European Psycho - Bond Haircuts and the current financial bonds sell-off

If you are in an emergency and need haircuts on your bonds, please contact Patrick Bateman...

Big sell-off in Financial bonds in the last two days.
Reason being, the EC Proposals for resolution regime relating to the treatment of senior financial bonds holders in the case of a bank facing difficulties in the Eurozone.

Only new senior debt will be exposed to losses outside a liquidation of a bank, through a debt-write down resolution tool. This process is to allow rapid restructuring in Europe of a bank's liability structure. The differences in insolvency laws in Europe did not allowed for a rapid wind down.
It is a move in the right direction given restructuring on a financial institution needs to be executed rapidly. It is also to alleviate the risk of government taking on the full brunt of the banks in difficulties and over-exposing taxpayers.
The example of Ireland clearly showed the issue, where Ireland's public finances were put in disarray due to the massive bail out need of its financial sector (please see previous posts on that subject: The European Vortex, The Irish Black Hole, Ireland in the need of a lucky Shamrock). The resolution of distressed banks lacked flexibility in the legal framework in Europe and put too much risks on already strained European public finances.
It is the application of a resolution regime which was supported by the G20. No firm should be too big to fail or too complicated to fail and taxpayers should not bear the cost of the resolution of the distressed bank as emphasized by the G20 previously.

The commission will report by the end of 2011 on appropriate measures for other kind of financial companies including insurance companies.

It's likely to raise the cost of debt for EU banks which ultimately has to be negative for bank equity. In a deleveraging environment given banks are leveraged play on the economy, one can expect the ROE (Return On Equity) of banks to be weaker in this new regulatary environment as well as smaller GDP growth period.

But why the sell-off?

Because it seems the language protecting existing debt is a bit weak in the working paper.

As I indicated in my previous post, the race for funding, and the risk of crowding out, will penalise weaker bank in the short term.

This is already happening on the widening of CDS spreads on peripheral banks for both senior and sub CDS, for instance, on the 7th of January, you can already see Spanish Banks spreads widening significantly:

Source: Anonymised CDS run from the market, sent on Bloomberg.

Spanish Banks CDS from the 8th of October 2010 until the 7th of January 2011:

European Banks CDS from the 8th of October 2010 until the 7th of January 2011:

Also note the spread between Itraxx Main 5 year and Itraxx Financial Senior, made new highs as well, 102 Itraxx Main 5 year versus Itraxx Fin Senior at around 204 bps.

As a reminder from a previous post:

Itraxx Western Sovereign Index 5 year is around 215 bps.
Normal Risk is inverted.
Corporate risk is tighter than Financial Senior risk which is also tighter than Sovereign Risk in Western countries.

"Deutsche Bank AG’s recent 1 billion USD of five-year, 3.25 percent notes fell 0.04 cent to 99.87 cents on the dollar, Trace data show."

"Allegheny Technologies Inc.’s 500 million USD of 5.95 percent notes due in January 2021 have risen 1.9 cents to 101.8 cents on the dollar, Trace data show. The Pittsburgh-based producer of specialty metals sold the debt on Jan. 4, Bloomberg data show". And Allegheny Technologies is rated BBB-...

Forget about hedging via the SOVX Index Option market with Volatility at 98%...It isn't cheap anymore...

Also in the news, Swiss National Bank confirmed it hasn't taken Portugal's foreign-currency bonds as collateral. It said the bonds were never part of its list of SNB eligible collateral due to settlement reasons.

At the same time you have VIX at 17.4%...and given NFP came at a disappointing 104K (unemployment rate at 9.4% down from 9.8%, please note you have 1.32 million discouraged workers...and that is a new record), complacency is the word to use (definition of complacency: "self-satisfaction accompanied by unawareness of actual danger or deficiencies").

VIX, one year graph as of the 7th of January 2011.

Bottom line, it seems there is less short term risk and more value in selected corporate bonds, than in financial ones or European Sovereigns at the moment.

Play it again Sam ! - European problems not going away in 2011...

Portugal came back to the market today and auctioned 500 millions euros worth of bills repayable in July. The yield stood at 3.686% from 2.045% back in September 2010 for similar maturity bills.

A year ago Portugal was only paying 0.592 % to borrow for six months.
Portugal need to raise 20 Billions Euros this year and it is not going to be cheap for them to do so.

On the 23rd of December, Portugal was downgraded by Fitch Ratings from AA- to A+. S&P might downgrade further Portugal to A- in April, which will automatically increase its cost of funding.

Moody’s said on Dec. 15 it may cut Spain’s Aa1 credit rating and on Dec. 16 placed Greece’s Ba1 bond ratings on review for a possible downgrade. Ireland’s credit rating was cut by five levels by Moody’s on Dec. 17.

Below table displays the European Government spreads versus Germany in early 2010 and the situation at year end:

Early 2010:

By year end:

2011 is the raising money race year. Competition between Sovereigns and Banks to raise money fast will be furious. It is already happening. Deutsche Bank and Rabobank kicked of the race on the 4th of January by selling US bonds. Deutsche bank issued 1 billion USD of 5 years notes paying 3.25% (130 bps more than comparable Treasuries), while Rabobank sold 2.75 USD billion of securities, according to data compiled by Bloomberg. On the 5th of January, it was the turn of Societe Generale and Intesa to tap the market and issue bonds.

Europe Banks Race Sovereigns to Bond Investors:
http://www.bloomberg.com/news/2011-01-05/europe-crisis-drives-banks-to-sell-bonds-before-sovereigns-credit-markets.html

“There are several European government bonds paying more than banks for debt so it’s hard for lenders to raise cash in this situation,” said Serafi Rodriguez, a fixed-income trader at Banc Internacional d’Andorra.

Both funding costs for banks as well as for sovereigns is going up as reflected in the widening of CDS spreads we saw last year.
Evolution of CDS spreads between the 21st of September until the 21st of December:

European Sovereigns CDS spreads widened:

Asian Sovereigns CDS spreads were stable:

The risk of "Crowding Out" is alive and real. I previously posted on this very subject in February 2010: Crowding Out.

Banks need to raise 1.1 trillion USD this year.
From January 2010 until December 2012 the amount needed to be raised by banks amounted to 2.2 trillions Euros.

The important issue of rising global yields is a very important one. Debt markets are going to be more and more discriminating. This has serious implications in the development of the government finance bubble. Some cracks appeared with Greece in 2010 and you can expect similar cracks to show in 2011. After Greece and Ireland, Portugal seems to be the most obvious next weakest link to unfold.

In this race to funding, and with the markets becoming more and more selective, the competition will be fierce in 2011. The implications for public finances will be great. The era of cheap funding is definitely over.

Western countries are still trapped in a secular bear market. Particularly the US. Unemployment is still hovering around 9.8% after 4 trillion USD increase in government liabilities in just 9 quarters in conjunction with an extended near zero interest rate policy. Dear Ben, there is nothing to be proud of and QE2 is not going to be the remedy for the structural issues and housing mess which are still plaguing the US economy.

In this environment, Gold can continue to rise in 2011 as illustrated by the current term structure for Gold futures:

In relation to the evolution of yield on 10 year European Government debt, Ireland and Greece have reached new highs:

Evolution of Greek 10 year yield in the last 6 months until the 5th of January 2011:

Evolution of Ireland 10 year yield in the last 6 months until the 5th of January 2011:

Play it again Sam...

Happy New Year 2011 ! Best wishes !

It has been a little bit more than a year I have started this blog.

I would like to thank all of the people who have supported it by providing me with specific reports, news and insights on markets.

I would also like to encourage you to make this blog even more interactive in 2011 by adding your comments to the posts I publish. Don't hesitate to contact me with your feedback.

If you like this blog please add it to your favorites. You can as well become a follower and recommed it if you like the contents of the posts.

Wishing you again all the best for 2011, sincerely,

Martin T.