And Now, Courtesy of Bridgewater … It’s Italy’s Turn

Tuesday, June 5th, 2012

Earlier today, by way of a simple graphic, the world’s biggest hedge fund, Bridgewater, was kind enough to remind the world just how pointless any debates about Europe’s future viability are if the primary funding conduit: the EFSF/ESM hybrid can not provide the cash needed for even half the combined funding needs of Italy and Spain. Now, Bridgewater strikes at Europe once again, this time redirecting the general attention to where it is long overdue: Italy.

Because while Spain has for months now, ever since the publication of the ‘Ultimate Doomsday Presentation‘ right here in Zero Hedge on April 7, been punished with ever widening bond and CDS spreads, and a local stock market which recently hit a 12 year low, Italy has largely avoided the vigilantes and general bearish scrutiny so far. The main reason for this is the assumption that Italian Banks had loaded up on enough LTRO cash that they had sufficient dry powder to buy up Italian bonds in the primary and, more importantly, the secondary market for at least a few more months. We bold “the assumption” because as Bridgewater calculates, the ‘dry powder’ number is far, far less than conventional wisdom had been expecting. In fact, at negative €48 billion in residual LTRO capital, Italy flat out has no additional cash with which to plug ongoing debt funding needs.

And with that, it is time to wave goodbye to the always wrong conventional wisdom, and to wave in the arrival of the vigilantes, who had been so missed in Milan since the fall of 2011 when they nearly toppled Europe’s fulcrum economy, and only the sacrifice of Silvio Berlusconi prevented an all out catastrophe on November 8, 2011. This time, the token replacement of an unelected token technocrat (and Goldman crony) will no longer appease anyone.

Source: JP Morgan’s Michael Cembalest

Tags: Assumption, Bridgewater, Catastrophe, Conventional Wisdom, Crony, Debates, Doomsday, Efsf, Fulcrum, Gold, Goldman, Hedge Fund, Italian Banks, Jp Morgan, Sacrifice, Scrutiny, Silvio Berlusconi, Stock Market, Strikes, Technocrat, Viability
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National Acronym Day in Europe. Don’t Underestimate the ECB

Wednesday, May 30th, 2012

National Acronym Day in Europe – Don’t Underestimate the ECB

by Peter Tchir, TF Market Advisors

May 29, 2012

So the EC wants the ECB to bypass the EFSF and use the ESM to recap EU banks? That was the rumor that shifted global stock markets by 1% in a matter of minutes?

It has been awhile see we looked at the EFSF Flowchart or had a detailed look at the EFSF Guidelines but it looks like it is time to dig a bit deeper into what is possible and what is not.

The ESM is not yet up and running. There was talk that it would be done by June or July of this year, but in typical EU fashion I don’t think much progress has been made towards that promise. So right now the EU is stuck with EFSF and the potential to set up the ESM.

The EFSF actually has a lot of powers. I’m not sure exactly why it is such a big deal if the EFSF (or ESM) invests directly in banks or lends money to countries to invest in banks. In theory the countries could lose on their bank investment but pay back EFSF loans? That is a possibility but it would seem more and more likely that if the bank rescues fail the sovereign is dead anyways, so the market might be reacting too much to that distinction.

The bigger problem is that the EFSF is not well set up to leverage itself. The EFSF is technically the entity that could be buying bonds in the secondary market. It is supposed to have taken over that role from the ECB, yet it hasn’t done that. Why not? It is possible that they haven’t figured out a good way to leverage the EFSF and therefore would get minimal bang for the euro by buying bonds in the secondary market without leverage. The same issues apply to its role in the primary markets. Yes, the EFSF can intervene in the primary markets, but again, had very convoluted leverage schemes, which would never work.

The problem isn’t so much what the EFSF is allowed to do, it is how constrained it is in terms of leverage and access to funding. There is almost nothing that can be done about how EFSF is set up at this stage, nor should there be. That messed up entity should be put out of its misery.

Europe’s big hope is to actually launch ESM and launch it with a banking license. If ESM can be launched, and it can get a banking license, then the EU has a powerful tool. The ESM is allowed to do all the things the EFSF can do – participate in new issues and the secondary market and lend to countries for them to support their banks. Without a banking license its firepower is limited. With a banking license it can leverage itself to a very high degree and can tap all the cheap funding already in place and whatever new programs the ECB decides to launch.

So worry less about any “new” powers the ESM might have and worry about 1) the ESM actually getting funded, and 2) the ESM getting a banking license. Germany was very resistant to the idea of the banking license. I assume they still are, but they have already given the ESM all the powers it needs, and has endorsed leveraging the capital, so a banking license might not be out of the realm of possibility.

With a banking license, the ECB can do a lot to help the ESM. The LTRO deals did a lot for the banks. They really have reduced the pressure on European banks. In spite of the fact that Bankia is a total mess, we are not reading headline after headline about how BBVA or SocGen or even DB are in trouble. The banking system is in much better shape than last year because of LTRO.

The market got carried away with the promise of LTRO as a sovereign debt savior. The market, more than the ECB, created the idea of banks buying lots of sovereign debt. That was never going to work because the banks that would do it, already had too much exposure to their national sovereign debt. It created a potential death spiral. Taking the concept of the “carry” trade and LTRO out of the banking system and into the ESM might have more of an impact.

The market has lots to worry about, whether it is China, Facebook, Banking Regulations, Fiscal Cliff, whether American Idol is rigged, economic data, etc., but we are still very much at the mercy of policy intervention. Strong signals of new QE for the U.S. seem more likely by the day, and in Europe, there is likely to continue to be a lot of contradictory comments, but banking license for the ESM seems more plausible than many of the other rumors (like Eurobonds or Greek Exit) and would be a powerful catalyst for a bounce in European equities.

The credit markets and CDS in particular seem tired. They don’t seem to have the energy to compete with the swings in equities. So far IG18 has traded in about a 1 bp range in spite of the gaps in equity futures. Even MAIN, right in the center of it all, has traded between 173 and 175.5. The high yield market, and HYG and HY18 both had big days yesterday, with cash up as much as 1%. We will likely see some give back there, but there really is no evidence that retail is giving up on high yield and there isn’t as much leverage in the market as there was in 2011 as hedge funds have been cautious and banks have cut their exposures.

Spanish and Italian bonds are definitely getting crushed today, but with Spanish 10 years above 6.5% and Italian 10 year bonds nearing 6%, the potential for intervention rises. The secondary market is affecting the primary market, which is driving up the cost of funds, creating more pressure on the budget deficits. The countries are painfully aware of that, as is the ECB. One ongoing frustration for the ECB is their inability to translate their short term rate setting of 1% into the sovereign debt market. They are looking for ways to ensure that policy can impact all sovereigns because without that occurring it makes their job far harder than the Fed’s where treasuries instantly respond to the Fed rate decisions.

Tags: Acronym, Banks, Buying Bonds, Countries, Distinction, Ec, ECB, Efsf, Esm, Euro, Europe, Fashion, Flowchart, Global Stock Markets, Invest, Loans, Matter Of Minutes, Primary Markets, Sovereign, Tf
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The Axis of Weeble is Definitely Wobbling

Monday, May 14th, 2012

Weebles wobbling, spinning tops running out of energy, running out of room to kick the can, whatever analogy you want to use, the world seems like an incredibly dangerous place.

Greece is going to leave the Euro. That is now pretty much everyone’s expectation. I continue to believe that although they are highly likely to leave, it isn’t for a few more months, and that there will be some real effort from the Troika, led by the ECB to resolve this situation. This isn’t about helping Greece. This is about saving what is left of Europe. What does a new currency really do for Greece? It sounds exciting and the conventional wisdom is that it lets them inflate their way out of their problem. I think all it will do is inflate them into a “Mad Max” world. How is Greece going to be able to afford gas and food if they revert to the Drachma on short notice? Greece doesn’t export enough to get a huge immediate benefit. Yes, it will be cheaper to produce in Greece, but very little is set up to take advantage of that right now.

But it is the ECB and the rest of Europe that need to worry. Greece needs further debt cuts even more than it needs a new currency. Not only would the ECB’s and IMF’s existing holdings be converted to the new currency, Greece may decide to default outright. The ECB and IMF are both staring at massive losses. If Greece goes to the Drachma and doesn’t change the debt to Drachma, then they will have killed themselves. That just isn’t possible. So switching to drachma, and then possibly even defaulting is what is necessary. How will the ECB and IMF deal with it? The ECB might have to make a capital call. That would send tremors through the system. The IMF will deal with it, but expect talk about countries pulling out of the firewall. There is talk about having the EFSF make the ECB whole. That’s not even taking money from one pocket and shifting it to another, it’s the same damn pocket. The market will not like that.

Shorting Germany, preferably bunds, is my favorite way to play this (with French bonds a close second). I think the next leg if it occurs wipes out the myth of Germany as “safe haven”. If Greece goes, losses to the Troika will be real and any attempt to paint over them will be too obvious. The staggering size of the commitments that will ultimately flow onto the shoulders of Germany and France will end the idea that somehow their credit is somehow better. The guarantees matter, and these bonds will be affected.

I still expect some “surprise” headlines bringing all the people involved to some form of resolution, that won’t obviously fix everything, but will buy time. Notice Draghi has not once said anything about this, and really he seems far and away the most competent person at the ECB.

Then back here, we can focus more on JP Morgan. Since 2007, JPM had a loss in one quarter only. They lost 9 cents in Q4 2008. The just made 1.70 in Q1 of this year. Citi had 9 quarters of losses in that period. Their worst quarter was -23.80 per share compared to a tiny 1.11 per share in Q1. MS had 6 quarters of losses, with the biggest being 3.61 AND they lost money in 2 quarters last year. Yes, $2 billion is a big number. It may have grown, it may turn out smaller. In any case, it is unlikely JPM will have a loss this quarter. This group and the overall risk management of the firm is part of why they have done so well relative to their peers. If you want to focus on the fact that $2 billion is a huge number to a normal person, that is fine, but you may be getting more angry than you should. The reality is that JPM, with $2.3 trillion in assets is huge, and every business they are in is big, and P&L swings will be large in $ terms, but seem completely reasonable in percentage terms.

Yes, regulatory scrutiny will intensify, but this is a problem at all big banks. The specific risk of this trade has been overdone. Unfortunately it is hard to tell how much of the price move is specific to one aspect or the other, so I can’t quite get comfortable with the situation in terms of getting long JPM, but will be looking at outperformance trades.

Futures have already had a wild ride, and I would expect that to continue throughout the day. MAIN is out to 169 +12 bps on the day. XOVER is at 718 +36 bps on the day. It is ugly, with minimal liquidity – even the best market makers are back to making 1 bp markets in MAIN. IG18 is opening at 112, which is 3.5 bps wider, and HY18 is at 94 3/8, so down about 5/8. The moves in XOVER and HY relative to MAIN and IG seem more normal than Friday, when we saw almost amazing outperformance in the HY space (where JPM is allegedly short).

Spain and Italy are under attack again. Ten year yields have hit 6.26% and 5.70% respectively while CDS is at 640 and 480 respectively. Scary numbers, though Spanish 10 year may be getting to the point where we see some ECB intervention in the secondary markets.

So with problems across the globe and the mood so dim, I can’t help but think we are set up for a rally on the back of any scrap of good news. I don’t see Greece hitting the breaking point just yet, and the market will digest the JPM loss as it thinks more rationally, and Spain and Italy are not so heinous that they should respond well to any ECB intervention.

Tags: Analogy, Axis, Conventional Wisdom, Currency, Dangerous Place, Drachma, ECB, Efsf, Expectation, Firewall, Gas And Food, Greece, Imf Deal, Mad Max, Massive Losses, Max World, Spinning Tops, Tremors, Troika, Weeble, Weebles
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The Spanish Bank Bailout Begins

Monday, May 7th, 2012

It was only a matter of time before the next bank bailout began despite all those promises to the contrary. Sure enough, as math always wins over rhetoric and policy, earlier this morning the shot across the Spanish bow was fired after PM Rajoy did a 180 on “no bank bailout” promises as recent as last week. From Dow Jones: “Spain may pump public funds into its banking system to revive lending and its recessionary economy, Prime Minister Mariano Rajoy said Monday, signalling a policy U-turn. The government had pledged to not give money to the banking industry that is struggling in the wake of a collapsed, decade-long, housing boom. “If it was necessary to reactivate credit, to save the Spanish financial system, I wouldn’t rule out injecting public funds, like all European countries have done,” Rajoy said in interview with Onda Cero radio stations. The weakness of Spain’s banks is weighing on the economy that contracted 0.3% in the first and fourth quarters, meeting most economists’ definition of a recession. The unemployment rate is at an 18-year high 24.4%, data showed April 27. Banks have sharply reined in credit in the face of rapidly growing bad debt and problems getting finance on international markets.” And explicitly we learn that Spain will inject EU7 bln of public funds via contingent-capital securities to support BFA-Bankia, El Confidencial reports, citing Economy Ministry officials it doesn’t name. It actually sounds cooler in the native: “El Estado inyectará 7.000 millones de dinero público para salvar BFA-Bankia.” So it begins. Which also means that the “Bad Bank” idea is about to be launched. So far so good… The only problem is that like the EFSF, like the ESM, like the IMF, all those “deus ex machina(e)” also had to find funding of their own… and failed: it is one thing to intend to rescue the system. It is another to find the cash to do it with.

In the meantime, the process has already commenced:

• BANKIA SHARES FALL 4.8% IN MADRID
• SPANISH PLAN FOR BANKIA TO BE ANNOUNCED IMMINENTLY
• SPAIN TO CLEAN UP BANKIA, CHANGE MANAGEMENT, OFFICIAL SAYS
• SPAIN IS WORKING ON PLAN FOR BANKIA, GOVT OFFICIAL SAYS

From Reuters:

Spanish Prime Minister said on Monday he would use public funds to rescue the country’s banks, but only as a last resort. He said an announcement on government plans for the banks would come on Friday.

Spain has already spent more than 18 billion euros ($23.61 billion) to clean up its banks, which were highly exposed to a property sector crash four years ago.

The banks have been forced into several waves of mergers and to recognize more than 50 billion euros in losses related to property lending and assets.

…

A Spanish government and Bank of Spain plan to reform Bankia will involve major changes at the bank’s management, government and Bank of Spain sources told Reuters on Monday.

“The plan is being finalised by the Economy Ministry and the Bank of Spain. It will include major changes in the management,” a government source said.

The source also said the Spanish government would approve on Friday the guidelines for setting up holding companies to park and sell off toxic real estate assets, including a framework to create 10- to 15-year “bad banks”.

A source from the Bank of Spain said that the plan for Bankia, which is likely to stick to its stand-alone strategy after the intervention, includes the possibility of asset sales.

“The possibility of strenghtening the balance sheet through asset sales is on the table,” the source said.

And more from DJ:

The ministry official added that the government and central bank are studying a specific clean-up plan for Bankia SA (BKIA.MC) and parent company Banco Financiero y de Ahorros SA, which could include a shake up of their management. Daily El Pais said Monday the government also plans an injection of state funds via convertible bonds with a rate of about 8%.

Bankia’s parent, considered one of the weakest banks in the Spanish financial sector, recently carried out a EUR2.75 billion write-down of the group’s assets by lowering the value of its real-estate holdings.

A Bankia spokesman declined to comment.

Spain’s central bank estimates the country’s banks’ total exposure to the country’s ailing real estate industry at EUR338 billion, of which it considers some EUR176 billion problematic.

In new evidence of a deepening downturn, the local statistics agency said Monday that industrial output fell by 7.5% in a calendar-adjusted annual rate in March, after falling by 5.3% in February and by 4.4% in January.

Translated: since this plan is a stillborn failure, the countdown is now officially on to the Spanish PSI. Only this time around, unlike in the case of Greece, one wonders how Merkel will spin the German funding in continent that no longer cares about “austerity”, i.e., deleveraging, and is all bout “growth”, i.e., ramping up debt issuance to the max.

Tags: Bad Debt, Bank Bailout, Banking Industry, Banking System, Bln, Capital Securities, Contingent Capital, Dow Jones, Economy Ministry, Efsf, El Confidencial, Esm, International Markets, Madrid Sp, Mariano Rajoy, Matter Of Time, Ministry Officials, Spanish Bank, Spanish Financial System, Unemployment Rate
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Why shorting Spanish and Italian Bonds is the Right Trade (Tchir)

Friday, May 4th, 2012

I continue to believe that longer dated Spanish and Italian bonds are poised for a significant sell-off. At this stage everyone knows the problems the two countries are facing. Spain’s economy seems to be doing worse than Italy, but Italy has a heavier debt burden.

Over the past few weeks, more and more investors are coming to the conclusion that either debt restructuring or a currency conversion or both are real possibilities. The short lived success of LTRO is very concerning. It demonstrates that liquidity has its limits when solvency is the real risk.

So my first premise is that the risk of restructuring or currency conversion is real. It is not imminent as politicians and central bankers continue to do what they can to avoid that outcome, but virtually everyone now believes that this is a potential, if not inevitable outcome. That has changed in the past few weeks and has not been fully digested.

The other key premise is that the ECB is unlikely to intervene in a meaningful way anytime soon. That seems to have been confirmed yesterday by Mr. Draghi himself. From conversations I had, the unintended consequence of the ECB’s tough stance during the Greek debt negotiations has meant that countries no longer welcome ECB intervention with open arms. If restructuring is on the table, having a party that is unwilling to take a loss yet holds all the cards when it comes to future financing of the banks, it is an awful situation. Greek post-PSI bonds trade poorly at least in part because of the ECB’s stance on its position. The ECB’s secondary market purchases of Greek debt turned out to be disastrous for Greece in their attempt to restructure and create a workable debt load. This has not been lost on Spain and Italy. The desire to retain flexibility in any future negotiations is incompatible with inviting the ECB to buy more bonds. That is one reason that the EFSF and ESM are supposed to assume that role. Though in typical EU fashion, rather getting those entities ready to assume secondary market purchases when the markets were calm, they dragged their feet and aren’t quite ready. The EFSF will eventually be ready to buy bonds. They will be the preferred buyer because they can be made to take a loss. That may become an issue as countries providing the guarantees that let EFSF function may decide it isn’t in their best interests to be the patsy at the negotiating tables.

So in my world, there is real risk of restructuring and currency conversion. It’s not going to happen tomorrow, and even I admit there is a chance it never happens, but the key is that this risk is real and is being acknowledged (at least privately) by virtually everyone involved in the market. Then, there is my view that the ECB will be slow to do anything. There “help” is not as universally viewed as good thing by those receiving it, and the political will within Europe to risk money for other countries is diminishing.

Before analyzing where we might get to, it is worthwhile seeing where we have been. This is the “off the run” 10 year Spanish bond. It was issued at the start of 2011, so the price runs through the time of the big EFSF expansion, the first time the ECB intervened in the secondary market for Spanish debt, the never ending series of summits, and the 2 LTRO programs.

This is the price of that bond. I have chosen price rather than yield, because that in the end is the key metric. When people worry about positions it is about how much money they might lose (or gain) and that is always in price terms. The bonds were issued just under par. They traded up (like any good new issue should) and bounced around between 100 and 102 until the crisis in Greece, Portugal, and Ireland got worse in the summer. At that time, “contagion” really hadn’t spread to Spain and Italy. After the market briefly rejoiced at the new and improved EFSF announcement, the market lost confidence that it was big enough, and for the first time, Spain and Italy faced real fear, rather than just the fear of fear. Bonds slid to 94. Bounced on some announcement, sold off again to 94, finally rallying all the way back to 104 after the ECB decided to intervene in the secondary market. That spike is worth watching. The bond went from 94 to 104 in a matter of days. That is how illiquid credit markets can be. Clearly nothing was solved, but the ECB intervention caused an incredibly sharp and immediate rally. This lost steam and then from mid October until late November the bonds slid in price virtually every day, until hitting a low of 92. Even during this period, there were a couple of strong days, but the final decent happened very quickly. There are periods of time in fixed income where liquidity vanishes.

A combination of summits and plans drove bonds quickly from 92 to 102. Then the dance of fear and greed played out, with some volatile trading in the 98 to 104 range, until, finally the LTRO in particular was enough to push bonds as high as 106, and that is really where this story begins.

Since the LTRO closed on February 29^th and the bonds were at 106, they have dropped to 99. Anyone who bought the bonds on that day on the assumption the banks would have a lot of demand for Spanish bonds has been horribly wrong. With only a 5.5% coupon, you have not yet accrued even 1 point of interest, but you have lost 7 points. You have lost more than the entire year’s interest. Carry sounds great, but mark to market always trumps carry.

So, here we are sitting at a price of 99 in Spain, and similar prices and yields in Italy. Who is going to buy these bonds? If selling pressure starts, who will actually step up and buy these bonds.

Big Domestic Banks

The big domestic banks would be the main hope. The markets would love to see the BBVA’s of the world step up and buy these bonds here. But they won’t. They have already stated that they are getting full on these bonds and they aren’t lying. The big banks are global and should be able to survive the crisis, even if the sovereign debt is restructured. The key to surviving and possibly thriving in the aftermath will be to retain some semblance of prudent risk management. These banks need to behave as ongoing concerns. They need to ensure that exposure to any single issuer isn’t so large that it can bring them down. As much as the countries want them to load up on their own sovereign debt, these banks are too big, and the senior people have too much wealth tied up in the banks, to do anything too drastic. They have done their part, but will not be a puppet of the state. If they buy more, it will be in t-bills which seem to have their own special niche in the world as even Greece never defaulted on their t-bills. So if selling pressure mounts and Spain has trouble issuing debt, these banks will increase their exposure only minimally, and it will be almost exclusively at the very short end of the curve.

Big Foreign Banks

It is one thing to lose money, it is totally a different thing to lose money on something that everyone said was bad. Big banks who rely on the ECB might “do their part”, but they will do as little as possible. Anything they buy so they can tell the regulators how helpful they are will be pre-hedged in the CDS market, or they too will focus on the very short end. They aren’t about to buy 10 year bonds, with big duration risk, especially when they trade so close to par. I find it hard to imagine any CEO at an American bank wants to have to answer a question about exposure to PIIGS and be forced to admit that he has increased the bank’s exposure. Even if the bank thought it was good risk/reward, they would not want to do it because of the almost certainly negative consequences that admission would have on their stock price. Big foreign banks will do even less than big domestic banks.

Small Domestic Banks

A lot of these banks are already “all-in”. One part of the bank is busy buying sovereign debt and supporting the nation. Another part of the bank is already negotiating on what the terms of its own bailout package need to be. They might add more but these banks are in many cases in real trouble. They have balance sheets full of “toxic” assets and have stuffed themselves silly on their own country’s debt. They might not quite be at that “it’s only wafer thin mint” point, but more purchases from this group will be small and focused on the short dated bonds. They need LTRO to exist in some cases, and will not buy bonds longer than the LTRO funding.

Small Foreign Banks

You might as well jump up and down and start screaming “short me, short me” at the top of your lungs if you are a small foreign bank and are considering buying longer dated bonds from Spain or Italy. If you are weak, you are hiding in your corner of the world and hoping no one notices you, and being seen as a bank desperate enough to buy 10 year Spanish or Italian bonds is unlikely to help your share price. Maybe the market will reward you for being so smart and seeing value where others don’t dare to tread, but more likely, the market would wonder why you are so desperate for yield that you are willing to take such risk. Those that really want the exposure may sell CDS as they get more leverage (still) and it is a bit further off the radar screen. If you are a strong small bank, why bother? You probably didn’t get strong by investing on a whim and there should be a lot of domestic opportunities to lend and make money. As a whole this group might buy some debt and might even go out in maturity as far as 5 years, but it won’t be an aggressive bid in the market.

Domestic Insurance Companies and Pension Funds

These are the right buyers. They have long dated liabilities and need assets to fund those. They are less concerned about currency conversion so long as their liabilities will also be converted. In the end, this will be the group that will need to step up and buy bonds and are in the best position to do it. Except for the fact that they have already done it. The insurance companies have already bought a lot of longer dated sovereign debt. They will buy more, but they too will want to get a better sense of the range of possible outcomes before adding more. They don’t care as much about currency risk if their policies would also be converted, but they do care about restructuring risk. If their assets are restructured, but they cannot reduce their obligations, then they have a real problem. Public pension funds might have the greatest ability to add bonds while we are still in a period of uncertainty as they may see their obligations decreased as pension benefit reductions would likely be a part of any overall restructuring effort. This group is the most likely source of real buying power, and I will be trying to monitor their activity closely, but I suspect right now that they too will be only tentative buyers.

Foreign Insurance Companies and Pension Funds

I cannot imagine these entities adding significantly to their exposure. They would be hurt by restructuring and buy currency conversion. Many of these funds are more focused on not losing money than by outperforming. They often have ratings based guidelines that will be more difficult for them to overrule than for their domestic equivalents. Finally, why take the risk. Outperforming your peers by a bit by being over-allocated to these bonds hardly seems worth the risk of being “that person”. The “idiot” who bent the rules to own more Spanish and Italian debt that eventually defaulted, which everyone will say should have been obvious to everyone. Career preservation will overwhelm any attempt to be aggressive and foreign insurance companies and banks will avoid adding exposure and are more likely to under-weight exposure so they don’t have to potentially sell if further downgrades occur.

Market Making Desks

Whether or not the Volcker rule is in place or would even apply, banks will have a self imposed Volcker rule on these bonds. No one is going to build up an inventory of bonds in anticipation of a wave of buying. Small trading positions (both long and short) will be a natural part of the operations, but the desks are running incredibly tight on the risk side, and at this stage, it is still probably easier to explain how you took a small short position and lost money, than taking a small long position and losing money. On the bright side, even if the flows are skewed to selling, the dealers are far less likely to lean on the market than in the past because they just don’t want to take much risk. I think these desks will be fairly neutral, with a slight bias to be short here, but a willingness to go long for a trade, particularly if we get above 6% again.

Mutual Funds/Retail Investors

I don’t see retail investors flocking to funds dedicated to investing in bonds of these countries, and I think most mutual funds will behave a bit like foreign insurance companies. They will have some holdings so they don’t underperform their benchmark (or peers) if the situation improves, but while rating downgrades remain a real possibility (and many funds have ratings based rules), they are going to be wary about having too much exposure. The risk of underperforming a bit in a rebound is lower and the fund can always try to catch up by chasing yield once the turnaround occurs. The risk of being caught long in a big down move and having to explain how you didn’t see it coming when it was on the front page of every paper is just so much worse. I don’t see selling pressure coming from here, but I also don’t see them providing a big source of fresh money, at least not until the ratings risk stabilizes, and the daily news flow is less horrific.

Hedge Funds and Prop Desks (not that they exist still)

This is the key group. This is the group that caused the recent sell-off. Funds had gotten excited and bought into the LTRO saves the world theory. They owned these bonds, and because the yields were so low, and the potential price gains were getting less obvious (at 106), they had to use some leverage in an effort to get to 10% returns after fees. They got caught long and are the ones who got stopped out of trades and turned small daily selling pressure into a quick, but serious downward move. I think the hedge funds are now skewed slightly to the short side. The weak longs got pushed out and the bear crew has moved in. The funds are short the market both in bonds and in CDS. They generally prefer CDS but there is some concern that the CDS settlement on Greece was pure dumb luck and that the documentation needs to be amended for sovereign CDS to be truly effective. CDS has never recovered as much as the bonds did. CDS remains closer to the wides and didn’t participate as much in the LTRO rally. This is in part because German bunds have done so well, but it is also because the government programs – LTRO, SMP, etc., have focused on manipulating bond prices and have been less effective at manipulating CDS prices.

After the ECB giving a signal that intervention isn’t likely to occur any time soon, the people who think Spain and Italy are still yielding too little will be more comfortable pushing in the bond market. Until now, the CDS bid (buyers of protection) haven’t had much of an impact on bonds. But if the bears now decide that the ECB won’t step up, and I’m correct on my assessment of other potential risk takers, then they will start leaning on bonds, and we can see a quick sell-off as at first bonds move to catch up with CDS and then they take turns driving each other wider/lower.

That is my expectation of what will happen and think Spain breaking 6% will trigger a fast and furious move to 6.5% for itself and although Italy is currently trading tighter than Spain, I think it would get to 6.5% as well as the sheer size of the market would overwhelm what liquidity there is and the better fundamentals in Italy would be ignored, at least temporarily.

E-mail: tchir@tfmarketadvisors.com

Twitter: @TFMkts

Tags: Buy Bonds, Conversations, Currency Conversion, Debt Burden, Debt Load, Debt Negotiations, Debt Restructuring, ECB, Efsf, Esm, Having A Party, Inevitable Outcome, liquidity, Politicians, Premise, Psi, Real Possibilities, Short Lived Success, Solvency, Unintended Consequence
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Europe: “€1 Trillion May Not Be Enough”

Monday, April 2nd, 2012

A core piece of last week’s European newsflow was that following much pushback, Angela Merkel, who understands the underlying math all too well, finally dropped her opposition to expanding the European “firewall” in the form of a combined EFSF and ESM rescue mechanisms, to bring the total “firepower” to €800 billion (ignoring for a moment that when the true dry powder of the combined vehicle is just about €500 billion net as explained here, hardly enough to rescue Spain, let alone Italy). Yet as has been explained here repeatedly, and as Merkel has figured out, this is easily the most symbolic expansion of a rescue facility ever. Because while the ECB’s agreement to allow Eurobanks to abuse its €1 trillion discount window for three years (which is what the LTRO is), following the replacement of JC Trichet with a Goldman apparatchik, at least infused the system with $1.3 trillion in new fungible liquidity (and resulted in a stock market performance boost for the ages, one which is now unwinding), the ‘firewall” does not represent new money, nor is a “firewall” to begin with – it is merely one massive contingent liability which will remain unfunded in perpetuity. Slowly the German media is waking up, and in an article in Der Spiegel, the authors observe that “Even a 1-Trillion Euro Firewall wouldn’t be enough.” And they are correct, because the size of the firewall is completely irrelevant, as explained later. All the “firewall” does is shift even more backstop responsibility on the only true AAA-country left in the Eurozone, Germany. However, the main cause of problems in Europe – a massive debt overhang which can at best be rolled over but never paid down due to the increasingly lower cash flow generation of Europe’s (and America’s) assets, still remains, and will do so until the debt is finally written down. However, it can’t because one bank’s liability is another bank’s asset. And so we go back to square one, which is that the system is caught in the biggest Catch 22, as we explained back in 2009. We are glad to see that slowly but surely this damning conclusion is finally being understood by most.

From Spiegel:

European finance ministers meeting in Copenhagen on Friday agreed to boost the euro-zone firewall to over 800 billion euros. The move marks another U-turn on the part of the Merkel administration, which recently dropped its opposition to increasing the fund. German commentators warn that even the new firewall may still be too small.

Austrian Finance Minister Maria Fekter announced on Friday that the permanent euro rescue fund, the European Stability Mechanism (ESM), would be expanded, by considering the around €200 billion in current bailouts as being separate from the €500 billion earmarked for the ESM — originally, the €500 billion figure was to have included the €200 billion in existing aid. The ESM, which is due to come into operation in mid-2012, will also be boosted by including around €100 billion in bilateral aid that was given to Greece in 2010, as well as aid from other EU funds, bringing the firewall’s total capacity to over €800 billion.

Fekter expressed her confidence that Friday’s move would be enough to calm the financial markets. “The markets are already signaling relative calm,” she said. “That shows that the markets can work with what we have set up here.”

The Nuclear Option

On Thursday evening, in the run-up to Friday’s summit, German Finance Minister Wolfgang Schäuble had said he was prepared to combine the existing bailouts with the new permanent mechanism. He said that the €800 billion capacity was “convincing” and “sufficient.”

But not everyone shares his view that the sum is enough. On Thursday, French Finance Minister François Baroin called for the permanent euro bailout fund to be increased to €1 trillion, to shore up market confidence and prevent contagion in the euro crisis. “The firewall, it’s a little like the nuclear option in military planning, it’s there for dissuasion, not to be used,” Baroin said in a radio interview. He was echoing calls made by the Organization for Economic Cooperation and Development (OECD) earlier in the week to boost the firewall to €1 trillion.

The German press is also finally starting to wake up:

The center-right Frankfurter Allgemeine Zeitung writes:

“It is to be doubted whether all members of the Bundestag actually understand the financial dimension and the technical details of the ESM. It doesn’t help matters that the federal government has repeatedly shifted its position on this issue — as the SPD’s floor leader Frank-Walter Steinmeier rightly pointed out.”

“But the entire euro rescue is a balancing act. On the one hand, fiscal discipline needs to be promoted. The pressure on the crisis-stricken euro-zone members to carry out reforms must not be undermined by the knowledge that, if they fail, they will be caught by a financial safety net. On the other hand, there is the need for solidarity. Those countries that are in a better position can ‘help the others to help themselves,’ as Schäuble put it.”

“As always in the EU, these things lead to compromises in practice, which also explains why the government has readjusted its position on the ESM. The high ratings that Merkel enjoys in the polls may be related to the fact that the Germans seem to intuitively understand this delicate maneuver.”

The left-leaning Die Tageszeitung focuses on the calls to boost the ESM to €1 trillion:

“A trillion! That’s how much money France is now demanding for the euro rescue fund. Until now, Chancellor Angela Merkel only wanted to come up with €700 billion. On the surface, it looks as if a Franco-German showdown is on the horizon. In fact, it is nothing more than a PR battle, where nothing is really new. It was already clear last summer that the existing EU rescue fund, the EFSF, was much too small to save Italy or Spain in an emergency. Even then, people were talking about €1 trillion as a target.”

“One trillion euros is a lot of money, and yet even this huge sum will not be enough. But again, that’s nothing new. For months, calculations have been doing the rounds that show that at least €1.5 trillion will be needed. The only interesting question left is how long it will take France and Germany to acknowledge this reality.”

The last observation is off on the right track but is nowhere near close enough to the true conclusion, which was stated here yesterday by Mark Grant:

The Firewall Lie

Whether some proposed firewall is $760 billion or $1.3 Trillion or $13 Trillion makes no difference as in zero, nada, nothing and null. It is an IOU, a promise to pay and it is not counted in any European sovereign debt numbers nor is it counted in the figures for the European Union’s debt. It will not stop Spain or Portugal or Italy from asking for or needing money. It will not stop contagion nor will it protect any nation from the calamities of another nation. If approved by the Finance Ministers it is not approved by the European Parliaments and even if approved; it accomplishes nothing besides one more unaccounted for contingent liability that is nowhere to be found on anyone’s books. This whole discussion is a head fake, a deception and a ruse carefully plotted out for investors in one more attempt to mislead the entire world. If you wish to be a statistic in the Greater Fool Theory be my guest but I refuse to be apart of this unadulterated scam.

In other words, the next time a crisis flares up, the only thing that will delay the unwind, as the LTRO 1 and 2 did in late 2011, is another fresh injection of liquidity, whether in exchange or not for worthless collateral which was unused to begin with, as only new money can delay the unwind.

Of course, with every new trillion in incremental cash, now that central bank balance sheets are growing exponentially, more and more is now spilling over into hard assets, despite a clogged monetary transmission mechanism. The longer Europe’s farcical crisis continues, the more the status quo will have to fight tooth and nail to prevent an explosion in hard asset prices expressed in fiat. This is a fight they will lose.

Tags: Angela Merkel, Apparatchik, Article In Der Spiegel, Backstop, Contingent Liability, Core Piece, Debt Overhang, ECB, Efsf, Esm, Europe 1, Eurozone, Firepower, German Media, Gold, Massive Debt, New Money, Perpetuity, Spiegel, Stock Market Performance, Trichet
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Austerity – Mais, non. Spending – Nein. PSI – Tal Vez?

Thursday, March 29th, 2012

by Peter Tchir, TF Market Advisors

Austerity hasn’t worked for countries. So far the austerity path has made situations worse, rather than better.  Without stimulus, economies have seen their problems compound.  So now virtually everyone is against the idea that austerity is helpful.

That takes us back to spending.   Maybe it’s just me, but spending is what got us into this mess in the first place. If spending worked so well and was so easy we wouldn’t have a sovereign debt crisis in the first place.  Virtually every country was spending, yet deficits grew and economies shrank.  Why is there any faith that spending now will work?  Are we so good at targeting specific things that will really, truly, work?  Not a chance.  Spending will ensure debt grows just as fast, make the problem even bigger in the end, but will make people slightly happier in the near term.

So if austerity doesn’t work, and spending hasn’t worked, what will?

PSI, or Default, or Restructuring.

Debts have grown so big, that the only way to bring them under control is to default on them in one form or another and wipe some out permanently.  Doing it sooner than later is key.

Now is the time.  Portugal 75% haircut.  Ireland 50%.  Spain 40% haircut (once they put all the Spanish guaranteed debt on balance sheet, they will need 40%).  Italy 25%.  Greece – just make EU and ECB eat the same dish they served to public sector.  Only IMF money is sacrosanct.  The ECB, EFSF, and EU can take losses like the rest of us.  The EU talks about “firewalls”, well, put up or shut up.  The ECB can print away the losses.

Using current data, here is the amount of debt at the sovereign level for each country (I think if they are going to do the restructuring, they should put on balance sheet a lot of the guaranteed debt, so they only have to do this once).

Portugal:  €171 billion * 75% = €128 billion

Ireland:    €122 billion * 50% = €61 billion

Spain:       €712 billion * 40% = €285 billion

Italy:      €1,631 billion * 25% = €408 billion

Total write-downs would be €882 billion.

A lot of banks have written down holdings in Portugal already and taken reserves on other countries.  Greece shows that banks had done a semi decent job reserving against it.  Let’s assume €100 billion of losses have been reserved against or already marked.

That leaves €772 billion of losses.

The ECB has about €175 billion of non Greek bonds on its SMP balance sheet (or a number close to that)?  Assume an average loss of 40% on that (it is a mix of debt from the various countries).  That is €70 billion accounted for.  The ECB should just print that money. Call it a one-time exercise. With all the default/restructuring, inflation isn’t likely to be a concern.

So that leaves €702 billion still that needs to be taken out of the system.

Unicredit has an equity market cap of €23 billion.  Intesa is about the same.  Assgen (an insurance company, where the bond ticker is so much more fun than actual equity ticker) has a market cap of €19 billion.  BBVA is €30 billion.  DB is €35 billion.

The losses will be a massive hit to the banking and insurance industry.  But to some extent, so what?  The big “money center” banks will all survive it.  The DB’s, SocGen’s, BNP’s, HSBC’s of the world will take some serious hits.  US banks will take some hits.  But they have plenty of equity capital to support it, and they made bad lending decisions.

The BBVA’s of the world will get hit extremely hard, but they should be able to survive it.  I’m less sure about some of the Italian banks as they seem to have bigger concentrations, but in the end, there are a lot of banks.

So let the restructurings begin and figure out what to do with the banks after.

Many will survive without assistance.

Some banks may fail.  If the ECB and EU and EFSF protect senior unsecured creditors from losses at the expense of equity and sub debt holders, then the risk of a banking death spiral goes away. How much needs to be protected and at what level is unclear.  Some banks that were truly over exposed should see losses to  bondholders too.  Less losses for the public to bear and more losses for the bad decision makers to bear.

Provide “Warren Buffet” style equity capital to banks that want it or need it.  Why shouldn’t the taxpayers make money like Warren does?  Stop with the easy money for banks, make them pay the country like they would a private investor.

There has been ZERO evidence that bank share prices influence lending. It doesn’t seem to matter what we currently do to banks, they aren’t lending much.  So let’s not worry about their share price.  So long as they have access to money, they will or won’t lend regardless of whether their share prices are low.

Banks that are prepared and prudent will thrive in this environment.

Rather than making it hard to start new banks, the ECB and Fed should encourage new banks. There has to be 10’s of billions of Private Equity money that would start good mid-size banks.  Heck, maybe we could get an i-Bank.  But seriously, new money has been crowded out of the space by zombie banks and kick the can policies.

Take the hit.  Figure out who excels, who fails, and for those in between, what is the cost of surviving.   Open the markets to new equity capital and new participants.

Maybe this is too harsh and will never work, but it is a better path than pursuing the same policies that have failed year after year.

Tags: Austerity, Balance Sheet, Debt Crisis, Debts, Dish, ECB, Efsf, Faith, Greece, Haircut, Hasn, Losses, Nbsp, Psi, Public Sector, Restructuring, Sovereign Debt, Stimulus, Tf, Time Portugal
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Goldman On Europe: “Risk Of ‘Financial Fires’ Is Spreading”

Wednesday, March 28th, 2012

Germany’s recent ‘agreement’ to expand Europe’s fire department (as Goldman euphemestically describes the EFSF/ESM firewall) seems to confirm the prevailing policy view that bigger ‘firewalls’ would encourage investors to buy European sovereign debt – since the funding backstop will prevent credit shocks spreading contagiously. However, as Francesco Garzarelli notes today, given the Euro-area’s closed nature (more than 85% of EU sovereign debt is held by its residents) and the increased ‘interconnectedness’ of sovereigns and financials (most debt is now held by the MFIs), the risk of ‘financial fires’ spreading remains high. Due to size limitations (EFSF/ESM totals would not be suggicient to cover the larger markets of Italy and Spain let alone any others), Seniority constraints (as with Greece, the EFSF/ESM will hugely subordinate existing bondholders should action be required, exacerbating rather than mitigating the crisis), and Governance limitations (the existing infrastructure cannot act pre-emptively and so timing – and admission of crisis – could become a limiting factor), it is unlikely that a more sustained realignment of rate differentials (with their macro underpinnings) can occur (especially at the longer-end of the curve). The re-appearance of the Redemption Fund idea (akin to Euro-bonds but without the paperwork) is likely the next step in countering reality.

Section 4 below is the most critical to understanding the pitfalls of the consensus thinking…

1. EFSF Has Helped Contain Tensions in Peripheral Hot spots

The EFSF, which became operational in August 2010, was the first authority empowered to redistribute fiscal resources to support adjustment programs across EMU member states. The Facility has EUR54.5bn in bonds outstanding (including EUR30bn as part of the Greek debt exchange) and EUR8.9bn in bills. Earlier this month, it was authorized to raise a total of EUR241bn. This amount exceeds the aggregate committed capital to the three program countries by roughly EUR50bn, partly to provide for liquidity buffers. By comparison, the amount of bonds outstanding from the European Investment Bank—another supranational issuer—is in the region of EUR405bn.

The EFSF supply replaces the market funding programs (covering amortizations and deficit) for Greece, Portugal and Ireland. Thus, from a flow perspective—and taking into account that most EMU countries are reducing their borrowing requirements—the net supply of EUR government bonds available to private investors is declining.

The stock of Euro area government debt has increased substantially in the wake of the 2008 financial crisis, as has been the case elsewhere. Reflecting a process of ‘mutualization’ of the debt owed by the smaller issuers through the EFSF, the average quality of the pool of investable Euro area securities is progressively being upgraded. The ECB has contributed to this dynamic by removing around EUR200bn-worth of debt from private hands through its Securities Market Program (EUR150bn of which are Italian and Spanish bonds).

The EFSF issuance does not constitute a ‘Eurobond’, defined as a claim backed jointly and severally by the EMU countries. Rather, investors in EFSF securities effectively hold a (credit-enhanced) portfolio of Euro area sovereign issuers, excluding those currently under financial assistance programs. The country allocations of the portfolio map the ECB’s ‘capital key’, which roughly correspond to GDP size. Relative to a bond market capitalization, the capital key over-weights Germany and under-weights Italy.

The EFSF has no paid-in capital, but rather is backed by financial guarantees (amounting to EUR726bn) that exceed the maximum lending capacity of the facility (EUR440bn, corresponding to the sponsorship of the highest rated countries). After the downgrade of France, the weighted average rating of the sovereign guarantors is AA minus, and the weakest constituent (Italy) is rated BBB. EFSF long-term bonds are currently rated AA+ by S&P, and have the highest rating by both Moody’s and Fitch.

The EFSF securities currently span maturities ranging between 3 months and 20 years. They trade below the Euro-swap curve at the short end, and around 100bp above it at the long end. Benchmark 10-yr EFSF bonds currently trade around 10-15bp above the corresponding maturity government bond issued by France—the closest rated core sovereign issuer. EFSF bonds are also broadly aligned with the weighted average funding cost for the facility’s sovereign backers, indicating that the benefits of over-collateralization and the costs of lower liquidity broadly offset each other (the Facility lends on to program countries at funding costs plus operational costs, and the recovery on loans is assumed to be zero by rating agencies). If bond yields move in line with what our valuation work suggests, EFSF securities should increase in value against the Euro-swap curve, and trade tighter in relation to France.

Demand for EFSF bonds from the first issuances has been split as follows: 46% to the Euro area, 33% to Asia and 10% to the UK. Central banks and Sovereign Wealth Funds purchased 38% of the bonds, with banks buying another 29% (see charts on the next page). The share acquired by Euro area financial institutions has progressively increased, as investors in the core countries switch away from low-yielding German Bunds in favor of securities that reflect the sovereign risk syndication being conducted directly through the fiscal schemes and indirectly on the ECB’s balance sheet.

2. Two Ways to Increase Pressure in the Fire Hydrants

Pressures to increase the EFSF’s endowment at the height of the sovereign crisis last year eventually resulted in allowing the Facility to leverage its resources. This has now been crystallized into two Special Purpose Vehicles (SPVs): a European Sovereign Bond Protection Facility and a European Sovereign Bond Investment Facility. The first scheme aims to provide partial risk protection certificates for sovereign bonds (i.e., a ‘first-loss insurance’ scheme). The second is a co-investment fund open to both the private and public sector dedicated to EMU area government bonds.

We assessed the idea of ‘first loss protection’ favorably when it was first circulated last year. The advantages of ‘credit wrapping’ new issuance of government securities are associated with the combination of a credit risk transfer from the guaranteed sovereign to its guarantors (the AAA-rated backers of the EFSF), which, in turn, benefit from a decline in systemic risk; and the reduction in refinancing risk accruing to the previous bond holders, which over time mitigates the potential segmentation of the market.

However, faced with the largely unquantifiable risks stemming from a potential breakup of the monetary union, the scheme has become less appealing to investors. The Protection Facility has other shortcomings too. Based on the rating agencies’ published methodologies, the rating impact of a higher recovery assumption in the case of Investment Grade securities is small (a 1-2 notch increase at most), hardly changing the position of countries such as Italy or Spain. Particularly if associated with multiple instruments, the protection certificate could be treated as a derivative instrument in banking books, rather than a ‘financial guarantee’. As such, it would fall under mark-to-market rules, with detrimental impacts on demand.

The Sovereign Bond Investment Facility is a more interesting proposition, especially if directed at the primary market. The first loss tranche is remunerated at the EFSF’s cost of funds. This is to the advantage of senior investors, who access a levered return (maximized by the Facility’s manager under a set of guidelines) with lower risk. As an example, Italy’s main fiscal problem pertains to its high debt stock, which needs to be rolled over. The SPV could cover 2 years’-worth of Italian medium-to-long-term maturity bond supply (around EUR400bn). The ‘equity’ tranche could amount to 30% (or EUR120bn), the ‘senior tranche’ could be 50% (EUR200bn) and the remaining ‘super senior’ tranche 20% (EUR80bn). Assuming a recovery assumption of 50%, the expected risk-weighted returns accruing to the senior tranche are attractive. For reference, EFSF July 2021 trades at 3.0%, while BTP August 2021 trades at 4.9%, and 10-year EUR Libor at 2.3%. With the capital allocation used in this example, the expected return on the senior tranche is around 220bp over the BTP, with a higher recovery.

So far, however, it is not clear who would participate in this SPV. Suggestions that sovereign wealth funds and/or the BRIC countries could become potential investors have not led to reported progress and have overlapped with demands for higher contributions from the BRICs to the IMF. Seniority considerations, the legal regime that governs any shortfall and the mechanism for a possible transfer of the participation from the EFSF to the ESM would need to be clearly spelled out for the scheme to work.

3. The ESM—The Permanent ‘Fire Department’

The European Stability Mechanism, or ESM, is a permanent facility that will replace the EFSF from July 2012. The ESM will have an initial lending capacity of EUR500bn (reviewed periodically) and a total subscribed capital of EUR700bn, of which EUR80bn will be in the form of paid-in capital to be phased in with a maximum of five installments.

Under current agreements, the consolidated lending capacity of the EFSF and ESM cannot exceed EUR500bn. But the authorities are actively discussing whether this limit can be increased by combining resources, even though it may not be for the entire capacity of the two funds (EUR940bn). One possibility could be that EUR500bn from the ESM will be added to the existing commitments of the EFSF (EUR17bn for Ireland, EUR26bn for Portugal and EUR102bn for the second Greek package), or to the EUR241bn the EFSF has already been authorized to issue. A decision is expected at the Finance Ministers’ meeting on March 30.

Increasing the total amount of the combined EFSF and ESM fund could have positive effects on the valuation of EFSF bonds, as a greater potential for sovereign credit risk syndication can lower the yield differential between constituents—in practice, German bonds would lose value, while those of Italy and Spain would increase in value. However, a number of issues that could affect the liquidity of the EFSF bond market still need to be addressed. Also, EFSF bonds will be close, but not perfect, substitutes of ESM bonds, because the two facilities enjoy different creditor status.

On the first issue, it is not yet clear what the EFSF’s role will be after July 2012. The EFSF will remain in place until the last bond issued matures. But it has not yet been decided whether new lending programs starting after July will come under the ESM, or whether the EFSF will be able to continue issuing bonds of existing programs. This decision will affect the depth of the EFSF bond market.

On the second issue, both EFSF and ESM loans are junior to IMF loans. However, while EFSF loans have the same creditor status as other sovereign claims on a country basis (pari passu), ESM loans enjoy preferred creditor status over other sovereign claims. This clause does not apply to ESM loans relating to a financial assistance program that came into existence before February 2, 2012, when the new ESM treaty was signed. Hence, while in theory ESM bonds have a better credit status than those issued by the EFSF, in practice this will depend on whether or not lending programs to countries other than Ireland, Portugal and Greece will be activated.

4. Too Much Combustible Material Still Around

The Euro area is a financially closed region, with more than 85% of sovereign bonds held by residents of the area. If we add to this the fact that most claims against governments are held by financial institutions domiciled in the area, the risk of ‘financial fires’ spreading is high. The prevailing policy view that bigger ‘firewalls’ would make investors more comfortable about purchasing sovereign bonds of EMU countries. This is predicated on the idea that the existence of a funding backstop would prevent credit shocks in one of the EMU members from spreading to other issuers. That said, we doubt the current infrastructure can produce the same effects on markets as the ECB’s long-term liquidity injections (LTROs). Our view is based on the following considerations.

• Size: Even if we combine the full uncommitted capacity of the EFSF and the ESM (EUR700bn), the total would not be sufficient to backstop the bigger markets of Spain and Italy. The former’s borrowing requirement (amortization plus deficit) over the next two years is EUR305bn, while the latter’s amounts to EUR525bn.
• Seniority: The ESM holds ‘preferred creditor status’ over existing bondholders (art.13 of the Treaty establishing the ESM). In practice, this means that if the facility is used to provide an EMU member country under conditionality, it would subordinate existing bondholders (twice, if the IMF also participates in a bailout). Given that investors are aware of this, they would require compensation to bear such risk. This could exacerbate, rather than mitigate, a crisis.
• Governance: The existing vehicles cannot intervene pre-emptively in markets at signs of tension. Rather, they would be activated only after a full crisis has erupted. The procedure envisages that the ECB would ring an alarm bell should tensions threaten the stability of the Euro area. The sovereigns experiencing tensions would need to formally ask for help, and sign a memorandum of understanding, before any financial support can provided. Admittedly, a ‘fast track’ option is also available, based on ‘light conditionality’ and allowing the EFSF to intervene in secondary markets. Still, the fixed size of resources could raise questions on the effectiveness of the operations.

5. What Could Help?

As we have indicated in previous research, based on relationships with relative macro and fiscal factors prevailing over the past 20 years, Italian government bonds should currently trade around 130bp over their German counterparts, and Spain at 200bp over Bunds. These spread levels are well below the 320-350bp prevailing at the time of writing. By reinforcing the notion of a ‘conditional mutualization’ of sovereign EMU debt, the expected increase in the size of the firewalls could help stabilize inter-country spreads. But for the reasons mentioned above, we doubt this would lead to a more sustained realignment of rate differentials with their macro underpinnings, particularly at the long end of the curve where uncertainties surrounding subordination are particularly acute.

We would therefore advance two ‘normative’ considerations:

• At this juncture, Spain remains under close scrutiny because of the interplay between the recapitalization of the non-listed banks (saddled with exposure to the housing sector, which has deteriorated on the back of the increase in unemployment) and the challenging fiscal targets that it needs to meet in 2012/2013. On 30 March, the Spanish government will announce the 2012 budget, which should remove part of the uncertainty around the size and quality of the fiscal measures. But concerns about the recapitalization of the non-listed banks are unlikely to diminish any time soon. We have long been of the view that an agreement between the Spanish government and the EFSF to support the recapitalization of the banking sector would be a productive use of pooled fiscal resources. It would avoid an increase in the funding needs and borrowing costs that Spain would face if it had to recapitalize banks using funds from the FROB. In this way, Spain could take advantage of EFSF funds, avoiding the ‘stigma’ of a macro-economic adjustment program, while the planned restructuring/recapitalization would be reinforced by external incentives and controls, and EMU-wide resources would be directed at one of the obvious sources of weakness of the common currency area.
• More broadly, we continue to think that a more direct approach to the ‘debt overhang’ problem affecting the Euro area would remove ‘combustible material’ and speed up the recovery. In this context, the proposal advanced by the German Council of Economic Advisors to set up a Euro area wide Redemption Fund appears to be one of the most promising. We plan to elaborate on this solution in forthcoming research, but the outline is fairly straightforward. The Council suggests creating a fund that would be jointly and severally guaranteed by EMU member countries, in which each participant would transfer government debt (ideally across the maturity structure, and in parallel with ongoing market access) in excess of 60% of GDP. Countries would pledge collateral to the fund, earmark revenues of a specific tax, and commit to repaying their liabilities over a long period (20-25 years). Alongside the fiscal compact and debt brake rules, this initiative has the merit of finally establishing a liquid security (the expected float is in the region of EUR2.5trn) which would reflect the Euro area’s comparatively high aggregate credit quality and thus represent a sound ‘store of value’.

Tags: Backstop, Bondholders, Debt Exchange, Differentials, Efsf, Esm, Fiscal Resources, Garzarelli, Goldman, Hot Spots, Interconnectedness, Limiting Factor, Mfis, Pitfalls, Realignment, Reality Section, Redemption Fund, Seniority, Sovereign Debt, Sovereigns
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Outlook: Can Normalization in a Non-Normal Market Persist? (Alfred Lee)

Sunday, February 26th, 2012

Can Normalization in a Non-Normal Market Persist?

by Alfred Lee, Vice President and Chief Investment Strategist,
BMO ETFs and Global Structured Investments
alfred.lee[@]bmo.com

Without question, equity markets around the world are off to a good start in 2012 with a general rotation out of defensive areas and into more cyclical oriented themes. More impressive is the market’s ability to shake off a number of negative headlines already seen in the new year. These include credit rating agency Standard & Poor’s (S&P) recent move to downgrade a number of Eurozone countries including France and following that up with the downgrade of the European Financial Stability Facility (EFSF). Though lower credit ratings typically results in higher borrowing costs when bonds are auctioned, yields of the downgraded European sovereign bonds barely rose after the news. Moreover, credit default swaps (CDS), or insurance against a default on sovereign bonds, have actually been trading at lower prices since the news of the downgrades. This suggests that the moves by S&P were already priced-in, as the downgrades were largely considered to be telegraphed to the market months ago. In addition, the European Central Bank’s (ECB) Long-Term Refinancing Operation (LTRO)¹ and the co-ordinated moves by the six central banks in November to provide cheaper swap borrowing rates has largely removed the perception of tail-risk² in the short term. Through the newly revised rules of the LTRO, the ECB allows banks to borrow funds for three years by posting collateral, to which eligibility requirements have been relaxed significantly. Thus, the perception of solvency of European banks have been significantly improved, despite a number French, Italian and more recently Spanish banks having been downgraded.

From a fundamental perspective, we have considered that most equity markets around the world to offer attractive valuations over the last three months. Though we have reduced our “overweight bonds” recommendation introduced last August to “slightly overweight” last month, we were still overly defensive in our allocation in January. While we remained largely favourable to U.S. equities throughout 2011, which in hindsight proved to be the right call, we have been waiting for momentum to return to Canadian stocks to avoid being caught in a value trap. The Dow Jones Industrial Average (Dow), our top broad equity market pick in 2011, showed a return of positive momentum in October, breaking out of its range-bound pattern and also recently registering a “golden-cross”³ pattern, early January. The S&P/TSX Composite Index (TSX), on the other hand, remained in a clear downtrend pattern since last March and has only recently broken out of that trend. In our equity allocation over the last year, we favoured more defensive oriented themes such as utilities, REITs and low volatility strategies. We continue to favour these themes as longer term core investments but given the strong market rally, we would use equity market pullbacks to tactically rotate some equity exposure to higher beta⁴ areas, as defensive names may lag over the next several months.

What Lurks Beneath?

Last year, the U.S. Federal Reserve (“Fed”) announced they would pledge to keep record low interest rates until 2013. Several weeks ago, in a surprise move, the Fed extended its commitment to low rates to 2014, which was largely recognized as an overly aggressive move, particularly considering that U.S. economic data has been coming in better than expected in most cases. Nevertheless, the move showed that the Fed is willing to take significant measures to maintain a risk-rally and the market now believes that there is a higher likelihood for further quantitative easing should the improvement in economic data lose momentum. As a result, over the next several months we believe an equity market rally may be possible, despite risk assets looking very overbought over the short-term. From a fundamental perspective, global equity markets are attractive and short-term liquidity measures may lead to a multiple expansion in valuations. However, the many global macro-economic concerns that weighed on the market last year largely remain unresolved and any political responses questioned by the market could potentially cause a market sell-off. Sentiment indicators such as the
CBOE/S&P Implied Volatility Index (VIX) are currently below historical averages but are finally showed some reaction to negative news, several weeks ago. As a result, we recommend using pull backs and trailing stop-loss orders to reallocate to equity markets. Risk mitigation tools such as stop-loss orders are critical given margin debt levels remain excessive, which makes a deleveraging event possible should investor sentiment sour over the ongoing European sovereign debt saga.

Tags: Alfred Lee, Attractive Valuations, BMO, Canadian, Canadian Market, Central Banks, Chief Investment Strategist, Credit Default Swaps, Downgrades, ECB, Efsf, Eligibility Requirements, European Banks, Eurozone Countries, Financial Stability, Fundamental Perspective, Negative Headlines, Risk 2, Solvency, Sovereign Bonds, Spanish Banks, Structured Investments
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Credit Vs Equity. Logical Vs Illogical?

Wednesday, February 15th, 2012

Via Peter Tchir of TF Market Advisors,

S&P futures have moved more than 20 points since 3:30. The first big move was on the back of a story that Greece really will commit to the whatever the EU demands. The second move was after China re-pledged to invest in Europe. IG17 is about 1.5 bps tighter than the wides of the day and is unchanged this morning. In Europe, Main is unchanged while stocks are up about 1% across the board. Even the 10 year bond which saw yields drop from 1.98% to a low of 1.92% are only back to 1.94%.

Why?

A letter from Samaras is unlikely to sway the EU from their path of “orderly” default. Whether or not the EU makes the right noises today and finally releases the PSI details, the path is for “orderly” default (whatever that means). Greece is not prepared to default yet, but for first time, it seems like both sides are actually preparing for that eventuality rather than hoping beyond reason that the situation will work out. Stocks chose to rally on the news of the letter (credit did a bit too), but the reality is it isn’t enough to change the path which is default.

The China story doesn’t seem anything new. Hasn’t China pretty much always remained involved. I think every credit person understands that China will lend money to Germany, France, and the Netherlands. They are somewhat indifferent about lending it directly or lending it via unleveraged EFSF. That isn’t news and shouldn’t be treated as news. If China says they will lever up EFSF, or give money to banks, or even buy Italian and Spanish debt directly, then it is interesting and new. This other stuff is just noise and a headline that changes nothing, since it is what they have pretty much said all along.

The GDP data out of Europe is “encouraging”. It came in at -0.3% vs expectations of -0.4%. Hmmm…That is annualized, so the estimate for the quarter was -0.1% and the number was -0.08%. That seems like rounding error. And the 3rd quarter was revised down by 0.1%.

We get some data today. I expect it to be okay since things like industrial production should benefit from the good weather, but any miss will definitely surprise the market.

Sentiment seems overly bullish, overly complacent, and the credit markets are sending a warning sign to stocks about irrational exuberance.

Tags: 3rd Quarter, Amp, Banks, Efsf, Europe Main, Eventuality, Futures, GDP, Gdp Data, Germany France, Greece, Hasn, Hmmm, Netherlands, Psi, Rounding Error, Samaras, Stocks, Story Doesn, T News
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