Credit - Hooke's law.

"A complacent satisfaction with present knowledge is the chief bar to the pursuit of knowledge." - B. H. Liddell Hart

"In mechanics and physics, Hooke's law of elasticity is an approximation that states that the extension of a spring is in direct proportion with the Load applied to it. Many materials obey this law as long as the load does not exceed the material's elastic limit. Materials for which Hooke's law is a useful approximation are known as linear-elastic or "Hookean" materials. Hooke's law in simple terms says that strain is directly proportional to stress." - source Wikipedia.

As a follow up to our recent conversation "Yield Famine", we decided this time around to venture towards a law of physics analogy, namely Hooke's law given the level of stress that can be ascertained from the level of core European yields making new record lows (Germany, France, Austria, Netherlands), which we think is indeed, directly proportional to the aforementioned stress. But it not only in Europe, we are seeing an extension of the "negative yield club", the United Kingdom as well is poised for joining the club:

"The CHART OF THE DAY shows the yield on the two-year gilt falling. It reached a record low 0.115 percent today. Similarly-dated Swiss rates dropped to minus 0.44 percent on July 16, with Germany’s and Denmark’s yields sliding to as low as minus 0.074 percent and minus 0.331 percent, respectively, two days ago. Shorter-maturity rates have turned negative for nations perceived as havens from the almost three-year-old debt crisis, which has sent Italian and Spanish yields to euro-era highs and countries including Greece, Ireland and Portugal seeking bailouts. A negative yield means investors who hold the notes to maturity will receive less than they paid to buy them." - source Bloomberg.

While we recently touched on the attractiveness of going long credit and going long equity volatility ("European Credit versus volatility looks increasingly appealing"), we also discussed in our last conversation the complacency and dwindling liquidity pushing investors out of their comfort zone in similar fashion the "yield famine" of 2006 and 2007 engineered the rise and fall of the structured credit market and other esoteric yield "enhancements" products. In our credit conversation, we would like to discuss the "unintended consequences" of this low yield environment will have to corporate balance sheets, which to some extent, tend to explain, why defaults tend to spike in a low rate deflationary environment such as today. But first, as always our credit overview.

The Itraxx CDS indices picture, with indices widening on the back of a worsening Spanish situation while falling core government bond spreads are making new record lows - source Bloomberg:

The Itraxx Crossover (High Yield CDS risk indicator - 50 European high yield credit entities) widened towards the 665 bps level, wider by 20bps on the day. Both the Itraxx Financial Senior 5 year index (25 banks and insurers) as well as the Itraxx Financial Subordinated 5 year index rose significantly in the process, respectively by 13 bps and 16 bps.

The current European bond picture with Spanish yields back above the 7% level while German government yields closing back to lower record level around 1.16% (1.20% on the 18th) with other European core bonds (France, Netherlands) making again new lows in this "yield famine" environment - source Bloomberg:

"Hooke's law": Core yields strain/levels are directly proportional to peripheral stress/levels.

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

Spanish Sovereign 5 year CDS now wider by 80 bps, making a new record high, above Italian Sovereign 5 year CDS in conjunction with Government Bond Yields. Back in March, in our conversation "Spanish Denial", we highlighted the differences between Italy and Spain. In our conversation "Modicum of relief"  in March we stated:

"We think Spain Sovereign CDS will drift wider, indicating increasing default risk perception given:
-Italy's shrinking budget deficit to -3.9% in 2011 from -4.6% in 2010,
-Spanish unemployment level expected to reach 24.3% in 2012,
-Spanish Prime Minister Mariano Rajoy has decided to side step the 4.4% deficit target for 2012, for 5.8%."

The core of our macro thought process is based upon the difference between "stocks" and "flows", as we indicated in our conversation "The Spread Also Rises", Cheuvreux Cross Asset Research from the 19th of March validated our macro approach we think:

"The sovereign debt constraint in Italy is that of a stock - a high accumulated indebtedness - rather than a flow due to operational deficits. Accordingly, the arithmetic of sovereign sustainability in Italy is much more sensitive to the ratio of the cost of debt to trend nominal GDP growth than in Spain."

"Spain's ten-year yield closed above 7% for only the fourth time in the euro era, as auction costs for two- and five-year issues spiked and bid-to-cover levels fell significantly, further pressuring the ECB for action. The associated impact on its banks and their funding costs drove the Bloomberg Industries Spanish Banks Index (BIERBESC) to fresh lows." - source Bloomberg.

Spain on Friday said its recession would extend into next year in conjunction with the region of Valencia asking for a rescue from the central government. Spain's GDP will fall 0.5% in 2013 rather than rising by 0.2% in 2013 as the government had predicted on the 27th of April. Regions face about 15 billion euros of debt redemptions in the second half, with Catalonia and Valencia making the bulk. Spain is truly in a deflationary trap with unemployment reaching 24.6% in 2012 instead of 24.3%. The forecast for 2013 is unemployment to be 24.3% instead of 24.2%.  Clearly a case of "A Deficit Target Too Far".

So the pressure is mounting on the ECB to intervene yet again in the markets as Spanish yields rise.

"In May 2010 the ECB securities market program began, peaking at 219.5 billion euros in March 2012 and recently holding at 211 billion for several months. Two three-year liquidity injections and a June euro area summit release have failed to stabilize yields, which in turn continue to buffet bank stocks and liquidity supply, suggesting new actions are required." - source Bloomberg.

No wonder our "Flight to quality" picture is displaying "Risk-Off" with Germany's 10 year Government bond yields falling again towards record low levels at 1.16% and the 5 year CDS spread for Germany well below 100 bps in the process back to March 2012 levels - graph below, source Bloomberg:

We do agree with our good credit friend namely that considering the lack of liquidity in the credit space and the very high correlation between asset classes, the coming weeks could see a significant spike in volatility in the European space, so "Mind the Gap" because "The Gap is back"- Both the Eurostoxx and German 10 year Government yields seems to be moving out of synch, with falling German Bund yields and a higher Eurostoxx 50 index. - Top Graph Eurostoxx 50 (SX5E), Itraxx Financial Senior 5 year CDS index, German Bund (10 year Government bond, GDBR10), bottom graph Eurostoxx 6 month Implied volatility. - source Bloomberg:

It is still the "D" world (Deflation - Deleveraging) - 2 year with two years core government going negative making, in true Hooke's law fashion, our "credit" springs are looking increasingly compressed.

As our good credit friend discussed on Friday, in terms of the news flow, nothing has materially changed:

"1-The EU finance ministers adopted the EU master Plan to bail out the Spanish banking system.  The decision paves the way for the EFSF to raise 30 billion euros. Spain’s bailout will start through the EFSF, which has 240 billion euros in remaining capacity. The permanent 500 billion-euro European Stability Mechanism (ESM) is on hold until a German court ruling due in September. But at the same time, the Province of Valencia is calling the Spanish central government for a bailout. Valencia next bond to be repaid is CHF denominated, matures on august 24th and was issued in march 2009 when the Euro/CHF was trading at 1.5350 (it trades now at 1.2000, which means that the municipality is facing an increase of 20% on the payment due, unless it was currency hedged, which we doubt).

Growth is slowing more in Spain, so we think we are heading for a full bail out of the Province of Valencia (Euro 6 billion, including a superb Euro 1 billion brand new stadium built with the help of the Province "credit card"), which will add pressure on the Spanish debt... Do not expect Germany or the ECB to rescue the world, because as we posited before we do not think they will. ("The Game of The Century").

2-EU is still discussing Cyprus bailout conditions. It seems we are talking of Euro 15 billion package, a lot considering the relative size of Cyprus.

3-Greek State Asset Sales Fund CEO (Mr Costa Mitropoulos) submitted his resignation to the government and is gone. Once again, it looks as if the Greek government promises to comply with the bailout conditions will not be met. I tend to think that our German, Finish and Austrian friends will pull the plug very soon.

4-The US economy is slowing down more as the country is following the path of the rest of the world. Remember, we live in an integrated Global Economy, and nobody is immune. Some US counties and municipalities are already defaulting, others will follow.

Quote: If you want to default, be one of the first to do it as there will not be enough money for everybody."

In relation to point number 3 above, EU Banks Greek Sovereign Exposure is down by 15.5 billion USD:

"Latest BIS data confirm that after further writedowns and asset sales, the total exposure of European banks to Greek sovereign bonds and public sector debt fell more than 70% quarter-on-quarter to end-March, and now stands at $6.4 billion. Should Greece exit the euro, resolution of private sector debt and guarantees remain the largest outstanding issue. (Corrects currency.)" - source Bloomberg.

We do agree with the following quote from James Hertling Bloomberg article - European Bailout Bid Gets Vote of No-Confidence as Markets Drop from the 20th of July:

“We’re looking at a situation when people are realizing we’re at a point of debt restructuring and repudiation,” Marc Ostwald, a fixed-income strategist at Monument Securities Ltd. in London, said in an interview today. “It’s cold-hearted reality. The great blag and bluff of the euro zone has always managed to kick the can down the road, but it is no longer a viable strategy. We’re getting to a crunch point.”

On the 18th of July, Deutsche Bank published in their Bank Research one slide resuming the political stalemate, the opposing positions between stakeholders suggesting the crisis will be a long drawn out affair:

As far as game theory is concerned, we have argued in our conversation "The European iterated prisoners' dilemma": "The only possible Nash equilibrium is to always defect"  - It looks to us increasingly probable that the outcome could be different to what is expected from Germany. The outcome for the European project is going to be rather binary. It is either "Federalism" or break-up."

We stick to our view.

The options market is validating our views as far as game theory is concerned as reported by Bloomberg. "Game-theory analysis shows the options market is underestimating the risk the euro will slide as European policy makers fail to take actions necessary to end their financial crisis, according to Bank of America Corp. “The options market is underpricing the risk of the voluntary exit of one or more countries and a weaker euro,” David Woo, head of global rates and currencies research at Bank of America Merrill Lynch in New York, said in a telephone interview. “Investors are holding out hope, and are complacent in believing, that policy makers will come in and save the day. That is simply wrong because what is good politics in Europe may not be good policies.”

"The top panel of the CHART OF THE DAY shows implied volatility on one-year options for the euro versus the U.S. dollar has plunged since last year, when yields on Spanish and Italian debt had surged, sparking speculation the debt crisis was spreading. The middle panel is a gauge of option demand for hedges against extreme moves in the common currency over the next year. The final graph shows demand for puts, which grant the right to sell the euro, relative to calls is the weakest since April. A call allows for purchases of the euro. Game-theory and cost-benefit analysis show Germany is unlikely to agree to issue euro-region bonds, viewed by strategists as important to stemming the crisis, and Italy and Ireland have the most incentive to voluntarily exit the currency bloc, Bank of America said. The so-called Nash equilibrium in a game in which Greece has the choice of adopting austerity or not, and Germany can choose between issuing Eurobonds or not, is no austerity and no euro bonds, the bank’s analysis shows. Game theory is a study of strategic decision-making. A Nash equilibrium, named after John Nash, a Nobel laureate in economic sciences, is a scenario in which no player in a strategic game has an incentive to unilaterally change an action. Bank of America forecasts the euro, at $1.2199 yesterday in New York, will trade at $1.2 at the end of September." - source Bloomberg.

Moving on to the "unintended consequences" of this low yield environment will have to corporate balance sheets, to some extent, it tends to explain, why defaults tend to spike in a low rate deflationary environment such as today. The fall in interest rates increases bond prices companies have on their balance sheets, exactly like inflation (superior to what an increase of 2% to 3% of productivity and progress) destroys the veracity of a balance sheet for non-financial assets. The conjunction of low interest rates with higher taxations will undoubtedly damage companies, particularly in Europe, and in a country like France, for instance, where public expenditure as a % of GDP is much higher (56%) than in Germany (45%). In fact, in our conversation "A Deficit Target Too Far" from the 18th of April, we argued: "We also believe France should be seen as the new barometer of Euro Risk with the upcoming first round of the presidential elections. Whoever is elected, Sarkozy or Hollande, both ambition to bring back the budget deficit to 3% in 2013 similar to their Spanish neighbor. We think it is as well "A Deficit Target Too Far" on the basis of our previous French conversation (France's "Grand Illusion").

In our conversation "The European crisis: The Greatest Show on Earth", we indicated:

"When it comes to credit conditions in Europe, not only do we closely monitor the ECB lending surveys, we also monitor on a monthly basis the “Association Française des Trésoriers d’Entreprise” (French Corporate Treasurers Association) surveys."
One particular important indicator we follow is the rise in Terms of Payment as reported by French corporate treasurers. The latest report is sending us again a clear warning signal indicative of a growing deterioration:

The monthly question asked to French Corporate Treasurers is as follows:
Do the delays in receiving payments from your clients tend to fall, remain stable or rise?
Delays in Terms of Payment as indicated in their May survey published in June have been reported rising by corporate treasurers. Overall +36% of corporate treasurers reported an increase compared to June (+27.8). The record in 2008 was 40%...
According to their latest survey realised early July 2012, the opinion of French treasurers for large corporates cratered in the last two months from -0.7% in May to -19% in July, the most significant drop in two months since this survey exist (first one was December 2005).

According to an article from John Glover from Bloomberg from the 20th of July - Europe’s $180 Billion of Maturities Lifts Swaps: Credit Markets:

"Speculative-grade corporate debt in Europe is the most expensive to insure against losses in 1 1/2 years relative to sovereign bonds as companies need to refinance as much as $180 billion of debt by 2014. An index of credit-default swaps on junk-rated European companies exceeds one for government bonds by 2.44 times, up from 1.65 in March, according to data compiled by Bloomberg. Finnish mobile-phone manufacturer Nokia Oyj led the increase among European non-financial companies, with a 136 percent jump in the last three months, followed by Rome-based toll-highway
operator Atlantia SpA, whose swaps climbed 72 percent.
Borrowers in Europe, the Middle East and Africa face $84 billion of junk-rated debt maturing next year and $96 billion in 2014, compared with 2011’s record bond sales of $70 billion, Moody’s Investors Service said. Their ability to service debt is being hurt by the worsening economic outlook, with the International Monetary Fund forecasting July 16 that output will shrink 0.3 percent in the euro area this year."

"Yield Famine" and Hooke's law, from the same Bloomberg article: 

"The divergence between high-yield corporate and government default risk is being exacerbated by investors snapping up bonds of the safest sovereigns, in some cases agreeing to pay to lend to the nations. Germany’s two-year note yield fell to minus 0.074 percent on July 18 while Austrian, Swiss and Finnish rates also turned negative this week for the first time." - source Bloomberg.

The deterioration in speculative-grade European company credit is being worsened by the outlook for economic growth, hence the risk of seeing a spike of defaults, in this low yield, deflationary environment. Lack of growth means lack of unemployment prospects and reduced tax revenues with increasing pressure in cash flows as indicated by the pressure in the terms of payments from the AFTE monthly survey. It is still a game of survival of the fittest. It’s also causing some companies to pay more to raise money or to be taken over when they cannot pay their debt as indicated in the Bloomberg article quoted above:
"Findus Group Ltd., the frozen-food company owned by private-equity firm Lion Capital LLP, will be taken over by its junior lenders in a debt restructuring after it breached debt covenants that creditors had waived in March, four people with knowledge of the situation said July 7. Under the plan led by Lion Capital, Highbridge Capital Management LLC and JPMorgan, junior creditors will write off more than 200 million pounds ($310 million) of mezzanine loans in return for ownership and provide 70 million pounds in a short-term credit facility, said the people, who declined to be identified because the discussions are private. They will inject 220 million pounds into the company, including 125 million pounds to reduce senior debt, the people said." - source Bloomberg.

Consolidation, defaults and restructuring are going to happen no matter what, for struggling corporates, struggling Spanish regions and provinces, as well as struggling countries. We touched on the subject for the European car industry with Peugeot in our last conversation. In similar fashion to our conversations involving shipping (Shipping is a leading deflationary indicator) and air traffic (Air Traffic is a leading deflationary indicator), the auto industry is as well facing a game of survival of the fittest in this current deflationary environment we argued.

The Bloomberg article concluded with the following quote from Andrew Sheet, European Credit Strategist at Morgan Stanley in London:
"If companies “don’t have cash on the balance sheet” they’re "not in a good place". If a company
generates free cash then it’s in control of its own future."

So, in relation to our title, in true Hooke's law fashion, given the "Yield Famine" we are witnessing, we believe our credit "spring-loaded bar mousetrap" has indeed been set and defaults will spike at some point, courtesy of zero interest rates. (The first spring-loaded mouse trap was invented by William C. Hooker of Abingdon Illinois, who received US patent 528671 for his design in 1894).

"If you build a better mousetrap, you will catch better mice."
George Gobel - American comedian.

Stay tuned!

Markets update - Credit - The European Overdiagnosis

"Analysis does not set out to make pathological reactions impossible, but to give the patient's ego freedom to decide one way or another."
Sigmund Freud

Following on our meditations on Bayesian outcomes, and the "European Principle of Indifference", it appeared to us appropriate this time around to focus on the unintended consequences of applying nonsensical decisions to nonsensical results, hence, we have decided this time around to use the analogy of overdiagnosis relating to our European issues:

"Overdiagnosis is the diagnosis of "disease" that will never cause symptoms or death during a patient's lifetime. Overdiagnosis is the least familiar side effect of testing for early forms of disease – and, arguably, the most important. It is a problem because it turns people into patients unnecessarily and because it leads to treatments that can only cause harm." - source Wikipedia

Indeed, this analogy seems to us particularly right relating to the current European and American "Balance Sheet Recession" which has been a recurring theme from Richard Koo, chief economist at Nomura Research Institute, as pointed out by Cullen Roche on Pragmatic Capitalism - "DEFICITS ARE GOOD DURING A BALANCE SHEET RECESSION":

"This (austerity) is akin to a doctor telling a patient suffering from pneumonia to go on a diet and get more exercise. While exercise is important, it assumes a healthy patient. If the patient is sick, he must build up his strength until he is physically capable of exercising again."

So, in a longer credit conversation than usual, we will first have a credit overview given recent significant price action (tightening spreads and much better tone in the credit space), before dealing more directly with the current" European Overdiagnosis" and unintended consequences courtesy of my global macro friends at Rcube Global Macro Research, quantifying "The likelihood of a Euro Breakup" in their latest paper, which follows on their previous analysis of Eurozone's core issue, namely Unit Labor Cost Divergence, which we discussed in our "European Flutter".

The Credit Indices Itraxx overview - Source Bloomberg:

"The Markit iTraxx Financial Index of credit-default swaps linked to the senior debt of 25 European banks and insurers now costs a record 120.5 basis points less than the Markit iTraxx SovX Western Europe Index of swaps on 15 governments. That compares with a 28 basis-point gap at the end of November and a previous high of 118 in July. Historically, it costs more to insure banks than governments." - source Bloomberg news - Abigail Moses and John Glover.

The Year of the Dragon should be rebranded the Year of the European Central Bank, given the significant tightening in credit indices which we have witnessed in Europe since the beginning of the year as indicated by Bank of America Merrill Lynch research - The ECB trade - 17th of January:

"The ECB funding “put”
Away from S&P’s downgrade distraction, we think funding stresses in the credit market have improved significantly over the last month. Three themes paint a better picture. Firstly, ECB 3yr LTROs have had big take-up, and more is to come.
Secondly, fixed-rate senior unsecured bank issuance has reached €15bn YTD, half of the entire 2H supply last year. And finally, as our banks colleagues highlight, government guarantee schemes can be a powerful solution to a bank funding crisis. With the ECB helping to transform funding pressures in credit, we think short-dated spreads can keep rallying."

As indicated above the fall in the Itraxx Financial Senior 5 year index has been significant versus the SOVx 5 year index (relating to 15 European sovereign CDS) courtesy of the breakdown in the correlation between Sovereign and credit spreads, as indicated by Bank of America Merrill Lynch in their report:

"Sovereign and credit spreads - the correlation is finally breaking
Thanks to ECB intervention, credit spreads have been much less correlated to sovereign spreads over the last month (although still positive). In fact, our work shows that the correlation between bank and sovereign spreads has fallen from 90% in mid December last year, to 40% currently. This isn’t far from the lowest correlation between the two since the start of 2010. How long this lasts will ultimately be a function of the outlook for peripheral sovereign debt, given banks’big exposure to the periphery."

In fact as my good macro friend pointed out early January, it is interesting to track the relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge):

Volatility has been falling faster than the Itraxx Crossover index and the index is clearly trying to catch up at the moment.

In relation to the liquidity picture, it has somewhat  improved as indicated in 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:

New reserve period for deposits started on the 18th. It will be significantly important to track upcoming peripheral government bonds auctions, given that, while the ECB's intervention is clearly supportive for banks, volatility will depend on the Greek PSI outcome, upcoming downgrades for banks and corporate rating downgrades (following up on sovereign downgrades and which have already started).

As Bank America Merrill Lynch put it in a note published on the 16th of January - "Perhaps it's not so bad after all":
"Banks better placed than sovereigns?
It is certainly the case that European banks have a lender of last resort who is dealing very flexibly with their needs – something the ECB has so far proved reluctant to do with sovereign debt."

But, there is a catch and Bank of America Merrill Lynch report from the 17th is on target:
"It isn't all about European banks' sovereign exposure - its also about private sector lending, not just sovereign bond holdings."

"How long the low correlation between bank and sovereign spreads lasts will ultimately be a function of the outlook for peripheral sovereign debt, and Standard and Poor’s sovereign downgrades don’t help. Despite the ECB’s welcome funding, European banks’ exposure to sovereigns remains vast, as chart 7 shows. Note European banks’ large private sector lending to peripheral countries." - source Bank of America Merrill Lynch.

And Bank of America Merrill Lynch to conclude their note with the following advice in relation to credit in 2012: "a more trading, "macro-driven" credit market."

Truth is, while everyone is anxious about the results relating to the Greek PSI, Sovereign CDS wise, Portugal looks to be the ideal candidate for some additional haircuts as we indicated in our last post "The European Principle of Indifference".
Sovereign CDS, between Ireland and Portugal, a new record between both countries with a spread difference of 604 bps - source Bloomberg:

Portugal 5 year Sovereign CDS is now at 1245 bps, which according to CDS data provider CMA equates to a cumulated probability of default of 65.67% within 5 years.

Meanwhile, the disconnect between the 10 year German Bund and the Eurostoxx is still noticeable but today we saw some widening courtesy of German Bund 10 year spread climbing 9 bps and closing on the 2% level, (we noticed this disconnect first time around in November in our post "Mind the Gap...") - source Bloomberg:

In relation to our previous conversations relating to bond tenders and other steps taken by banks to shore up capital requrements (BBVA benefiting from a tax credit courtesy of a goodwill impairment as discussed recently), it was interesting to see the Wall Street Journal catching up with us in relation to the unusual steps taken by some European banks to raise capital in order to reach the 9% Core Tier 1 Capital threshold set up for June 2012 -
"Banks Seeking Capital Ideas - European Lenders Are Taking Unusual Steps to Meet Their Cash Requirements". But what also caught our attention was seeing Bank of America entering as well the raising capital game of bond tenders, offering to buy back 1.5 billion dollars worth of subordinated bonds on the 19th of January. As reported by Zeke Faux in Bloomberg:
"Bank of America is reducing long-term debt as Chief Executive Officer Brian T. Moynihan, 52, seeks to cut holdings, expenses and staff while raising capital to meet demands from regulators for a larger cushion against losses."
So European bankers, please take solace, you are not alone.
"The bank is offering about 95 cents for those securities, it said in the statement", according to Bloomberg, on 6.22% Subordinated bonds due in September 2026, which amounts to a smaller haircut than what we have witnessed in Europe recently on some subordinated bond tenders last couple of months.

But back to our main story, namely European politicians' "Overdiagnosis". What could happen if austerity bites too much, could it lead to Euro Breakup? This is what my friends at Rcube Global Macro Reasearch have recently worked on:

The Likelihood of a Euro Breakup

Since late November, the 2 year yields of both too-big-to-fail PIIGS have crashed (by 350bp for Italy and 320bp for Spain). This indicates that the latest initiatives to save the Euro – most notably the LTRO – have succeeded in lowering the perceived short-term risk of a Euro breakup. This is undeniably a bullish signal for risky assets in the short term. On the other hand, 10 year yields remain stubbornly high, especially in the case of Italy (which is still trading at around 6.5%). This shows that the market believes (as do we) that the question of the Euro’s long-term viability remains unresolved. In order to quantify the likelihood of a Euro exit for each endangered country, we have built a simple model based on CDS spreads and excess unit labor costs. Before showing the model itself, let’s explain why we don’t believe that solving the PIIGS’ government debt problems (through ECB initiatives and fiscal austerity) will be sufficient to prevent a Euro breakup.

In our recent paper about unit labor cost divergence (Macro Analytics 19/12/2011), we suggested that the Euro’s issues went beyond the current debt crisis. The Euro created competitiveness imbalances between Eurozone countries by preventing currency adjustments, which were prevalent in the period between the end of the Bretton Woods system (in 1971) and 1999:

We see some occasional swings, but the dominant pattern is a rather regular fall of most currencies – at different speeds - against the Deutsche Mark, the only exceptions being the Austrian schilling and the Dutch guilder. Unsurprisingly, countries whose currency deteriorated the most during this 28 year period were the PIIGS (the Greek Drachma led the trend with an impressive 95% devaluation against the DEM). When we look at unit labor costs compared to Germany between 1995 and 2012, we notice that countries’ rankings are close to being the opposite of their former currencies’ strength:

If we more thoroughly analyze the relationship between the devaluation rhythm of former currencies’ (+: depreciation, - : appreciation) during the 1971-1995 period and unit labor cost increases between 1995 and 2012, we find a Pearson correlation coefficient of 0.70, and a Spearman correlation coefficient of 0.87. This indicates a strong (albeit non-linear) relationship between those two data items.

Despite the stories about the Mileuristas in Spain, the Milleuristi in Italy and the 700€ Generation in Greece, wage-earners in the PIIGS faired relatively well on a productivity-adjusted basis during the 1995-2008 period, as if they were still being paid in a weak currency that justified regular wage increases. As an illustration of this, we recently learned that Italians now have the highest net worth amongst G8 countries, despite the dismal performance of Italy’s economy over the last decade (this is also a byproduct of Italy’s housing bubble).

Had the Euro never existed, it is fair to assume that PIIGS’ currencies would have naturally adjusted to compensate for their high relative unit labor costs. As countries renounced their ability to devaluate, their competitiveness suffered considerably. Even in the case of France, which is not (yet) considered as one of the PIIGS, its balance of trade went from +3.2% of GDP in 1997 to –3.0% in 2011.

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”.  

It is an understatement to say that finding a politically acceptable solution to restore labor cost balance within the Euro framework will be difficult. In addition to the deep cuts that are currently being imposed on government budgets, real wages will have to fall across the board (and not only minimum wages). As people tend to think about money in nominal terms (Keynes’ money illusion), it might end up being easier to find a smart (i.e. non chaos-inducing) way to return to a system of floating currencies, rather than to impose years of internal devaluations.

This is the main reason why we believe that the question of the Euro’s long-term survival goes beyond knowing whether the ECB will finally use its proverbial bazooka during the next 12 months. Even if Greece’s government debt was reduced to zero (which could end up being the case someday), it would not change anything regarding its current lack of competiveness (exports: 7% of GDP, imports 21%). As an anecdote, we recently read that Greece had to import olive oil from … Germany.

A simple model to assess market-implied Euro exit probabilities:

We believe that a large part of Eurozone countries’ CDS spreads reflect their long-term probabilities of exiting the Euro, rather than their default risk within the Eurozone. Indeed, even though we’re not sovereign debt experts, it seems evident to us that if a country was to exit the Eurozone and switch to a new currency, it would have to convert its government debts to the new currency. This would most likely constitute a default in legal terms for most countries[1], but we cannot imagine a country keeping a huge debt denominated in a foreign currency. This would create a Weimar-type vicious circle and would inevitably crush the new currency into oblivion.  Additionally, defaulting without exiting the Euro would not solve the competitiveness issue of many European economies (we’ll soon be able to check this theory with Greece).

If we assume that new currencies would have to devaluate to readjust their unit labor costs to their 1995 level, we can work out theoretical recovery values after redenomination (from which we take a haircut of 20% to take into account overshooting). We then calculate 1-year and 5-year Euro implied exit probabilities by using a simple formula for default probability (Default Probability = Spread / ( 1 – Recovery Rate) ]. This gives us the following implied exit probabilities for the main EZ countries[2] that have a 5 year CDS spread higher than 100:

Despite the rather simplistic assumptions we made in our calculations, these levels appear to be close to what we would have expected: in the short-term (1 year or less), exit probabilities are rather low for most countries, with the exception of Ireland and Portugal. Too much political capital has been invested in the Euro by the last two generations of politicians. Additionally, it would be a mistake to believe that the system is out of ammunition. In a fiat money world, the ECB cannot run out of Euros.  Everything ultimately depends on politicians’ (especially Merkel’s) willingness to “save the Euro”. On its own, the ultimate kick in the can (massive debt monetization) would certainly extend the Euro’s life for quite a few years.  

Consequentely, we believe that the Euro will muddle through for a while, in a climate of painful fiscal tightening for most European countries…

However, if as we fear will be the case, austerity plans do little to address the underlying competitiveness problems faced by many countries, their growth rates will remain anemic. Instead of the rosy “J curve” that would have been promised to justify deep cuts in government expenses, weak EZ countries will experience the dreaded “L”. Rather than going through another purge, some countries will then make the choice to exit the Euro. In this context, the 5 year implied exit probabilities do not appear to be exaggerated to us. 

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[1] Under ISDA rules, G7 countries (Germany, France and Italy) could decide to redenominate their debt without provoking a credit event.

[2] Outside from Greece whose default/exit probability is already 100%

"The physician must give heed to the region in which the patient lives, that is to say, to its type and peculiarities."
Paracelsus

Stay Tuned!

The writing is on the wall...

Sovereign CDS for Spain is now trading at 257 bps for 5 year, and Portugal has now joined the highest default probabilities list from CMA DataVision. Portugal 5 year CDS trades at 312 bps. The cumulated probability of default for Portugal now equates 22.91%.

Greece Sovereign CDS is trading at 835 bps for 5 year, with a CPD (Cumulated Probability of Default) of 49.72%, just behind Argentina, which trades at 1073.17 bps and has a CPD of 50.06%.

Greece is not like Argentina, it is in a worse shape.

In this post, we will look at some solutions coming from the man who was at the helm of Argentina's finances in 2001, Domingo Cavallo as well as leverage still in the system and the ongoing discussions around banking reforms.

Domingo Cavallo, the fomer minister of finance of Argentina gives a good analysis of what should be followed by Greece, Spain and Portugal to restructure their economy:

http://www.voxeu.org/index.php?q=node/5018

"Greek debt woes could spark contagion within and beyond Europe. Argentina’s former finance minister and co-author draw four lessons from Argentina’s crisis: devaluation/exit is not the answer; orderly debt restructuring involving a ‘Brady Plan’ now is better than a disorderly one later; fiscal consolidation that improves external competitiveness is a must; all these must be done simultaneously."

Domingo Cavallo gives in this article make some good points on what should be done:

Three Lessons
"The main lessons for Greece stemming from Argentina are, in our opinion, as follows. First, devaluation (exiting the eurozone) is not the answer, particularly since the post-crisis world outlook is unlikely to be as benign with Greece as it was with Argentina. Re-adopting the drachma and letting it fall in value relative to the euro would cause a sharp deterioration in the balance sheets of both the government and the private sector. On the other hand, a forcible conversion of euro-denominated financial assets and liabilities into drachmas (a replication of what Argentina did in 2002) would, in all likelihood, set in motion a perverse devaluation-inflation spiral, as people would want to substitute away from drachmas into euros to avoid losing purchasing power if they stay in drachmas.

Second, any sovereign debt restructuring must be planned and executed in an orderly manner, with bilateral discussions between creditors and debtors, and with an active support from the international financial organizations, both in Europe and Washington DC (i.e., the IMF). These organizations can get more bang for their bucks if instead of trying to bailout Greece’s creditors over the next two years, they use their limited financial resources to enhance, a la Brady plan, new bonds that are swapped for the old ones in exchange for haircuts in principal, interest or both. A default followed by unilateral and incomplete debt restructuring several years later, as done by Argentina in the previous decade, would be the wrong model to follow.

Third, there must be fiscal consolidation. But, this cannot be limited to cutting spending and raising taxes. It must also include fiscal measures designed to improve external competitiveness so as to ease the fiscal adjustment.

Last but not least, the three ingredients of the recovery plan (fiscal consolidation, debt restructuring, and the enhancement of competitiveness) must take place simultaneously."

Furthermore, Domingo Cavallo raise a very interesting point in relation to VAT versus Payroll Tax:

"In a previous article, we suggested that Greece could achieve the same effect on competitiveness that could be achieved under a 20% real exchange rate devaluation by raising the collection of the value added tax (VAT) while simultaneously reducing payroll taxes. We think that this is an idea that merits consideration not only in Greece, but also in Portugal and Spain. Given the importance we give to this subject, we devote the rest of this note to explain our proposal in more detail.

One characteristic of taxation in many countries—typically in Continental Europe, but also in Latin America and other regions—is that payroll taxes, which finance social security, are extremely high (see Table 1). Of course, this is due to the fact that social transfers are also very high. However, there is no reason why these transfers have to be financed by payroll taxes, especially if there is room to increase other, more neutral, taxes.

Take the VAT, for example. Unlike payroll taxes, which are levied on labour income, the VAT is levied on final consumption. This has two main advantages: it promotes formal job creation and it stimulates private saving. In countries like Greece, Portugal and Spain, this can kill three birds with one stone by helping to reduce unemployment, informality in the labour market, and the current account deficit. Furthermore, the fact that the VAT is levied on final consumption and not on investment or exports (capital goods purchases are deductible as VAT “credits” and exports are tax exempt) makes the substitution of VAT for payroll taxes a competitiveness-enhancing tool. As such, it is like devaluing the local currency, but without the inflationary pass-through to domestic prices or the disrupting balance sheet effects."

In addition to these proposed measure, one could also argue that Spain need to drastically reform its labour market which is critically hindered by its very rigid system.

Many economists blame the high jobless rate in Spain on the high cost of firing workers. This makes employers quite reluctant to hire staff and encourages the use of temporary contracts that have few benefits and rights. 24.3 % of Spanish employees are currently on temporary contracts.

In Spain, workers on full contracts are entitled to severance pay of as much as 45 days per year worked, one of the highest levels in Europe. Under the Spanish government reform it would be reduced to 33 days for some contracts.

Although the Spanish government is pushing ahead with the labor reform plan, it has so far failed to calm markets as reflected in the continuous widening in Sovereign CDS spreads.

Spanish 10 year bonds yielded an all time high against the German 10 year Bund today at 4.87%. This is 2.23% more than German 10 year Bund.

Three-month dollar libor rates rose to an 11-month high of 0.53894% , while euro rates edged up to 0.65563%, exceeding levels reached last week to set a six-month high.

The situation for European banks is getting difficult as highlighted by Georges Soros comments in this article from Reuters:

http://www.reuters.com/article/idUKTRE65E5JT20100615

"European banks had bought large amounts of the sovereign bonds of weaker euro zone countries for a tiny interest rate differential, Soros said.

"That's one of the reasons why the banks are so over-leveraged and why the German and the French banks own Spanish bonds," he said.

"Now ... they have a loss on their balance sheets which is not recognised and it reduces the credibility of those banks so the banking system is in serious trouble," he said.

"The commercial paper market, for instance, in America is now refusing to lend to European banks so there is even a funding crisis and the ECB (European Central Bank) has to step in and the banks are unwilling to lend to each other," he said."

European banks are getting punished for their greed in trying thier quest to capture more yields on riskier government bonds.

Too much greed can be dangerous because it clouds good judgement and good risk management. We have already witnessed the devastating results in the US where the hunt for yield (due largely to Alan Greenspan's low rates environment) led to the financial debacle. Investors in supposedly AAA securitized products (CDOs, etc.) showing promising yields, were wiped out.

A report published by the BIS reviews the role leverage played in the crisis:

http://www.bis.org/publ/cgfs34.pdf?noframes=1

"Leverage in structured products and the US housing market downturn
Structured credit products referencing US subprime mortgages exposed investors to much higher leverage and losses than the stress scenario modelling they performed had implied. First, an investment in a subordinated tranche of a subprime residential mortgage-backed security had a leveraged exposure to the underlying subprime mortgage loans (embedded leverage).
Second, re-securitisation compounded the multiplier effect of embedded leverage. For example, mezzanine tranches of mortgage securitisations (which themselves have embedded leverage) were often purchased by CDOs, which in turn issued senior and subordinated tranches, creating additional leverage on top of that embedded leverage in subordinate tranches.
The magnitude of this embedded leverage was estimated by investors with models using assumptions about the likely future path of house prices. Hence, investors could not always be certain about the degree to which their exposure to the mortgage market was leveraged at the time of investment. When delinquency assumptions associated with subprime mortgage securitisations of 2005–07 proved to be far too low, the leverage and losses experienced by investors were much greater than anticipated."

Now European Banks are sitting on hefty losses on their balance sheets, because of their exposure to the weaker parts of Government bonds in Europe. So much for good risk management...

In addition to this behavior, leverage in some European Banks is still higher than their American counterparts which went through the painful process of deleveraging and had to raise massively capital to shore up their impaired balance sheets.

“In the early days of banking, liability was not just unlimited; it was often as much personal as financial. In 1360, a Barcelona banker was executed in front of his failed bank, presumably as a way of discouraging generations of future bankers from excessive risk-taking."

Bank of England Financial Stability executive director Andrew Haldane

http://www.bankofengland.co.uk/publications/speeches/2009/speech409.pdf

"From the earliest times, the relationship between banks and the state was often rocky.
Sovereign default on loans was an everyday hazard for the banks, especially among states vanquished in war. Indeed, through the ages sovereign default has been the single biggest cause of banking collapse. It led to the downfall of many of the founding Italian banks, including the Medici of Florence."

Andrew Haldane describes as well the current issue with State Support:

State support stokes future risk-taking incentives, as owners of banks adapt their strategies to maximise expected profits. So it was in the run-up to the present crisis. In particular, five such strategies were clearly in evidence:

• Higher leverage: The simplest way of exploiting the asymmetry of payoffs arising from limited liability is to increase leverage. For example, if the capital ratio of the hypothetical bank were to halve from 10% to 5%, the beta of the bank’s equity would double (Figure 2). In that event, the imbalance between privatised gains (above the zero axis) and socialised losses (below the zero axis) would increase. Private investors would harvest more of the upside and export more of the downside.
There is clear evidence of this strategy being pursued over long sweeps of history.
UK banks migrated North-West over the past ten years, with balance sheet expansion financed by higher leverage. Because UK and European banks were not subject to any regulatory restriction on simple leverage, there was no effective brake on this leverage-fuelled expansion.Higher leverage fully accounts for the rise in UK banks’ returns on equity up until 2007. It also fully accounts for the subsequent collapse in these returns.

The high-leverage strategy pursued by UK and European banks rather effectively privatised gains and socialised losses.
• Higher trading assets: An alternative means of replicating the effects of higher leverage is to increase the proportion of assets held in banks’ trading books. Trading assets are marked to market prices, thereby increasing their sensitivity to aggregate market fluctuations (beta). To illustrate, assume that a bank holds 90% of its assets in the banking book (with a beta of zero) and the remainder in the trading book (with a beta of one). That gives an asset beta of 0.1 and an equity beta of unity (Figure 1). But if the size of the trading book is doubled to 20% of assets, this doubles the equity beta of the bank."

Andrew Haldane also indicates how to reduce the risk taking habits for banks in his paper

What options best tackle excessive risk-taking incentives? A number suggest themselves, some modest, others more radical.
• Introducing leverage limits: One simple means of altering the rules of the asymmetric game between banks and the state is to place heavier restrictions on leverage. European banks were not subject to a regulatory leverage ratio in the run-up to crisis. They exploited that loophole. Closing it would bring about a clockwise rotation in banks’ payoff schedule, lowering the beta of banks’ equity returns and reducing risk-taking incentives.This is an easy win. Simple leverage ratios already operate in countries such as the US and Canada. They appear to have helped slow debt-fuelled balance sheet inflation. The Basel Committee is now seeking to introduce leverage ratios internationally. To be effective, it is important that leverage rules bite. They need to be robust to the seductive, but ultimately siren, voices claiming this time is different. That suggests they should operate as a regulatory rule(Pillar I), rather than being left to supervisory discretion (Pillar II)."

Finally to conclude this post, relating to Bank reform, Andrew Haldane in his excellent paper says the following:

"Events of the past two years have tested even the deep pockets of many states. In so doing, they have added momentum to the century-long pendulum swing. Reversing direction will not be easy. It is likely to require a financial sector reform effort every bit as radical as followed the Great Depression. It is an open question whether reform efforts to date, while slowing the swing, can bring about that change of direction."