CREDIT UPDATE – LONG HOPE, SHORT FAITH

By Martin, Macronomics

“A good solution applied with vigor now is better than a perfect solution applied ten minutes later.” - General George S. Patton

Call it a bear squeeze or a short squeeze, the action today in the credit space is clearly pointing to short covering with some players capitulating and forced to cover their short positions in both Corporate Single names CDS as well as in some credit indices.  Regardless of how you call it, given the short bias of the street, some got hurt pretty bad probably today, not helping their profit and loss trading account in the process.

So yes, another long post, looking slightly at the periphery with Hungarian mortgages and approaching the hot subject of Bank recapitalization and the somewhat apparent issue of raising equity.

Here is the market overview for Itraxx Credit indices in the European space – Source Bloomberg:

Itraxx Crossover CDS index 5 year of 50 High Yield names tighter by 23 bps on the day to around 746 bps.
Itraxx Main Europe CDS index 5 year (Investment Grade) tighter by 5.5 bps to around 173 bps.
Itraxx Financial Senior CDS index 5 year closed the day tighter by 8 bps to around 233 bps and the Itraxx Financial Subordinate Index declined 16 bps to around 468 bps.
Itraxx Main Europe 5 year CDS index (Investment Grade) versus Itraxx Crossover 5 year CDS index (High Yield):

Slightly better between both indices from the widest point.

Letting off the gas in the credit space, European Gas companies an example of the tightening move in the single name CDS space:
[Graph Name]
Source CMA

The Liquidity picture – Source Bloomberg:

Some improvement. Keep in mind the drop in the level of deposits at the ECB is due to the start of the new reserve period as of yesterday (September reserve period was shorter at 28 days). Also we learned today that the ECB had lent 1.4 billion USD to 6 European banks for three months at a fixed rate of 1.09%. One bank was also allotted 500 million dollars in its weekly operation, reason being and we know from our previous credit conversations as reminded by Bloomberg: “European banks need dollars to fund their own lending in the U.S. as well as to clients elsewhere doing business in the world’s leading reserve currency.”

So all in all, we have, Itraxx Financial Senior 5 year index falling, Eurostoxx rising with German Bund 10 year bond yield above 2%, Volatility falling in the process – Source Bloomberg:

As you can see Eurostoxx and German Bund yield moving in lockstep, as there is a reduction in the flight to quality mode.

Germany Sovereign 5 year CDS level and German 10 year bond yield, from divergence to convergence – Source Bloomberg:

In the Emerging Markets Bond Yield space we also have a significant tightening wove. We discussed previously the sell-off in Emerging debt in the post “Markets update – Credit – Anterograde and Retrograde amnesia” – JP Morgan EMBI Global Diversified – Source Bloomberg:

The J.P.Morgan Emerging Markets Bond Index Global (“EMBI Global”) tracks total returns for traded external debt instruments in the emerging markets:

And in relation to the SOVX Western Europe 5 year CDS index versus the SOVx CEEMA (Central Europe and Middle-East and Africa) we have complete convergence currently as both trade roughly at the same levels – Source Bloomberg:

But what I have been following more closely in the Sovereign CDS space for the last couple of months is the relationship between France Sovereign 5 year CDS and Austria 5 year Sovereign CDS:

Why did it catch my attention? Because I am expecting Austria’s sovereign CDS to trade wider than France at some point, given the exposure of Austria’s banking sector to Eastern Europe and in particular Hungary where a new law has been passed allowing foreign currency mortgages borrowers in Hungary to repay their loans at a fixed exchange rate with large discounts to current FX market rates, which will trigger losses to Austrian Banks.

According to an article from CreditSights from the 11th of October relating to Erste bank in particular and Hungary in general:

“With subsidiaries of foreign banks accounting to 80% of the banking system, the bulk of the losses will be suffered by western European banks. These include Erste Bank, Raiffeisen Bank International, Intesa, Unicredit, Bayerische Landesbank and KBC.”

Under the new legislation borrowers can repay their mortgage in a single instalment at a HUF/CHF rate of 180 or a HUF/EUR rate of 250. Current FX rates are around 239 for HUF/CHF and HUF/EUR is around 297, a 25% and 16% discount according to CreditSights.

And the losses are significant, according to Boris Groendahl in Bloomberg on the 10th of October:

“Erste Group Bank AG, eastern Europe’s second-biggest lender, fell the most in more than two years in Vienna trading after saying that it expects to post a full-year loss of 800 million euros ($1.1 billion) this year.

Erste wrote down the value of its Hungarian and Romanian units by a combined 939 million euros, the Vienna-based bank said in a statement today. Erste won’t pay a dividend for 2011 and shelved for at least a year a plan to repay 1.2 billion euros of aid from the Austria government.”

Ouch…

And Boris Groendahl in Bloomberg adding:

“Erste is writing off its remaining 312 million euros of goodwill in Hungary and made additional bad-debt provisions of 450 million euros. The lender will also inject 600 million euros of fresh capital into its business, Hungary’s fourth-biggest bank.”

And about the mortgage relating problems in Hungary this is what CreditSights had to say in their report in relation to the size of the problem and the deleveraging needed:

“For several years now, the widespread practice in Hungary of mortgage borrowers taking out loans in foreign currencies, predominantly the Swiss franc, has seemed like an accident waiting to happen.”

And we know it did…

CreditSights size up the problem:

“With foreign currency mortgages accounting for roughly 75% of total mortgage loans in Hungary on a system-wide basis (of which 80% are in Swiss francs), this will result in some losses for the banks.”

And CreditSights to add:

“Based on the latest disclosure by Erste Bank, it appears that the proportion of mortgage lending in foreign currency is even higher for foreign banks than the 75% system average, reaching about 100% in the cases of Erste Bank and Raiffeisen International.”

The two largest Austrian banks and CreditSights estimates the impact could be significant as the 10% to 30% of mortgage borrowers could take advantage of the new legislation covering mortgages issued before 2009.

CreditSights estimates under three scenarios (10%, 20% and 30%) pre-tax losses, as a percentage of the banks consolidated, annualised 1H11 pre-tax profit ranging from 6.6% for Erste Bank (10% scenario) to 19.7% (30% scenario) and 2% to 6% for Raiffeisen International.

And CreditSights to conclude:

“Although the specific damage from the FX mortgage legislation looks containable, the legislation casts wider doubt on contract enforceability in the system in the context of a difficult economy, which is likely to lead to other impairments.”

So, when the economic situation change, the government can indeed, change the rules…

But another interesting item from the CreditSights article was relating to the CDS exposure for Erste:

“180 million euros P&L reclassification of CDS protection written by the bank, to account for it in the derivatives category, instead of classifying the CDS as financial guarantees. This followed a clarification from the IASB (International Accounting Standards Board), that, in order to use the guarantee classification and avoid marking contracts to market, a protection seller would have to suffer a loss on an underlying reference instrument. The CDS book largely relates to Western European sovereigns and amounts to between 2 billion euros and 2.5 billion euros. Some of this in periphery countries, but total sovereign exposure (including derivatives) to Greece, Portugal, Spain, Ireland and Italy is down to 0.6 billion at 3Q11, from 1.9 billion at FY10, within which the Greece/Portugal component has been reduced to just 10 million euros. Management pointed out that the CDS book was built up prior to the euro zone sovereign crisis as a risk diversification trade to compensate for Erste Bank’s concentration in Central and Eastern Europe. The recognition of formerly unrealised losses accumulated from prior years in Available-for-Sale reserves in shareholders’ equity leads to simultaneous adjustments of 310 million euros to regulatory capital, or 460 million euros to shareholders’ equity in the balance sheet.”

So to compensate for Eastern Europe exposure, Erste bank sold CDS protection on Western Europe countries prior to the European sovereign crisis. No comment.

And that leads me to the intense discussions on the subject of banks recapitalization in Europe as the EBA (European Banking Association) is discussing plans for banks to maintain a 9% Core Tier 1 Capital benchmark. According to Bloomberg article from Ben Moshinsky and Aaron Kirchfeld:

“Nine percent of core capital based on EBA definitions may be roughly equivalent to the 7 percent of reserves that lenders will be obliged to hold from 2019 under measures agreed last year by the Basel Committee on Banking Supervision.”

As a reminder, in July, the EBA stress test required Core Tier 1 threshold was put at 5%, 1% lower than the 2010 level of the EBA stress test at 6%.  So where is the money going to come from?

In relation to discussions surrounding Capital Regulation, contrary to many beliefs, Bank Equity is not expensive. It is a myth.
A study realised by Stanford University by Anat R. Admati is a must read and available here:
Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Expensive

Anat R. Admati is a professor of finance and economics at Stanford University and the co-author of “Fallacies, Irrelevant Facts and Myths in the Discussion of Capital Regulation: Why Bank Equity Is Not Expensive.”

and a summary of the presentation made to the Bank of England by the co-author is available here, a must read:
http://www.bankofengland.co.uk/publications/events/ccbs_workshop2011/presentation_admati.pdf

“Historical Facts About Bank Capital
• In 1840, equity funded over 50% of bank assets in US.
• Over the subsequent century equity ratios declined
consistently to single digits.
• There is evidence that steps to enhance “safety net”
contributed to this. In the US
– National Banking Act, 1863
– Creation of the Fed, 1914
– Creation of FDIC, 1933.
• Similar trends in UK, Germany. More trading business.
• Bank equity did not have limited liability everywhere
in the US until 1940s!”

Banks have fought bitterly against increasing equity buffers which is the cheapest and easiest way to recapitalize banks. Why? because allowing high payouts to shareholders, namely bank employees in many cases, allows financial institutions to raise their leverage. The author of the study Anat R. Admati voiced his opinion on the 25th of February in the following Bloomberg article:

Fed Runs Scared With Boost to Bank Dividends: Anat R. Admati

“In 1994, the Financial Accounting Standards Board wanted executive stock options to be expensed to reflect their actual cost. Industry opponents threatened that doing so would prevent entrepreneurial firms from obtaining financing, impede growth and reduce U.S. competitiveness.

Massive lobbying forced the board to back off. A decade later, after WorldCom Inc., Enron Corp. and other corporate scandals, the political atmosphere was different, and the FASB finally changed the rules. Since 2006, all companies must treat executive options as an expense. And the doom and gloom we were promised? There is no evidence that expensing options had any negative economic consequences.”

and Anat Admati to comment:

“Like homeowners who took a mortgage with little down payments, when banks are highly leveraged, their equity can be easily wiped out by small declines in asset values. If 95 percent of a bank’s assets are funded with debt, even a 3 percent decline in the asset value raises concerns about solvency and can lead to disruption, the need to “deleverage” by liquidating inefficiently, and possible contagion through the interconnected system. As we have seen, this can have severe consequences for the economy.”

Source – Anat Admati -http://www.bankofengland.co.uk/publications/events/ccbs_workshop2011/presentation_admati.pdf

“While equity is used extensively to fund productive business, bankers hate to use it. With more equity, banks have to “own” not only the upside but also more of the downside of the risks they take. They have to provide a cushion at their own expense to reduce the risk of default, rather than rely on insurers and eventually taxpayers to protect them and their creditors if things don’t work out.

Fixation with return on equity also contributes to bankers’ love of leverage because higher leverage mechanically increases ROE, whether or not true value is generated. This is because higher leverage increases the risk of equity, and thus its required return. Focus on ROE is also a reason bankers find hybrid securities, such as debt that converts to equity under some conditions, more attractive than equity.”

Source – Anat Admati -http://www.bankofengland.co.uk/publications/events/ccbs_workshop2011/presentation_admati.pdf

“More equity… would restrict [banks’] ability to provide loans to the rest of the economy. This reduces growth and has negative effects for all.” Josef Ackermann, CEO of Deutsche Bank (Nov. 20, 2009).
Wrong…

Anat Admati concluded his Bloomberg column by adding:

“The muddled debate on capital regulation has left us with only minor tweaks to flawed regulations, even after banks’ catastrophic failure in the crisis and the lasting consequences for the economy.The proposed solutions that regulators in the U.S. are focused on, such as resolution mechanisms, bail-ins, contingent capital and living wills, are based on false hopes. They can’t be relied on to prevent a crisis. Increasing equity funding is simpler and better than these pie-in-the-sky ideas.”

And why do banks need more regulations and larger equity capital buffer?

The answer is given to us by Simon Jonhson, who served as chief economist at the International Monetary Fund in 2007 and 2008, and is now a Massachusetts Institute of Technology professor and a senior fellow at the Peterson Institute for International Economics in the following Bloomberg article – “Low Bank Capital Is Next Fiscal Crisis“:

Why was the financial crisis so devastating to the real economy? The answer is that, in large part, financial firms had become so highly leveraged, meaning they had very little real equity relative to their assets. This was a great way to boost profits during the economic boom, but when the markets turned, high leverage meant either that firms failed or had to be bailed out. Many financial firms in trouble at the same time means systemic crisis and a deep recession. In effect, a financial system with dangerously low capital levels creates a nontransparent contingent liability for the U.S. budget through the fall in GDP and loss of tax revenue.”

Source – Anat Admati -http://www.bankofengland.co.uk/publications/events/ccbs_workshop2011/presentation_admati.pdf

For more on the subject:
Procyclical bank risk-taking and the lender of last resort” – Mark Mink © voxEU.org

“Providing banks with liquidity support thus effectively allows them to use maturity transformation as a means to lower their borrowing costs, without worrying too much about the higher illiquidity risk.

Through reducing banks’ borrowing costs, the prospect of receiving liquidity support also stimulates forms of bank risk-taking other than maturity transformation. First, it provides banks with an incentive to increase their leverage, i.e. to use more debt and less equity to finance their activities. Doing so, however, comes at the risk of a small decline in asset value being sufficient to wipe out banks’ equity buffers and cause them to become insolvent.”

“A leader is a dealer in hope.” - Napoleon Bonaparte

So yes, markets are indeed long “false” hopes and most likely, short faith, or short leaders, or both.

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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  • VRB II

    Great stuff Martin again.
    I’ll get to the white papers this weekend and thank u for the intellectual capital.

  • Jan

    John and Jimmy has 5000$ each. Let us assume Jimmy gives John his 5000$. Now John found a new bank called The John’s Bank and subscribes 10000$ of its stocks. So the bank’s capital is 10000$. Now the bank opens for business and receives a deposit of 10000$ from Mark. Later the bank lends to Jimmy 110000$, let’s assume it’s 6 months loan. 6 months later Jimmy doesn’t pay the loan back. John’s Bank go bankrupt. Mark get his 10000$ back from the FDIC. John’s Bank stocks price is 0, so John loses 10000$. But Jimmy, who pocketed 110000$ without paying back a penny, gives his friend John 60000$. So, we have John and Jimmy with 50000$ each…
    Did i miss something?

  • rhp

    nope, this was done all the time in the mortgage industry in the housing bubble, where the appraiser and the buyer would be in cahoots. A property that was rundown and previously assessed at $100,000, would be appraised at 400,000 by the appraiser and a loan obtained from an out of town bank that was not familiar with the area. The appraiser and borrower would split the $$ or the appraiser would get a cut, the loan would not be repaid, and the bank would be left holding the bad loan (to be bailed out by you know you……….!)

    This is one reason if you are currently refinancing, that you cannot use your own appraiser any longer……..

    OK, this was all off topic, but………