheaper funding, are expected to pay back more than those in the south.

But with more than a third of the LTRO having gone to Spain and a quarter to Italy, the reluctance of peripheral banks to repay will weigh heavily. Morgan Stanley, which expects €116bn to be repaid in its base case, has said it expects repayments will be a “spectator sport” for many banks in the periphery.

So far, only Commerzbank and Banco Sabadell have confirmed they will repay early, with the Spanish bank signalling it will return 10% to 20% of what it took. Although that might deliver a quick public relations boost, bankers warn alternative funding is just too costly to justify switching. Sabadell sold a five-year €1bn covered bond earlier this month paying a coupon of 3.375%.

Extra debt?

Debt bankers say there is little evidence of banks issuing extra debt in recent months to repay the LTRO money, with almost all banks sticking to funding plans announced months ago. That indicates banks would have to either sell assets or draw down some of their deposits at central banks.

Banks currently have €223bn stored away in the ECB’s deposit facility, down from almost €800bn last summer. Such deposits earn nothing, meaning banks in effect lose money, but some argue that might be a price worth paying for a while longer.

“Banks have to be very careful,” said one senior capital markets banker. “Things can change very quickly in funding markets as we have seen over the last few years, and treasurers will be reluctant to draw down their liquidity buffers held at central banks because it gives them that extra bit of insurance.”

According to some banks that tapped ECB facilities, the LTRO also provides another form of protection, allowing banks to partially hedge against a possible break-up of the eurozone. Indeed, some larger banks tapped the LTRO via their subsidiaries in peripheral countries as a way to swap assets there into euros ahead of any possible redenomination into local currencies and subsequent devaluation." - source IFR.

As we argued back in our conversation "Zemblanity" in September last year in relation to the LTROs:
"The main concern of European authorities has been trying to break the close relationship between sovereign risk from financial risk. Many European politicians are expecting that the European Banking Union will finally break this relationship. But in fact, the ECB's two LTRO operations so far have not only increased the link but made it in effect more acute."

Gareth Gore from the IFR review in his article "Early LTRO repayments far from certain" confirmed that not only the link has not been severed but it has been increased. According to ECB data, Spanish banks increased their holdings of government debt from about €180bn before the LTRO to more than €260bn shortly afterwards.

We previously studied the demise of Monte Paschi di Siena, Italy's oldest bank which was brought up by its strategy of piling up in domestic sovereign bonds in our conversation "The Uneasiness in Easiness". As a reminder:
"But what in effect our "Generous Gambler" did previously with the two LTRO operations has been reinforcing in effect the link between weaker peripheral financial institutions with their sovereign country, causing some to pile up on their domestic sovereign bonds and in effect precipitating their demise for some. Italian oldest bank Monte dei Paschi di Siena SpA, was encouraged to "gamble" by committing too much money to Italian bond holdings, (in similar fashion Greek banks were over exposed to Greek Sovereign debt and we know how well it ended...) as indicated by Bloomberg:

"The CHART OF THE DAY shows Italian government bond holdings of the nation’s biggest banks by percentage of tangible capital and average maturity. Monte Paschi, founded in 1472 and rescued
twice in the last three years, made a treasury bet that was four times bigger than one by UniCredit SpA, the nation’s largest lender, and lasts three times longer than Banco Popolare SC’s.
The bank’s exposure to a single asset class cost it a capital shortfall of 3.3 billion euros ($4.2 billion), according to the second round of stress tests completed last year by the European Banking Authority. The world’s oldest bank is borrowing an additional 1.5 billion euros by selling bonds to the state after it asked for 1.9 billion euros in 2009." - source Bloomberg.

So thank you ECB, the LTRO gamble, courtesy of our "Generous Gambler", was indeed an offer too good to refuse but too toxic to defuse, for some:
"Italian banks doubled their treasury holdings in the last three years even as Europe’s debt crisis eroded their country’s credit quality. That strained regulatory capital that was already stretched by a round of banking mergers. Monte Paschi Chairman Alessandro Profumo, hired this year to clean up the bank, said it was government debt and not a 9 billion euro purchase of Banca Antonveneta SpA that damaged his company." - source Bloomberg.

The LTROs have had so far a debilitating effect on the strength of weaker peripheral financial institutions we think contrary to many beliefs."

The LTROs were never a long term solution but an integral part of the "Fabian Strategy" against the "bond vigilantes".

When it comes to banking woes and specific Spanish banking woes, as we posited on numerous occasions, in this deflationary environment, the game of survival of the fittest has led to a war for deposits in many European countries and in Spain in particular finally leading to the Bank of Spain stepping in to rein in the hostilities and revisiting the introduction of caps to time deposit rates as indicated by Bloomberg:

"The Bank of Spain may be revisiting the introduction of caps to time deposit rates in Spain, in an effort to stem the continued deposit war and increase in deposit costs, news reports suggest. This recalls 2011, when speculation that a similar rule would be implemented failed to materialize. Should a limit be successfully enforced and deposit costs fall, net interest income gains could be significant." - source Bloomberg

By trying to put an end to the deposit wars, the Bank of Spain ambitions to reduce the pressure on banks' earnings and profitability which would reduce the capital shortfall for some Spanish banks and the level of capital injunctions needed. It is once again a "Fabian strategy", buying time that is.

In our May 2012 conversation "From Hektemoroi to Seisachtheia laws?", we put forward Nomura's take on  the cheap funding provided by the LTROs from their note Eurozone and Basel III - Fears for Tiers, from the 4th of May:

"Subordination is a recurring aspect of the eurozone debt crisis. This has taken the form of private sector investors in government debt being junior to not just the IMF into a debt restructuring, but also to the ECB and its SMP. It also takes the form of unsecured bank creditors being effectively subordinated by the growing reliance of banks on secured funding, as assets are pledged as collateral and balance sheets grow increasingly encumbered. The ECB's 3yr LTRO collateralised loan facility has accelerated balance sheet encumbrance and exacerbated a shortage of collateral in Europe. Unsurprisingly, eurozone monetary data confirm that banks are still struggling to raise term-funding.

The challenge that many banks face in raising term-funding is particularly problematic as over the coming years the eurozone banking sector will need to implement the Basel III liquidity framework. This forces institutions to increase the maturity of their funding profile. (The EBA estimate the Basel III funding shortfall at EUR1.9trn, which is around 75% of the size of the European senior debt market, and we use simplifying assumptions to calculate the demand for term-funding from the eurozone banks at around EUR4.9trn.) Early adopters of Basel III (most notably banks in Australia and New Zealand) have shown that this process leads to sharply rising bank funding costs, wider lending rate spreads to the policy rate, and as a consequence a lower "neutral" central bank policy rate. This latter point in turn has notable consequences for the conduct of monetary policy and the behaviour of yield curves, which tend to flatten and shed curvature at lower yield levels.

We already expected Basel III to spur these changes over the coming years, but the impact will be magnified if the unsecured financing markets do not recover. This will increase the extent to which Europe experiences a war for deposits among banks, the extent to which lending rates rise and the extent to which balance sheets shrink."

A war for deposits has indeed happen in Spain regardless of the cheap funding provided by the two LTROs!

European banks have still less equity relative to assets than their US peers and will continue to have to shrink or boost capital as regulators demand reduced leverage as reported by John Glover in his article from the 17th of January "European Banks to Shrink as U.S. Peers Set Pace":
"During the past six months, the average cost of insuring against default by the largest U.S. lenders for five years was71 basis points less than for European banks, according to prices in the credit-default swap market.
Banks in the Americas raised $536 billion of new capital in the 12 months starting in the fourth quarter of 2008, almost 40 percent more than their European peers, data compiled by Bloomberg show." - source Bloomberg

Finally, as far as the reimbursement of the 1st tranche of the LTRO is concerned at the end of January, what really matters is the fact that banks have been able to boost liquidity measures with illiquid assets as indicated by Bloomberg's Chart of the Day:

"Regulators are allowing banks to boost liquidity with assets that proved tough to sell when markets froze in the 2008 credit crunch. The CHART OF THE DAY shows how relative yields on the lowest-rated investment-grade corporate bonds, now accepted by regulators as liquid assets, blew out to as much as 7.3 percentage points during the crisis when investors shunned the notes, according to Bank of America Merrill Lynch index data. Higher-rated AA securities, previously the minimum accepted, held tighter than 1 percentage point over benchmarks. The Basel Committee on Banking Supervision eased rules on the amount and range of easy-to-sell assets lenders must have available to cover a 30-day run on deposits or other short-term disruptions to funding. Corporate debt, which previously had to be graded in the top four ratings categories to be considered liquid, now can be graded as low as BBB-, one step above junk. “I just don’t think corporate bonds are liquid enough to be included, especially if you need to sell in any size,” said Chris Bowie, head of credit portfolio management at Ignis Asset Management in London, which oversees about $110 billion of assets. “Banks will struggle to sell in a crisis, or if wholesale markets close like they did in 2008.” The Basel Committee delayed full implementation of the rules until 2019, rather than 2015 as originally proposed. Lenders will be permitted to use lower-rated securities to cover as much as 15 percent of their liquidity requirements and the value of the corporate bonds used will be discounted by 50 percent." - source Bloomberg.

By allowing lenders to use lower-rated securities to cover the liquidity requirements, with still very thin equity buffers in the European banking space, the regulators are no doubt taking a serious "Cool Hand", we think.

"The hardest tumble a man can make is to fall over his own bluff." -  Ambrose Bierce, American journalist.

Stay tuned!