Markets update - Credit - The Italian Peregrine soliton

"In mathematics and physics, a soliton is a self-reinforcing solitary wave (a wave packet or pulse) that maintains its shape while it travels at constant speed." - source Wikipedia

"A single, consensus definition of a soliton:

1. They are of permanent form;
2. They are localised within a region;
3. They can interact with other solitons, and emerge from the collision unchanged, except for a phase shift." - source Wikipedia

Another interesting day in the ongoing European crisis.

It is of no surprise with liquidity dwindling as we move towards year end to see a lot more ongoing volatility, definitely not helping. It seems Six Sigma standard deviation is not the norm anymore, it is higher still. So another long post, focusing on our Italian Peregrine soliton, liquidity issues affecting bid-offer prices and touching on fine-tuning risk weighting assets for banks to shore up Core Tier 1 capital.

Italy took centre stage today with some epic price movements:

Italian 2 years:  --- 6.37 yesterday ---- 7.13 today ---- +75 bps

Italian 5 years:  --- 6.87 yesterday ---- 7.62 today ---- +75 bps

Italian 10 years: --- 6.77 yesterday ---- 7.38 today ---- +61 bps


Time for a market overview.

The Bond Picture - Source Bloomberg:

Italy reaching "Terminal velocity"? The move today was epic to say the least.

Here is the intraday picture for 10 year Italian Government bond yield move- Source Bloomberg:

The CDS picture, Italy and Spain 5 year Sovereign CDS drifting apart - Source Bloomberg:

New record, 140 bps apart.

In the process, CDS wise, everything Italian widened - Source CMA:


Banks as well as Italy and Italian Companies - Source CMA:


Triggering in the process, flight to quality, Germany 10 year Government bond trending back to record lows - Source Bloomberg:

There is an interesting disconnect between the move in the 10 year German Bund and the Eurostoxx, while it had been moving in lockstep until recently, it appears the divergence between both does not look correct, so mind the gap - Source Bloomberg:

Volatility rising in the process as shown in the bottom level of the graph displaying 6 month implied volatility and V2X index.

France as well was not spared either with today's price action, given its exposure to Italy, with the 10 year Government bond spread level with Germany reaching another record in the process, coming close to 150 bps - Source Bloomberg.

OAT and EFSF Bonds widening versus German 10 year Government Bond yield - Source Bloomberg:

At this stage we know that EFSF will not be enough to deal with ongoing contagion to Italy.

The liquidity picture, not improving, new reserve period starting at the ECB hence the drop in the deposit levels at the ECB - Source Bloomberg:

In relation to liquidity dwindling as we move steadily towards year end, and dealers not particular eager to add risk towards year end, bid-offer spread are rising, but in relation to Italian debt, they have been soaring according to Bloomberg Chart of the Day relating to 2 year Italian Bonds bid-offer spreads:

By Matthew Brown - November 9 - Bloomberg:

"The gap between prices at which traders buy and sell Italian bonds has soared this week as market makers became less willing to deal in the nation’s debt, sapping liquidity from Europe’s largest bond market.
The CHART OF THE DAY shows the so-called bid-ask spread on Italian two year notes. The gap widened to 44 basis points today, the most since January, and up from 4 in March. Italian two-year yields climbed 98 basis points to a euro-era record 7.36 percent today, while 10-year yields climbed above 7 percent, the level that presaged Greece, Ireland and Portugal requesting international bailouts."

In recent post we have been discussing how banks will need to tackle revamped regulation needing them to beef up their core Tier 1 capital, as required by the European Banking Association.
We have already touched on the subject of DVA, bond tenders, debt to equity swap, upcoming deleveraging and of course reduction of appetite for risk with the reduction of the size of the trading book via attrition of Risk-Weighted-Assets.
As indicated by Bloomberg today by Liam Vaughan in his article "Financial Alchemy Foils Capital Rule as EU Banks Redefine Risk". It is worth mentioning the creativity of banks in dealing with capital rules imposed by regulators. When rules doesn't work your way, it is time to adapt:

"Banks in Europe are undercutting regulators’ demands that they boost capital by declaring assets they hold less risky today than they were yesterday.
Banco Santander SA, Spain’s largest lender, and Banco Bilbao Vizcaya Argentaria SA, the second-biggest, say they can go halfway to adding 13.6 billion euros ($18.8 billion) of capital by changing how they calculate risk-weightings, the probability of default lenders assign to loans, mortgages and derivatives. The practice, known as “risk-weighted asset optimization,” allows banks to boost capital ratios without cutting lending, selling assets or tapping shareholders.
Regulators in Europe, seeking to stem the region’s sovereign-debt crisis, ordered banks last month to increase core capital to 9 percent of risk weighted assets by the end of June."

And from the same article, an interesting comment from Adrian Blundell-Wignall deputy director of the Organization for Economic Cooperation and Development’sfinancial and enterprise affairs division in Paris:
"By allowing sophisticated banks to do their own modeling, we are allowing the poacher to participate in being the game-keeper”.

Yes, every bank uses their own models for calculating their RWA (Risk-Weighted-Assets) which are submitted once a year to national regulators according to the article.

Also from the same article:

"Sheila Bair, who stepped down as chairman of the Federal Deposit Insurance Corp. in June, has called Europe’s adoption of risk-weighting “naive.” The Washington-based regulator guarantees most consumers’ deposits in U.S. banks. “It is in a bank manager’s interest to say his assets have low risk, because it enables the bank to maximize leverage and return on equity, which in turn can lead to bigger pay and bonuses,” Bair wrote in Fortune magazine on Nov. 2. “Indeed, even during the Great Recession, as delinquencies and defaults increased, most European banks were saying their assets were becoming safer.
Some regulators, including Bair, have pushed for a leverage ratio that would require lenders to hold a fixed amount of capital against total assets.
One reason there’s a difference between risk-weighted assets and total assets is that some securities, such as certain sovereign bonds, carry a zero risk-weighting, requiring banks to hold no capital.

‘Gaming the System’

“A basic leverage ratio would be rougher, but it takes away the risk of gaming the system,” said Stephany Griffith-Jones, an economist and lecturer in financial markets at Columbia University in New York. “We need to move away from outsourcing regulation of the banks to the banks.” European bank stocks have tumbled 31 percent this year, valuing firms at 62 percent of tangible book value."

And the article to conclude quoting Mark Harrison, a Barclays
analyst, who is based in London:

“Gaming RWAs isn’t helpful, particularly if the objective is to convince the market to invest in banks again,” Harrison said. “The risk is that it’s counterproductive, because there
is even less faith in what the banks are telling you.”

Raising capital for Banks is therefore going to be an interesting exercise indeed in the coming months.

"Running a casino is like robbing a bank with no cops around." Ace Rothstein (Robert de Niro) in the movie Casino by Martin Scorsese

"Running an investment bank is like robbing a casino with no gaming regulators around."
Martin, Macronomics.

Stay Tuned!

Markets update - Credit - Complacency

"Don't let your special character and values, the secret that you know and no one else does, the truth - don't let that get swallowed up by the great chewing complacency."
Aesop

At this juncture, following our various credit and markets conversations, it is important to revisit some of the points we have discussed in relation to liquidity, funding pressures and deleveraging, and in the process, revisiting some of our calls.

But, before we go through the details (and the truth is in the detail...), it is time for a quick market overview relating to Friday's price action.

The Credit Indices Itraxx overview - Source Bloomberg:

What we have is extreme volatility, with Itraxx Credit Indices experiencing big price movements, in an environment where liquidity is dwindling, as we move towards year end, it will make matters not better but worse. Nearly 90 bps intraday move on Friday for Itraxx Crossover (High Yield indicator). To give you an idea, on a 10 million Euros notional Itraxx Crossover CDS, contract, 1 basis point movement equates to around 3500 Euros (DV01) move in your marked to market Profit and Loss.

And in relation to the European High Yield market, it briefly re-opened, we had Ba3 rated Faurecia coming to the market with a Senior Unsecured 350 million Euros 2016 bond offering at 9.375% yield. Faurecia is one of the largest international automotive parts manufacturers in the world. French car manufacturer PSA Peugeot Citroën is Faurecia's controlling shareholder, holding around 57.4% stake. Faurecia is in a cyclical business. In 2008 it breached its loan covenants.

While Natalie Harrison from Reuters, in the deal review gives us the reason for the financing in her article "DEAL REVIEW: Faurecia debut survives high-yield storm":

"The bond, executed in conjunction with a new syndicated loan facility, will refinance a EUR250m loan that parent Peugeot was forced to put in place three years ago when four banks backed out of lending to the company.

The bond is also part of the company's well-publicised plans to diversify its funding sources away from banks and follows its fund-raising in the schuldshein market the previous week."

There are two important points above, remember the truth is in the detail, the proceeds will be used to repay the facility set up by parent company due to previous funding issues encountered in 2008, lack of funding because banks are deleveraging, meaning credit contraction, which we know by now will have economic consequences. Morgan Stanley published a very interesting paper on the 4th of November - Credit Continuum - Understanding Credit in a Low Yield World:

"HY vs. IG: Owing to callability, economic sensitivity, duration and default risk, we find that high yield tends to have weaker performance than investment grade in falling rate environments."

And in relation to the ECB rate cut, I am afraid, it is coming late and it is "Much ado about nothing" as a senior credit market maker commented:

"The ECB rate cut was another surprise for the market and shows that the mild recession has already reached Europe as I expected."

And added:

"The rate cut will help sentiment but not really the refinancing need for Governments."

 In terms of financing needs for 2012, we discussed this subject with Cullen Roche in his post - "THE IMPOSSIBLE REFINANCING BURDEN...."

The Government Bond picture:

Italian bond yields creeping higher still...

Flight to quality mode is switched on again - "Risk-off", German 5 year sovereign CDS versus 10 year German Government Bonds yield:

But, in a low yield environment, defaults tend to spike.

Morgan Stanley in their note relating to "Understanding Credit in a Low Yield World added:

"Low Yields Tend to Coincide with Higher Spreads and Default Rates: While low yields are often associated with slow growth, thereby justifying wider credit spreads, other factors can keep spreads wide, including the trouble companies have in inflating away their nominal debt (higher default risk). History tells us that if growth eventually picks up while yields stay low (1930s-1950s), spreads can indeed normalize."

Deflation is still the name of the game and it should be your concern credit wise (in relation to upcoming defaults), not inflation as per Morgan Stanley's note:

"While one could argue that default rates could be high during times of higher yields owing to higher debt service cost, the opposite is actually true. High inflationary environments allow corporations to inflate away their nominal debt as their assets (and revenues) grow with inflation, leading to lower default rates. Low inflation environments, like the one we’ve had for the past 25 years, tend to be ones where defaults can spike."

The liquidity picture is Europe is not improving - Source Bloomberg:

We all know by now why liquidity matters...

So, no time for complacency, as my good credit friend put it from our conversations in a couple of sensible points:

"As we move now toward the end of the year and the market still seems to have some momentum to go higher (both in equity and in credit prices), I would like to focus on various news and information that will drive the market in the future.

1-Bank of America Corp. may bolster its balance sheet by exchanging preferred securities for a total of $6 billion of common shares and debt. The proposed transactions may lower interest and dividend costs and improve capital levels, the Charlotte, North Carolina-based lender said in a regulatory filing. The firm may seek to issue as much as 400 million common shares and $3 billion of senior notes in privately negotiated deals...Will other banks follow suit? We have already seen European banks trying to raise capital ahead of the European Summit decision: Tier 1 tender offer at some steep discount (BPCE, Banco Espirito Santo) and Subordinated Debt tender/exchange for equities (Banco Espirito Santo) at a big cost for both bonds and shares holders…I think we will see more banks taking the same path to raise capital in the next 9 months.

2-The EFSF leverage details are still unknown and the SPV supposed to attract investors...has not attracted real money so far. There have been a lot of words and hope, but nothing real. So a lot of assumptions about the efficiency of “The European Backstop” may well appear to be wrong.

3-Greece will not be able to pay its debt with the actual “voluntary 50% haircut” accepted by private investors. I crushed the numbers many times; the Greek total debt reduction will not be bigger than 35% of the country total liabilities, which is far from being enough for the economy to recover. I expect more pain for debt holders in the future, unless Greeks decide on what they can afford to repay.

4-The European economy is already in a mild recession. Even the new ECB chairman acknowledges it. But banks balance sheet deleveraging and austerity budgets throughout Europe will weigh more on the economy, which will have far reaching consequences worldwide. I think the outcome is totally under estimated by market players. As an example, according to the BIS, European banks lend today roughly $ 3.5 trillion to the emerging countries, while the number for the US banks is only roughly $ 975 billion, and for Japanese banks about $ 750 billion.

5-Starting in January 2012, the refinancing needs for States, banks and corporate will be “enormous”. It will occur at a time of economic weakness, with a looming credit crunch. Do not be too complacent as there will necessary be casualties."

We discussed bond tenders from point number 1 in our post "Subordinated debt - Love me tender?":
"We expected others to follow suit and given the difficulty for the weaker players in the peripheral space to access capital at a reasonable rate, as well as needing to boost their core Tier 1 capital base, it was of no surprise to see Portuguese bank Banco Espirito Santo following French bank BPCE in tendering some of its subordinated debt on the 18th of October, but this time around, we have a debt to equity swap"

My good credit friend commented at the time:

"Banco Espirito Santo total market cap is approximately euro 1,743 million…which means 83.5% dilution for the current shareholders!"

And I added:

"So, in our debt to equity swap, courtesy of the subordinated bond tender, not only the subordinated bond holder is taking a hit, but our shareholder as well. Love me tender?"

Here is a recap on the levels for Banco Espirito Santo Tier1 Subordinated bonds as of the 3rd of November:
BESPL T1 INDICS
EXCHANGE LVL @ 1.80 (equity price at the time of exchange...)
BESPL 5.58% 07/14 41/45 (cash price) - 61 (47.5 adj)
BESPL 4.5% 03/15 46/49 (cash price) - 66 (51.3 adj)
BESPL 6.625% 05/12 52/56 (cash price)- 74 (57.6 adj)
Adj. exchange px calculated using current stock price (1.40)

The recent European Banking Association reaction relating to beefing up Core Tier 1 capital to 9% before June 2012 is akin to shooting oneself in the foot. How can you raise private capital in these challenging market conditions and refinance at the same time?

On that very subject, JP Morgan published its Banking Sector Outlook for 2012 on the 4th of November entitled - The Great Bank Deleveraging:

"In our opinion European banks increasingly face the challenge of being stuck between a rock (increased regulatory requirements) and a hard place (pressure to grow lending whilst facing increasing funding pressures). Banks will need to deal with increased funding and solvency pressures, in addition to regulatory constraints on liquidity management, which ultimately should incentivize banks to reduce balance sheets. We think that this strategy will mostly be undertaken by banks rolling over a lower proportion of non-loan assets and loan commitments at maturity, rather than the aggressive pursuit of asset sales."

And JP Morgan to estimate the impact:

"Given these constraints, we have modelled a deleveraging strategy for a peer group of 28 of the largest European banks for which we estimate a net reduction of €834bn in assets over a 12 month period. We highlight that this reduction in balance sheet size is mostly driven by the attrition of loan and non-loan assets as these mature, with limited scope for asset sales given the potentially negative impacts on solvency. In our opinion there is greater scope for deleveraging of non-loan assets such as securities inventories as these reach maturity given that these may not be eligible for the purposes of LCR (Liquidity Coverage Ratio). If we scale up our estimate of balance sheet reduction to the broader European banking sector we derive a total deleveraging outcome of €1,993bn which would represent 4.7% of total sector assets and is in line with the recent guidance from the IIF (Institute of International Finance). It will be difficult to assume that such deleveraging will not have an impact on the broader economic environment."

And in relation to term funding, JP Morgan estimates:

"We expect that term refinancing pressures are likely to persist for the European banking sector in 2012, particularly given the more limited scope for Yankee issuance which was valuable support for the sector in H1’11. In our opinion the implementation of a guarantee scheme will be crucial in achieving some type of market normalization and we think is a preferable alternative to the extension of tenors on ECB liquidity facilities. We think that a guarantee scheme will necessarily have to operate at a supra sovereign level, with the pricing of such facilities being more problematic than they were in 2008/09 given the difficulty in establishing pre-crisis spread levels for the participating banks. While there has been a lot of focus on the reduced access of European banks to US money market funding, we expect that this will be replaced by increased recourse to ECB funding."

JP Morgan also agrees with our previous discussions relating to debt tenders and debt to equity swaps trend:

"Our base case is that the implementation of a statutory bail-in regime will result in the authorities having the discretion to impose losses on the more subordinated parts of the capital structure (Tier I and Tier II) before exposing taxpayers to potential losses. In our opinion there is a lot less resistance to forcing losses on legacy subordinated debt instruments, as we have seen amongst the Irish banking sector where specific legislation provided the flexibility to force such losses, an outcome which in future may be achieved under a standardized resolution regime.
We also highlight increased risks with regard to issuer behavior on the exercising of calls on legacy Tier I and Tier II capital instruments."*

*This is exactly what we previously discussed in our post "Crash Test for Dummies" on the 18th of September:

"But, it is clear that not all banks have the same liquidity/funding costs, particularly today. So the game is going, once again to be as follows, remember: "The recent significant increase in credit spreads for many financials have been driven by the markets concerned about the ability of the weaker players to access credit at reasonable rates." (Macro and Markets update - It's the liquidity stupid...and why it matters again... ), banks with access to cheaper senior term funding than the cost of their outstanding LT2, for them, an early call could make sense, compared to the cost of issuing senior debt. For the others, I am not so sure..."

I concluded at the time:

"So, dear credit friends, I am afraid to say that, skipping calls, are going to happen, and will trigger losses because end of the day, why would you call a bond, if it costs you more to issue a new one?

This time is different? Nope. It is still deleveraging."

As Aesop put it: "the truth - don't let that get swallowed up by the great chewing complacency."

In relation to the EBA's estimate of 106 billion euro of capital shortfall for bank, it is complacent, to say the least...

Here is what JP Morgan had to say relating to the above in their report:

"We therefore subject the 70 institutions defined in the last stress test to the incremental stress from the July exercise as well as the valuation adjustments of the October test to a core Tier I ratio of 9%. While we acknowledge that time may have been a factor for the last EBA stress tests, we think that it would have been relatively straightforward to make the necessary adjustments to derive a more complete picture for the sector’s solvency requirements. Under these scenarios we highlight that the capital shortfall for the sector for the 70 banks goes from a risible €0.9bn in July to the €106bn in October, with our combination of these stress scenarios highlighting a capital shortfall of €280bn. While time may have been a factor in the EBA producing a more limited stress test, we also note the very obvious inconvenience of producing a capital shortfall which may have been significantly beyond the available resources."

No stress, no test; no test, no stress...

As a reminder from our conversation "Long - Hope Short Faith":

"Something has gotta give" - subordinated bondholders or shareholders, or both:

And DVA will bite back shortly as well bank earnings, remember it works both ways, on spread widening, as well as on spread tightening...I call it the boomerang effect.

On a final note, here is what UBS had to say relating to Sovereign CDS in relation to naked ban and CDS not triggering on the 4th of November "Unintended consequences":

"Although the sovereign CDS market is small in terms of net exposure, the consequences could be severe if belief in the instrument’s ability to pay out wavers or there is an outright ban on sovereign CDS. Investment bank counterparty risk management depends on sovereign CDS to hedge sovereign exposure, as does market making of government bonds in the secondary market. A loss of faith in sovereign CDS as a hedge would force market makers to cut their inventory, which would lead to a rise in sovereign yields and funding costs. Sovereigns could be shut out of the OTC market as banks would be unable to hedge their counterparty exposure."

"My dear brothers, never forget, when you hear the progress of enlightenment vaunted, that the devil's best trick is to persuade you that he doesn't exist!"

Charles Baudelaire, French poet, "Le Joueur généreux," pub. February 7, 1864

"The greatest trick the devil ever pulled was to convince the world he didn't exist"
Roger "Verbal" Kint- The Usual Suspects

Stay tuned!

Markets update - Credit - Leda and the (Greek) Swan and why Europe matters for Emerging Markets

"Leda and the Swan is a motif from Greek mythology in which Zeus came to Leda in the form of a swan. According to later Greek mythology, Leda bore Helen and Polydeuces (Pollux), children of Zeus, while at the same time bearing Castor and Clytemnestra, children of her husband Tyndareus, the King of Sparta." - Source Wikipedia.

The Greek referendum, "swan"-tail risk like event, inspired me to use this time around this particular reference to Greek mythology, Leda and the Swan. I found it interesting, as the union of Leda and Zeus in the form of swan, led to the birth of Helen (which ultimately led to the demise of Troy and the Trojan War), but it also led to the birth of Castor and Polydeuces (Pollux), the Dioscuri:

"The Dioscuri were regarded as helpers of mankind and held to be patrons of travellers and of sailors in particular, who invoked them to seek favourable winds." - Source Wikipedia.

So now the ECB has a stark choice, similar to the one Pollux was given by Zeus, to save his dying brother Castor by sharing his immortality with his mortal brother (namely European peripheral countries) or spend his time in Olympus (letting Europe fail, one country after another). The ECB is the only institution that can step in and become the lender of last resort, effectively becoming in essence a FED like entity which should be backed by a central treasury (and we discussed this point in our last conversation), or doing nothing and our Greek swan might take us to another path...

We know that Pollux made the right choice and enabling in the process, the two siblings to become the two brightest stars in the constellation (Gemini).

And the Dioscuri "characteristically intervened at the moment of crisis, aiding those who honoured or trusted them." - Source Wikipedia.

But I digress, once again, time for a Credit Market overview as there are plenty of items to discuss.

The Credit Indices Itraxx overview - Source Bloomberg:

There was some small respite today following the massive surge in credit indices which followed the announcement of the Greek referendum.
The Itraxx Crossover CDS 5 year Index (High Yield gauge) fell about 15 bps around lunch time, following its preceding massive widening of nearly 85bps on the 1st of November (Itraxx Indices summary for the 1st of November: Europe Main at 180 (+22 bps), Sub Financial at 480 (+65 bps) and Crossover at 725 (+85bps). Big widening movement).

While the absolute spread between Itraxx Financial Senior Index 5 year CDS and Itraxx Main Europe 5 year CDS (Investment Grade) seems to be receding somewhat from a wide point of 114 bps reached in September - Source Bloomberg:

The absolute spread between Itraxx Financial Senior 5 year CDS index and Itraxx Financial Subordinate 5 year index has yet to recede to more normal levels, indicating ongoing difficulties for Financial institutions to secure subordinated funding at acceptable level, meaning the only source of funding for core European institutions being Senior Unsecured debt or covered bonds - source Bloomberg:


According to Barclays Capital High Grade Supply update relating to October (23.3 billion Euros unsecured bonds issued, including 9.3 billion Euros of Financial bonds issued); Euro Investment Grade issuance was significantly better in October than in September but here is what they had to say:

"Overall we remain relatively sanguine on the funding needs of European financials. We would expect them to actively exploit any periods when secondary market conditions improve and primary markets open up more fully. However, even if credit markets endure yet another bout of significant volatility, European financial institutions retain a large number of alternative funding options, including covered bonds, MTN placements, the non-Euro debt markets, deposit funding and balance sheet shrinkage.
Alternative funding channels have been further supported by the ECB’s announced resumption of the Covered Bond Purchase Program, and extended by the announced plan to initiate government guarantee scheme for bank liabilities. Further, the ECB has committed to generous liquidity provision until mid-2012. Given all this, we would echo the view of our bank analysts that at this juncture asset quality rather than liquidity is the primary driver of spread performance of European banks."

So, if we have a very negative reaction with heightened volatility at the beginning of 2012, courtesy of a bad outcome for the upcoming Greek referendum, it could become problematic for banks to access term funding, given traditionally, the beginning of the year is a very heavy month of issuance in the credit space.

In fact the funding needs for 2012 are significant. According to Bloomberg article from Ben Martin and David Goodman from the 25th of October citing CreditSights, Europe Banks must find 900 billion dollars in 2012:

"Banks in Europe have to refinance 655 billion euros ($911 billion) of senior bonds next year and may need government backing if the debt crisis continues to block access to markets, according to CreditSights Inc.
“Unless funding access eases, we might see banks having to use government guarantees again, and it will add to the pressure on them to reduce assets in order to lower refinancing needs,” said Simon Adamson, an analyst at the independent research firm in London. “I would think only a small proportion has been pre-funded, given that the markets have been virtually closed since July.
Western European lenders raised about 80 billion euros of senior unsecured debt this year, according to data compiled by Bloomberg. That’s down from 97 billion euros for the same period in 2010, as investors worry that banks, the biggest holders of sovereign debt, will face losses as the crisis escalates."

If banks cannot access term funding, given the deleveraging they ambition to do, it could put additional pressure on bank lending, in effect reducing access to credit for the economy, namely triggering another credit crunch in the process.

And my good credit friend to comment:

"European banks are the key to the future, and bank shares are still bleeding with no fundamental improvement to be expected in the near term. Raising capital remains difficult for most actors, even after the EBA (European Banking Association) reduced the capital needs significantly compared to what was initially estimated by various professionals. So we are entering one of these very interesting times in history where we will see banks reducing their balance sheet at the same time when European governments start implementing austerity budgets. Such a combination is definitely not supportive for the European economy as a whole, and will have far reaching impacts on the Global worldwide economy (Yes, European banks lend worldwide, not only to Europe)."

Here are some important facts to bear in mind - Source Bloomberg - Allison Bennett and Ye Xie - 7th of October 2010:

"The $3.4 trillion in lending to emerging markets from banks in Europe, including Germany and the U.K., compares with $299 billion from Japan and $727 billion from the U.S., according to BIS data as compiled by Royal Bank of Canada."

From the same article:

"European banks’ lending to Hungary amounted to more than 70 percent of that country’s GDP, according to estimates by Barclays Capital based on BIS data. Lending to Poland reached 40 percent of GDP, and that to Brazil and Mexico was equal to about 20 percent of their economies.
Lenders are already cutting back. London-based HSBC Holdings Plc was the No. 6 arranger of syndicated loans in the Asia-Pacific region outside Japan last quarter, down from No. 4 a year earlier, Bloomberg data show. Montrouge, France-based Credit Agricole SA dropped to 21 from 17, while Royal Bank of Scotland Group Plc, which sold assets in Asia after receiving the biggest bailout in banking history from the British government during the financial crisis, fell to 25 from 19."

Source - Emerging Markets Bank Lending Conditions Survey - IIF

The liquidity picture has not materially improved - Source Bloomberg:

In relation to flight to quality, risk-off came back with a vengeance on the 1st of November with a massive tightening movement on German 10 year government yields (25 bps, biggest decline in a day since 1992) and German Sovereign 5 year CDS widened as well in the process, from convergence, to divergence again:

Truth if the bond picture in the European space is increasingly becoming a concern with Italian 10 year yields reaching 6.24% (and not only for MF Global) - Source Bloomberg:

We also continue to see Italy 5 year Sovereign CDS widening versus Spain 5 year Sovereign CDS - Source Bloomberg:

Yet another record, with 125 bps between Italy and Spain, CDS wise.
French 10 year bonds are not spared either versus their German counterparts - Source Bloomberg:

A new record today, reaching 129 bps.

French bonds were not helped by the suspension of the EFSF bond auction which was supposed to take place today- Source Bloomberg:

Given banks are reluctant to raise new fresh capital by issuing right issues which in effect would dilute existing shareholders, the ongoing deleveraging process threatens economic growth in essence. The issue of circularity we discussed means that the higher government bonds yields rise, the higher premium banks will have to concede via new bonds issuance, the higher the risk of capital shortfall and cost of funding, the higher need to reduce the balance sheet and restrain credit.

There is no cheap option there. Capital injection will have to proceed at some point. As Liam Vaughan and Gavin Finch in their Bloomberg article from the 31st of October stated (Europe Tries to Recapitalize Its Banks Without Injecting Capital):

"Greece’s six banks will need to raise about 30 billion euros, more than any other EU member state, the EBA said. That shortfall is covered by existing backstop arrangements with the EU and International Monetary Fund, so Greek lenders wouldn’t have to tap investors, according to the EBA."

From the same article relating to EBA June 2012 core tier one capital target of 9%, banks need to raise at least 106 billion euros according to the EBA's calculations:
"Southern European banks that can’t raise capital may still need to shrink their balance sheets by as much as 40 percent to meet the new requirements and run the risk of having to rely on state injections, Mediobanca analysts including Alain Tchibozo wrote in a note to clients on Oct. 28."

In effect putting sovereign ratings at risk in the process and crushing economic growth at the same time and affecting Emerging Markets as well.

"Liquidity is a backward-looking yardstick. If anything, it’s an indicator of potential risk, because in “liquid” markets traders forego trying to determine an asset’s underlying worth - - they trust, instead, on their supposed ability to exit."
Roger Lowenstein, author of “When Genius Failed: The Rise and Fall of Long-Term Capital Management.” - "Corzine Forgot Lessons of Long-Term Capital"

We know by now from our many conversations, liquidity does indeed matter.

Stay tuned!