Author Archive for Martin T., Macronomics

European Banks and Why the Deleveraging Has Only Just Begun

By Martin T., Macronomics

“Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.” – Winston Churchill

Figure 1 was extracted from Bank of America’s note “Banking on the Banks” from the 16th of May, clearly illustrates why the deleveraging has only just started in Europe.

“Meanwhile, Europe continues to lag the improvements seen in the US economy and markets. Quite simply, Europe’s economy struggles with too many banks, too much debt and too little growth. A long history of empire, trade, war and commerce means a long history of banking. The world’s first state-guaranteed bank was the Bank of Venice, founded in 1157, and the world’s oldest bank today is also Italian, Monte Paschi di Siena (founded 1472). In many European countries, bank assets dwarf the size of the local economy and are far in excess of other regions in the world.” – source Bank of America Merrill Lynch.

Why the credit crunch in European countries?  Because this deleveraging was accelerated by the fateful decision taken by the European Banking Association of imposing European banks to reach a Core Tier 1 capital ratio of 9% by June 2012. It has not only broken the credit transmission mechanism to the real economy in Europe but caused a credit crunch as well (see figure 2).

mt1(Figure 1 – bank assets as % of GDP)

mt2

(Figure 2 – EU private sector credit growth)

Time for a Pullback? Get Some Greenbacks!

By Martin T., Macronomics

“If a window of opportunity appears, don’t pull down the shade.” – Tom Peters

As we highlighted in our conversation in May 2012 – “Risk-Off Correlations – When Opposites attract”: Commodities and stocks have become far more closely intertwined as resources have taken on a greater role with China’s economic expansion and increasing consumption in Emerging Markets.

In numerous conversations, we pointed out we had been tracking with much interest the ongoing relationship between Oil Prices, the Standard and Poor’s index and the US 10 year Treasury yield since QE2 has been announced.

Looking at the recent weaknesses in commodities such as oil and copper, one could decently argue that the time might have come to take a few chips off the gambling table.

This feeling of “uneasiness” seems to be shared by Bank of America Merrill Lynch which indicated on the 21st of February the following important points:

“This week’s Thundering Word from our investment strategists reiterates their view that a pullback is likely across risk assets but that this would be very healthy for the longer-term reflation story.

On this basis they advocate buying volatility near term. We highlight 3 key reasons for a near term pullback in risk assets:

-Market complacency: our Global Financial Stress Index (GFSI) is at a multi-year low, while the new BofAML Bull &Bear index which measures market sentiment is at a multi-year high (chart 1).

-Easing has eased: Monetary policy minutes of both the Fed and the Bank of England indicated this week that the era of QE is slowly coming to an end.

-Defensive price action: The two best performing US equity sectors year-to-date are Staples and Health Care. Credit markets have stalled. We remain bullish on the reflation story in Japan but note that domestic small caps, a key barometer of local belief in domestic demand, just dropped 20%.

A longer term trade is to buy the USD which is no longer correlated with volatility and has benefitted from the recent increase in risk appetite. Our house view is that the USD may be embarking on a strong secular uptrend; the only risk being any unexpected derailment of the US house price recovery.

A key element of the USD strengthening story is global rebalancing with Asia no longer deemed the world’s producer and the US the world’s consumer. As a result assets tied to the China production story are slowly derating – note the underperformance of materials stocks versus the global equity market in the past 12 months. However, some currencies also tied to the story such as the Australian dollar and the Canadian dollar are taking longer to derate and hence constitute good shorts against our long USD stance.”

As per our previous May 2012 conclusion, whereas opposite attracts during “Risk-Off” periods, the greenback could still prove to be a powerful magnet should we experience a bout of pullback in risky assets.

“If you are not willing to risk the unusual, you will have to settle for the ordinary.” – Jim Rohn, American businessman

The Change in the Volatility Regime – Part 2

By Martin T., Macronomics

“If you change the way you look at things, the things you look at change.” – Wayne Dyer, American psychologist

Yesterday we touched on the implications relating to regime changes in the volatility space.  The phenomenon currently in the US is similar in Europe where European equity volatility trading has been trading marginally below the VIX.  This is displayed in the chart below from Cheuvreux’s recent Cross Asset Research paper from the 7th of January – The Tactical Message:

“The VStoxx index of implied volatility has followed the American example by falling to a cycle-low. The increase in America’s political-fiscal risk premium since September has allowed indices of European equity volatility to trade marginally below the VIX.” – source Cheuvreux Cross Asset Research, 7th of January 2013.

Cheuvreux makes the argument that the decline in financial volatility is a general phenomenon, with the lead coming from debt markets. Further, they argue that there is more to it than financial repression:

(Source Cheuvreux/Bloomberg
MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.
CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.)

Back in March 2012 our cross-asset friend noted the relationship between Treasuries vs Equities and Forex volatility:

“If the bond market’s move truly is the start of a long rates repricing for “good” reasons (namely finally validating the huge risky assets run-up of these last 4 months on better macro data) then it makes sense to see a risk transfer from the equities/forex sphere to the bond market’s sphere. As a matter of fact, we noticed this kind of discrepancy during a rather similar period : in Q4 of 2010, following the QE2 announcement, where we saw 10 year yield move up 100 bps, SPX and most risky assets rallyed hard with the same type of cross-asset vols opposite moves.

However these kind of disconnections in cross-asset vol markets generally do not last long. A correction in risky assets or a larger bond market rout would effectively probably see SPX and forex short volatilities move up rather quickly. We’re talking short-term volatility here so obviously timing is key to put on recorrelation trades as you need to be right pretty fast…”

At the time of the bond market correction of March 2012, there was a similar disconnect, as indicated by Cheuvreux’s graph between the CVIX and MOVE index, where Treasury volatilities were up substantially and risky asset volatilities (equities and Forex volatilities) remained at the low end of their recent range.

We see a similar pattern in early 2013.

“Always remember that the future comes one day at a time.” – Dean Acheson, American statesman

Stay tuned!

Long Dated Volatilities – A Regime Change?

By Matin T., Macronomics (This part 1 of a two part post)

“The cost of liberty is less than the price of repression.” - W. E. B. Du Bois, American writer

The recent significant fall in implicit volatilities  means that long dated volatilities (1 year) of most significant equity indices are now testing the frontier level between the post-crisis lows and the ultra low regime of 2004-2007.

Implicit 1 year volatility for the S and P500 (SPX) – source Bloomberg:

Could it be an attractive entry point or more simply a clear indication of regime change? We have to agree with our-good cross-asset friend that we have a hard time believing in the regime change when taking into account the fundamental macro picture. Could it simply be the broader impact of financial repression? One has to wonder.

Financial liberalization, for instance in Emerging Markets, has been a good way to attract foreign investments. It has often led to a rise in volatility given investors had been reaping in the process higher daily return rates. When equity market becomes more open, there are increases in stock return volatility (on the subject see the study realised by Vuong Thanh Long, Department of Economic Development and Policies at the Vietnam Development Forum – Tokyo Presentation – August 2007).

Regime switches also lead to potentially large consequences for investors’ optimal portfolio choice, hence the importance of the subject.

In relation to Regime Changes and Financial Markets, Andrew Ang, from Columbia University and NBER, and Allan Timmermann from the University of California, San Diego, made an interesting study in June 2011-

Regime Changes and Financial Markets:

“When applied to financial series, regimes identified by econometric methods often correspond to different periods in regulation, policy, and other secular changes. For example, interest rate behavior markedly changed from 1979 through 1982, during which the Federal Reserve changed its operating procedure to targeting monetary aggregates. Other regimes identified in interest rates correspond to the tenure of different Federal Reserve Chairs (see, for example, Sims and Zha, 2006). In equities, different regimes correspond to periods of high and low volatility, and long bull and bear market periods. Thus, regime switching models can match narrative stories of changing fundamentals that sometimes can only be interpreted ex post, but in a way that can be used for ex-ante real-time forecasting, optimal portfolio choice, and other economic applications.

Second, regime switching models parsimouniously capture stylized behavior of many financial series including fat tails, persistently occurring periods of turbulence followed by periods of low volatility (ARCH effects), skewness, and time-varying correlations. By appropriately mixing conditional normal (or other types of) distributions, large amounts of non-linear effects can be generated. Even when the true model is unknown, regime switching models can provide a good approximation for more complicated processes driving security returns. Regime switching models also nest as a special case jump models, since a jump is a regime which is immediately exited next period and, when the number of regime is large, the dynamics of a regime switching model approximates the behavior of time-varying parameter models where the continuous state space of the parameter is appropriately discretized.

Finally, another attractive feature of regime switching models is that they are able to capture nonlinear stylized dynamics of asset returns in a framework based on linear specifications, or conditionally normal or log-normal distributions, within a regime. This makes asset pricing under regime switching analytically tractable. In particular, regimes introduced into linear asset pricing models can often be solved in closed form because conditional on the underlying regime, normality (or log-normality) is recovered. This makes incorporating regime dynamics in affine models straight forward.

The notion of regimes is closely linked to the familiar concept of good and bad states or states with low versus high risk, but surprising and somewhat counterintuitive results can be obtained from equilibrium asset pricing models with regime changes. Conventional linear asset pricing models imply a positive and monotonic risk-return relation (e.g., Merton, 1973). In contrast, changes between discrete regimes with different consumption growth rates can lead to increasing, decreasing, flat or non-monotonic risk/return relations as shown by, e.g., Backus and Gregory (1993), Whitelaw (2000), and Ang and Liu (2007). Intuitively, non-monotonic patterns arise because “good” and “bad” regimes, characterized by high and low growth in fundamentals and asset price levels, respectively, may also be associated with higher uncertainty about future prospects than more stable, “normal” regimes which are likely to last longer. The possibility of switching across regimes, even if it occurs relatively rarely, induces an important additional source of uncertainty that investors want to hedge against. Inverse risk-return trade-offs can result in some regimes because the market portfolio hedges against adverse future consumption shocks even though the level of uncertainty (return volatility) is high in these regimes. Further non-linearities can be generated as a result of investors’ learning about unobserved regimes.”

As highlighted above, the importance of regime change is paramount to asset allocation given:

“-The relation between the investor horizon of a buy-and-hold strategy and the optimal portfolio varies considerably from one regime to the other. 
-For example, in a bear regime, stocks are less favored and short-term investors allocate a smaller part of their portfolio to stocks.* 
-On the contrary, in the longer run, there is a high probability to switch to a better regime and long-term investors dedicate a larger part of their portfolio to stocks. 
-In a bear regime the share allocated to stocks increases with the investor’s horizon.”
- source The Princeton Club of New-York, 27th of April 2012, EDHEC-PRINCETON Institutional Money Management Conference.

*Hence the reason why retail investors have been net sellers of stocks since 2007.
“Since they started selling in April 2007, eight months before the start of the Great Recession, individual investors have pulled at least $380 billion from U.S. stock funds, a category that includes both mutual funds and exchange-traded funds, according to estimates by the AP. That is the equivalent of all the money they put into the market in the previous five years.” (“AP IMPACT: Ordinary folks losing faith in stocks”, AP News)

U.S. Equities’ Long-Term Real Returns

By Martin T., Macronomics

Courtesy of our good friends at Rcube Global Macro Research, please find enclosed their recent note focusing on US Equities’ Long Term Real Returns. Enjoy!

Our research generally focuses on tactical investment horizons (3‐6 months). In this paper, however, we consider long‐term real returns for US equities, for which we have reliable data since 1871.

Nota bene:

By real returns, we mean total returns (i.e. dividend included) divided by the CPI. We chose to analyze the US market as it has longest and most accurate historical data. Our data originates from Shiller’s website: http://www.econ.yale.edu/~shiller/data.htm. Earlier data exists (as early as 1802), but is plagued with survivorship bias.

When we look at price alone (as many observers do), we see no evidence of a long term trend. Rather, we have two distinct 70‐year periods: pre‐WW2: +1.0% annual price appreciation; and post‐WW2: +7.4% annual price appreciation. However, as we know, price appreciation is insufficient to quantify returns, especially when we consider long investment periods. Indeed, a rational long‐term investor should look at (and hope to maximize) real total returns, which take into account dividends and inflation.

When we look at the S and P 500’s real total return, the picture looks very different:

Taking into account dividends and inflation, we can admire the remarkable stationarity of S and P 500’s real returns around a long‐term trend (6.5% per year). Even the 1929 crash and the 1970s’ stagflation represent small deviations from the overall trend.

A long‐term trend of around 6.5% essentially means that an equity investor’s purchasing power doubles every 11 years, which is in itself the strongest argument for permabulls and buy‐and‐hold proponents.

That being said, many believe that the 6.5% real return – which is also known as “Siegel’s Constant” – is a historical freak and is unlikely to continue further.

In a controversial Investment Outlook published last August, Bill Gross compared this 6.5% long‐term real return to long‐term real GDP growth (around 3.5%), and concluded that the stock market was a “Ponzi scheme”, with stockholders having been “skimming 3% off the top each and every year, at the expense of lenders, laborers and the government”. In a comment that reminisced Business Week’s famous 1979 cover, the “Bond King” then proclaimed that the “cult of equity was dying”.

It appears to us that this analysis is flawed (and indeed, it was immediately rebutted by Dr. Jeremy Siegel, as well as other academics). Although it is true that the market value of equities cannot grow above GDP forever, Bill Gross seems to have ignored the fact that around half of stock returns originate from distribution to shareholders, in the form of dividends and share buybacks.

There is therefore nothing wrong in the fact that equity real returns are higher than real GDP growth. Even in a zero‐growth economy, companies would still have earnings that can be used to distribute dividends or buy back shares, which would lead to higher than zero real returns for equities.  We’ll return later to the question of the link between equity real returns and economic growth.

Regardless of the sustainability of 6.5% real returns in the future, nobody would dispute that it is hardly a“constant”, especially for short‐term horizons.

If we define 10 years as the lower range of what constitutes a long‐term investment horizon, the standard deviation of forward returns is still fairly wide (around 5.2%). This highlights the need to look for methods of predicting 10‐year forward returns.

One such method, introduced by Robert Shiller in his 2000 book Irrational Exuberance, involves using cyclically adjusted P/E ratios (CAPEs) to predict 10‐year forward returns. CAPEs are P/E ratios that use past 10‐year average earnings in order to smooth out cycles.

The S and P 500’s CAPE is currently around 21, which is substantially higher than its long‐term average (16.5). Although bearish observers use these figures as a sign of overvaluation, it is worth noting that 10‐year forward real returns would be around 4.4% according to the above regression equation.

In any case, the CAPE regression only explains around 25% of 10‐year forward returns. Moreover, this analysis is performed in‐sample, whereas an investor operating in real time during the sample period would not have access to the whole dataset.

If we remain in an in‐sample framework, we can obtain R2s that are much better than 25%.

First we can note that corporate profits as a proportion of GDP are one of the most mean‐reverting time series in economics.

Nota bene:
Although total corporate profits and S and P 500 profits are not the same thing, their growth rate is rather similar over long time periods (3.23% per year for total corporate profits vs. 3.17% for S and P 500 profits between 1947 and 2008):

Low profits as a proportion of GDP lead to business failures, reduced competition, and therefore higher margins further down the road (and vice versa).

From this point of view, buying when earnings are high and selling when earnings are low (as suggested by PE‐based methods) does not seem such a great idea.

Rather than taking the 10‐year earnings average as the denominator, we could therefore use real GDP.
Incidentally, the total market cap / GDP ratio (which is a related concept) is Buffet’s favourite macro measure of value for stocks.

This time, we find a long‐term trend of around 3% for the ratio (i.e. the same 3% that stockholders
supposedly “skim off” at the expense of others, according to Bill Gross).

Although the S and P 500 real return / real GDP ratio looks rather trend‐stationary, it has had rather wild swings around the trend, which indicate potentially interesting opportunities to trade in and out of the market.

Indeed, we obtain a rather nice R2 of 57% when we regress the detrended ratio against 10‐year forward real returns.

Currently, we’re close to fair value, as the overshoot from the 90s (Greenspan’s “irrational exuberance”) finally seems to have been digested. This does not preclude another “undershoot”, such as the one we had in 2008, as investors revise their economic growth assumptions downwards, especially in deleveraging developed economies.

Nota bene:
Although there seems to be a long‐term elasticity of one between equity real returns and realized economic growth, changes in long‐term growth expectations and/or risk premia can have a huge impact on valuations. If we simply look at the Gordon‐Shapiro model and assume a denominator (expected rate of return – expected growth) of around 5%, a 1% decrease in long‐term expected growth decreases the value of equities by 20%. We believe that this explains much of equities’ “excess volatility puzzle”.

Again, this is an in‐sample analysis (just like the CAPE model). Although we still get an R2 of around 40% if we use a running regression instead of a fixed in‐sample regression (and use the first 40 years of the sample as a “learning period”), no one can assert that 3% long‐term returns above real GDP growth are an intangible law of nature.

To conclude, assuming long‐term forward equity real returns to be around 3% plus foreseeable economic growth provides us with a ballpark figure. It avoids making blatantly wrong assumptions about long‐term equity real returns (such as believing that they can be around 10%, like many investors still do).

Additionally, it is important to note that this brief study concerns only the United States, a country that won two world wars and avoided socialist experiments during the last century. It would be interesting to calculate the trend of the real equity return / real GDP ratio for other countries. Unfortunately, reliable data on long‐term real returns is hard to obtain for most countries, as they generally originate in the early 1970s (e.g. MSCI Indices).

We will however try to gather more data on this vast subject, as well as publish additional short studies about long‐term returns of other asset classes.

“Common sense is the most fairly distributed thing in the world, for each one thinks he is so well-endowed with it that even those who are hardest to satisfy in all other matters are not in the habit of desiring more of it than they already have.” – Rene Descartes, French philosopher.

Stay tuned!

 

Chart of the Day: Convergence Between VIX and V2X

By Martin T., Macronomics

“To every action there is always opposed an equal reaction.” – Isaac Newton

The last few days have seen a pick up in demand for downside protection on the S and P500, when it seems no one at the moment has nothing left to protect against in Europe, which explains somewhat the recent convergence move between the VIX and its European equivalent V2X – source Bloomberg:

Please note Futures have yet to realise this convergence.  As a reminder from our March conversation (The two main drivers of equity volatility), and as indicated by our Global Macro friends at Rcube at the time:

“The two main drivers of equity volatility are for us, credit availability (Merton model) and revisions of earnings forecasts estimates. Equity volatility is also logically driven by the direction and the magnitude of revisions of forward earnings estimates. In 2010 and again in 2011, equity vol spiked while earnings forecasts remained strong.”

The convergence between VIX and its European equivalent V2X – Source Bloomberg

“Hesitation increases in relation to risk in equal proportion to age.” – Ernest Hemingway

 

Chart of the Day: Markets and Economists Optimistic Ahead of Fiscal Cliff

By Martin T., Macronomics

“Hope is definitely not the same thing as optimism. It is not the conviction that something will turn out well, but the certainty that something makes sense, regardless of how it turns out.” - Vaclav Havel

“The policy uncertainty index has three underlying components: 1). newspaper coverage of policy-related economic uncertainty; 2). number of federal tax code provisions set to expire; 3). disagreement among economic forecasters as a proxy for uncertainty.” - source Policyuncertainty.com, Bloomberg, Societe Generale Cross Asset Research – 27th of November 2012

Why Have Global Macro Hedge Funds Underperformed?

By Martin T., Macronomics

“There is no better than adversity. Every defeat, every heartbreak, every loss, contains its own seed, its own lesson on how to improve your performance the next time.” – Malcolm X

Many pundits have recently looked at the lackluster performances of Hedge Funds from the European crisis perspective. We would like to have a different approach, namely the one of volatilities.

Courtesy of our good friends at Rcube Global Macro Research, the answer appears to be simpler. It’s the volatility stupid! Or lack thereof….

“Volatility across all asset classes has crashed. As the chart below highlights, when this happens, global macro strategies tend to suffer on both an absolute and relative basis.”

“While investors have poured massive amounts in long equity volatility products over the last 9 months, as a hedge against long stocks exposure, this strategy failed spectacularly. We believe more pain lies ahead for long equity volatility trades.”

We would like to highlight an interesting pattern in VIX futures, illustrated by the following kernel regression analysis between these variables:

X: the sum of 100 days Z-Score of the S and P500 Index and the SPVXSTR Index (a rolling long VIX strategy, tracked by the VXX ETF).

Y: Annualized expected returns of the SPVXSTR Index.

We see that when we are at the low end of the range (meaning that volatility does not react to a market dip, which is currently the case), further weakness should be expected on vol forwards.

Regarding other measures of sentiment/positioning, investors still seem to be extremely defensive while stock markets have rallied substantially over the last few months. This remains the most hated bull market in recent history.

Classic measures of sentiment are still deeply negative and at levels that are usually reached after medium to long term bear markets.

The CBOE put/call ratio reached historical highs on both the 10 and 90 days sma last week:

Stocks have very substantially lagged credit this year. We have advertised in recent publications why we believe corporate credit outperformance is over.

The recent sharp improvement in US consumer sentiment doesn’t seem to have been priced by the stock to bond ratio.

We are also aware that earnings revisions have been on the weak side recently.


In addition to the great points made by our good friends from Rcube, with interest rates at zero it is as well very challenging for Global Macro Hedge Funds to play an economy against another in currencies markets due to the fall in volatilities.

To bring some solace to Global Macro Hedge Funds, their biggest liquidity and volatility providers, namely top investment banks, are suffering as well, as reported by Neal Amstrong article in Bloomberg – Biggest Traders Hurt as Fed to ECB Crush Volatility – on the 23rd of November:

“The world’s largest currency traders say foreign-exchange revenue is sliding as central-bank policies stifle price swings and cut volumes by $300 billion a day. Deutsche Bank AG, the biggest dealer based on Euromoney Institutional Investor Plc data, says narrower margins cut revenue “significantly” last quarter. Barclays Plc, the third-largest, says foreign-exchange sales are dropping and fourth-placed UBS AG says it has been hurt by lower volatility. Daily turnover as measured by CLS Bank, operator of the largest currency-transaction settlement system, slid 6 percent to $4.72 trillion in the third quarter from the year-earlier period. The combination of interest rates at, or near, record lows in the U.S., Europe and Japan is diminishing the allure of the dollar, euro and yen, the three most-traded currencies. From Switzerland to Brazil, central banks are establishing controls on exchange rates, making it less lucrative to trade the franc to the real. “With interest rates being at zero it’s very difficult now to play the cyclical differences in economies,” David Bloom, global head of currency-market strategy at HSBC Holdings Plc in London, said in a telephone interview on Nov. 20. “We’re in a structural world where if you have an economic event, you are best placed to think about it in terms of equities or bonds rather than foreign exchange.”

“Past performance speaks a tremendous amount about one’s ability and likelihood for success.” - Mark Spitz

The Decline of Japanese Corporations as Illustrated by the CDS Market

By Martin T., Macronomics

“What is at a peak is certain to decline. He who shows his hand will surely be defeated. He who can prevail in battle by taking advantage of his enemy’s doubts is invincible.” - Cao Cao

The CDS market is a clear illustration of the surge of Chinese and Korean corporates versus the slow decline of Japanese corporates – source Bloomberg:

The Itraxx Ex-Japan CDS index above (Blue line) is primarily weighted in Chinese and Korean corporates whereas the Itraxx Japan CDS (Red line) is very much weighted by the following sectors: Technology, Utilities, Shipping and Steel which are currently under tremendous pressure at the moment.

“Nature’s laws must be obeyed, and the period of decline begins, and goes on with accelerated rapidity.”  - Warren De la Rue, British Scientist.

Spain Surpasses 90′s Perfect Storm

By Martin T., Macronomics

“It is better to meet danger than to wait for it. He that is on a lee shore, and foresees a hurricane, stands out to sea and encounters a storm to avoid a shipwreck.” – Charles Caleb Colton, English writer

While we already touched on the subject of “Rogue Waves” in our conversation “the Italian Peregrine soliton”, being an analytical solution to the nonlinear Schrödinger equation (which was proposed by Howell Peregrine in 1983), being “an attractive hypothesis to explain the formation of those waves which have a high amplitude and may appear from nowhere and disappear without a trace, the latest surge in Spanish Nonperforming loans to a record 10.51% and the unfortunate Sandy Hurricane have drawn us towards the analogy of the 1991 “Perfect Storm”.

Generally rogues waves require longer time to form, as their growth rate has a power law rather than an exponential one. They also need special conditions to be created such as powerful hurricanes or in the case of Spain, tremendous deflationary at play when it comes to the very significant surge in nonperforming loans.

Looking at the comparison between Sandy and the 1991 “Perfect Storm” Wave Height Analysis, Sandy has been telling us indeed a story of its own when it comes to wave conditions collected offshore Delaware on the 29th of October:

- source gCaptain, gCaptain is the top-visited maritime and offshore industry news blog in the world – NOAA buoy 44009. Sandy is shown in red while the “Perfect Storm” is in blue. (x-axis=Days since 10/23, y-axis=wave height in meters).

The Perfect Storm:
“On October 30, 1991, a buoy located 425 km (264 mi) south-southeast of Halifax reported a peak wave height of 30.5 m, or 100 ft., representing the highest wave height ever measured on the Scotian Shelf. Further south, a buoy located East of Cape Cod reported maximum sustained winds of 56 mph with gusts to 75 mph, and a significant wave height (meaning the average height of the highest waves) of 39 feet, or 12 meters, on October 30, 1991.” – source gCaptain.

Sandy Wave Heights:
“Oct 29, 2012 21Z wind/wave analysis has indicated 47 ft sea heights (again meaning the average height of the highest waves) associated with Hurricane Sandy. The storm is now even being declared the Atlantic’s Ocean’s biggest-ever tropical storm.” – source gCaptain

The Spanish storm surge, fast rising Nonperforming loans – source Bloomberg:

While the 1990-1994 saw a significant rise in nonperforming loans peaking at 8.99% in April 1994, the period going from 31st of October 2006 to the latest figure of 10.51% saw nonperforming loans rising significantly above the 1994 record in similar fashion hurricane Sandy has beaten the record of the 1991 “Perfect Storm”.

While we recently touched on correlations and causation, in significant fashion to “rogue waves”, for such “freak” phenomenon to occur, you need no doubt special conditions, such as the conjunction of fast rising unemployment (high winds), economic contraction (falling pressure towards 940 MB), and credit contraction as well as austeriy measures.

In that context, we decided to realise a similar comparison exercise between Hurricane Sandy and the “Perfect Storm” with the two periods that saw rising nonperforming loans in Spain in number of months:

While during the first crisis in the 1990, the wave of surging NPLs peaked after 50 months at 9.15%, in the on-going Spanish crisis, we are yet to see the peak in the surge of nonperforming loans with the latest record being broken at 10.51% after 70 months.

Whereas Hurricane Sandy has told us a story of its own versus 1991 “Perfect Storm”, the on-going Spanish crisis is as well telling us a special one as well with its economy contracting for a fifth quarter, declining 0.3% through September, compared to 0.4% the prior quarter with consumer prices rising 3.5% from a year earlier. Spain will most likely miss its 6.3% overall deficit goal for 2012 given after eight months the government shortfall was already at 4.77%, wider than the full year target. According to Bloomberg’s survey of economists, the shortfall points to 6.5% for the deficit and the 2013 outlook points to a contraction of 1.4% of GDP compared to the government’s prediction of 0.5%. Unemployment is expected to rise above 27% by 2014.

Spain is busy setting up a bad bank with the transfer of 45 billion euros worth of assets with a discount of 63.1% for foreclosed assets and 45.6% average discount on for loans, which is a condition for a European bailout of as much as 100 billion euros for its banking sector. The bad bank will also apply a 79.5% discount for foreclosed land, 63.2% on unfinished developments and 54.2% on foreclosed new homes.

With 200 billion euros of financing needed for 2013, Spain is indeed facing a perfect storm…

“Anyone who says they’re not afraid at the time of a hurricane is either a fool or a liar, or a little bit of both.” – Anderson Cooper

Stay tuned!

Credit Outlook – Hooke’s Law

By Martin T., Macronomics

“A complacent satisfaction with present knowledge is the chief bar to the pursuit of knowledge.” - B. H. Liddell Hart

“In mechanics and physics, Hooke’s law of elasticity is an approximation that states that the extension of a spring is in direct proportion with the Load applied to it. Many materials obey this law as long as the load does not exceed the material’s elastic limit. Materials for which Hooke’s law is a useful approximation are known as linear-elastic or “Hookean” materials. Hooke’s law in simple terms says that strain is directly proportional to stress.” - source Wikipedia.

 As a follow up to our recent conversation “Yield Famine“, we decided this time around to venture towards a law of physics analogy, namely Hooke’s law given the level of stress that can be ascertained from the level of core European yields making new record lows (Germany, France, Austria, Netherlands), which we think is indeed, directly proportional to the aforementioned stress. But it not only in Europe, we are seeing an extension of the “negative yield club”, the United Kingdom as well is poised for joining the club:
“The CHART OF THE DAY shows the yield on the two-year gilt falling. It reached a record low 0.115 percent today. Similarly-dated Swiss rates dropped to minus 0.44 percent on July 16, with Germany’s and Denmark’s yields sliding to as low as minus 0.074 percent and minus 0.331 percent, respectively, two days ago. Shorter-maturity rates have turned negative for nations perceived as havens from the almost three-year-old debt crisis, which has sent Italian and Spanish yields to euro-era highs and countries including Greece, Ireland and Portugal seeking bailouts. A negative yield means investors who hold the notes to maturity will receive less than they paid to buy them.” - source Bloomberg.
While we recently touched on the attractiveness of going long credit and going long equity volatility (“European Credit versus volatility looks increasingly appealing“), we also discussed in our last conversation the complacency and dwindling liquidity pushing investors out of their comfort zone in similar fashion the “yield famine” of 2006 and 2007 engineered the rise and fall of the structured credit market and other esoteric yield “enhancements” products. In our credit conversation, we would like to discuss the “unintended consequences” of this low yield environment will have to corporate balance sheets, which to some extent, tend to explain, why defaults tend to spike in a low rate deflationary environment such as today. But first, as always our credit overview.
The Itraxx CDS indices picture, with indices widening on the back of a worsening Spanish situation while falling core government bond spreads are making new record lows - source Bloomberg:
The Itraxx Crossover (High Yield CDS risk indicator – 50 European high yield credit entities) widened towards the 665 bps level, wider by 20bps on the day. Both the Itraxx Financial Senior 5 year index (25 banks and insurers) as well as the Itraxx Financial Subordinated 5 year index rose significantly in the process, respectively by 13 bps and 16 bps.
The current European bond picture with Spanish yields back above the 7% level while German government yields closing back to lower record level around 1.16% (1.20% on the 18th) with other European core bonds (France, Netherlands) making again new lows in this “yield famine” environment – source Bloomberg:
“Hooke’s law”: Core yields strain/levels are directly proportional to peripheral stress/levels.
Italy’s 5 year Sovereign CDS versus Spain 5 year Sovereign CDS with Spain coming again under renewed pressure on the back of Sovereign government yields – source Bloomberg:
Spanish Sovereign 5 year CDS now wider by 80 bps, making a new record high, above Italian Sovereign 5 year CDS in conjunction with Government Bond Yields. Back in March, in our conversation “Spanish Denial“, we highlighted the differences between Italy and Spain. In our conversation “Modicum of relief“  in March we stated:

We think Spain Sovereign CDS will drift wider, indicating increasing default risk perception given:
-Italy’s shrinking budget deficit to -3.9% in 2011 from -4.6% in 2010, 
-Spanish unemployment level expected to reach 24.3% in 2012,
-Spanish Prime Minister Mariano Rajoy has decided to side step the 4.4% deficit target for 2012, for 5.8%.”

The core of our macro thought process is based upon the difference between “stocks” and “flows”, as we indicated in our conversation “The Spread Also Rises“, Cheuvreux Cross Asset Research from the 19th of March validated our macro approach we think:

The sovereign debt constraint in Italy is that of a stock – a high accumulated indebtedness – rather than a flow due to operational deficits. Accordingly, the arithmetic of sovereign sustainability in Italy is much more sensitive to the ratio of the cost of debt to trend nominal GDP growth than in Spain.”

“Spain’s ten-year yield closed above 7% for only the fourth time in the euro era, as auction costs for two- and five-year issues spiked and bid-to-cover levels fell significantly, further pressuring the ECB for action. The associated impact on its banks and their funding costs drove the Bloomberg Industries Spanish Banks Index (BIERBESC) to fresh lows.” - source Bloomberg.
Spain on Friday said its recession would extend into next year in conjunction with the region of Valencia asking for a rescue from the central government. Spain’s GDP will fall 0.5% in 2013 rather than rising by 0.2% in 2013 as the government had predicted on the 27th of April. Regions face about 15 billion euros of debt redemptions in the second half, with Catalonia and Valencia making the bulk. Spain is truly in a deflationary trap with unemployment reaching 24.6% in 2012 instead of 24.3%. The forecast for 2013 is unemployment to be 24.3% instead of 24.2%.  Clearly a case of “A Deficit Target Too Far“.
So the pressure is mounting on the ECB to intervene yet again in the markets as Spanish yields rise.
“In May 2010 the ECB securities market program began, peaking at 219.5 billion euros in March 2012 and recently holding at 211 billion for several months. Two three-year liquidity injections and a June euro area summit release have failed to stabilize yields, which in turn continue to buffet bank stocks and liquidity supply, suggesting new actions are required.” - source Bloomberg.

No wonder our “Flight to quality” picture is displaying “Risk-Off” with Germany’s 10 year Government bond yields falling again towards record low levels at 1.16% and the 5 year CDS spread for Germany well below 100 bps in the process back to March 2012 levels - graph below, source Bloomberg:

We do agree with our good credit friend namely that considering the lack of liquidity in the credit space and the very high correlation between asset classes, the coming weeks could see a significant spike in volatility in the European space, so “Mind the Gap” because “The Gap is back”- Both the Eurostoxx and German 10 year Government yields seems to be moving out of synch, with falling German Bund yields and a higher Eurostoxx 50 index. – Top Graph Eurostoxx 50 (SX5E), Itraxx Financial Senior 5 year CDS index, German Bund (10 year Government bond, GDBR10), bottom graph Eurostoxx 6 month Implied volatility. – source Bloomberg:
It is still the “D” world (Deflation – Deleveraging) – 2 year with two years core government going negative making, in true Hooke’s law fashion, our “credit” springs are looking increasingly compressed.

As our good credit friend discussed on Friday, in terms of the news flow, nothing has materially changed:

“1-The EU finance ministers adopted the EU master Plan to bail out the Spanish banking system.  The decision paves the way for the EFSF to raise 30 billion eurosSpain’s bailout will start through the EFSF, which has 240 billion euros in remaining capacity. The permanent 500 billion-euro European Stability Mechanism (ESM) is on hold until a German court ruling due in SeptemberBut at the same time, the Province of Valencia is calling the Spanish central government for a bailout. Valencia next bond to be repaid is CHF denominated, matures on august 24th and was issued in march 2009 when the Euro/CHF was trading at 1.5350 (it trades now at 1.2000, which means that the municipality is facing an increase of 20% on the payment due, unless it was currency hedged, which we doubt).
Growth is slowing more in Spain, so we think we are heading for a full bail out of the Province of Valencia (Euro 6 billion, including a superb Euro 1 billion brand new stadium built with the help of the Province “credit card”), which will add pressure on the Spanish debt… Do not expect Germany or the ECB to rescue the world, because as we posited before we do not think they will. (“The Game of The Century“).
2-EU is still discussing Cyprus bailout conditions. It seems we are talking of Euro 15 billion package, a lot considering the relative size of Cyprus.
3-Greek State Asset Sales Fund CEO (Mr Costa Mitropoulos) submitted his resignation to the government and is gone. Once again, it looks as if the Greek government promises to comply with the bailout conditions will not be met. I tend to think that our German, Finish and Austrian friends will pull the plug very soon.
4-The US economy is slowing down more as the country is following the path of the rest of the world. Remember, we live in an integrated Global Economy, and nobody is immune. Some US counties and municipalities are already defaulting, others will follow.
Quote: If you want to default, be one of the first to do it as there will not be enough money for everybody.”
In relation to point number 3 above, EU Banks Greek Sovereign Exposure is down by 15.5 billion USD:
“Latest BIS data confirm that after further writedowns and asset sales, the total exposure of European banks to Greek sovereign bonds and public sector debt fell more than 70% quarter-on-quarter to end-March, and now stands at $6.4 billion. Should Greece exit the euro, resolution of private sector debt and guarantees remain the largest outstanding issue. (Corrects currency.)” - source Bloomberg.
We do agree with the following quote from James Hertling Bloomberg article - European Bailout Bid Gets Vote of No-Confidence as Markets Drop from the 20th of July:
We’re looking at a situation when people are realizing we’re at a point of debt restructuring and repudiation,” Marc Ostwald, a fixed-income strategist at Monument Securities Ltd. in London, said in an interview today. “It’s cold-hearted reality. The great blag and bluff of the euro zone has always managed to kick the can down the road, but it is no longer a viable strategy. We’re getting to a crunch point.”
On the 18th of July, Deutsche Bank published in their Bank Research one slide resuming the political stalemate, the opposing positions between stakeholders suggesting the crisis will be a long drawn out affair:
As far as game theory is concerned, we have argued in our conversation “The European iterated prisoners’ dilemma“: “The only possible Nash equilibrium is to always defect“  - It looks to us increasingly probable that the outcome could be different to what is expected from Germany. The outcome for the European project is going to be rather binary. It is either “Federalism” or break-up.”
We stick to our view.
The options market is validating our views as far as game theory is concerned as reported by Bloomberg. Game-theory analysis shows the options market is underestimating the risk the euro will slide as European policy makers fail to take actions necessary to end their financial crisis, according to Bank of America Corp. The options market is underpricing the risk of the voluntary exit of one or more countries and a weaker euro,” David Woo, head of global rates and currencies research at Bank of America Merrill Lynch in New York, said in a telephone interview. “Investors are holding out hope, and are complacent in believing, that policy makers will come in and save the day. That is simply wrong because what is good politics in Europe may not be good policies.”
“The top panel of the CHART OF THE DAY shows implied volatility on one-year options for the euro versus the U.S. dollar has plunged since last year, when yields on Spanish and Italian debt had surged, sparking speculation the debt crisis was spreading. The middle panel is a gauge of option demand for hedges against extreme moves in the common currency over the next year. The final graph shows demand for puts, which grant the right to sell the euro, relative to calls is the weakest since April. A call allows for purchases of the euro. Game-theory and cost-benefit analysis show Germany is unlikely to agree to issue euro-region bonds, viewed by strategists as important to stemming the crisis, and Italy and Ireland have the most incentive to voluntarily exit the currency bloc, Bank of America said. The so-called Nash equilibrium in a game in which Greece has the choice of adopting austerity or not, and Germany can choose between issuing Eurobonds or not, is no austerity and no euro bonds, the bank’s analysis shows. Game theory is a study of strategic decision-making. A Nash equilibrium, named after John Nash, a Nobel laureate in economic sciences, is a scenario in which no player in a strategic game has an incentive to unilaterally change an action. Bank of America forecasts the euro, at $1.2199 yesterday in New York, will trade at $1.2 at the end of September.” - source Bloomberg.
Moving on to the “unintended consequences” of this low yield environment will have to corporate balance sheets, to some extent, it tends to explain, why defaults tend to spike in a low rate deflationary environment such as today. The fall in interest rates increases bond prices companies have on their balance sheets, exactly like inflation (superior to what an increase of 2% to 3% of productivity and progress) destroys the veracity of a balance sheet for non-financial assets. The conjunction of low interest rates with higher taxations will undoubtedly damage companies, particularly in Europe, and in a country like France, for instance, where public expenditure as a % of GDP is much higher (56%) than in Germany (45%). In fact, in our conversation “A Deficit Target Too Far” from the 18th of April, we argued: We also believe France should be seen as the new barometer of Euro Riskwith the upcoming first round of the presidential elections.Whoever is elected, Sarkozy or Hollande, both ambition to bring back the budget deficit to 3% in 2013 similar to their Spanish neighbor. We think it is as well “A Deficit Target Too Far” on the basis of our previous French conversation (France’s “Grand Illusion”).
In our conversation “The European crisis: The Greatest Show on Earth“, we indicated:
“When it comes to credit conditions in Europe, not only do we closely monitor the ECB lending surveys, we also monitor on a monthly basis the “Association Française des Trésoriers d’Entreprise” (French Corporate Treasurers Association) surveys.”

One particular important indicator we follow is the rise in Terms of Payment as reported by French corporate treasurers. The latest report is sending us again a clear warning signal indicative of a growing deterioration:
The monthly question asked to French Corporate Treasurers is as follows:
Do the delays in receiving payments from your clients tend to fall, remain stable or rise?
Delays in Terms of Payment as indicated in their May survey published in June have been reported rising by corporate treasurers. Overall +36% of corporate treasurers reported an increase compared to June (+27.8). The record in 2008 was 40%…
According to their latest survey realised early July 2012, the opinion of French treasurers for large corporates cratered in the last two months from -0.7% in May to -19% in July, the most significant drop in two months since this survey exist (first one was December 2005).

According to an article from John Glover from Bloomberg from the 20th of July - Europe’s $180 Billion of Maturities Lifts Swaps: Credit Markets:

Speculative-grade corporate debt in Europe is the most expensive to insure against losses in 1 1/2 years relative to sovereign bonds as companies need to refinance as much as $180 billion of debt by 2014. An index of credit-default swaps on junk-rated European companies exceeds one for government bonds by 2.44 times, up from 1.65 in March, according to data compiled by Bloomberg. Finnish mobile-phone manufacturer Nokia Oyj led the increase among European non-financial companies, with a 136 percent jump in the last three months, followed by Rome-based toll-highway operator Atlantia SpA, whose swaps climbed 72 percent.
Borrowers in Europe, the Middle East and Africa face $84 billion of junk-rated debt maturing next year and $96 billion in 2014, compared with 2011’s record bond sales of $70 billion, Moody’s Investors Service said. Their ability to service debt is being hurt by the worsening economic outlook, with the International Monetary Fund forecasting July 16 that output will shrink 0.3 percent in the euro area this year.”
“Yield Famine” and Hooke’s law, from the same Bloomberg article:
“The divergence between high-yield corporate and government default risk is being exacerbated by investors snapping up bonds of the safest sovereigns, in some cases agreeing to pay to lend to the nations. Germany’s two-year note yield fell to minus 0.074 percent on July 18 while Austrian, Swiss and Finnish rates also turned negative this week for the first time.” - source Bloomberg.

The deterioration in speculative-grade European company credit is being worsened by the outlook for economic growth, hence the risk of seeing a spike of defaults, in this low yield, deflationary environment. Lack of growth means lack of unemployment prospects and reduced tax revenues with increasing pressure in cash flows as indicated by the pressure in the terms of payments from the AFTE monthly survey. It is still a game of survival of the fittest. It’s also causing some companies to pay more to raise money or to be taken over when they cannot pay their debt as indicated in the Bloomberg article quoted above:

“Findus Group Ltd., the frozen-food company owned by private-equity firm Lion Capital LLP, will be taken over by its junior lenders in a debt restructuring after it breached debt covenants that creditors had waived in March, four people with knowledge of the situation said July 7. Under the plan led by Lion Capital, Highbridge Capital Management LLC and JPMorgan, junior creditors will write off more than 200 million pounds ($310 million) of mezzanine loans in return for ownership and provide 70 million pounds in a short-term credit facility, said the people, who declined to be identified because the discussions are private. They will inject 220 million pounds into the company, including 125 million pounds to reduce senior debt, the people said.” - source Bloomberg.

Consolidation, defaults and restructuring are going to happen no matter what, for struggling corporates, struggling Spanish regions and provinces, as well as struggling countries. We touched on the subject for the European car industry with Peugeot in our last conversation. In similar fashion to our conversations involving shipping (Shipping is a leading deflationary indicator) and air traffic (Air Traffic is a leading deflationary indicator), the auto industry is as well facing a game of survival of the fittest in this current deflationary environment we argued.

The Bloomberg article concluded with the following quote from Andrew Sheet, European Credit Strategist at Morgan Stanley in London:
“If companies “don’t have cash on the balance sheet” they’re “not in a good place”. If a company
generates free cash then it’s in control of its own future.”

So, in relation to our title, in true Hooke’s law fashion, given the “Yield Famine” we are witnessing, we believe our credit “spring-loaded bar mousetrap” has indeed been set and defaults will spike at some point, courtesy of zero interest rates. (The first spring-loaded mouse trap was invented by William C. Hooker of Abingdon Illinois, who received US patent 528671 for his design in 1894).

“If you build a better mousetrap, you will catch better mice.”
George Gobel – American comedian.

Stay tuned!

The European Iterated Prisoners’ Dilemma

By Martin T., Macronomics

The only possible Nash equilibrium is to always defect. The proof is inductive: one might as well defect on the last turn, since the opponent will not have a chance to punish the player. Therefore, both will defect on the last turn. Thus, the player might as well defect on the second-to-last turn, since the opponent will defect on the last no matter what is done, and so on. The same applies if the game length is unknown but has a known upper limit.” - source Wikipedia

In continuation to game theory references, given we recently touched on the subject in our conversation “Agree to Disagree“, we thought this time around we would make a reference to the prisoners’ dilemna. After all, in Europe, it is all about game theory, given than many pundits are arguing whether Germany will cooperate or not in resolving the on-going European woes, pledging its balance sheet in the process.

In game theory and in relation to our European iterated prisoner’s dilemma we have :

“If it is supposed here that each player is only concerned with lessening his time in jail, the game becomes a non-zero sum game where the two players may either assist or betray the other. In the game, the sole worry of the prisoners seems to be increasing his own reward. The interesting symmetry of this problem is that the logical decision leads each to betray the other, even though their individual ‘prize’ would be greater if they cooperated. In the regular version of this game, collaboration is dominated by betrayal, and as a result, the only possible outcome of the game is for both prisoners to betray the other. Regardless of what the other prisoner chooses, one will always gain a greater payoff by betraying the other. Because betrayal is always more beneficial than cooperation, all objective prisoners would seemingly betray the other.
In the extended form game, the game is played over and over, and consequently, both prisoners continuously have an opportunity to penalize the other for the previous decision. If the number of times the game will be played is known, the finite aspect of the game means that by backward induction, the two prisoners will betray each other repeatedly.

In casual usage, the label “prisoner’s dilemma” may be applied to situations not strictly matching the formal criteria of the classic or iterative games, for instance, those in which two entities could gain important benefits from cooperating or suffer from the failure to do so, but find it merely difficult or expensive, not necessarily impossible, to coordinate their activities to achieve cooperation.” - source Wikipedia.

For now every European politicians in Europe seem to “Agree to Disagree”, it looks to us increasingly probable that the outcome could be different to what is expected from Germany. The outcome for the European project is going to be rather binary. It is either “Federalism” or break-up. In fact it is Germany who has always pushed for more integration, more “Federalism”. In September 1994 both Karls Lamers and Wolfgang Schauble from the CDU presented their project of accelerated integration to France. It entailed a faster integration within the European Union for Germany, France, Belgium, Luxembourg and Holland. France at the time was under “Cohabitation”, Socialist French President Mitterrand had as Prime Minister Edouard Balladur from the opposing party, having lost ruling majority in the parliamentary elections leading to a political stand-off which lasted for two years. The European game is therefore in the political French camp. President François Hollande having garnered a strong political support in the recent parliamentary elections, it will be interesting to watch if French politicians will indeed accept to lose their powers for the collective good, or, if they decide to cling on their individual mandates and powers and a “Federal Europe” will not happen. Will the French surrender again? We dare to ask, staying politically correct in our conversation (“Cheese-eating surrender monkeys”, being a derogatory description of French people that was coined in 1995 by Ken Keeler, then-writer for the television series The Simpsons).

Looking at the “social-clientelism” mentality which has prevailed in French politics in the last 30 years, and given the trauma stemming from the European 2005 referendum, one has to posit the French willingness in moving towards a full lasting Federal European Union.
While many are comparing the need for Europe to evolve in a comparable way to the evolution of the United States towards a full Federal Union. We do not have to go that far to find a more relevant example to the current European plight. In fact as our good credit friend mentioned in one of our most recent conversation, he pointed rightfully towards…Switzerland! The Federal Constitution adopted in 1848 is the legal foundation of the modern Swiss federal state. It is among the oldest constitutions in the world.
There are three main governing bodies on the Swiss federal level: the bicameral parliament (legislative), the Federal Council (executive) and the Federal Court (judicial).
Europe already has all three.

“The Swiss Parliament consists of two houses: the Council of States which has 46 representatives (two from each canton and one from each half-canton) who are elected under a system determined by each canton, and the National Council, which consists of 200 members who are elected under a system of proportional representation, depending on the population of each canton. Members of both houses serve for 4 years. When both houses are in joint session, they are known collectively as the Federal Assembly. Through referendums, citizens may challenge any law passed by parliament and through initiatives, introduce amendments to the federal constitution, thus making Switzerland a direct democracy.

The Federal Council constitutes the federal government, directs the federal administration and serves as collective Head of State. It is a collegial body of seven members, elected for a four-year mandate by the Federal Assembly which also exercises oversight over the Council. The President of the Confederation is elected by the Assembly from among the seven members, traditionally in rotation and for a one-year term; the President chairs the government and assumes representative functions. However, the president is a primus inter pares with no additional powers, and remains the head of a department within the administration.” - source Wikipedia.
The Swiss cantons also have a permanent constitutional status and, in comparison with the situation in other countries, a high degree of independence. Under the Federal Constitution, all 26 cantons are equal in status (pari-passu…). Each canton has its own constitution, and its own parliament, government and courts. Switzerland also boasts, in similar fashion to the US, a Federal Supreme Court.
So could it be France derailing the whole European project in the end rather than Germany? We wonder.
But we ramble again, erring on the political side. Time for our credit overview, revisiting our pet subject of bond tenders and the ongoing issues in the peripherals, particularly in Spain, given we recently received the results for the Spanish Bank Recapitalisation independent estimate and 62 billion is the number.

 

“The Gap is closed” we indicated on the 16th of June in relation to the European space. Now both the Eurostoxx and German 10 year Government yields seems to be moving in synch, lower that is while credit spreads for financials as indicated by Itraxx Financial Senior 5 year CDS index is moving wider following rating agencies multiple downgrades and on-going concerns on peripheral sovereign yield levels - Top Graph Eurostoxx 50 (SX5E), Itraxx Financial Senior 5 year CDS index, German Bund (10 year Government bond, GDBR10), bottom graph Eurostoxx 6 month Implied volatility. – source Bloomberg:

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

Last week Spanish risk premium reached a new historical high breaching easily the 7% level, with renewed concerns on Spanish banks given the rise in Spanish bad loans. (reaching 8.72% in April from 8.37% in March).

As Societe Generale clearly indicated in their recent global research alert, the markets have indeed lost confidence in Spain:

The challenge European leaders face at the 28-29th June summit is to come out with a big plan as indicated in their recent note by Societe Generale: “Comprehensive restructuring of the economy/the banking sector is  required to restore market confidence….due to a rise in national and regional public debt…”.
Indeed, Government debt to GDP could reach 90% of GDP in 2012:

“Spain’s budget deficit is expected to end 2012 at 5.3%, vs 8.9% in 2011, so government debt could reach 90% of GDP this year. On top of that, Spain holds a rising amount of regional debt (which has doubled since December 2008) and contingent liabilities, such as the FROB (Fund for Orderly Bank Restructuring). Taking into account these two elements and the current recession in Spain, debt could rapidly reach unsustainable levels.” -source Societe Generale.

Unfortunately, Spanish property market and bank restructuring go hand in hand and as many pundits have indicated, Spanish property bubble and deleveraging has yet to start effectively as indicated by the below graph from Societe Generale:

“House prices could decline by a further 20-25% in an adverse scenario (see last week’s results of the independent evaluation of the Spanish banking sector).” - source Societe Generale.

The Spanish Test Assumptions:

The Stress Test Property Assumptions may not be aggressive enough – source Bloomberg:

“A 19.9% yoy drop in Spanish house prices for the adverse scenario could easily be exceeded if confidence is not restored by the recently announced bailout. At 1Q, yoy declines ranged between 7% and 12% depending on the source, while from 1Q08 highs, house price declines total 21%. Should this rate of deterioration continue, the 4.5% 2013 forecast decline may prove conservative. - source Bloomberg.

The results from the independent audit, the Spanish Assumptions at least looks credible for retail, for corporate less so, according to Bloomberg:

“A 6.8% contraction of lending supply for 2012 and 2013 looks reasonable for retail lending when compared with experience through the crisis. A 6.4% and 5.3% decline for corporate loan supply looks far less cautious when considering that January 2012 data showed a 6% yoy drop, before sovereign fears heightened.” - source Bloomberg.

Another issue with the results from the Spanish Test Assumptions comes from the GDP worst case scenario retained no lower than 2009 experience as shown by Bloomberg:

“A decline of 4.1% in Spanish GDP for 2012, the adverse scenario used in the stress test, is less severe than the 4.4% yoy drop of 1H09. While this scenario is calculated from a lower absolute GDP base, it is key for bad-debt experience, unemployment and credit supply. Coordinated EU action is needed to drive long-term interest rate assumptions lower.” - source Bloomberg.
We do not want to be seen as party spoilers, but as we posited in relation to the numerous EBA (European Banking Association) test for financial institutions, no test, no stress, no stress, no test…

No wonder Spanish Financial CDS has been on widening trend – source CMA:

[Graph Name]

 

Unless significant steps are taken in the next European summit, and we mean “shock and awe”, given Spain and Italy have significant funding needs until 2014, the game might be coming to an end leading to the defect of some players in the process of our “European iterated prisoners”:

- source Societe Generale.

From this similar Societe Generale note, higher loan delinquencies and low industrial production are the main risks:
“Risk 1: Spanish loan delinquencies, back to the 90s
-Spanish bank delinquent loans increased again to 8.72% in April, from 8.37% in March, thereby reaching an 18-year high. This trend is likely to
persist as unemployment and bankruptcies continue to rise.
-Acceleration in number of delinquent loans means Spanish banks are likely to suffer from increasingly larger losses in the future
-Report carried out by two consulting firms estimates Spanish banks’ capital shortfall at up to 62bn euros.
Risk 2: European industry deteriorates
-Eurozone industrial production fell 2.3% compared to the same month last year, driven down by the southern Europe countries.
-If the Eurozone fails to undertake the necessary structural reforms, the northern European countries could get drawn into southern Europe’s downward spiral.
-In contrast, US industry has remained quite resilient since the beginning of the year, with total industrial production in May up 4.7 percent yoy.”

 

We will not delve again into the difference between “Stocks and Flows” central to our thought process namely the United States and Europe growth differentiation as we already touched on this subject in our conversation “Growth divergence between US and Europe? It’s the credit conditions stupid…“.

Moving on to our pet subject of subordinated bond tenders, as at some point, as we argued recently (Peripheral Banks, Kneecap Recap), losses will have to be taken, it is all going Dutch, Dutch auction that is. While ailing Portuguese bank BCP (Banco Comercial Português) announced on the 20th of June a bond tender relating to mortgage backed securities, BBVA bought back some asset-backed bonds too on 26 senior and 25 mezzanine portions of bonds backed by consumer loans, mortgages and business loans, with prices ranging from 46 to 95%. All part of “liability” management exercises to raise some capital and strengthen the capital base, meaning more pain for bondholders in the process.

While the 62 billion being the estimated amount earmarked by independent consultants Oliver Wyman and Roland Berger, burden sharing is currently being considered with the European Union in respect to a 100 billion euro rescue package for the Spanish financial system.

“The government in Madrid is also considering giving more power to the national regulator to restrict sales of loss-absorbing securities such as preferred stock to individuals, said the person. De Guindos has said that preference shares shouldn’t have been sold to retail investors.
Supervisors “failed” over the sale of preference shares to retail investors, said De Guindos June 5 in the Senate.
Spanish lenders sold 22.4 billion euros ($28.2 billion) of preferred stock to individual investors through retail branches. Banks have offered clients holding most of that amount to swap the securities into common stock or other subordinated instruments, according to data compiled by CNMV, the financial markets supervisor.” - source Bloomberg
We correctly foresaw this process for weaker peripheral banks.
First bond tenders, then we will probably see debt to equity swaps for weaker peripheral banks with no access to term funding, leading to significant losses for subordinate bondholders as well as dilution for shareholders in the process.” - Macronomics – 20th of November 2011.

We wrote in October 2011 relating to bond tenders and the move towards debt to equity swap:

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.”

It is still a game of survival of the fittest, even for some Italian banks, given Monte dei Paschi di Siena (MPS), Italy’s third-biggest bank, according to December 2011 EBA exercise, had a capital shortfall of Euro 3.3 billion. The bank, which must also repay 1.9 billion euros of state aid provided in 2009… Monte Paschi may use the government’s aid program, the so-called Tremonti bond, as part of its plan to boost capital by end of June 2012 (9% Core Tier 1 Capital), Il Sole 24 Ore reported. Also, S and P put MPS’s ratings on Watch Negative citing pressure on the bank’s financial position from a combination of deteriorating asset quality metrics, weakened earnings, and low financial flexibility. Separately, the main shareholder of MPS, the Monte Paschi Foundation has reportedly reached an agreement with its creditor banks to restructure its debt. S and P placed its ‘BBB/A-2′ L-T and S-T counterparty credit ratings on Italy-based Banca Monte dei Paschi di Siena SpA (MPS) on CreditWatch with negative implications. Agency also put all of its ratings on MPS’ subordinated, junior subordinated, and hybrid debt issues on CreditWatch negative. The rating action reflects S and P’s view as the convergence of various negative pressures on MPS’ financial profile. Monte Paschi First-Quarter profit fell 61% on higher write downs and has a market value of around 2.8 billion euros. MPS is considering selling its 2.5% stake in the Bank of Italy to the central bank to reach the June 2012 threshold.
As indicated by Bloomberg, Italian corporate and household bad debt totaled 109 billion euros ($138 billion) in April, an increase of 15 percent from a year earlier, according to Bank of Italy data.
Non-performing loans rose to 5.4% in March, up from 3% in June 2008, according to Italian Banking Association data. Impairments, excluding writedowns, rose to 58 billion euros from 50 billion euros. CDS on UniCredit, (Italy’s largest bank) rose to 532 basis points on June 19 from 292 on March 19, according to data compiled by Bloomberg.
With unemployment rate at 10.2% in April the highest in most than 12 years, Italian banks as well as their Spanish peers are facing economic deterioration facing but are not plagued by housing related issues and high household private debt levels.

If it could be of any solace to European Banking woes, the new capital regime for US Banks will as well trigger at some point some “liability” management exercises namely bond tenders as indicated by CreditSights in their note – US Banks – The New Capital Regime – Bonjour Basel – 24th of June 2012:

“US banking regulators released proposals for new capital rules for banks aimed at complying with Dodd-Frank Basel III. The new guidelines apply to all US banks with some variations/differences for banks over 50 billion USD in assets and were mostly in-line with expectations.
The new guideline call for higher levels of capital, which could make the financial system safer but also reduce returns and cause banks to reassess their balance sheets. They believe that new requirements fortify the banks’ ability to absorb losses and withstand a potential systemic shock, which is a positive for fixed income investors and both positive and negative for equity.
US banks will now have a new set of minimum capital requirements, incorporate additional capital buffers and limitations outlined in Basel III and phase-out trust preferred securities in accordance with the Dodd-Frank Act.When the new limits are fully phased-in, banks are required to maintain a common equity Tier 1 ratio of 7% and Tier 1 ratio of 8.5%, including a capital conservation buffer of 250 bps. The limitations and changes to risk weights could influence business decisions including lending and mortgage servicing.
Trust preferred securities are phased-out reflecting the requirements of the Dodd-Frank Act.
Non cumulative preferreds continue to receive Tier 1 capital treatment and could make up the majority of non-common equity Tier 1 capital. As a result, they expect issuers and investors to focus primarily on preferreds to address their non-common equity Tier 1 Capital and yield needs, respectively.”

On a final note Money Markets wager ECB will cut deposit rate as indicated by a recent Bloomberg Chart of the day:

“The CHART OF THE DAY shows that the Eonia-OIS measure, which estimates interbank borrowing costs over the next three months, fell below the 25 basis points the ECB pays for deposits. The last two times this happened the central bank cut the rate within two weeks.” - source Bloomberg
“There are few ironclad rules of diplomacy but to one there is no exception. When an official reports that talks were useful, it can safely be concluded that nothing was accomplished.”

John Kenneth Galbraith

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