CREDIT UPDATE – ALL QUIET ON THE WESTERN FRONT

By Martin T., Macronomics

“We have lost all sense of other considerations, because they are artificial. Only the facts are real and important to us. And good boots are hard to come by.”

– Erich Maria Remarque, All Quiet On The Western Front, Ch. 2

“The phrase “all quiet on the western front” has become a colloquial expression meaning stagnation, or lack of visible change, in any context.” – source Wikipedia

All Quiet On The Western Front is a novel by Erich Maria Remarque. The book was published in 1929, and it was the author’s way of coming to terms with the war. We thought this time around, a reference to this classic would be appropriate looking at recent events in the European space, because, as the colloquial expression goes, when it comes to the European situation, the lack of visible change, with the economic stagnation clearly moving towards recession, we think the title of the post is spot on. The book by Erich Maria Remarque has also a history with censorship as the book was banned in Germany.

As our good credit friend put it recently:

“The recent German industrial production posted a decrease of 1.3% against a decline of 0.5% expected.
Growth should remain non-existent in Europe, which should put more pressure on the sovereign credits (Spain first).
When somebody has too much debt and cannot reimburse it, how do you bail him out? Obviously by restructuring his debts, which imply losses for his creditors.
But when one lends him more money in order for him to pay back what he owes, he is not bailing him out but rather pushing him in a bigger hole! The game until now has been to “print” more money and to add more debt on the shoulders on the indebted ones, to gain some time in the hope that growth will resume and reduce de facto the weight of the existing debt burden and the additional new debt issued to support the initial debt troubles.
This is a big misunderstanding of debt dynamics and its effects on the economy. When debt becomes too big, which it is now the case in many parts of Europe, the servicing drains all the available cash flows and reduces the growth potential.”

So yes “All Quiet” on the Western European Economic Growth front – US PMI versus Europe PMI – source Bloomberg

In Nomura recent “10 things we did not know” published on the 5th of April, they indicated:

Maybe looking to Asia for the epicenter of the next risk-off move is not the right idea

“Did you know that in the latest PMI releases, emerging markets are outperforming G10 economies, while European PMIs are still below 50 and Asia is the main driver of improvement?”

“All Quiet” on the Western European Unemployment  front – source Bloomberg:

European unemployment increased to the highest in more than 14 years in February, the highest level since June 1997 before the euro was introduced…Around 17.3 million people are now unemployed in Europe.

“All Quiet” on the Western European Peripheral banking front – source Bloomberg:

“Banco Espirito Santo SA (BES), Portugal’s biggest publicly traded bank, dropped to a record low in Lisbon trading after announcing a plan to sell as much as 1.01 billion euros ($1.3 billion) of new stock. 

The shares fell as much as 27 percent, or 31.2 euro cents, to 85.5 cents and were down 15 percent at 9:21 a.m. in the Portuguese capital, giving the lender a market value of 1.44 billion euros. 

Espirito Santo, based in Lisbon, said yesterday after the close of trading that it will offer 2.56 billion shares to existing shareholders at a subscription price of 39.5 cents each. The stock price closed yesterday at 1.167 euros. 

The rights offer will allow the bank to buy out its partner in an insurance unit and to increase its core Tier 1 capital ratio to 10.75 percent from 9.21 percent. Espirito Santo said it also agreed to buy 50 percent of the BES Vida insurance unit from Credit Agricole SA (ACA) for 225 million euros.” – source Bloomberg

In our conversation relating to bond tenders “Subordinated debt – Love me tender?“, back in October Banco Espirito Santo had announced a capital increase in effect via a bond tender. Banco Espirito Santo was trading at 1.51 euros per share and it meant that the debt to equity swap initiated in October lead to a dilution of 83.5% of the shareholders. Banco Espirito Santo total market cap was approximately euro 1,743 million in October last year.  At the time we argued:

“The need to raise capital will be acute for peripheral countries due to issue of circularity we previously discussed. Given we know by now that access to capital is only open to better quality issuers in the financial space, the current level of financial spreads for weaker issuers, make it impossible for them to access funding at reasonable rates. Survival of the fittest is still the name of the game with the liquidity support provided by the ECB for these weaker players.”

“All Quiet” on the Western European Housing front – source Bloomberg:

The pain in Spain: Housing in the doldrums, but it isn’t only Spanish people suffering the fall in real estate prices, according to Bloomberg’s article from Sharon Smyth from the 14th of February, immigrants lured in the Spanish housing Boom are losing most in the imploding Spanish Market (European subprime crisis in the making?):

Immigrants Lured in Boom Lose Most in Imploding Spanish Market: Mortgages -Unwanted Assets:

Financial institutions have foreclosed on 328,720 homes since 2007, according to Plataforma de los Afectados por la Hipoteca, a group known as PAH that campaigns against evictions. Repossessed houses in Spain are valued at 43 percent less on average than the appraisals on the mortgages, Fitch Ratings said in a Dec. 15 report.
Lenders, whose bad loans as a proportion of total lending jumped to a 17-year high of 7.42 percent in October, have also acquired properties from developers to cancel debt and may have as many as 900,000 finished, unfinished and foreclosed homes on their books, according to Borja Mateo, author of “The Truth About the Spanish Real Estate Market.””

We agree with Bloomberg’s editors take that Spain is entering a dangerous deflation trap, given the very significant fiscal tightening requested by the European leaders to achieve an overly ambitious target of 3% in 2013:

Spain Not Greece Is the Real Test for the European Union – Bloomberg
The problem is not that Spain’s new austerity plan is too timid. Just the opposite: Under EU orders, Spain is promising what might be the tightest fiscal squeeze that it or any other European economy has ever faced. The new plan calls for the budget deficit to fall from 8.5 percent of gross domestic product to 5.3 percent this year. Since the economy is already shrinking, this requires a discretionary fiscal tightening of roughly 4 percent of GDP — with the unemployment rate already standing at about 23 percent.”

In their latest European Credit Tracker UBS argues the following in relation to the impact the LTRO has had on the Spanish banking system. We have long argued it amounted to “Money for Nothing“:

“Collectively these sum to €233 billion, which we believe is likely to have been more than the increase in ECB drawings. However,banks have shrunk their Spanish loan books by €54 billion in the period, reducing funding needs though obviously contributing to the country’s economic contraction. Therefore there is likely to have been less left of the funds for lending or further government bond purchases, in our view.”

– source UBS

In their note, UBS also indicated as well credit trends in February 2012:

“The latest data release by the ECB showed a m/m decline of €19.4bn in total credit in Feb 2012. All major economies except Germany showed a m/m increase in total credit (€2.8bn). Once again m/m credit declined the most in Spain (-€9.1bn), declining 13 times in the past 14 months.”

– source UBS

We hate sounding like a broken record but, no credit, no loan growth, no loan growth, no economic growth and no reduction of aforementioned budget deficits:

“So austerity measures in conjunction with loan book contractions will lead unfortunately to a credit crunch in peripheral countries, seriously putting in jeopardy their economic growth plan and deficit reduction plans.”- “Subordinated debt – Love me tender?” – Macronomics, October 2011

“In Spain the annual growth rate of loans to household adjusted for sales and securitization is -2.7% as against the unadjusted growth rate of -2.0%.” – source UBS

In August 2011 we wrote in our conversation “It’s the liquidity stupid…and why it matters again…“:

Lack of funding means that bank will have no choice but to shrink their loan booksIf it happens, you will have another credit crunch in weaker European economies, meaning a huge drag on their economic recovery and therefore major challenges for our already struggling politicians.

As a reminder, 50% of banks earnings for average commercial banks come from the loan book: no funding, no loan; no loan, no growth; and; no growth means no earnings.”

Hence our BIG reservations in relation to the unachievable Spanish deficit target of 3% in 2013. (which interestingly gives us our title for our upcoming credit post – “A Deficit Target too far”, in reference to 1977’s movie “A Bridge Too Far” relating to the overly ambitious Operation Market Garden, but we ramble again…).

“I rambled all the time. I was just like that, like a rollin’ stone.”
Muddy Waters

Stay Tuned!

Martin T., Macronomics

Martin T. is a credit specialist with a London based bank. During his career he's had different roles within various banks, covering everything from FX to High Grade Bonds. He has always been passionate about markets and particularly on Macro trends.

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  • rhp

    thanks martin,

    unless some other “black swan” intervenes first, your continued reporting on this black swan that isn’t a black swan at all but a slow rolling catastrophe in the making keeps me grounded in “what is”. It reminds me of the players in “The Big Short” who had to sit tight for a couple of years while everyone was going crazy bidding up the MBS’s. It is not hard to see where this train is headed. It’s just how much track is left………

    rhp

  • Sormiou

    Great post Martin.
    I’d make a further observation on Europe :
    as I’ve been repeatedly saying on past articles comments the real elephant in the (european) room
    is France.
    Only 8 days left before a first round of presidential elections that should see the extreme wings reach almost a third
    of the votes, while both main candidates (Hollande and Sarkozy) still deliberately refuse to talk about their vision of Europe (more integration or not?) and the unbearable budget situation of the country.
    There is no valid macro reason to see french rates trade closer to bunds than they do from Italian rates.
    A huge bug in search of a windshield in my opinion, as is the country’s sky high real estate market that could be the other last shoe to drop for french banks’ overleveraged balance sheets.

  • Octavio Richetta

    Great article and great observation by rhp. with the risk of sounding as a broken record, I keep on saying the European Sovereign Debt Crisis will be a lot worse than the subprime-initiated US crisis.

  • Mr. Market

    No, “”all is NOT (!!!) quiet on the western front””. Credit market conditions have been worsening since mid 2011. Even in the US.

    And the US (and the rest of the world) is NOT isolated from developments in Europe. E.g through the (world wide) demand for commodities and commodity prices.

  • http://macronomy.blogspot.com Martin

    Of course they have, that’s why we kept telling in our credit conversations that “Lending surveys” do matter a lot, in relation to economic growth (Europe, EM, etc). Our title was ironic Mr Market…

  • http://www.lisastewartlaw.com Social Lawyer

    The irony was lost on me too.

  • http://Macronomy.blogspot.com Martin

    Apologies then, if you have read some of our recent posts relating to credit, the lack of transmission of liquidity awarded to banks via LTRO 1 and 2, has not translated to the real economy. We have used the “all quiet” analogies because a storm is brewing. Lack of credit will mean lack of economic growth for some such as Spain.

    Best,

    Martin