Credit - The Yield Skeksis

"The ignorant mind, with its infinite afflictions, passions, and evils, is rooted in the three poisons. Greed, anger, and delusion." - Bodhidharma 

While watching the on-going "Yield Famine", with credit investors dipping their toes more and more clearly outside their comfort zone and snapping up CLOs (Collateralized Loan Obligations), providing the necessary fuel for the biggest surge in corporate buyouts since the outset of the financial crisis, we thought our weekly analogy should, no doubt, refer to some of the main antagonists, the Skeksis, from Jim Henson's legendary 1982 fantasy film the Dark Crystal.

In the Dark Crystal, the Skeksis are the corrupt rulers of the planet Thra, having inherited it from their benevolent Urskek predecessors. While they are the embodiment of their knowledgeable predecessors, due to the accelerated decomposition of their bodies, the Skeksis constantly search for ways to prolong their lives at all costs. In similar fashion to the Dark Crystal Skeksis, our Yield Skeksis constantly search for ways to enhance their yield returns.

The primary method of the original Skeksis was to expose themselves to sunlight channeled directly through the Dark Crystal, though the amount of energy replenished to them was greatly dependent on the conjunction of Thra's three suns. In similar fashion, our Yield Skeksis are highly dependent on interest levels set up globally by the Central banks to replenish their level of "energy". 

Another method used by the original Skeksis to prolong their lives at all cost was to drain the lifeforce from other life-forms by exposing them to the reflect beams of the Dark Crystal, with the life-force collected in a liquid form (or coupons for our Yield Skeksis) and drunk only by the Emperor, who regains his youthful appearance. The effect on the drained victims was to turn them into near-mindless husks which the Skeksis use as slaves.

Looking at the incredible surge of Greece ASE equity index since 2012 (up more than 110%), in similar fashion to the end of the Dark Crystal, following the unification of the crystal triggering in effect the merger between the Mystics and the Skeksis, the land is shown rejuvenated and equities rallied:

No doubt, our post from the 4th of March 2012 entitled "Equities, there is life (and value) after default!", indicates the powerful effect of bond restructuring / partial default can have on equities. It looks "crystal clear" to us, but we ramble again...

Of course our reference to the corrupt Skeksis from the Dark Crystal and some European politicians would be purely fortuitous as the saying goes. Although the Skeksis are capable of forming alliances, they are by nature extremely paranoid toward each other. After all the Skeksis were only 10 compared to the 27 members of the European Union:

-The Emperor skekSo (having originally been an energetic ruler who enjoyed lavish festivity and sporting events which he invariably won. As he aged however, he became increasingly paranoid and spiteful).

-The Chamberlain skekSil (skekSil is the most devious, most notably as his intentions are never fully revealed and seemingly contradictory).

-The Scientist skekTek (the other Skeksis fear him out of ignorance of his work. His fascination with anatomy was very great he went as far as amputating his right arm and leg, replacing them with mechanical constructs).

-The Ritual Master (aka High Priest) skekZok (spearheads the various rituals the Skeksis practice such as the "Ceremony of the Sun", and sees their laws as absolute).

-The The Garthim Master (aka General) skekUng (his constant blundering in the capture of the surviving gelflings fails to evoke the desired respect of his subjects).

-The Gourmand skekAyuk

-The Slave Master skekNa

-The Treasurer skekShod (He frequently bribes the other skeksis into temporarily loaning him their personal possessions).

-The Scroll Keeper (aka Historian) skekOk, (also the most dishonest as he constantly rewrites the Skeksis' history to suit his allegiances and propaganda needs).

-The Ornamentalist skekEkt (skekEkt is nonetheless described in The World of the Dark Crystal as an extremely vain and callous character who would gladly cause the death of countless animals for the sake of fabricating one cloak).

but we wander in our thoughts once more.

Similar to the Skeksis from the Dark Crystal, by preventing the ultimate restructuring  in Europe (which will eventually happen), creative destruction cannot happen in true Schumpeter fashion.

Following a quick overview, we would like to focus once again on the broken credit transmission mechanism in Europe in general and in peripheral countries in particular.

The indicator we have been monitoring, has been the 120 days correlation between the German Bund and its American equivalent, namely the US 10 year Treasury notes. In "Risk Off" periods we have noticed that the 120 days correlation had been close to 1 in 2010, 2011 and 2012, whereas in "Risk On" periods, the correlation was falling to significantly lower level. Currently the correlation is falling towards 70%, indicative of the on-going "Risk-On" in risk assets. - source Bloomberg:

The divergence between the performance in US equities (S and P500) and the Eurostoxx 50 has been clearly receding recently following the Italian elections scare, the red line in the graph being Italian 10 year yields - source Bloomberg:

In similar fashion, this divergence between US equities and Europe equities can be seen in the evolution of VIX versus its European counterpart V2X - source Bloomberg:

The short volatility spike in both the VIX and V2X has clearly receded, with V2X receding from 24 towards 17.

We have been monitoring as well the relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge) - source Bloomberg:

The significant tightening witnessed this week in credit indices, has led the European High Yield risk gauge to recede towards the lowest points of 2010 and 2011, closing around 405 bps. The benchmark of 50 companies mostly speculative-grade ratings has fallen 47.5 bps this week, the biggest fall since January 4th and the lowest level since July 2011, supported by the US jobless rate and nonfarm payrolls number on Friday coming at 236 K.

But when it comes to the 7.7% unemployment level touched in the US. As far as we are concerned, unless we start seeing both a rise in velocity M2 and the US labor participation rate, we will remain skeptical about the much vaunted US recovery underway - source Bloomberg:

So, you might have 7.7% unemployment level but the US labor participation rate is still trending down and is now at 63.5%, a 32 year low and velocity remains muted. As we argued in our conversation "Zemblanity":

"Does the end (lowering unemployment levels) justify the means (increasing M) or do the means justify the end (deflationary bust)?"

So can someone please demonstrate to us how "this time it is going to be different" in terms of outcome for the US labor market given the "paradox of thrift" with bank reserves sitting idle at the Fed like we indicated in our previous conversation, with a broken transmission to the US economy, and questions surrounding fiscal stimulus which could potentially alleviate the situation (tax breaks for small companies anyone...)?"

Moving back to our Yield Skeksis analogy and relating to "Pareto Efficiency" in a Pareto efficient economic allocation, no one can be made better off without making at least one individual worse off, it is that simple, and the losers today being unfortunately the younger generation in "developed" countries, leading to high unemployment in Europe and lower growth.

We have highlighted the deflationary forces at play in Europe in our shipping conversations, the lack of credit and the broken credit transmission channel have led to poor growth prospects in conjunction with a significant rise in bankruptcies in Europe leading to a continuous rise in unemployment levels. The recovery in exports and shipping which could bring some improving growth prospects for Europe is clearly hindered by unemployment levels - source Bloomberg:

"Unemployment within the euro zone is expected to increase to 11.95% in 2013 from 11.7% in 2012, and to improve slightly to 10.8% by 2015. Lower unemployment is crucial for expanding global demand for goods, keeping capacity loose and rates depressed. The recovery in the shipping industry will not be fully realized without improving unemployment trends."  - source Bloomberg.

But if you think that in this game of survival of the fittest, the prolonged impact has only impacted the greed of  "Yield Skeksis" in a true Pareto efficient way, the QE induced rise in Bunker fuel prices has as well killed off the "velocity" of ships forcing them in essence to adjust their supply chain to survive:

"Slow steaming, or moving slower to conserve fuel, has affected 90% of shippers' supply chains and 85% of them had to make changes to their operations, according to a survey by Centrx and St. Joseph's University. Given the longer transit times, shippers are increasing inventory levels and moving to multiple carriers to gain access to additional departure times." - source Bloomberg.

Courtesy of ZIRP, our Yield Skeksis have seen:
-Falling Yields (in the Dark Crystal movie, originally, Gelflings were most ideal in essence extraction until they were exterminated and Podlings were used in their place, their lifeforce having a temporary effect on the drinker)
-Falling labor participation rate
-Falling velocity

In relation to the European government bond picture, this week Spanish 10 year yields closed around 4.85% and Italian 10 year yields around 4.57% whereas German government yields closed around 1.50% levels - source Bloomberg:

But even the excess liquidity which have been provided to financial institutions via LTRO 1 and LTRO cannot prevent the return at some point of sovereign risk - source Bloomberg:

"Excess euro-zone bank liquidity, defined as ECB current and deposit accounts less reserve requirements and marginal lending, drove falling yields and improved bank liquidity from late 2011. Current concerns on Italian political instability and delivery on austerity targets demonstrate that while retained LTRO funds continue to ensure adequate liquidity, bond yields and bank funding costs may rise again. Excess liquidity in the euro-area banking system fell below 400 billion euros for the first time since December 2011, when the first ECB long-term refinancing operation (LTRO) was announced and disbursed. Collectively, 224.7 billion euros of LTRO I and II have been repaid since the end of January. If excess liquidity falls further, scrutiny will likely fall on Euribor, EONIA and other liquidity-cost indicators. - source Bloomberg

Moving on to the subject of the broken credit transmission mechanism in Europe in general and in peripheral countries in particular, we have long argued that LTRO liquidity injections amounted to "Money for Nothing". 

Only 61 billion of Euros came back to the ECB relating to the second tranche of the LTRO, indicative on the  cautious stance of financial institutions in peripheral countries, which had been the biggest beneficiary. This is not really a surprise given that Italian banks for instance are seeing a steady rise in bad loans as the political gridlock is staving growth in the process. This is clearly indicated by Sonia Sirletti and Fabio Benedetti-Valentini in their Bloomberg article from the 7th of March entitled - Italian Banks' Bad Loans Seen Rising as Gridlock Hampers Growth:

"Italian corporate and household non-performing loans rose to a record in December, reaching 125 billion euros, according to data from the Italian Banking Association. Banks’ gross non-performing loans as a proportion of total lending increased to 6.3 percent from 5.4 percent a year earlier. France’s BNP Paribas SA, which owns a retail bank and consumer credit unit in Italy, and Credit Agricole SA reported higher bad-loan provisions from their Italian branch networks in the fourth quarter. 

Italy’s central bank has increased inspections and is urging banks to take more provisions. “In periods of market tension, the intensity of supervision cannot be relaxed,” Governor Ignazio Visco said in a speech on Feb. 9. “The Bank of Italy review of the top 25 banks likely means an increase in non-performing loans coverage” in the fourth quarter, Francesca Tondi, an analyst at Morgan Stanley, wrote in a report March 6. “We think 2013 accounts will also be affected by still-growing NPLs and the need for more coverage. 

Sovereign Debt:

UniCredit shares as much as doubled in Milan trading, and Intesa surged as much as 73 percent, after European Central Bank President Mario Draghi’s July pledge to do “whatever it takes” to defend the euro. Those gains began to erode over the past month as Italian government borrowing costs increased in the run-up to the elections. “Any renewed rise in funding costs would be the equivalent of a tightening in monetary conditions, with the potential to slow the economy,” Credit Suisse Group AG analysts including Yiagos Alexopoulos and Christel Aranda-Hassel said in a note last week. Italian banks tied their fortunes more closely to the financial strength of the state in 2012, increasing holdings of the country’s sovereign debt by 58 percent to 331 billion euros. Italy has 2 trillion euros of debt, more as a share of its economy than any developed nation other than Greece and Japan.” - source Bloomberg

This provision pressure on Italian banks can already be seen in the growing spread difference between German, and Italian Corporate loans with costs widening - source Bloomberg:

"The cost of accessing a corporate loan in Italy is nearly 1.5% higher than the equivalent in Germany. In mid-2011, Italian new loans were priced more cheaply than Germany's and since 3Q12, new corporate lending in Italy has cost more than in Spain. Coupled with lower repayment of LTROs by Italian banks than witnessed in Spain and political turmoil, the outlook for credit costs and supply in Italy is deteriorating." - source Bloomberg.

But it is not only Italy which is stricken by this broken credit mechanism transmission to the real economy. Spain has well is facing similar issues of significant rising corporate loan costs - source Bloomberg:

"The cost of a new corporate loan in Spain of more than 1 million euros for a duration of one to five years reached a four-year high in January, underlining how supply and cost of credit to Spain's corporates remains a source of concern. While IMF analysis suggests significant progress has been made on reform, and anecdotal evidence suggests that the domestic deposit war may soon come to an end, supply of credit remains poor." - source Bloomberg

According to Bloomberg, Rates on consumer credit loans up to one year in duration fell 0.8% in Spain and 0.4% in Italy during December but not enough to offset the pressure coming from rising nonperforming loans.

As we posited in January 2013 in our conversation "Cool Hand", the Bank of Spain has been revisiting the introduction of caps to time deposit rates in order to reduce the deposit war which started in 2012. While there is no doubt, early signs, of some sort of ceasefire, as indicated by Bloomberg. The lower than anticipated refund of the LTRO in conjunctions with rising nonperforming loans, might not be enough to increase credit access to the real economy - source Bloomberg:

"Interest rates on new spanish household deposits, with less than one year maturity, fell more than 50 bps to 2.43% in January, the biggest absolute drop for four years. Following five straight months of growth in deposits with an agreed maturity, this hints at improving liquidity and banking conditions following many months of bank restructuring and reform." - source Bloomberg.

The fall to 2.43% is the biggest monthly decline since Bank of Spain records began in 2003.

Truth is when it comes to the deleveraging process for European financial institutions, much more is needed when one looks at the level of Loans to Deposits as indicated by Morgan Stanley in their note from the 1st of March on European Banks:

Credit wised, the Loan-to-bond refinancing, or disintermediation, is another growth driver in European High Yield markets as European banks tighten lending conditions. According to Bloomberg, analysis shows 50% of funding in Europe from loans vs 40% in U.S. so while banks are in retrenching mode, companies are switching to the bond market rather that asking banks for loans with the stringent covenants normally attached to bank loans:

After all our the greed of our "Yield Skeksis" knows no bound and if ones looks at CLO demand for AAA  rated portions, one could see that the average spread on institutional loans was 377.6 basis points last month, down from 515 at the end of June 2012, as reported by Bloomberg and according to S&P Capital IQ Leveraged Commentary and Data.

Back in 2007 the tightest level was 243.3 basis points. On top of that and according to Bloomberg, borrowers obtained more than $88 billion in loans last month from non-bank lenders, exceeding the pre-crisis peak of $55 billion in April 2007 and more than tripling the $26.7 billion received in January, according to JPMorgan Chase & Co. More than 80 percent of the loans made this year were used to reduce borrowing costs or extend maturities.
On top of that ZIRP engineered by the Fed has managed to raise the level of corporate takeovers to 86.6 billion dollars in the US in February, the busiest month since July 2008 according to data compiled by Bloomberg.

Given the appetite of our Yield Skeksis it remains to be seen how low spread can go in order for them to replenish their level of "energy", but that's another credit bubble story, we think.

"It is greed to do all the talking but not to want to listen at all." - Democritus

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!

Credit - Eastern Promises

"One promises much, to avoid giving little."
Luc de Clapiers - minor French writer, a moralist. Friend of Voltaire.

In our previous conversation "Credit - Something Wicked This Way Comes"as a tribute to American Writer Ray Bradbury, while looking at the ongoing nightmarish European carnival, we mentioned the carnival's leader in Bradbury's book being the mysterious "Mr. Dark". In the book, he bears a tattoo for each person who, has been lured by the offer to live out his "secret fantasies" (markets rumors such as using ESM funding to recapitalized peripheral banks). We thought we would use as a reference for our title this time around the 2007 British-American-thriller-crime film directed by David Cronenberg "Eastern Promises" given the main characters wore detailed tattoos: "Basically their history, their calling card, is their body." - Viggo Mortensen

While our reference to "Eastern Promises" is a reference, somewhat to continuous "broken promises" from the likes of "Mr Dark" in our European carnival, it is also a reference to the growing eventuality of a Euro Break up in the sense that the collapse would be reminiscent of the collapse of the 15 State-Ruble zone in 1994. It is also a reference to December 2011 market talks about "Eastern Promises", namely that China would be the white knight to the rescue of Europe, which came at the time with reports that China's central bank was preparing a $300bn vehicle to invest in the US and Europe. These "Eastern Promises" hopes were dashed on Thursday as the country's sovereign wealth fund said it will not buy any more debt in Europe until the region takes radical steps to restore credibility: "The risk is too big, and the return too low," said Lou Jiwei, the chairman of the China Investment Corporation. He also said in May:

"If European governments want to issue bonds, CIC is not a main target institutional investor."

Of course, why would they, given the "unintended consequences" of the Greek PSI with the imposed subordination of private bondholders in favor of the ECB and EIB leading to a "buyers strike".

Anyone who believes China will be the White Knight is deluded. China has been executing its long term strategy for decades. They are investing on their own terms and in "real assets" like agricultural land, prime buildings, infrastructure (ports, toll roads, energy networks, rail) and commodity and mining companies to name a few. We do not think China will invest in Euro bonds, ESM bonds or any other "European promises".

So while our European carnival moves on from one country to the next, with the heightened possibility of a break-up, deposits are indeed moving East, leaving Germany awash with cheap deposits, as it is becoming a magnet for depositors, seeking a safe haven.
So in our credit conversation, we will go through these "Easter" deposits movements and the collapse of the 15 State-Ruble zone in 1994. But, as always, first our credit overview.

The Itraxx CDS indices picture on Friday - source Bloomberg:

Although Itraxx Crossover 5 year CDS index (50 European High Yield entities - High Yield credit risk gauge) is slightly tighter, the SOVx index representing the CDS gauge risk for 15 Western European countries (Cyprus replaced Greece recently in the index) remains at elevated levels around 323 bps and so does the Itraxx Financial Senior Index at 277 bps, while much tighter, a further indication of the existing correlation between financial and sovereign risk. It also indicates that the ECB's support so far is still resting with the financial sector.

Itraxx SOVx index versus Itraxx Financial Senior 5 year CDS (senior unsecured financial risk gauge) - source Bloomberg:

The spread difference between Sovereign Risk and Financial Risk has been rising to 44 bps recently indicating additional stress in the sovereign space. No surprise given they are some rising concerns relating Cyprus, which replaced Greece in the SOVx index comprising 15 Western Europe countries and Fitch recently downgraded Spain three notches from A to BBB on Thursday following the Spanish auction which saw Spain placing 2022 bonds at around 6.04% (At a sale of the 5.85 percent January 2022 bonds on April 19, Spain paid an average yield of 5.743 percent according to Bloomberg).

As indicated in the below graphs from a recent study made by French bank Natixis on the 7th of June, correlation between Sovereign risk and Financial risk is different between countries since January 2010 - Spain versus Germany:



For instance in the graph indicating Spain 5 year Sovereign CDS versus Santander 5 year Senior CDS, correlation is at 0.92. In Germany, the second graph, since January 2010, Germany's Sovereign 5 year CDS correlation with Deutsche Bank Senior 5 year CDS has only been 0.76.
From the above, one can clearly conclude that the more stress you get on a country's sovereign debt, the higher the correlation with the financial sector.

Friday's price action in the European Bond Space saw Spanish yields wider towards 6.20%. Germany saw their yields falling again to 1.29%  in another move towards "flight to quality" - source Bloomberg:

Indeed, time is running out for Spain, time is running out for the ECB to deliver a substantial policy response to pull the "European carnival" back from the brink.
As Nomura put it in their recent note "ECB : Primed for QE?" from the 1st of June:
"It feels like we have been here before. The euro area seems to be edging closer to its breaking point. Markets are again calling on the ECB to deliver a substantial policy response that can pull the euro area back from the brink. Our core view is that an ECB policy response is coming, initially as rate cuts and ultimately QE in the form of outright asset purchases."

“Time is really the only capital that any human being has, and the only thing he can’t afford to lose.’” – Thomas Edison

But as Nomura put it in the same note, "Mr Dark's" European promises are luring less and less believers to the markets altar:
"Markets, however, have little faith in a banking union plan for three reasons. First, Bankia may not be alone, so the ESM would need more funds to support potentially large parts of the Spanish banking sector. Second, it is highly unlikely there will be any political backing for a plan in Northern Europe that uses taxpayer money to directly bail out Spanish banks. Third, markets have lost patience with the incremental approach taken so far by policymakers. The Governor of the Banca d'Italia summarised the view of the international investment community, namely that international investors have doubts about the ability of euro-area governments to ensure the survival of the single currency. The view is plain and simple . time is about to run out."

We would have to concur with the above statement. Time is the most precious commodity and it has been properly wasted as far as Europe is concerned.
“Time stays long enough for those who use it.“ – Leonardo Da Vinci

Nomura also added in their note:
"If markets are losing faith that the euro area will survive, that's very serious. Foreign exchange traders have already voted: in effective terms, the euro is now at its lowest level since 2003."

Moving on to the subject of deposits flying to German banks with Germany's appeal working as a powerful magnet (we already discussed the dollar's magnet appeal in our conversation - "Risk-Off Correlations - When Opposites attract"), as indicated in Bloomberg by Annette Weisbach, Nicholas Comfort and Boris Groendahl, Germany is awash with liquidity:
"As Europe’s sovereign debt crisis escalates, Germany is becoming a magnet for depositors keen to stow their savings in the euro area’s safest market.
Deposits in Germany rose 4.4 percent to 2.17 trillion euros ($2.73 trillion) as of April 30 from a year earlier, according to European Central Bank figures. Deposits in Spain, Greece and Ireland shrank 6.5 percent to 1.2 trillion euros in the same period, including a 16 percent drop for Greece, the data compiled by Bloomberg show.
As banks in Europe’s periphery fret over lost deposits, German lenders are awash in liquidity that comes on top of more than 1 trillion euros the ECB has made available in three-year loans to banks since December to ease the flow of credit. The prospect of Greece leaving the 17-nation euro region is fueling the capital flight as parties opposed to the terms of the country’s second bailout prepare for a new ballot on June 17 after winning most of the votes in elections last month. “The longer the debt crisis lasts, the more funds will flow to Germany,” said Dieter Hein, a banking analyst with Fairesearch GmbH in Frankfurt suburb Kronberg. “People think of Germany as the euro area’s safest country.” The funds are a boon for domestic lenders, contributing an extra 5 billion euros in customer deposits at Deutsche Bank AG from September to March. Frankfurt-based Commerzbank AG added about 7 billion euros in deposits in the first three months of 2012, helping to erase its need to tap bond markets for refinancing this year, according to a May 9 presentation."

The "Flight to quality" picture as indicated by Germany's 10 year Government bond yields (well below 1.50% yield) with 5 years Germany Sovereign CDS slightly above 100 bps - source Bloomberg:

We voiced our concerns to "Mr Dark" in our last credit conversation "Something Wicked This Way Comes" the following from our conversation "From Hektemoroi to Seisachtheia laws?"
"We keep repeating this, but it is still very much a game of survival of the fittest....Cash is clearly king in the Basel III framework and, as Nomura put it, will therefore could lead to a war for deposits in Europe...The British stiff resistance to the latest regulatory proposals come from the fact that banks are very large in the UK relative to their GDP."

As confirmed by Bloomberg's article a war for deposits is happening given:
"Bank deposits are a main source of funding independent of the interbank and wholesale markets. Deposits by retail clients in particular are less likely to be withdrawn quickly in times of stress because the funds are secured by state-backed deposit insurance programs. New liquidity rules proposed by the Basel Committee on Banking Supervision stipulate that retail and small-business
deposits are a source of funding that’s almost as stable as equity in crisis situations.
A loss of deposits leaves banks in Greece and Spain even more dependent on the ECB for funding."

In facts German banks can thank their good fortune and the appeal of their safe-haven country given that following the downgrades of German banks this week by rating agency Moody's (undertaking the review 114 financial institutions, after Italy, and Spain). As Bloomberg rightfully so indicates:

"Moody’s Investors Service, which downgraded Commerzbank and six other lenders in Germany this week, said the credit rating cuts would have been deeper if not for the banks’ diversified funding."

So, German banks thank you European depositors united.

From the same article, dear credit friends, welcome to the European "war for deposits"!

"Non-German banks are trying to attract customers by offering higher interest rates than German peers. New clients with 10,000 euros of available cash would get annual interest rates of 2.4 percent for deposits without maturity at Paris-based BNP Paribas SA’s Cortal Consors unit, and 2.55 percent at MoneYou, a unit of Amsterdam-based ABN Amro Bank NV, according to financial consultant FMH Finanzberatung. That compares with 0.25 percent at Deutsche Bank and 0.3 percent at most German saving banks."

In relation to the 1994 demise of the 15 State-Ruble zone in 1994, as budget deficits spiraled out of control, only two members survived. Remember, it is still a game of survival of the fittest.

Euro Breakup Precedent Seen When 15 State-Ruble Zone Fell Apart - by Catherine Hickley, Bloomberg:

"While differences between the Soviet Union and the EU are greater than their similarities, there are parallels that may prove helpful in assessing the debt crisis, historians say. Both were postwar constructs set up in response to a collective trauma; in both cases, the founding generation was dying out as crisis hit and disintegration loomed."

Europe's "Prisoner's dilemma" (The prisoner's dilemma is a canonical example of a game analyzed in game theory that shows why two individuals might not cooperate, even if it appears that it is in their best interest to do so):

"The alternative scenario of deeper political union in a bid to save the euro may be even more dangerous, the British historian Antony Beevor said in an interview in Stockholm, where he was promoting his new book, “The Second World War.” “We are about to see a terrifying paradox,” Beevor said. “If the European Union goes for sudden unification to control the economies of the south which are doing so badly, then we are going to see almost an elective dictatorship from Brussels, with just the presidential elections being direct. That is going to produce the opposite of what they wanted -- i.e. it will reawaken the monster of nationalism.”

It will not reawaken the monster of nationalism, the monster is already awake, in Greece:
"Golden Dawn, a Greek nationalist party with a red-and-black logo resembling a disentangled swastika, entered parliament for the first time in the May 6 election." - source Bloomberg.

But it isn't an isolated phenomenon. Populism is rising in France, in Hungary to name a few. Pandora's box has been opened.

As far as we know, in relation to the rise of populism in Europe on the back of this "European carnival", it has long been our expectations, (we reminded ourselves this evolution in our conversation "The Charge of the Light Euro Brigade" ):

In July 2010 in our conversation - "I promise to pay the bearer on demand...- Panics and Populism", we argued the following:
"Populism movements are deeply correlated to Panics and Depression throughout human history.
The emergence of the Tea Party movement in the US in 2009 is reminiscent of the rise of the Greenback Party, which was active between 1874 and 1884, following the US civil war. The Greenback Party was born because of the Great Depression of 1873."We would add that the same process of rise in populist movements and extremism happened in Europe in the 1930s.
As a reminder we also indicated:
"The over expansion of credit and loosening of credit standards seem to always led us to economic crisis.
The panic of 1873 was followed by a similar panic in 1893 in the US.
Similar to 1873, the crisis was caused by railroad overbuilding and unsound railroad financing which led to a series of bank failures. Compounding market overbuilding and a railroad bubble was a run on the gold supply and a policy of using both gold and silver metals as a peg for the US Dollar value. Until the Great Depression, the Panic of '93 was the worst depression the United States had ever experienced.
The market overbuilding and the real estate bubble led to the financial crisis of 2007 which started with subprime."
Same apply to Ireland and Spain, over expansion of credit led to a real estate bubble.

The demise of the 15 State-Ruble zone in 1994:

"In the end, it was Russia that dealt the death blow to the ruble zone by setting ever-tighter restrictions and introducing a currency reform in 1993 that took fellow members by surprise."

We think the breakup of the European Union could be triggered by Germany, in similar fashion to the demise of the 15 State-Ruble zone in 1994 which was triggered by Russia, its most powerful member which could lead to a smaller European zone. It has been our thoughts which we previously expressed (which we reminder ourselves in "The Daughters of Danaus"):

Back in November, in a conversation with Cullen Roche on Pragmatic Capitalism - "The Impossible Refinancing Burden...", we argued:

"To put it simply there is no way Italy can refinance without the ECB acting as lender of last resort. The EFSF has not enough firepower to support both peripherals and the bank recapitalization process. It is either one or the other. Given the issue of circularity and the need for economic growth to break debt dynamics, I do not see the solvency issue resolved without the ECB stepping in. The big question is, would Germany allow the ECB to alter its DNA given it would contravene the Lisbon treaty, if it starts intervening massively? I have some doubt about it, and it is a scary prospect. So far the Bundestag and German Constitutional court have stepped in to rein in the expansion of the EFSF, because they do not want to betray German people. Either they know it is not the solution and are buying some time to allow for more integration within Europe and using it as a bargaining tool to force Greece and others to concede their independence somewhat in exchange of stronger support, or, the game is for Germany to buy some time and leave and join force with Austria, Finland, the Netherlands, and leave peripherals on their own."

Could Germany be like Hypermnestra and decide to go her own way as the Danaides story goes? But once again we divagate in our thoughts."

As Ivan Krastev, chairman of the Centre for Liberal Strategies in Sofia was quoted in the Bloomberg article mentioned above on the demise of the 15 State-Ruble zone in 1994 :
“A currency is about trust”
“There is a need for an emotional sense of shared citizenship to have a common currency. It is good to have a shared sense of belonging.”
 
On a final note, we leave you with a table indicating the total Euro Zone Bank Bail-inable liabilities, a subject we discussed recently in "Something Wicked This Way Comes":

"Total euro-zone bank liabilities reached a new high of 33.9 trillion euros in April. Assuming "bail-inable" liabilities, plus capital, have to meet a minimum 10% of total liabilities by 2018, as mentioned in the E.C. working paper, a total of 1.1 trillion euros of bail-inable bonds could be required, in addition to current capital of 2.25 trillion." - source Bloomberg.

"Unless commitment is made, there are only promises and hopes... but no plans."

Peter Drucker

Stay tuned!