Air Traffic is a leading deflationary indicator

"He who rejects restructuring is the architect of default." - Macronomics.

Following on the theme of deflationary indicators (see our conversations "Shipping is a leading credit indicator" - "Shipping is a leading deflationary indicator"), we thought this time around we would venture towards Air Cargo and Airlines, given that on June 5 the Lex Column in the Financial Times asked an interesting question in relation to Europe and Airlines: "How many airlines does Europe need? Certainly not 40, providing 8.5 per cent more seat  capacity in 2011 compared with 2007. One theory says that the region could live with three flag carriers (Lufthansa, International Airlines Group and Air France-KLM), a couple of budget airlines (Ryanair and easyJet) and perhaps, a few niche players. But while consolidation talk is plentiful, the actual pace of airline rationalisation remains fairly stately."

As we posited in our "Shipping" conversations, as far as Airlines are concerned, in similar fashion, it is as well a global game of survival of the fittest.

In fact Lex Column concluded their 5th of June EU consolidation conversation by the following:

"Ultimately, though, credit withdrawal pressures may be required to achieve rationalisation. Last year, these pushed Malev and Spanair out of the skies. It could be an even tougher winter ahead."

We already know from our various credit conversations relating to 2011 issues, namely access to dollar funding, that many European banks have in fact scaled back from dollar-funded businesses such as aircraft financing. In similar fashion to shipping we believe credit withdrawal will accelerate the pace of rationalisation in the European skies.
As a reminder:
Last year issues surrounding liquidity issues and difficulties in accessing dollar funding mean most European banks are paring back on their Structured Finance Operations: Definition of Structured Finance business - source Credit Agricole CIB:
"The Structured Finance business consists in originating, structuring, and financing operations involving large-scale exports and investments in France and abroad, often backed by collateral security (e.g. aircraft, ships, corporate real estate, or commodities), as well as complex and structured loans.
The Structured Finance division comprises nine finance segments: aviation and rail / shipping finance / tax-based leases / natural resources, infrastructure and power / real estate and lodging / export and trade finance / acquisition finance / transactional commodity finance / structured finance advisory."

So in our Air Traffic conversation we will first look at Air Cargo as a leading deflationary indicator then at the ongoing issues plaguing Airlines which will lead to consolidation.

According to a note by Nomura published on the 12th of June, Air Cargo is a leading indicator of chemical volume growth and economic activity:
"Our air cargo indicator of industrial activity came in at -7.6% (y-o-y) in May, following -7.8% in April and -4.3% in March. As a readily available barometer of global industrial activity, air cargo volume growth is a useful indicator for chemical volume growth."

It has also been a very reliable indicator in relation to industrial production according to Nomura:
"Over the past nine years' monthly data, there has been an 85% correlation between air cargo volume growth and global industrial production (IP) growth, with an air cargo lead of one to two months. In turn, this has translated into a clear relationship between air cargo growth and chemical industry volume growth."

Nomura’s proprietary air cargo indicator shows a high correlation (85%) with global industrial production:

Moving on to the ongoing issues plaguing the Airlines industry, as recently as yesterday IATA (the International Air Transport Association) has almost doubled its 2012 loss forecast for European airlines and said the continent's debt crisis could wipe out an expected global profit according to Bloomberg - IATA Doubles Loss Forecast for Europe Airlines on Crisis:
"Carriers in Europe may lose $1.1 billion this year, compared with a March forecast for a $600 million loss, the airline body said today at its annual meeting in Beijing. It reiterated a forecast for a $3 billion global profit. The worldwide estimate could be reduced if the European economy worsens more than expected, the group said. “If there’s a full-blown crisis, all bets are off,” Tony Tyler, head of IATA, which represents about 240 carriers, said in a Bloomberg TV interview yesterday. “It will have a big impact on the world economy and a huge impact on airlines.”
Global profits are already set to fall from $7.9 billion last year, as recessions in the U.K., Spain and other European countries damp demand and erode gains from lower fuel prices. Deutsche Lufthansa AG (LHA), Air France-KLM (AF) Group and International Consolidated Airlines Group SA (IAG), Europe’s three biggest full- service carriers, have all announced plans to cut staff or restructure operations following first-quarter losses."

Although the recent fall in fuel costs could been seen as good news for Airlines, in the 1st quarter of 2012, soft pricing and high fuel costs had already meant losses for European airlines due to weak price elasticity for European carriers as indicated by Bloomberg on the 26th of April:

"Most European airlines will record losses in 1Q, according to consensus expectations. Load factors improved on depressed air fares, which rose 6% on average during the period, barely enough to cover the 400 bps to 500 bps of margin loss due to higher fuel costs. Substantial hedging should alleviate some, not all, of the pain." - source Bloomberg

In fact given that many carriers hedge more than 70% of fuel consumption, it is highly unlikely that the recent fall in fuel prices will make a big difference to their difficult situation:

"European airline fuel hedges could alleviate the effects of a 1Q fuel price increase. Jet fuel prices rose 16% yoy and 9% sequentially. The effect of high fuel prices could be damped as many carriers hedged more than 70% of fuel consumption for the period. Hedges are typically most effective when prices rise significantly sequentially." - source Bloomberg, 26th of April.

So as we posited in our conversation - "Growth divergence between US and Europe? It's the credit conditions stupid...", same apply to US Airlines versus European Airlines, its the credit conditions stupid given, as indicated by Bloomberg in their article - IATA Doubles Loss Forecast for Europe Airlines on Crisis:
"IATA raised its profit forecast for North American carriers to $1.4 billion from $900 million. The airlines will boost earnings from $1.3 billion last year as they refrain from adding many flights amid a 0.5 percent growth in demand, the slowest pace worldwide, the group said."

As far as traffic is concerned, in similar fashion to shipping (see our previous posts), traffic to the Americas have been the biggest beneficiary as indicated by Bloomberg in April:

"Lower airfares boosted international demand and improved load factors for European carriers in 1Q. Traffic to the Americas saw the best improvement, probably aided by depressed U.S.-to-Europe air fares. Asia-Pacific region traffic, the second-biggest market, also improved during the period on lower fares." - source Bloomberg, 26th of April.

As far as Europe consolidation is concerned, the game of survival of the fittest is truly on. For instance, Air France-KLM in the first quarter of 2012 took market shares to its rival IAG (the British Airways and Iberia company formed in January 2011) as reported by Bloomberg on the 26th of April:

"Domestic load factors improved in 1Q for the top full-service European airlines, though they remained weak at about 67 on average, on a 3.6% traffic gain and with capacity unchanged. Air France added capacity and increased traffic, improving load factors and gaining market share from IAG, which cut capacity during the quarter." - source Bloomberg.

Europe has already seen some airlines collapse this year, including Hungary’s Malev and Spain’s Spanair as a matter of fact.

When it comes to low cost airlines, the fight is as well truly on, in a weak pricing environment where Ryanair's loss in the 1st quarter was, as reported by Bloomberg, EasyJet's treasure:

 "Ryanair's 2.3% capacity cuts weighed on low-cost European airlines' domestic capacity growth (3.4%) in 1Q amid weakness in pricing. EasyJet countered Ryanair's contraction by adding 7% capacity during the period, increasing market share. Domestic load factors were unchanged for European low-cost carriers on a 1% increase in traffic." - source Bloomberg 26th of April.

Although US Airlines have been benefiting from European woes, according to Bloomberg, American, United Airlines are most exposed to a potential fall in Latin America Airfaires:

"Non-premium airfares for U.S. to Latin America travel fell for the second straight month in May, by 3%, while premium fares fell sharply by 28%, indicating Latin America passenger yields may slow. American Airlines and United are the most exposed to demand changes to the region because they are the biggest carriers to Latin America by traffic." - source Bloomberg, 17th of May.

But in this global deflationary environment, it is not only affecting American and European carriers facing potential headwinds such as pricing issues, weak earnings and consolidation threats. Australian airline Qantas predicted a 91% drop on the 5th of June 2012 leading to an 18% slump in its share price on the day:

"Qantas Airways Ltd., Australia’s largest carrier, plunged to a record low in Sydney trading after
saying annual profit may fall as much as 91 percent because of losses on overseas routes and higher fuel costs.
The carrier, which listed in 1995, slumped as much as 18 percent, the biggest drop since February 2009, to as low as A$1.16 at 1:52 p.m. in Sydney as the benchmark S&P/ASX 200 Index
rose 1 percent. Credit-default swaps rose to an eight-month high.
Underlying profit before tax may be A$50 million ($49 million) to A$100 million in the year ending June because of a A$700 million increase in fuel bills and a doubling of losses at Qantas International, the airline said today. The Sydney-based carrier could also lose its investment-grade credit rating at Standard & Poor’s following the profit warning, said National Australia Bank Ltd." - source Bloomberg

On the 5th of June Qantas 5 year CDS  jumped 15 bps to 365, their highest since October 2011,
according to CMA data. S and P downgrading the carrier from BBB is likely and a two-grade two-grade cut to a non-investment level is an “outside possibility,”  according to National Australia Bank said in a research note as reported by Bloomberg.

In similar fashion to Wilbur Ross planning shipping expansion as industry distress grows for shipping (which we discuss in our recent shipping conversation), the sharks are circling the stricken airline industry as well, with Qantas shares jumping 11% today, their biggest gain in more than 5 years as reported by Bloomberg. This jump has led Qantas to hire Australian bank Macquarie Group Ltd to ward-off the predators - "Qantas Hires Macquarie for Takeover Defense After Slump":
"Qantas may be more attractive to bidders after its stock slumped to its lowest levels on record last week after forecasting the first annual net loss since a 1995 initial public offering. The airline, which can only legally be controlled by Australian investors, is battling rising losses on international services as rivals from the Middle East and Asia lure passengers."

Similar to the shipping industry, consolidation, defaults and restructuring are going to happen no matter what, in the Airline industry in our on-going deflationary game of survival of the fittest.

"The first thing you have to do is accept that decay sets in and there's nothing you can do about it."
Francesca Annis

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!

Credit - Something Wicked This Way Comes

"Capital as such is not evil; it is its wrong use that is evil. Capital in some form or other will always be needed."
Mahatma Gandhi

Following the passing of great American writer Ray Bradbury today, we thought our credit rambling title had to be a reference to ones of Ray Bradbury's book as a form of tribute to one of our favorite writers. The 1962 novel by Ray Bradbury is about a nightmarish traveling carnival that comes to a Midwestern town one October. Looking at the ongoing nightmarish European carnival's, which has returned earlier this year, one has to wonder if indeed something wicked is coming our way. The carnival's leader in the book is the mysterious "Mr. Dark" who bears a tattoo for each person who, lured by the offer to live out his secret fantasies (markets rumors such as using ESM funding to recapitalized peripheral banks). Each person succumbing to these fairy tales has become bound in service to this (European) carnival of "Mr. Dark".

The book by Ray Bradbury "Something Wicked" has an emphasis on the more serious side of the transition from childhood to adulthood, a point we discussed precisely in our conversation "St Elmo's fire" in relation to our "European carnival" traveling from one member to another, like dominos falling, were we argued: "Looking at the attitude of our "European Brat Pack", one has to wonder if our European Politicians will ever adjust to their respective responsibilities and embrace somewhat adulthood which would in effect determine whether our Saint Elmo's fire evolves towards a positive outcome in Ludovico Ariosto's fashion, (leading to the rise of the Dioscuri), or to the negative association of Saint Elmo's fire, namely disaster and tragedy."

As our good credit friend put it:

"The capital markets have not paid enough attention to various pieces of the global puzzle falling into places, and the true picture is a cause of concern. The overall capital structure of the current financial system is at risk. Financial institutions are in dire need of capital and bailing them out will drag sovereigns (issue of circularity) with them unless policy makers decide to follow a path they have refused so far (following Lehman Brothers bankruptcy). The no-no policy (no loss for bondholders – no loss for shareholders) advocated by Paulson when he was in charge of the Treasury is not valid anymore. Investors will have to take losses if leaders want to save their populations from disaster (Greece is the canary in the coal mine). So shareholders and subordinated debt holders should be wiped out, and senior bonds holders could become the new shareholders if there is not enough capital. How long can leaders still expose their countries to such big risks is unknown, but debt to equity swaps should make the headlines again at some point."

Indeed, it has been a recurring theme of ours in our various conversations, namely that additional pain will have to be inflicted to both bondholders and shareholders. Given the EU proposals for restructuring and managing banks in crisis, something wicked indeed is coming this way, at least towards financial bondholders and shareholders. As ECB President Mario Draghi asked clearly today, the ESM (the permanent EU bailout fund) is not currently set up to be a shareholder in banks:

"Do we want an ESM that is a shareholder in banks?"

So, in this conversation we will review the need for capital which cannot be resolved by liquidity injections alone and the recent Bank Bail-ins proposal. At some point, as our good credit friend put it, losses will have to be taken.

But before we go through this important subject, it is time for a quick credit overview.

The Itraxx CDS indices picture on Friday - source Bloomberg:

Today had a positive "short covering" tone in the credit space with Itraxx Crossover 5 year CDS index (50 European High Yield entities - High Yield credit risk gauge) tightening significantly by 27 bps on the day. 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 321 bps and so does the Itraxx Financial Senior Index while tighter by 13 bps on the day, a further indication of the existing correlation between financial and sovereign risk.

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

We presented the issue of circularity indicated by Martin Sibileau in our conversation "The Daughters of Danaus":

"The circular reasoning therefore resides in that the recapitalization of banks by their sovereigns increases the sovereign deficits, lowering the value of their liabilities, generating further losses to the same banks, which would again need more capital."

We also argued at the time:
"As far as the Danaides punishment/Circularity issues goe, the Spanish banking woes threaten to cancel out austerity benefits meaning that we will not see meaningful reduction of deficits due to this vicious circle and deflation trap Spain is victim of."

Of course, most Spanish banks are in favor of seeking European funds given neither the banking system nor the government can afford to absorb the losses. As reported by Charles Penty in  Bloomberg in his article "Spain Bankers Backing EU Aid Highlight Doubts on State Finances", according to Santiago Lopez, an analyst at Exane BNP Paribas in a May 29 report:

"Spain’s financial system may still need 45 billion euros in taxpayer money, including 30 billion euros to clean up three previously nationalized banks and 15 billion euros for other lenders."

On top of that, from the same article:
"JPMorgan’s estimate that Spain may need a bailout costing as much as 350 billion euros."

Today's price action in the European Bond Space saw Spanish yields receding towards 6.28%, remaining elevated and a cause for concern in Spain's ability to access funding which it will attempt on the 7th of June for 2016 and 2022 bond auctions. France and Germany saw their yields widen respectively by 8 bps and 12 bps - source Bloomberg:

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:

Moving on to the subject of capital raising needs, Spanish banks which have suffered rating downgrades (Bankia and Bankinter downgraded to junk by Standard and Poor's on the 25th of May) as well as rising funding costs face a 43 billion euro funding hole according to analysts, warning that they might not be able to roll over covered bonds (secured by pools of prime loans) that mature in the next 18 months according to Bloomberg in their article 'Spanish Banks Face Covered Bond Funding Squeeze" from the 1st of June:

"The seven largest Spanish banks -- Banco Santander SA, Banco Bilbao Vizcaya Argentaria SA, Banco De Sabadell SA, Bankinter SA, Banco Popular Espanol SA and Banco Espanol De Credito SA --with a total of 171.4 billion euros ($211.5 billion) in outstanding covered bond debt, have 43 billion euros maturing over the next 18 months, according to data compiled by Bloomberg.
No benchmark-sized public covered bond from a Spanish issuer has been sold for 10 weeks, and further issuance is unlikely in the near-term, according to analysts. Issuance in the first five
months of 2012 is at 36 percent of the total for 2011, according to figures from Leef Dierks, head of covered bond strategy at Morgan Stanley."

In relation to Spanish covered bonds, the secondary markets has been on the receiving end as far as Spanish banking woes are concerned as indicated by the same article:

"The issue-weighted average price of 348 Spanish covered bonds stood at 92.15 cents on the euro on May 30. Even the strongest issuers have seen their covered bonds fall in value. Banco Santander SA’s 4.5 percent covered bond maturing in July 2016 has declined to 98.37 cents on the euro from 101.65 in May. The asset-swap spread traded up to 350 basis points over mid- swaps on May 29, a near-one percentage point increase in the month and 47 basis points higher than its previous high on Dec. 2, 2011."

But it isn't only access to the most senior part of the bank capital structure which is proving difficult for Spanish banks. The access to the senior unsecured market is as well proving more and more elusive for Spanish banks:

Still below 2011 levels as indicated by Bloomberg, but another cause for concern:

"Since recovering to above par in March, the mid-yield on senior unsecured debt for Spain's two largest banks has risen steadily. Though still below November highs, sustained elevated yields will drive up the cost of refinancing. Bloomberg data show the two banks have 28.6 billions of euro-denominated senior unsecured debt maturing by 2014."

At the same time EU Banks withdrew 37 billion dollars of Interbank Support from Spanish banks according to Bloomberg:

"EU interbank exposure to Spain's banking system fell $37 billion dollars during 4Q11. Though liquidity fears were temporarily relieved by two ECB LTRO facilities, Bankia's troubles have driven unsecured funding costs higher. Should the withdrawal of interbank capacity continue faster than Spanish banks can deleverage, significant funding problems may return." - source Bloomberg.

Something Wicked indeed...as the title goes.

If it was only Spanish banks feeling the heat of Interbank lending drying in Q4 2011...

"Global cross-border claims fell $799 billion in 4Q11, 80% driven by a drop in interbank lending. Within this, euro zone cross-border claims fell $364 billion as institutions retrenched and shrank balance sheets. Absent further stimulus or a crisis solution, this draining of interbank support may become problematic as the ECB liquidity programs expire." - source Bloomberg

As the BIS put it in their Quarterly June 2012 report:

"Three features characterise the sharp decline in cross-border claims on banks in the fourth quarter. First and foremost, internationally active banks reduced their cross-border lending to banks in the euro area. Second, they also reduced cross-border interbank lending in several other developed countries, albeit by a lesser amount. Third, they cut interbank loans much more than other instruments.

Cross-border claims on banks located in the euro area fell by $364 billion (5.9%), which is equivalent to 57% of the decline in global cross-border interbank lending during the quarter. It was the largest contraction in crossborder claims on euro area banks, in both absolute and relative terms, since the fourth quarter of 2008. Cross-border lending to banks located on the euro area periphery continued to fall significantly. Lending to banks in Italy and Spain shrank, by $57 billion (9.8%) and $46 billion (8.7%), respectively, while claims on banks in Greece, Ireland and Portugal also contracted sharply.

Nonetheless, exposures to these five countries accounted for only 39% of the reduction in cross-border interbank lending to the euro area. BIS reporters also reduced their cross-border claims on banks in Germany ($104 billion or 8.7%) and France ($55 billion or 4.2%)."

In this elevated financial risk environment as indicated by the high level of Itraxx Financial Senior 5 year CDS, no wonder some European banks are on a quest of securing funding as indicated by Fabio Benedetti-Valentini in Bloomberg on the 25th of May "SocGen Search for Crisis Funding Takes Bank to German Car Buyers":

"Societe Generale SA’s quest for funding is prompting the bank, France’s second-largest, to mine
sources not tapped before: German car loans and Dim Sum debt. Seeking shelter from Europe’s resurgent sovereign debt crisis, Societe Generale and France’s three other large, listed banks -- BNP Paribas SA, Credit Agricole SA and Natixis SA --are seeking new ways of financing their balance sheets."

Lessons learned from 2011? Maybe. From the same article:

"Burned by last year’s liquidity crunch, Societe Generale, BNP Paribas and Credit Agricole are shrinking balance sheets in most overseas markets and cutting sovereign-debt holdings. The four Paris-based banks bolstered assets in France by 11 percent last year to 3.72 trillion euros ($4.67 trillion) while cutting commitments in other European countries by about 7 percent, according to the lenders’ data compiled by Bloomberg. BNP Paribas in 2011 cut assets even in Belgium and Italy, its largest retail-banking markets outside France, by 1.6 percent and 3.8 percent respectively, its annual report shows. Societe Generale boosted French assets by 15 percent and got most of its new debt placed with investors in northern Europe."

In relation to their respective funding needs:

"To protect against a refinancing drought, France’s three largest banks have completed about three quarters of their 2012 plans to issue at least 42 billion euros of debt with maturities over one year. Societe Generale went so far as to securitize 700 million euros of German car loans from a unit representing less than 0.5 percent of its balance sheet." - source Bloomberg.

So in effect, European banks while scaling back from dollar-funded businesses such as aircraft financing, are trying to find ways to diversify their sources of long-term funding such as private placements, Dim-Sum bonds (Societe Generale sold 500 million renminbi bonds to fund its Chinese operations), and securitizing German car loans (Societe Generale at its BDK unit, representing 8% of its medium and long term issuance between January and April 23rd).
funds as the region’s deepening debt crisis makes unsecured debt
sales scarcer and more expensive.

As far as the LTROs effects are concerned and investments funds strategy, as indicated in a recent note by CreditSights entitled "Eurozone Investment Funds Use LTROs to Exit Euro" from the 4th of June, they indicated the following in relation to banks' bonds take up:

"Eurozone investment funds increased their allocation to bonds by 69 billion euros in the first quarter; the largest net purchase of bonds since the third quarter 2010.

However the vast majority of that net allocation to bonds, 57 billion euro, was to emerging markets. Indeed the allocation was the largest by investment funds on record.

Investment funds also increased their allocation to banks’ bonds by the largest amount since the third quarter 2009. But that was entirely an allocation to two-year-and-shorter dated bank bonds. Funds reduced their holdings of longer-dated bank debt by 2 billion euro."

In relation to the subject of Banks Bail-in legislation, senior unsecured creditors will indeed be facing the music to cover costs from failing banks under the European plans unveiled today, meaning an end to the era of bank bailouts, in an attempt to move towards a more unified financial supervision. Under the plan, national governments would impose annual levies to set up enough cash for a resolution fund available to a failing financial institution. As of the 1st of January 2018, outstanding senior unsecured liabilities of European Banks will be "bail-in-able", excluding short-term debt (less than 1 month).
The "unintended consequences" of such a plan have been discussed in our conversation "From Hektemoroi to Seisachtheia laws?" as indicated by Nomura:

"the sooner a bank can increase its long-term debt issuance, raise its term deposit funding, or unwind its balance sheet before its competitors do the same, the cheaper its funding costs will be and the less pressure it will face to reduce its balance sheet. In this respect, the current effective subordination of unsecured creditors of eurozone banks due to the balance sheet encumbrance issue allied to a general aversion of creditors to increase exposure to banks is particularly worrisome as this impedes the ability of banks to obtain term-funding."

Yes, "Something Wicked This Way Comes" and as CreditSights put it in their note relating to the European Bank Bail-in - "D-Day for European Bank Bail-ins":

"Bail-in allows the authorities to write down some liabilities to allow the bank to remain in business. Our view is that normal insolvency proceedings are not an effective way of dealing with failing banks and preventing systemic crises, and that a resolution regime is therefore a sensible alternative. We also agree that if governments are determined that public funds should not be used to finance bank rescues, then either banks will have to have significantly higher equity and subordinated debt, or senior creditors will potentially have to be subject to write-down or conversion into equity.

However we think regulators and politicians are in denial about the consequences for banks'funding models. This will push banks towards deposits and covered bonds as principal funding instruments, which seems to alarm some regulators. Senior unsecured debt will be more expensive - some investors will inevitably view it as contingent capital - and the universe of investors will shrink. The Commission's own impact assessment reckons that the total funding cost of banks in the EU would increase on average by a range of 5 to 15 bp, reflecting an estimated average increase in yields on bail-in-able instruments of 87 bp. We suspect this significantly underestimates the likely costs and is one reason we recently revised our recommendations on European banks to Underweight."

So, thank you "Mr Dark" for the "Bail-in" invitation to your nightmarish European carnival. But, you won't be wearing another tattoo because we will not be lured in believing in yet another "secret fantasy". In our conversation "From Hektemoroi to Seisachtheia laws?" we once again voiced our concerns Mr Dark:
"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."

Deposit guarantee funds preference is more negative for bondholders. The resulting structural subordination means they will rank pari-passu (classes of bonds or shares having equal rights of payment or level of seniority) with unsecured claims and it could soon be a factor for UK banks if the government follows the ICB’s recommendations...

On a final note we leave you with a Bloomberg chart, showing that Indetex SA, owner of Zara clothing chain has overtaken Banco Santander SA as Spain's second-biggest company by market value as surging profit attracts investors growing wary of banks:

"The CHART OF THE DAY shows the market capitalization of Arteixo, northern Spain-based Inditex, and that of Santander. The world’s largest clothing retailer has almost trebled since the fourth quarter of 2008 to 42.1 billion euros ($53 billion), while Spain’s biggest bank has fallen more than 50 percent since 2010 to 41.6 billion euros. Telefonica SA, Spain’s biggest phone company, is the largest stock on the IBEX 35 index, with a value of 48.4 billion euros." - source Bloomberg, 21st of May.

“Really knowing is good. Not knowing, or refusing to know, is bad, or amoral, at least. You can't act if you don't know. Acting without knowing takes you right off the cliff.” 
  ― Ray Bradbury,  Something Wicked This Way Comes

Stay tuned!