The Unbearable Lightness of Credit
By Martin T. – Macronomics
August 14, 2012
“Liquidity is a backward-looking yardstick. If anything, it’s an indicator of potential risk, because in “liquid” markets traders forego trying to determine an asset’s underlying worth – – they trust, instead, on their supposed ability to exit.” – Roger Lowenstein, author of “When Genius Failed: The Rise and Fall of Long-Term Capital Management.” – “Corzine Forgot Lessons of Long-Term Capital“
Yes, we are wandering again but we do see similarities in the current European “complacent” situation with the Brezhnev Doctrine, first and most clearly outlined by S. Kovalev in a September 26, 1968 Pravda article, entitled “Sovereignty and the International Obligations of Socialist Countries”. This doctrine was announced to retroactively justify the Soviet invasion of Czechoslovakia in August 1968 that ended the Prague Spring, along with earlier Soviet military interventions, such as the invasion of Hungary in 1956. “In practice, the policy meant that limited independence of communist parties was allowed. However, no country would be allowed to leave the Warsaw Pact, disturb a nation’s communist party’s monopoly on power, or in any way compromise the cohesiveness of the Eastern bloc. Implicit in this doctrine was that the leadership of the Soviet Union reserved, for itself, the right to define “socialism” and “capitalism”.” – source Wikipedia.
“The “Sinatra Doctrine” was the name that the Soviet government of Mikhail Gorbachev used jokingly to describe its policy of allowing neighboring Warsaw Pact nations to determine their own internal affairs. The name alluded to the Frank Sinatra song “My Way“—the Soviet Union was allowing these nations to go their own way” – source Wikipedia
“Germany faces the prospect of a referendum at some point in the future on its relationship with Europe after senior coalition members said the country’s role in tackling the euro-area crisis should be put to a public vote.
A referendum on closer European Union integration may become inevitable if proposed legislative changes rob national governments of budgetary rights, said Rainer Bruederle, the parliamentary floor leader of Chancellor Angela Merkel’s Free Democratic coalition partner. The Constitutional Court will signal in a Sept. 12 ruling when the boundaries of law in ceding rights to supranational institutions have been reached, he said.
“We may come to a point where a referendum about Europe becomes necessary,” Bruederle told the Hamburger Abendblatt newspaper in comments that were confirmed today by his office. “The future development of the debt crisis will show how much the EU countries will be asked to give up sovereignty.” Referendums are traditionally shunned in Germany since a 1934 plebiscite backed the fusing of the posts of chancellor and president, allowing Adolf Hitler to become supreme leader, or Fuehrer.
Finance Minister Wolfgang Schaeuble, a Christian Democrat like Merkel, first raised the possibility of overturning that tradition in June, when he said in an interview with Der Spiegel magazine that Germany’s role in the crisis meant the boundaries of the constitution would be reached sooner than he had thought a few months earlier.”- source Bloomberg.Back in June, in our conversation “Eastern Promises” we did write the following:
“We think the breakup of the European Union could be triggered by Germany, in similar fashion to the demise of the 15 State-Ruble zone in 1994 which was triggered by Russia, its most powerful member which could lead to a smaller European zone. It has been our thoughts which we previously expressed (which we reminder ourselves in “The Daughters of Danaus“).”
Remember, it is still a game of survival of the fittest after all:
Overall economic data weakness from China, Europe and the US should put some pressure on Credit indices in the coming weeks as the decline in economic activity should start weighting on corporate cash flows as well as on companies’ abilities in servicing debt obligations. As investor confidence deteriorates further, Itraxx CDS risk gauge should rise, so watch closely next week Zew index for investors’ confidence. While this week the movement for credit indices was subdued courtesy of poor liquidity during this summer lull, this “unbearable lightness of credit” is unlikely to last.
As we posited in our conversation “Hooke’s law” end of July:
“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 employment prospects and reduced tax revenues with increasing pressure in cash flows as indicated by the pressure in the terms of payments from the AFTE (French corporate treasurers) monthly survey. It is still a game of survival of the fittest.”
Yes, European High Yield returned +2.5% over the past month, with CCCs outperforming, and Investment Grade bonds by contrast returned +1.7% and the 12 month European speculative-grade default rate fell 2.7% from 3.0% at YE 2011 according to Morgan Stanley. But deflation is still the name of the game, as we indicated back in November 2011 in our ”Complacency” credit conversation. It still should be your concern credit wise (in relation to upcoming defaults), not inflation as per Morgan Stanley’s note:
“While one could argue that default rates could be high during times of higher yields owing to higher debt service cost, the opposite is actually true. High inflationary environments allow corporations to inflate away their nominal debt as their assets (and revenues) grow with inflation, leading to lower default rates. Low inflation environments, like the one we’ve had for the past 25 years, tend to be ones where defaults can spike.”
“Considering the lack of liquidity in the credit space and the very high correlation between asset classes driven by the European politicians, the coming weeks could see another significant spike in volatility in the European space so watch out for that “sucker punch”. “Same applies to European stocks in relation to the recent rally which has clearly broken ties with Economic data and Dr Copper (cooper prices being a leading indicator):
“The five-month rally in European stocks has broken from underlying economic data and will probably end as the European Central Bank disappoints investors seeking further steps to support growth, according to strategists at Barclays Plc.
As the CHART OF THE DAY shows, Germany’s benchmark DAX Index tends to move in tandem with the Ifo institute’s index of business sentiment in Europe’s largest economy. The Stoxx Europe 600 Index has historically tracked copper prices, which are driven by projections for demand. That movement has diverged since early June, with the Stoxx 600 rallying for nine consecutive weeks.” – source Bloomberg.
Both the Eurostoxx and German 10 year Government yields seems to be moving again in synch in what seems to be another short burst of “Risk-On”, with rising German Bund yields and a higher Eurostoxx 50 - 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:
As far as the European bond picture is concerned, lack of ECB intervention means Spanish 10 year yields remain elevated at 6.87, slightly below 7% whereas Italian 10 year yields are below 6% around 5.88% and German government yields fell slightly below 1.40% around 1.36% – source Bloomberg:
The late tightening of the German 10 year yield was linked to the declaration of Mr Katainen from Finland who clearly voiced Finland’s lack of support for using the ESM for secondary market buying:
“After a few months we would have spent all our money on bond purchasing programs and we wouldn’t have a firewall at all,” Mr. Katainen told The Wall Street Journal in an interview in his Helsinki office Wednesday”.
Mr Katainen also added:
“It is always good if there is a threat of growing bond yields if a country doesn’t behave responsibly.”
It looks to us, Finland is indeed adding pressure on Spain to “tap out” in our European mixed martial arts “Fight of the Century” and validating the analogy we made last week relation to operant conditioning chamber (also known as the Skinner box):“When the subject correctly performs the behavior, the chamber mechanism delivers food or another reward. In some cases, the mechanism delivers a punishment for incorrect or missing responses. With this apparatus, experimenters perform studies in conditioning and training through reward/punishment mechanisms.” – source Wikipedia
As far as Finland is concerned, they won’t support issuing joint euro-zone bonds, debt backed by all 17 nations in the currency zone, spreading the burden.
In this European rumble it seems that the more Spain hold on, the more pressure builds on Italy, as indicated by Andrew Frye in Bloomberg – “Monti’s Bond Frustrations Mount as Yields Stay High“:
“Italian Prime Minister Mario Monti’s frustrations with the bond market are surfacing as spending cuts destroy growth without the reward of cheaper borrowing costs. Italian gross-domestic product contracted an annual 2.5 percent in the second quarter as Monti sought to appease lenders by trimming the budget and increasing taxes. Even though Monti will bring the deficit within European Union limits this year, Italy still pays 453 basis points more than Germany to borrow for 10 years, within 50 basis points of the gap when Monti took office on Nov. 16. Monti, with eight months left to serve, is campaigning to prevent a bailout on his watch.” - source Bloomberg.
From the same article:
“Monti outraged German politicians with an Aug. 5 interview in Der Spiegel magazine where he said European leaders need to show more independence from legislatures. Bolder action to fight surging borrowing costs is needed, he said, such as backing his call for the euro region’s permanent rescue fund to secure a bank license, boosting its fire power. A day after releasing a statement saying he still believed in democracy, the Wall Street Journal released a month-old interview where Monti said that Italy’s yield premium to Germany would be 1,200 basis points if Berlusconi, who sustains his non-
political government, were still in power. Prior to Monti’s apology, a senior member of Berlusconi’s People of Liberty Party threatened to topple the government.” - source Bloomberg.
Was Mario Monti in favor of a Brezhnev Doctrine as far as European woes are concerned? We wonder.
In relation to Italian woes, what really caught our attention was Standard and Poor’s downgrade on Friday of all Patrimonio Uno CMBS Italian ratings:
“We have lowered all of our ratings in Patrimonio Uno CMBS, to reflect our view on the risk of a possible departure of the principal tenant before loan maturity, and on the transaction’s sensitivity to country risk.”
Patrimonio Uno CMBS is an Italian CMBS transaction that closed in 2006, and is currently backed by a loan secured on 49 properties mostly let to the Italian Ministry of Economy and Finance. The notes are backed by a senior loan arranged by Banca Intesa SpA, Banca Nazionale del Lavoro SpA, and Morgan Stanley Bank International Ltd. in December 2005. The loan financed the acquisition of 75 commercial properties from the Italian Ministry of Economy and Finance (MEF; BBB+/Negative/A-2) and other public entities. It is ultimately backed by the net proceeds from the liquidation of, and the
availability of rental income from the properties in the portfolio, of which 49 remain. At closing, 60% of the acquisition was funded by the loan, while the balance was funded through equity via the issuance of fund units sold to institutional investors. The notes will mature in 2021.
The properties backing the transaction can be generally classified into four
-Office buildings: Most of these properties are occupied by local the
MEF departments and agencies, or by other public entities. The properties vary in quality and are located throughout Italy.
-Police training centers: This category includes 12 complexes with multiple uses including offices, training classrooms, and dormitories. We consider that, in general, these centers could be used as office properties without any significant conversion costs.
-Fire departments/police stations: This category includes six properties across Italy.
-Others: This category comprises three hotels and a single retail property.
The properties were revalued in 2011 at EUR593 million, and the current loan balance is about EUR294 million. In their analysis, they have considered the recovery value expectations, but also a scenario in which the MEF vacates the properties in 2014. In this scenario, their analysis has assumed that the properties would be relet at lower rents. They consider that the indexation under the MEF lease has resulted in the passing rents being slightly over-rented when compared with current market rents. A departure of the tenant in 2014 would also result in the amortization credit being diminished.
It is still deleveraging and deflation with additional cost cutting involved from the Italian government and more assets shedding in the process.
Moving on to the subject of liquidity in the credit space and given it has been five years now since the BNP Paribas fund freeze marking the beginning of the financial crisis (On Aug. 9, 2007, Paris-based BNP Paribas halted withdrawals from three investment funds that had declined 20 percent in less than two weeks because it couldn’t “fairly” value their holdings.), we would like to start by a quote from Frederic Bastiat in relation this very subject of liquidity in the credit market:
“That Which is Seen, and That Which is Not Seen”
BNP Fund Freeze Shrinks Holdings Five Years After Crisis Ignited – by Matthew Leising and Mary Childs, Bloomberg:
“When a Brookfield Investment Management Inc. analyst saw bonds of Accuride Corp., the wheel manufacturer in Evansville, Indiana, at 94 cents on the dollar in December, he decided it was time to buy. The problem was the price wasn’t real. The debt was only available at 104 cents. “When it actually came time to shake them loose from somebody’s hands, that’s where the disconnect came in,” said Richard Cryan, co-manager of high-yield corporate debt at the New York-based firm, which oversees $150 billion of assets. Unable to find a seller at the lower price, they gave up.”
The unintended consequences of banks deleveraging and increased regulations means banks are in risk reduction mode leading to lower inventories provided to the market place which are at the lowest levels since 2002. Traders are as well jumping ship towards Hedge Funds. We already touched in liquidity issues in our conversation “Yield Famine“:
“While everyone is happily jumping on the credit bandwagon in this “yield famine” environment, we would advise caution given liquidity, as we discussed on numerous occasions (and liquidity mattered a lot in 2011…), is an important factor to consider in relation to investor confidence and market stability. Deleveraging for banks means a significant reduction in RWA (Risk Weighted Assets) leading to dwindling liquidity for cash rich investors as dealers play close to home.”
As indicated by the Bloomberg article quoted above, “Mind the Gap”:
“Even though the crisis is over and there’s no lack of money for those who need it, the credit market is still going through fundamental changes as Wall Street’s traditional role evolves.
For Melissa Weiler, a money manager who helps oversee $10 billion at Crescent Capital Group LP, the message came through recently when it took her team took two months to unwind a
retailer’s bonds from their portfolio. Before the crisis, that would have been done in less than a week, she said. “If you decide to exit a name because the credit is deteriorating — guess what? — you’d really like to sell at the quoted level of 95 but you might have to be willing to accept a price of 90 or less given the lack of liquidity on a given day,” Weiler said in a telephone interview from the alternative credit-asset manager’s office in Santa Monica, California. “Timely execution has increasingly become a challenge.” – source Bloomberg.
In credit markets, liquidity can fast become an issue, hence our initial quote from Roger Lowenstein, author of “When Genius Failed at the start of our credit conversation.
In addition to the impact on liquidity due to the on-going bank deleveraging, it is important to discuss the consequences of the gradual disappearance of “implicit guarantees” which, we think were the direct causes of the financial crisis. On the anniversary of the financial crisis, we think it is very important to look at the complex subject of implicit guarantees and its meaning. Given we regularly read Dr Jochen Felsenheimer’s monthly letter from Assénagon Credit Management, we would like to quote him from his most recent letter which is a must read:
“Implicit guarantees are multi-dimensional problem and exist within the financial system in a wide variety of ways. It should be emphasised that in this case there is no active guarantor in the sense of someone issuing a guarantee. It is more the case that the market is left with the opinion that a particular party will step in an emergency, thus the guarantee which the market assumes is implied on an explicit character precisely when the guarantee becomes more valuable, i.e. when the probability of it being used rises.
The odd thing about implicit guarantees (also abbreviated to IG below) can be seen in the fact that they
1. cause misallocations
2. …result in incentive problems,…
3. …can force the involuntary guarantor to issue a hard guarantee because the bets on the IG have reached systemically important proportions and…
4. …the guarantor being pushed from a passive to an active role means the anticipation that there will be a guarantee is met and the game starts over again.
Now you will find a large number of IGs in the global financial system. These remain inoperative in quiet times, as the probability of the guarantee being used is very small. In recent years, however, some IGs have become evident, now representing a central problem in the global financial system:
1. The implicit government guarantee for (systemically important) banks
This topic is the central issue of not just the euro crisis, but all banking crises. The market assuming that governments will stand by distressed banks in various ways in an emergency causes multiple misallocations within the system.
a). It is these IGs which make the banks systemically important in the first place. A prime example of this is the aforementioned case of Lehman Brothers. Banks themselves have an incentive to become systematically important, as this increases the likelihood that an implied guarantee will turn into an explicit one in an emergency.
b). Banks operate too riskily and hold to little capital, as in the race to become systematically important they can achieve a competitive advantage against their peers by means of bloated balance sheet.
c). The link between the banking system and the state is inevitably increasing. By buying government bonds banks even improve their position, as doing so in turn increases their systemic importance. In an emergency, the state will become the owner of the bank or will buy bank bonds and will thus become an explicit guarantor.
d). Banks strengthen their procyclical behavior by definition. It would be erroneous to think (as some economists have suggested) that you can break the procyclicality of banks by allowing them more latitude now, as the basic problem described above will not be solved. Establishing laxer rules for banks now would do nothing more than prove the market was right in expecting IGs – with the aforementioned consequences.
e). On the other hand, investors are demanding too low an interest rate when they lend banks money and are thus stoking the cycle.
A large number of financial products in which the banks’ default risk is wrongly priced in develop. And do so for this reason alone! These financial products attract investment money and thus contribute to misallocation.
2. The implicit guarantee for EU member states
The basic problem in the EU can be boiled down to the fact that there was an attempt to achieve a convergence of economic development in the member states by means of a lax common monetary policy. In view of the IG priced in by the market, the risk premiums demanded of the peripheral countries were too low. In 2010, the credo of European politics was still that no member state would be dropped. In 2012, Greece was restructured, no explicit guarantee could be given and since then the market has struggled even more to value IGs. IGs thus render the market mechanism inoperative and worsen the problem in Europe. Investors’ money flows to the countries with the highest spreads and what initially looked like conversion has turned out to be a speculative bubble. Without a firm set of guidelines, the market is not able to assess the probability of default within the EU. This uncertainty is reflected in the yield spreads in Spain and Italy, which explains the question posed by many economists about the difference between these countries and the situation in the UK and the US.”
Of course many more interesting points can be found in this aforementioned Assénagon monthly letter from Dr Jochen Felsenheimer, but as far as banks are concerned in relation to the disappearance of IGs (Implicit Guarantees), the prospect of bail-ins and depositor preference regimes in Europe justify a greater focus on asset encumbrances according to a recent report by Fitch (Major European Banks’ Balance-Sheet Encumbrance and the Creeping Subordination of Senior Bondholders), as reported on the 8th of August by “The Covered Bond Report” note – “Bail-ins depositor preference justify senior fears, says Fitch”:
“The rating agency said it believes “there is a growing risk that asset encumbrance, bail-in concerns and possibly even depositor preference will trigger an ever-increasing cycle of asset encumbrance at European banks and that low or even ‘zero recovery’ assumptions for senior bank debt might become the norm”, which would reduce the supply of senior unsecured debt in the long term.
Fitch notes that asset encumbrance and unsecured bondholders’ potential recoveries relative to secured creditors only matter if a bank actually defaults, and that such events are rare, as demonstrated by the chart below. This plots the five year global cumulative default rate over 20 years to the end of 2009 (0.9%) for the banks that Fitch rates against the five year global cumulative failure rate (7.1%).”
“Consequently, that secured creditors benefit from collateral protection has, historically, only rarely mattered in concrete terms for unsecured bondholders,” it said, adding that it would hardly be worth progressing with an analysis of encumbrance if such a very low bank default rate could be confidently predicted to continue.
However, James Longsdon, co-head of EMEA Financial Institutions at Fitch, said that bank defaults are likely to become more frequent as legislators move to make shareholders and creditors, rather than taxpayers, bear the losses of a failed bank.
“This gradual erosion of implicit sovereign support for senior debt is in fact a greater threat to senior unsecured debt ratings than subordination risk,” he said.
In its report Fitch said that the explicit possibility of bailing-in certain creditors in a going-concern scenario adds “a whole new dimension” to the debate about encumbrance, as eligible bail-inable creditors will be exposed to enforced write-down or write-off, while other excluded liabilities are not.” – source “The Covered Bond Report”
As far as the supply of senior unsecured bank debt in concern please note that the supply is already falling:
“The proportion of senior unsecured debt issued by banks in Europe this year has fallen below 50 per cent of new issuance for the first time in five years, underlining how problems in the eurozone and new regulations are driving banks to tie up more of their assets to access funding. The amount of senior unsecured debt, traditionally seen as the bedrock of bank funding, issued by European banks fell 28 per cent to €182bn in the first seven months of this year, according to Fitch. As a proportion of total debt issued by banks in Europe, senior unsecured debt accounted for just 43 per cent. Northern European banks and even some Italian and Spanish banks have continued to issue senior unsecured debt this year. However, bond investors are concerned that banks are tying up too much of their capital to secure funding.” – source Financial Times.
Yes, in this “unbearable lightness of credit / low yield” environment default will indeed spike at some point even for banks, consequence of the gradual disappearance of IGs (Implicit Guarantees). One can also argue that the advantage of explicit guarantees is that markets tend to “function” better under them. To quote again Dr Jochen Felsenheimer from his latest monthly letter:
“The advantage of explicit guarantees is that the market can value them and that the guarantee can be taken up – even in a crisis! For this reason, we can quote the “last man standing” at this point, the president of the German Federal Constitutional Court, Andreas Vosskuhle:”The constitution also applies during the crisis”. That is a hard guarantee, both for politicians and for investors!”
On a final note and in continuation of the theme of “implicit guarantees” given Hungary is our pet subject when it comes to “systemic risk” as shown in the below graph relating to Serbian dinar and Romanian leu: “An IMF deal is the quickest and easiest route to regain investor confidence,” according to Neil Shearing, the chief emerging markets economist at London’s Capital Economics Ltd:
”The CHART OF THE DAY shows the dinar and the leu are trading close to all-time lows against the euro as the Balkan countries face a delay in loan talks with the International Monetary Fund. Those movements mirror the forint’s fall earlier this year after Hungary’s negotiations with the IMF stalled on concern the central bank’s independence was being clipped. The forint rose after Prime Minister Viktor Orban backed down. The three countries have turned to the IMF and the European Union as slumping currencies hampered central bank efforts to reduce rates after the debt crisis prompted an economic contraction. Serbia’s law restoring the government’s influence over the central bank and Romanian political tension delayed talks with the lenders, eroding investor confidence.” – source Bloomberg.
“When forces that are hostile to socialism try to turn the development of some socialist country towards capitalism, it becomes not only a problem of the country concerned, but a common problem and concern of all socialist countries.” – Leonid Brezhnev speech at the Fifth Congress of the Polish United Workers’ Party on November 13, 1968 – The Brezhnev Doctrine
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