Credit - The Raft of the European Medusa

"The man who has experienced shipwreck shudders even at a calm sea."
Ovid

"The Raft of the Medusa (French: Le Radeau de la Méduse) is an oil painting of 1818–1819 by the French Romantic painter and lithographer Théodore Géricault (1791–1824). Completed when the artist was 27, the work has become an icon of French Romanticism. It is an over-life-size painting that depicts a moment from the aftermath of the wreck of the French naval frigate "Méduse", which ran aground off the coast of today's Mauritania on July 5, 1816. At least 147 people were set adrift on a hurriedly constructed raft; all but 15 died in the 13 days before their rescue, and those who survived endured starvation, dehydration, cannibalism and madness. The event became an international scandal, in part because its cause was widely attributed to the incompetence of the French captain perceived to be acting under the authority of the recently restored French monarchy." - source Wikipedia

Following up on the theme of navigation and sailing dear to our heart, given "The Tempest" raging and the unraveling of the "Mutiny on the Euro Bounty" courtesy of the high stakes poker game being played by Greek politicians and their European creditors (reminiscent of "Schedule Chicken" once more...), we have decided to use yet another sailing analogy but this time referring to Géricault's painting masterpiece "The Raft of the Medusa".

"In an effort to make good time, the "Méduse" (Medusa) overtook the other ships, but due to poor navigation it drifted 100 miles (161 km) off course. On July 2, it ran aground on a sandbank off the West African coast, near today's Mauritania. The collision was widely blamed on the incompetence of De Chaumereys, a returned émigré who lacked experience and ability, but had been granted his commission as a result of an act of political preferment." - source Wikipedia.

Similar to the fate of the Medusa ship, the story so far has been the European Commission in an effort to make good time in reducing budget deficits, decided to impose unrealistic budget reduction objectives ("A Deficit Target Too Far") while imposing drastic reduction in bank leverage and balance sheets, courtesy of the European Banking Association (EBA) June 2012 deadline of 9% of Core Tier 1 capital. These combined actions led to credit contractions, no surprise there, leading to reduced economic growth in Europe compared to the US ("Growth divergence between US and Europe? It's the credit conditions stupid..."). While utter financial meltdown disaster was narrowly avoided thanks to the ECB's LTRO operations, the lack of experience or ability (or both...) of the captains of our "European Flutter" ship have indeed landed the European project on a sandbank, with of course, a "raft" full of "unintended consequences" such as mutiny, with Greek bond subordination during the recent PSI leading to insubordination (a buyers strike...) in parts of the European bond market.

So in our long credit conversation, we will of course look at the recent price actions, but we will focus on Greece and the recent comparisons made with Argentina being the comparison "du jour" (of the day), rebuking in the process some "urban legends" and economic myths.

But first our credit overview!

The Credit Indices Itraxx overview - Source Bloomberg:

The price action was undoubtedly experienced in the European morning session with a significant widening of most Itraxx Credit indices coming from rising tensions in the European Government bonds space. Itraxx Crossover 5 year CDS index widened to 751 bps (50 European High Yield entities), before receding in the afternoon to end up around 740 bps. Itraxx Main Europe 5 year CDS representing 125 Investment Grade entities widened as well, and moving towards the 200 bps, indicating significant risk perception rising in the European credit space. This index, like most, has been steadily rising for the last seven days. Both indices have reached their highest level since the 9th of January according to Bloomberg. The financial space wasn't spared either with Itraxx Financial Senior 5 year CDS index, representing a gauge for renewed financial tensions, touched 300 bps before receding slightly in the afternoon, whereas the Itraxx Financial Subordinated 5 year CDS index jumped towards the 500 bps level, closing around 480 bps. Upcoming additional Moody's downgrades of additional European banks (Moody's has already cut 26 Italian banks), will cause this index to drift wider still. We have discussed the impact of the upcoming downgrades on subordinated bank debt in our last conversation "Interval of Distrust".

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

High Yield Risk perception rising in conjunction with Volatility.

At the same time we are seeing Financial risk reconnecting fast with Sovereign risk, as indicated by the convergence of Itraxx Financial Senior Spread 5 year CDS and SOVx Western Europe 5 year CDS - source Bloomberg:

The spread between the Itraxx SOVx Western Europe and Itraxx Financial Senior is moving towards 0 clearly indicating the LTRO effect is a becoming a distant memory with an increased correlation of both indices with rising sovereign risk concerns (Spain, Italy). The drop witnessed in March in the graph is due to Greece falling out of the SOVx index (15 Western Europe countries) and replaced by Cyprus ("SOVx Western Europe - And Then There Were 14...").

The current European bond picture with Spain experiencing a serious bout of volatility in conjunction with Italy- source Bloomberg

Spanish 10 year government yield intraday movements on the 16th of May - source Bloomberg:

Moving fast and furiously towards 6.50% yield levels before receding due to rumors of ECB emergency meeting and possible re-activation of SMP (Securities Market Programme).

As indicated by Bloomberg, Spain spread over bund at 450 bps, has been previously a key level for previous European bail-outs - source Bloomberg:

"With Spain's CDS reaching new highs (544 bps), the spread of its 10-year sovereign over the German bund has reached 4.5%, a level viewed as significant for triggering bailouts in both Portugal and Ireland. At a time when profitability is falling thanks to new provision rules, elevated sovereign CDS and spreads will also drive higher funding costs for Spain's banks." - source Bloomberg.

The slump in Spanish bonds risks LCH margin increases which is concerning. This margin increase on the LCH exchange could happen given in the past the 450 bps difference with German Bund has been the threshold as indicated by Bloomberg:

"LCH said in October 2010 that a yield premium of more than 450 basis points would “be indicative of additional sovereign risk,” and may cause it to “materially increase the margin required for positions in that issuer.” Clearing houses guarantee trades are completed by standing in the middle of two counterparties, and raise margin requirements to protect themselves against losses should one side of the trade fail."

"Spanish government bonds risk incurring higher trading costs at LCH Clearnet Ltd. as their performance relative to Europe’s safest assets deteriorates. The CHART OF THE DAY shows the difference in yield between Spanish 10-year bonds and a benchmark of AAA rated euro-region sovereign debt is approaching 450 basis points for the first time since the shared currency was created. LCH, Europe’s biggest clearing house, increased the cost of trading Irish and Portuguese bonds by 15 percent when yield spreads for those securities climbed to similar levels." - source Bloomberg.

The 10 year German Bund and the Eurostoxx seem to reconnect at least from a directional point of view with volatility rising as indicated in the bottom part of the graph - source Bloomberg:

Some change in the "Flight to quality" picture, with wider Germany 5 year CDS closing towards 100 bps and 10 Government bond well below 1.60% yield level - Source Bloomberg:

As a reminder, bear in mind we previously saw a spike in Germany's sovereign CDS back on the 29th of November 2011 ("The Eye of The storm"), prior to the German "failed" auction which lead to a significant widening of the German Bund yield above 2.30%, when Germany's sovereign 5 year CDS went above the 100 bps level. We are getting closer to 100 bps for Germany's sovereign CDS. The cost of insuring German debt is rising fast, even as its bond yields are falling. Credit-default swaps on Germany jumped 10 basis points this week to a four-month high of 98, signaling worsening perceptions of German credit quality. The German Sovereign CDS was at 67 basis points on March 19 according to Bloomberg.

In relation to Spanish banking woes, Bankia share price is indeed suffering from the "partial" nationalization process undertaken by the Spanish government and from the plight of its real estate issues and significant exposure, being the focus of attention - source Bloomberg:

The second phase of real estate provisioning reforms announced on the 11th of May, enforces a 30% generic reserve coverage of performing loans instead of 7% and make it compulsory for banks to transfer all problem foreclosed assets into a separate work-out subsidiary at "fair value", which will have to be appraised by an independent auditor, in similar fashion to what Ireland did for the set-up of its work-out entity NAMA. The additional cost to banking giant Santander will be 2.7 billion euro of provisions in addition to the 2.3 billion euro ear-marked for provision to be passed before end of 2012. While Santander, has not provisioned the 2.3 billion needed under RDL 1 (Royal Decree Law 02/12), BBVA has so far provisioned 175 million euro in the first quarter. The total cost for each of them will amount to one or two quarters worth of earnings on a net basis according to CreditSights (5 billion euro for Santander, around 4.025 billion for BBVA). For our ailing Bankia, the cost will amount to 4.7 billion euro pre-tax, which is more than ten times 2011 pre-tax profit...Oh dear...

According to CreditSights, the New Real Estate Rules means significant additional provisioning under RDL 2:

"Additional provisioning under phase 2 will cost the whole banking system almost 30 billion euro in 2012, on top of 39 billion euro from Phase 1, most of which has still to be charged to income statements over the next three quarters."

As we type, Bankia shares have touched a new low, falling another 26% to 1.29 euros experiencing a similar fate witnessed with Portuguese banks Banco Espirito Santo and Banco Comercial Português (BCP).
Banco Espirito Santo stock price evolution - source Bloomberg:

Banco Comercial Português (BCP) stock price evolution - source Bloomberg:

We believe subordinated debt to equity swaps are coming for some weaker financial institutions with more pain for both shareholders and bond holders ("Peripheral Banks, Kneecap Recap"). Bankia's IPO initiated in July 2011 drew 347,000 investors, most of them individuals, have lost as of today's price action two-thirds of their ill-fated 2011 investment. The IPO, as indicated by Bloomberg was successful because it was made on "illusory promises":

"To lure buyers, Bankia held out the promise of distributing about 50 percent of its net income as dividends. “The IPO was mainly a dividend play, so it appealed particularly to retail investors when interest rates elsewhere are so low,” said Ipox’s Schuster. “Bankia has a strong retail network and that’s basically how the deal got done. Now not only their shares get diluted, it’s also a question mark whether Bankia will be able to deliver future dividends.”

15 underwriters or undertakers, one as to ask oneself, given as indicated by Bloomberg:

"A total of 15 underwriters led by Bank of America Corp., Deutsche Bank AG, JPMorgan Chase & Co. and UBS AG earned a commission of about 1.2 percent on the 3.1 billion-euro IPO, or about 37 million euros, data compiled by Bloomberg show. While managers were taking orders for Bankia’s IPO, investor concern about Europe’s deepening debt crisis was already propelling Spanish bond yields to what was then a euro-era record. The lender had to reduce its IPO price by about 26 percent from its initial range in order to complete the sale.

The IPO “has been considered a reference point for the Spanish banking industry” and was completed “in the middle of a true storm in the markets that imposed the toughest financial conditions of the last decade,” Rodrigo Rato, Bankia’s chairman at the time, said in a speech on July 20."

Individuals bought about 60 percent of the shares on sale in the IPO...

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

Like experienced shipwreckers we did shudder during the calm sea ("Plain sailing until a White Squall?").

Moving on to the subject of Greece being compared to Argentina by many pundits, we would like to make the following points:
Most Greek Banks are most likely bust. Greek Banks 5 year CDS on the 16th of May - source CMA:

Greek banks had negative equity given their very large exposure to Greek government bonds. As a reminder Greek banks are required to reach 9% Core Tier 1 by September 2012 first via private sources and if it fails then government. We discussed the issues of raising private sources faced by Apostolos Tamvakakis, chief executive of National Bank of Greece, launching a recent desperate last-ditch attempt in securing private funding in our recent conversation "Kneecap Recap". Greek private bank shareholders will be wiped-out. 30% of National Bank of Greece shares are in the hands of foreign investors such as Bank of New York Mellon, BlackRock, Allianz, Pictet, Prudential Financial, Aviva, AXA, HSBC and BBVA, according to Bloomberg data as we indicated in our recent post.

No wonder the Greek stock index is still tanking on the 16th of May - source Bloomberg:

We already touched on the value of Greek financial shares in our conversation "Equities, there's life (and value) after default! - Russia, Argentina, Iceland, examples for Greece":

"Given the outstanding weight of financials in the Greek ASE index and knowing their current Greek debt holdings, Alpha Bank, National Bank of Greece, EFG Eurobank and Piraeus bank respective equity is probably worth zero. It should in theory equate to an additional write down of at least 16.74% of the ASE Greek index." - Macronomics - 4th of March 2012.

At the time of our conversation the ASE index was at 741...Now below 555.
Financial weights as of the 16th of May 2012 in the ASE index, Banks =15.44% - source Bloomberg:

Greek Banks May Face Same Dilemma as Argentine Banks in 2001-02 according to Bloomberg:

"A key problem faced by the Argentine banks as fears of devaluation drove depositors to switch to foreign currency was the resultant currency mismatch on its balance sheet. Pressure to address this drove many banks to increase foreign-currency lending, which brought with it increased default risk, an issue which Greek banks may need to address."

Greece is not Argentina, and will fare worse as indicated by Bloomberg:

"GDP growth was negative in Greece during the last 14 quarters. While Argentina's banks and economy recovered quickly with 9% GDP growth and a rebound in consumer spending in 2003, austerity measures and lingering sovereign concerns suggest that Greece and its consumers may struggle to achieve this, implying a slower return to profitability for its banks."

Argentine Banking Asset Loss a Stark Warning to Greek Banks - source Bloomberg:

"While Argentina suffered significant deposit outflows prior to devaluation, deposit growth was 19% by the end of 2002, rising to 26% in 2003. By contrast, loans in the system did not return to growth until 2004 and many years later the recovery in assets is far behind deposits. Should a similar fate befall Greece, funding for recovery may be hard to secure." - source Bloomberg.

In relation to Greece, its neighbor Bulgaria (475 kms of frontier with Greece) enjoy a 10% corporate tax rate and a 20 tax rate on individuals. A record rise has been registered in the number of people crossing the Bulgarian-Greek border at Easter:

A total of 220,000 people and 77,600 vehicles crossed the border at the five checkpoints between Bulgaria and Greece on the four days off at Easter (between Friday and Sunday). For comparison, nearly 48,000 vehicles and 142,000 people crossed the border at Easter in 2011...

We have long been enthusiast readers of Dr Felsenheimer from Asset Management Assénagon monthly credit letter. In his latest letter Dr Felsenheimer clearly indicates Dr Krugman lack of understanding of the banking system, core to the current European crisis:

"Dr Krugman now suggests a solution based on three elements: Firstly, the ECB should buy government bonds. Secondly, the foreign trade imbalances between the member states should pursue an expansionary policy to help countries reduce their debt through moderate inflation."

Dr Felsenheimer's clearly indicates why Dr Krugman's assessment is incorrect, given Dr Krugman seems to ignore the interdependence of banks and governments:

"The purchase of government bonds by the ECB (however it is implemented) increases precisely this interdependency further still. You don't need to be a market moralist (if such a thing exists) to see the purchase of government bonds by a central bank as a Ponzi game. But to force the reduction of foreign trade imbalances is to argue against all microeconomic reason. Such a policy would of course solve the problem of the target II balances en passant. However, we should first of all ask how such an imbalance reduction could be achieved. It is clear that reducing a trade surplus is easier than reducing a deficit. This means that Germany in particular would have to accept export restrictions, which would be in direct opposition to the desire for growth impetus. Ultimately, the ECB's extremely expansionary policy must be held partly responsible for the crisis. The demand for further expansion in turn represents the danger of further speculative bubbles.

The US has pursued a response to the crises of recent years very close to that of Krugman's theory, at least regarding the role of the FED (the largest investor in US government bonds). Any sustained success however is questionable. Even though Europe has pushed the US out of the headlines in recent months, the US debt situation has not improved at all.

Should we not maybe do exactly the opposite of what classical theory suggests? Does a restrictive monetary and fiscal policy not mean that the entire banking system has to "deleverage" and shrink its enormous balance sheets? It could be argued that the state should step in to help during such a transition (e.g. by partially compensating for the cuts in lending that would be expected), however that is something completely different to pursuing expansionary policies itself.

Less liquidity in the banking system reduces the danger that speculative bubbles will form, it forces the necessary consolidation in the banking system and it puts pressure on countries to pursue a sustainable economic policy to attract investors. The logical consequences of the European solution (assuming that this is largely continued even during Hollande's presidency) is that it involves a painful adjustment process that already been underway for two years. The Anglo-Saxon method does not promise a solution, but rather a postponement of the problem. It does not solve the fundamental problems of the euro zone."

A bank is a leverage play on the economy. It is the second derivative of a sovereign.

This is exactly the solution Sweden implemented during its 1990s crisis.

Sweden, suffered a banking crisis in the early 1990s and then again in 2008 and 2009. They chose to inject capital into struggling banks only in return for equity to avoid raising deficits and burdening taxpayers. The government in 2008 set up a financial stability fund by charging banks an annual fee and enacted various crisis-management measures including a bank guarantee program to help support lending.The fund will grow to 2.5 percent of gross domestic product by 2023 and stood at 35 billion kronor ($5.2 billion) at the end of 2010, including shares in Nordea Bank AB, according to the Swedish National Debt Office.

The Swedish example comes to mind when thinking about the ongoing interdependence between banks and governments. Cheuvreux in their recent note "Why the nordics are a safe haven" touched on the deep restructuring process followed by Sweden, which lead to the disappearance of some banks (survival of the fittest) and the following results:

"The rule is only: spend less than you earn…

In addition to substantial tax increases to balance the budget and reduce debt, the social security payments were capped resulting in real decreases as the pay-outs were not kept in line with GDP growth. In addition, checks and balances were introduced with automatic stabilisers which did not allow spending to outstrip growth, such as seen in the pension system where significant reform was passed by all the major political parties in 1995.

Furthermore in the budgetary process the role of the Ministry of Finance has been strengthened forbidding spending ministries to launch proposals without financing, not allowing parliament to make unfunded amendments, introducing a rolling budget ceiling that must not be breached as well as a 1% budgetary surplus intended as a saving to handle the retirement of the baby boomers in the 2020s, i.e. a Swedish balanced budget includes a 1% extra margin of safety which can be compared to the European average budget deficit of around 6%." - Cheuvreux - Why the nordics are a safe haven - 2012.

In addition to Dr Krugman's unwillingness of understanding interdependence, the idea that Germany's economic prosperity has been built on "vendor financing" to peripherals countries is a myth. In a recent paper published by François Chauchat from Gavekal we learned that: "exports to Southern Europe have contributed to only 13% of the increase in German exports since 2000 and never amounted to more than 5% of German GDP. In comparison, exports to non-EMU countries rose to 25% of GDP recently, from 15% in 2000. So even though Germany lent a lot to southern Europe - making its financial sector very vulnerable - this financing was used more to buy Chinese products, oil and commodities than German goods."

Eastern promises for Germany according to Moscow-based economist Liam Halligan:
"Russo-German trade Europe's 'biggest untold story' says top economist" - Chris Sloley - Citywire:
"Russia’s biggest trading partner is now Germany and Germany’s biggest trading partner is now Russia, having overtaken France,’ he said.
‘It is the biggest untold story but western papers don’t want to talk about it. It is part of a trend of Germany looking increasingly east and you feel it much more strongly if you are working in the east and how this has changed on the ground.’"

Finally the Argentina crisis should be a warning on Spanish Banks' Sovereign Holdings (we already know what happened to Greek banks bond holdings...):

"Spanish banks increased their sovereign holdings by 48% since November 2011, Italy increased theirs by more than 30%. Argentine bank sovereign holdings and government loans rose to 21% from 10% of total assets in 1995-01. A consequence of this was less private sector funding, a risk for Spain and Italy should conditions worsen and deleveraging continue." - source Bloomberg.

“Panics do not destroy capital – they merely reveal the extent to which it has previously been destroyed by its betrayal in hopelessly unproductive works” - John Mills, “Credit Cycles and the Origins of Commercial Panics”, 1867

Stay tuned!

Credit - Interval of Distrust

"Realism doesn't mean outright pessimism" - Max Lerner - American journalist.

"The principle behind confidence intervals was formulated to provide an answer to the question raised in statistical inference of how to deal with the uncertainty inherent in results derived from data that are themselves only a randomly selected subset of an entire statistical population of possible datasets. There are other answers, notably that provided by Bayesian inference in the form of credible intervals. The idea of confidence intervals is that they correspond to a chosen rule for determining the confidence bounds, where this rule is essentially determined before any data are obtained, or before an experiment is done. The criterion for choosing this rule is that, over all possible datasets that might be obtained, there is a high probability that the interval determined by the rule will include the true value of the quantity under consideration. That is a fairly straightforward and reasonable way of specifying a rule for determining uncertainty intervals. The Bayesian approach appears to offer intervals that can, subject to acceptance of an interpretation of "probability" as Bayesian probability, be interpreted as meaning that the specific interval calculated from a given dataset has a certain probability of including the true value, conditional on the data and other information available. The confidence interval approach does not allow this, since in this formulation and at this same stage, both the bounds of interval and the true values are fixed values and there is no randomness involved." - Philosophical issues - source Wikipedia

Given recent events relating to significant losses suffered by JP Morgan due to (mis)-measured VaR (Value at Risk), we thought our title would be appropriate, following the aforementioned events. JP Morgan restated its 1Q12 VaR associated with its Chief Investment Office from 67 million USD to 129 million USD. A VaR of 67 million USD at a 95% confidence level (hence our title...) implied that JP Morgan should not have incurred losses in excess of 67 million USD on more than three business days during the quarter. But we ramble again. We will refrain going into more details about yet another example of being fooled by randomness in true Nassim Taleb fashion, or the mis-behavior of markets as depicted by the great Benoit Mandelbrot. We already touched on "optimism bias" in our "Bayesian Thoughts" conversation:

"Humans, however, exhibit a pervasive and surprising bias: when it comes to predicting what will happen to us tomorrow, next week, or fifty years from now, we overestimate the likelihood of positive events, and underestimate the likelihood of negative events. For example, we underrate our chances of getting divorced, being in a car accident, or suffering from cancer. We also expect to live longer than objective measures would warrant, overestimate our success in the job market, and believe that our children will be especially talented. This phenomenon is known as the optimism bias, and it is one of the most consistent, prevalent, and robust biases documented in psychology and behavioral economics."

Tali Sharot - The optimism bias - Current Biology, Volume 21, issues 23, R941-R945, 6th of December 2011.

Hopefully for JP Morgan, should their bonds widen significantly, they might be in a position to recoup some of these losses courtesy of FAS 159 and DVA... So in our credit conversation "The Tempest" where we touched on the issues of the banking system in Spain leading to the recent "partial" nationalization of Bankia (for now...Spanish Government to convert 4.5 billion euro of FROB aid previously given to Bankia group parent BFA into shares, giving government as much as 45% ownership), we will focus this time around on the ongoing deleveraging process and the impact of upcoming downgrades in the financial sector (Moody's is reviewing 114 European financial institutions). But first, a credit overview.

The Credit Indices Itraxx overview - Source Bloomberg:

Credit markets this week have indeed hit "bad weather" courtesy of the news flow in both Spain and Greece, with the Itraxx Crossover 5 year CDS index (High Yield risk gauge, 50 European entities) crossing the 700 bps level and 40 bps wider since last Friday, a new series 17 high since the last rebalancing of the index which occurred on the 20th of March this year. Once again the dominating force in the widening movement was in the financial space, with a clear underperformance for the Itraxx Financial Subordinate 5 year CDS index, wider by around 12 bps to 438 bps (40 bps wider since last week) whereas Itraxx Financial Senior 5 year index was wider by around 7 bps to 266 bps (20bps wider since last Friday). Credit Agricole posted a 75% drop in first quarter earnings impacted by exposure to Greece and the Spanish Government pushed forward a plan to ramp up provisions in the financial sector.

Since November last year we have been arguing about the heightened probability of seeing more and more debt to equity swaps in the financial space (and no, it wasn't a question of "optimism bias" from our part or outright pessimism...). In fact we learnt that the governing body of the Credit-Defaults swap markets ISDA and its credit steering committee are about to begin a formal process to revamp the CDS contracts to take into account how debt-to-equity exchanges would be treated after bankruptcy, as indicated by Matthew Leising in Bloomberg on the 9th of May - ISDA Said to Begin Biggest Revision to Credit Swaps Since 2009:

"Credit-default swaps users will meet this week in New York and London to discuss changes to the contracts in what may become the biggest revisions since 2009, according to people familiar with the situation.

Possible changes to standard contracts, which are governed by the International Swaps and Derivatives Association, include how debt-for equity exchanges would be treated after a bankruptcy, specifying that credit swaps only cover losses from defaults that occur after their purchase and clarifying how the date of a so-called credit event is determined, said the people, who asked not to be named because the discussions are private."

The importance of debt-for equity exchanges in CDS contracts from the same article:

"The concern arose in the bankruptcy of CIT Group Inc. when the commercial lender proposed to exchange its debt for equity before the credit swaps settlement date, one of the people said. Because only bonds and loans are deliverable under the current standard swaps contract, that left the possibility of having no debt with which to settle the contracts."

"Unintended consequences" and fixing flaws relating to Sovereign CDS contracts, the Greek example as reported by Matthew Leising in Bloomberg :

"Credit swaps payouts after a government debt exchange would be tied to the ratio of the face value of the new bonds to the old bonds. That would seek to prevent scenarios where payments are limited to swaps buyers because the new bonds are trading close to par, a concern of market participants after Greece undertook the biggest sovereign-debt restructuring in history. Credit swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt."

Good intentions, given you probably want to "cash in" while you can on your Sovereign CDS contract, but as the Greek example is clearly showing, new bonds have not been trading close to par for very long...

"Greece’s 10-year bond price has dropped below that of the security it replaced in the biggest-ever debt restructuring two months ago, suggesting investors are betting the nation will default.

The CHART OF THE DAY shows the price of Greece’s 2 percent bond maturing in 2023 sank to 18.995 percent of face value yesterday, below the 19.005 closing level of the bond it superseded. The security, which began trading after the March 9 debt restructure, has tumbled as deadlocked talks over the formation of a new government reignited concern Greece won’t meet the terms of two international bailouts, increasing the risk it will leave the euro currency bloc and fail to pay back its creditors." - source Bloomberg.

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

Spanish bonds came back above 6% while German bund yields hit record new lows. In our conversation "The European Opprobrium" back in February, our good credit friend and ourselves had been discussing the following:

"Will subordination of private bondholders versus the ECB lead to insubordination?

If true, here are the questions you should ask yourself:

Will the new bonds be senior to the old bonds? If so, expect private investors to go on strike and buy much less sovereign bonds as they will be subordinated to the ones owned by Public institutions in the future. Also, some private investors may decide to try their chance in Court and argue against the subordination de facto."

When it comes to Spanish debt we have already started to see "insubordination" leading to a private investor "buyers strike" ("Mutiny on the Euro Bounty"):
"The Spanish Treasury, in the ship's bunker, might encounter some problems in placing Spanish debt, which until recently had been absorbed by docile domestic banks. The two largest Spanish banks, Santander and BBVA have said they had reached the maximum levels allowed in terms of their policy in risk concentration and consequently will not increase their purchases of Spanish debt from now on."
So next week auctions for both Spain and Italy should be interesting, given the bank recapitalization exercise taking place which could further more erode confidence in Spanish sovereign debt. The additional burden of providing support for the "problematic" 184 billion euros of assets identified by the Bank of Spain is indeed a cause for concern in relation to the financial aspect of the operation. The government is expected to demand banks to set aside a further 35 billion euros to cover sound loans in their real estate portfolios. The government has already obliged banks to make provisions of 54 billion euros to cover bad assets, and in our last conversation, we already touched on the level of provisions already passed by Spanish banks. Some banks haven't really started (BBVA, Santander need to provide around 2.3 billion euro each in 2012 under the RDL). The government asked the banks to set aside 30 percent of their sound loans to house builders, up from a current 7 percent, but the banks, including major players Santander and BBVA, had pushed back with a lower number (call it "insubordination" or mutiny...).

If it were only Spanish banks being on a "buyers strike"...
"Gao Xiqing, president of China Investment Corp., said the nation’s sovereign wealth fund has stopped buying European government debt on concerns about the region’s financial turmoil: “If European governments want to issue bonds, CIC is not a main target institutional investor,”
source Bloomberg - CIC Stops Buying Europe Government Debt on Crisis Concern.

No wonder our "Flight to quality" picture as indicated by Germany's 10 year Government bond yields dipping below 1.50% is so telling (10 bps tighter in a week). It is indeed deflation (デフレ). - source Bloomberg:

In this game of survival of the fittest, as we posited before, it is all about capital preservation rather than capital appreciation. As David Rosenberg put it recently: We are no longer in the era of capital appreciation and growth. "The “baby boomers” are driving the demand for income which will keep pressure on finding yield which in turn reduces buying pressure on stocks. This is why even with the current stock market rally since the 2009 lows – equity funds have seen continual outflows. The “Capital Preservation” crowd will continue to grow relative to the “Capital Appreciation” crowd."

We agree with Nomura's recent note - European political implications: new bund target 1.25%:
"Recent developments have reinforced our strategy recommendations: short non-core markets, and stay long Bunds. We are close to our 1.50% initial target on 10yr Bunds, but see the rally extending further so move our target to 1.25% on DBR 1.75% 07/22. This new target could be breached if no fresh policy response to the crisis emerges. After all, we still believe that absent a proportional policy response, a break-up of the euro is probable rather than possible."

The "D" world (Deflation - Deleveraging) - 2 year German Notes evolution versus 2 making again new lows versus 2 year Japanese Notes - source Bloomberg:

In a deleveraging/deflationary world:
"The corner stone of asset management is not capital “appreciation” but capital “preservation”."

In a recent note published by Credit Suisse focusing on Japan and deleveraging:
"It seems there is plenty of evidence to suggest that global overleveraging and bursting of various asset bubbles (ranging from banking to property to trade imbalances) is moving most developed countries/regions along similar progression line as what occurred in Japan over the past 20 years."

"As can be seen in the above graph, in 1998, the key developed economies (i.e., the US, the UK, Eurozone and Japan or G4) carried a total debt burden (public plus private) of around US$65 tn, or approximately 300% of the GDP.
However, by 2008 (amid the unfolding crisis), the overall level of debt expanded to US$131 tn or 370% of GDP. It continued to climb to US$140 tn or almost 400% of GDP by 2011. On the current trajectory, the overall level of debt should climb to almost US$143 tn by 2013 but should be slightly down in proportion to GDP to around 380%.
In order to place this debt burden into perspective, one should remember that since the end of World War II, the average burden was not much more than 240–250% (broadly 60% each for household, business, financials and government sectors). In other words, if the overall debt burden were to return back to more normal levels (say by the end of 2013), the overall debt level would need to decline towards US$100 tn (i.e., fall of US$35–40 tn).
A return to the 1998 levels would still require a drop in debt levels to around US$115–120 tn or a fall of up to US$20 tn." - source Credit Suisse - Japan: Back to The Future - 10th of May 2012.

Balance Sheet Recession? It's the private sector stupid!
"Clearly, the area of greatest expansion of debt burden between 1998 and 2008 occurred in the private sector. Once again, looking at G4, the overall private sector debt was around US$50 tn in 1998. However, by 2008, it reached US$100 tn, rising from 230% to almost 290% of GDP versus the historical average of around 190%. Since 2008, the private sector has embarked on a de-leveraging process, which is likely to reduce G4 private sector debt by around US$3–4 tn (by 2013), easing debt burden as a percentage of the economy to around 260–270%.
The other side of the private sector de-leveraging is a rising public sector debt. We estimate that by 2013, the public sector debt across G4 will rise to 120% of GDP (excluding significant contingent liabilities and unfunded liabilities). In other words, debt to GDP of the public sector, which was broadly in line with the historical average of around 60%, could easily double by 2013." - source Credit Suisse - Japan: Back to The Future - 10th of May 2012.

So what happened in Europe? Bank leverage...

"There was a similar acceleration in Eurozone’s total and private sector leverage levels over the last 10–15 years (paralleling the US experience, except that most of the increase in Eurozone was driven by financial and corporate rather than household sectors). As can be seen below, Eurozone’s private sector’s leverage is currently close to 290%, up from just over 200% in 1998." - source Credit Suisse - Japan: Back to The Future - 10th of May 2012.

"Most of the key Eurozone economies have so far failed to achieve any meaningful reduction in private sector debt, with the prevailing levels broadly in line with the US and Japan for France and Spain (around 270–290% of GDP), although the Italian and German private sectors are far less leveraged.

At the same time, leverage of some of the more vulnerable economies such as Portugal and Ireland as well as larger non-Eurozone economies (such as the UK) remains uncomfortably high. Private sector debt to GDP in the UK is between 300% and 400% of GDP (depending on the degree of adjustment for the UK’s global financial hub status) while Irish private sector debt is a crushing 550–600% of the country’s GDP and Portugal’s private sector debt is close to 280–290%." - source Credit Suisse - Japan: Back to The Future - 10th of May 2012.

Moving on to our second subject of upcoming Moody's downgrade of 114 European financial institutions, Morgan Stanley caught our interest with their recent note on European banks - Who Will Catch the Falling Banks?":

"Moody’s review has been pushed back, but we don’t believe that indicates any softening in approach. With many bonds expected to drop out of the IG indices, or at least go sub-IG at Moody’s, we believe there are few investors willing to step in – at least at current levels – to meet any forced sellers/nervous holders."

We've been ranting like a broken record in relation to subordinate debt; Morgan Stanley's note is indeed confirming our long standing position:
"Downgrades in LT2 could be 5-6 notches, not ‘just’2-3, in our view. We are concerned that investors haven’t fully grasped that LT2 will be affected by Moody’s downgrades of senior ratings plus removal of support notching – with BNP’s LT2s potentially dropping five notches to Baa3 and UBS’ six notches to Ba1, for example.
59% of the € iBoxx Tier 1 index will have dropped out once Moody’s downgrades are done, compared to 1 January 2012, we expect. LT2 indices will see dropouts too, with an expected 19% in the same time period. The volume of falling angels – €18 billion of Tier 1 and €17 billion of LT2 – is unprecedented and hence we are concerned about subsequent price action.
Will HY buyers save them? We don’t think so. Our survey of HY investors suggests most don’t have to closely follow an index and a move from 25% to 32% of the €HY iBoxx index, still wouldn’t make those who don’t look at banks now suddenly get interested. In our view, prices have to cheapen significantly from here to attract them; the same going for insurers who have spent years de-risking bank capital. Retail investors are ratings insensitive, but demand here is not enough to avoid a price correction, in our view."

Bracing for a sell-off impact, from the same Morgan Stanley note:
"We appreciate that a number of Tier 1 index dropouts, including large names like UniCredit, have recently happened without much disturbance to the market. However, the sheer volume of bonds dropping out in the next couple of months will be unprecedented – following the Moody’s downgrades, we expect €18 billion of Tier 1 and €17 billion of LT2 to have dropped out of the € IG indices since the start of the year."
Hence our "interval of distrust"...Oh well...

In this deleveraging process, capital rules for bank capital have yet to be addressed. We have already argued like many before us, that contrary to many beliefs, Bank Equity is not expensive. It is a myth as clearly demonstrated by Anat R. Admati - “Fallacies, Irrelevant Facts and Myths in the Discussion of Capital Regulation: Why Bank Equity Is Not Expensive.”
We share the same views as Simon Johnson, the Ronald A. Kurtz Professor of Entrepreneurship at the M.I.T. Sloan School of Management, as indicated in his latest views published in the New-York Times:
"Breaking Up Four Big Banks"
A view which is gathering traction, courtesy of the latest losses incurred in the financial sector due to oversized positions that went badly wrong.
Rules for Bank Capital Still Aren’t Mended Four Years On: View by Bloomberg Editors - 7th of May 2012:
"Bank capital is of paramount importance because it is capable of absorbing losses. If a well-capitalized bank gets into trouble, its shareholders suffer, but depositors, the taxpayers who insure their deposits and the rest of the financial system are protected. Wafer-thin capital -- in other words, huge leverage -- was the main reason the crash propagated as it did.
The new accord proposes that banks maintain equity capital of 4.5 percent of risk-adjusted assets, plus a 2.5 percent added buffer. Equity of 7 percent is an improvement over Basel II, but still far less than needed. Even under the new regime, some supposedly risk-free assets would require little or no capital backing, so equity as a proportion of total assets would be lower. Basel III sets a floor of just 3 percent for equity as a proportion of total assets. A much higher figure -- as high as 20 percent of assets -- is called for."

On a final note, we would like to add that complacency and weak interval of confidence based on flawed assumptions or models can be dangerously deceitful when markets lack direction as demonstrated by Eugene F. Fama and Kenneth R. French, the creators of a model explaining equity returns:

"As the CHART OF THE DAY shows, each component of their three-factor model dropped last year for the first time since 1994. The declines occurred even though the Standard and Poor’s 500 Index was little changed.
Fama, a University of Chicago professor, and French, a professor at Dartmouth College in Hanover, New Hampshire, put together the figures used for the chart. They track return gaps between stocks and Treasury bills, between the shares of smaller and larger companies, and between value and growth stocks.
Although market returns had the biggest swings among the three factors in the past half century, “the volatility of the size and value premiums is nevertheless high,” Fama and French wrote in a paper analyzing the numbers. The research, posted on their blog three days ago, is based on data from the University of Chicago’s Center for Research in Security Prices.
Last year’s total return for all U.S. stocks, weighted by market value, was 0.9 percentage point less than the return on one-month Treasury bills with monthly reinvestment." - source Bloomberg.

"When evil acts in the world it always manages to find instruments who believe that what they do is not evil but honorable." - Max Lerner

Stay tuned!

Markets - Credit - The Tempest

"Worm or beetle - drought or tempest - on a farmer's land may fall, Each is loaded full o' ruin, but a mortgage beats 'em all."
Will Carleton - American poet.

Back in March we wondered if in our Credit Space it would be "Plain sailing until a White Squall", and by the end of the month in our conversation relating to Spain "Spanish Denial", we started asking ourselves: "One has to ask oneself if the time has not come to start taking a few chips off the table."

Looking at the recent price action in Europe, with the unnerving news flow following the recent Greek elections in conjunction with troubling news from the Spanish banking giant Bankia (third largest Spanish banking group), our analogy this time around refers to one of Shakespeare's last play "The Tempest", but we ramble again.

Given the acceleration in the news flow from the Spanish banking sector, following a quick credit overview we will focus on the recent Bankia headline and the continuous decline of weaker peripheral banks and the potential outcome. It still very much a game of survival of the fittest (we recently discussed the subject of bank recapitalisations in our conversation "Kneecap Recap").

The Credit Indices Itraxx overview - Source Bloomberg:

Mind the gap...while London markets were closed on Monday, and credit markets fairly muted on Monday, Tuesday was a different story altogether. Itraxx Crossover CDS 5 year index (50 High Yield entities, HY risk gauge) was wider by 22 bps and overall credit indices were wider across the board, Financials Indices taking as well a leading positioning in the widening move with Itraxx Financial Senior 5 year index wider by around 12 bps and Itraxx Financial Subordinate 5 year index wider by 14 bps.

No surprise there given the bad news flow coming from Bankia. As one Index Market Maker commented:

 "In my opinion, the way out for the Spanish bank system is to hurt bond holders further down the capital structure (i.e subordinated bond holders) and the bail-in proposal is supportive of senior bondholders but not for subordinated bond holders."

We have to concur. Of course it the way out! It support our long standing views expressed in our post "Peripheral Banks, Kneecap Recap, Kneecap Recap":

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

It is particularly bound to happen as we wrote it last year given we read on Bloomberg today the following:

"Prime Minister Mariano Rajoy said most Spanish regions, the nation’s “whole financial sector” and most big companies can’t finance themselves on debt markets.

“Today the Treasury is practically the only one that finances itself on the markets,” he said in the Senate today.

“That’s why we have to send the message that we will meet the deficit target.” Rajoy declined to answer a question from reporters as he left the Senate on how much public money may be used to overhaul Bankia."

So dear equity friends, "Mind the Gap" - There is a disconnect between the 10 year German Bund, touching new record lows and the Eurostoxx, it appears the divergence between both does not look correct, and warrant caution - source Bloomberg:

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.

The "Flight to quality" picture as indicated by Germany's 10 year Government bond yields (well below 2% yield), new record low dipping below 1.55% versus 5 year Germany Sovereign CDS stable at 85 bps. It's deflation (デフレ) and "Risk-Off". - source Bloomberg:

 
That Japanese European feeling - 2 year German Notes evolution versus 2 making new lows versus 2 year Japanese Notes - source Bloomberg:

Moving on to the subject of Spain in general and Bankia in particular: "We do expect to see more debt to equity swaps for some weak peripheral banks".
 While discussing the implications of upcoming Moody's downgrade for 114 European banks and Basel III impacts for the European financial sector ("From Hektemoroi to Seisachtheia laws?") we implied: "We think upcoming downgrades means more collateral posting and more haircuts on collateral that can be pledged for funding at the ECB and dwindling "quality assets" therefore even lower German Bund Yields..." and as our Rcube friend mentioned in the same conversation:
"This year, it appears that Spain and/or Italy are going to be the culprits of a third summer of Eurozone distress."

The latest news on Bankia was that the government has forced the removal of Bankia's management and replaced its CEO with an experienced banker (formerly with BBVA). As indicated by Barclays in their Euro area economics morning comment, it is indeed an important move:
"It is also important because Bankia is by far the largest among the problem institutions. The size of its credit portfolio is nearly EUR200bn, of which 22% is to construction and developers (the bank has a net provisioning ratio of c 43% of problem loans in this sector). The Spanish media has also indicated that the government intends to inject public funds into the institution. Some newspapers have indicated that it could be done through the use of CoCos and with the injection of (public) FROB funds for about EUR7-10bn.
In our view the key to a resolution of Bankia (and to the rest of the problem banks) is a comprehensive, prudent and transparent valuation of their assets, including the legacy real estate assets. This asset evaluation process ideally should involve an independent third party. And it should be followed by a public recapitalization plan (with burden sharing by junior bond holders). If this process is managed swiftly and transparently it could help to restore market confidence."

Bankia Stock price evolution - source Bloomberg:

Bankia was formed on December 3, 2010 as a result of the union of seven Spanish financial institutions, with major presence in their areas of influence. The merger of the seven savings banks, known as 'cold fusion', took only four months, with the integration contract being signed on July 30, 2010.

The 3.3 billion euro IPO for Bankia was done in July 2011 with 824.57 millions shares offered at 3.75 euros a piece, now worth less than 2.25 euros, down 37.39% year to date ((Bankia market cap = E4.4bn). Bankia’s auditor, Deloitte, has not signed off on its 2011 accounts, fuelling further doubts about its asset quality.

According to Spanish newspaper "El Confidencial", the government is planning a capital injection of 7 billion euro. Two government sources also said the injection of public money into Bankia would likely take place through convertible shares, also known as Contingent Convertible bonds (or CoCos), but that other options were also being looked at.
As our good credit friend put it:
"According to recent news, the Spanish government intends to nationalize Bankia and to subscribe to Cocos (Contingent Capital) issued by the bank. To my view, this is definitely not the cheapest solution as the government will have to inject money that it is having already issues raising. Politically, this is not a good play while imposing harsh austerity measures with soaring unemployment. A better solution would be to force a conversion of debt to equity (In a debt-for-equity swap, a company's creditors generally agree to cancel some or all of the debt in exchange for equity in the company). Doing so will not require 7 to 10 billion funds, but would of course dilute shareholders and destroy bond holders (haircut)."

The FROB (Fondo de Reestructuracion Ordenada Bancaria - Spanish Restructuring Fund) had already dealt last year with a few ailing institutions but so far not in the size of Spanish giant Bankia. The state-funded bailout vehicle FROB has injected nearly €15bn into the banks. It injected last year 2.465 billion euro in NovaCaixa's capital with a discount of around 75 to 85% price to book. Also, CaixaBank's 1Q12 results were hit hard by real estate provisions and the bank was forced to merge with ailing Banca Cívica in 2011.

So far, the Spanish government solution has been consolidation (Savings banks reduced from 45 to 17). The set-up of a bad bank would imply price discovery and coming clean on true asset valuations. This exactly what our good credit friend mentioned in our conversation "Mutiny on the Euro Bounty" in relation to Spanish bank issues and valuations:
"Main Spanish banks have so far refused the government suggestion to create a bad bank which would carry all property toxic assets, arguing that they could manage their assets on their own. The dire reality is that the creation of such bad bank will bring transparency to asset prices, which is not what Spanish bankers want! The murkier the market, the better it is to extend and pretend..."

and we replied at the time in relation to bond tenders in the Spanish RMBS space:
"Interestingly enough, while consolidation is being underway and encouraged by Spanish authorities, this week two bond tenders caught our attention, this time in the Spanish RMBS space, from Banco de Sabadell for an aggregate principal outstanding post amortisation amount of around 1,270 million euro and Banco CAM for 5,693 million euro. The decline in prices for these securities would have been steeper if not for the tender offers..."

Of course the decline would have been steeper! Transparency in asset valuations would finally help in discovering the extent of the problems plaguing the Spanish Financial sector. The set-up of a "Bad Bank" in similar fashion to Ireland's NAMA, would indeed force price discovery and true valuations provided a third party assessor is drafted to help in the  set up process as indicated above in Barclays comments.

As indicated by Deutsche Bank in their latest note on Spanish Financials - A new Royal Decree in the making:

"As soon as this coming Friday (surprisingly early), the government could approve a new Royal Decree (RD2) affecting the Spanish financial system. As a reminder, in early February another RD (RD1) was approved, requiring banks to double (by year-end 2012) the provisions for existing real estate risks (E25bn), while moving forward on loss recognition (via a new generic provision requirement for performing RE loans).

When quantifying how much is “enough” is impossible

While we argued in our latest sector piece that RD1 requirements looked

largely sufficient to cover existing real estate (RE) risks, the market seems to lack the patience and the visibility to wait and see whether the new provisioning levels will be sufficient (considering the NPA formation will accelerate); thus, overhang risk (in the form of underlying RE losses) persists in terms of banks’ solvency/P and L. The potential creation of a bad bank could be a positive step to calm down markets. However, at this point, we are skeptical that this may be the silver bullet for which the market is looking; the challenge is the lack of a consensus view when quantifying the size and form of this silver bullet (e.g., what is the “adequate” level of impairments? Will concerns stop at RE or will they extend to SME/mortgage lending?).

What to expect when you are expecting: provisions and bad bank (BB)

On a hypothetical announcement regarding more provisions (PM Mr. Rajoy said in an interview that the “RD2 will go and value RE assets again”), if the government does not want to contradict itself too much in relation to the RD1, the only area where it has some leeway is in the generic provision requirement for still-performing RE loans. We regarded this cushion as useful (though we are not sure whether it is sufficient) to tackle concerns around whether banks were providing an accurate picture of still-performing RE loans (i.e., restructured loans to non-viable clients). With the RD1, the generic provision was equivalent to 7% of still-performing RE loans (E10bn of incremental provisions). The NPA of the RE sector stands at c.50%; we estimate this will move to 70% by 2013. On the BB, there are numerous questions, the most relevant being: (1) the transfer price of the assets (we believe that requiring banks to transfer the assets below the RD1’s markdown levels will mean a low rate of participation by the institutions and a second round of equity raising –

even if some equity is freed up after the transfer – which the system is not in a position to take, except the larger names); and (2) who finances the BB. It could be the financial system (we believe this would not break the negative circular reference seen by the market), the government(probably a good solution depending on the transfer price, though any freeing up of funding will be dependent on whether the BB issues debt, which is exclusively subscribed by the banks), or Europe/IMF (unlikely due to the likely heavy conditionality accompanying the aid)."

As a reminder, BBVA and Santander need to provide around 2.3 billion euro each in 2012 under the RDL, and neither charged a meaningful portion of this in the first quarter (zero for Santander, and €174 mln for BBVA) so far in 2012. Caixabank has already met its 2012 RDL requirement of 2.4 billion euro in the first quarter.

Without credit growth resuming, the ambitious target deficits will not be met in Spain. The conditions for growth needs credit growth to resume, as shown by the recent credit growth in the US (see our conversation - "Growth divergence between US and Europe? It's the credit conditions stupid..."). Spain has to go through resolving the Spanish banking encumbered balance sheets.

This is clearly indicated in a recent note by Cheuvreux - Spain, too much already but still not enough:
"Banks still have a lot of bad assets to deal with, in part thanks to regulatory forbearance. The official stance of the new government in this respect is very straightforward. Its aim is to clean up some of the excessive leverage through new impairments. Supposedly, the cleaner balance sheets and lower leverage following this action would allow loans to flow to where there is demand. A clear strategy does not necessarily make it a good one. And some banks are even vocal about what's next (both Santander and CaixaBank have publicly stated that private loans will have to fall by around EUR300bn-400bn over the next few years).
We believe the private sector deleveraging poses significant challenges for the Spanish economy going forward. Going back to the surplus/deficit per sector, a private deleveraging process would need to be countered by higher public spending to compensate for the fall in GDP. This was the case in Japan in the early 90s but it is not plausible for Spain within the current EU configuration, where fiscal austerity is king. In this regard, note that the Spanish government has undertaken to reduce the budget deficit from around 8.2% in 2011 to 5.3% and 3% in 2012 and 2013, respectively (gaps of around EUR40bn and EUR55bn, respectively).
More importantly, it is unclear whether corporates are willing to borrow given:
1) high levels of debt and B/S deterioration as the price of assets fall; and 2) many companies, particularly in the property sector, are unable not only to borrow more but to even pay back their existing debt. Consequently, a number of corporates are moving into debt reduction mode as opposed to maximising profitability. This is not helped by the ongoing credit crunch, as shown by higher lending spreads. See charts below."
Spain: Spreads in New Loans (%) - source Cheuvreux - Bank of Japan:

Spain: Lending Growth - source Cheuvreux:

LTRO was good news but will not promote lending growth - Cheuvreux (hence our "Money for Nothing" argument...):
"In a perfect world, the availability of an affordable (1% cost) source of medium-term (three years) funding would certainly promote lending to the private sector. There is sufficient empirical evidence to suggest, however, that neither low rates nor QE programmes foster lending to the private sector in highly leveraged economies. This has certainly been the case in Japan, the US and the UK where an enlarged monetary base did not lead to an increase in lending demand."

While the restructuring of the banking sector is a pre-condition in resuming enough credit growth to sustain economic growth, Cheuvreux estimates that the banking sector restructuring will take out 50 billion euro from taxed earnings and has clearly negative views for growth in Spain in 2011, forecasting a -2.4% print and -0.9% in 2013:

"True realism consists in revealing the surprising things which habit keeps covered and prevents us from seeing."
Jean Cocteau

Stay tuned!