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Wednesday, November 30

Guest Post: Credit - The Eye of the Storm

Guest post by Martin from Macronomics

Markets update - Credit - The Eye of the Storm.

"The fishermen know that the sea is dangerous and the storm terrible, but they have never found these dangers sufficient reason for remaining ashore."
Vincent Van Gogh

As we move towards the nth European summit of the last chance on the 9th of December and with liquidity becoming scarce by the day, in today's post we will review ongoing liquidity issues, as well as some recent market developments and some previous calls.

On the recent price action, my good credit friend commented:
"As equity traders still enjoy a kind of Bull Run based on very thin air, credit traders keep on focusing on facts that could alter the metrics for the months to come, or, on events that could change the credit momentum. Even though European politicians have finally understood what needs to be done to place their economies on a strong footing, they are facing many hurdles, as political agendas collide with the needed structural reforms. So, it will take a lot of time, and time is a luxury that market participants cannot afford. Why? Because the overall system and our society does value “time” as something that humanity as a whole is short of. Consequently, we are experiencing a major social shift in term of savings behaviour and capital allocation. This is what I call a global re-pricing of all assets, which bears a lot of risks if it occurs disorderly."

But first, as always, it is time for a credit market overview before our long conversation.

The worsening liquidity picture in four charts. ECB Overnight Facility, Euro 3 months Libor OIS spread, Itraxx Financial Senior 5 year index, Euro-USD basis swaps level - source Bloomberg:

The current European bond picture with contagion to core Europe - source Bloomberg:

German 10 year government yield rising in lockstep with German 5 year sovereign CDS, following the failed auction casting doubt on the safe haven status of German bonds which had prevailed so far this year - source Bloomberg:

The Credit Indices Itraxx overview - Source Bloomberg:
While we have somewhat receded since our last post, in relation to CDS credit indices levels, volatility remains elevated, and liquidity is becoming an issue, given bid-offer spread for Itraxx Financial Subordinate 5 year CDS is 10 bps whereas it is is only 5 bps on the Itraxx Crossover 5 year CDS index (European High Yield gauge).
A market maker commented:

"Another fairly thin session as we approach Dec 9. Environment continues to be tough to trade -- just take a look at some of the intraday index moves. It becomes increasingly more difficult if you're a single name bank cds trader and trying to "hedge" your book. You are guaranteed to lose money on almost every occasion as you cross bid/offer."
Intraday movement remains indeed very elevated in the Credit Indices space:
Itraxx Financial Senior 5 year index closed around 340 bps (today's range was 330-355).
Itraxx Financial Subordinate 5 year index closed around 588 bps (today's range 569-626...).

Itraxx Financial Senior 5 year CDS versus Itraxx Subordinate 5 year CDS - source Bloomberg:

The same market maker commented on the above:

"Snr vs Sub relationship in Index is also not moving. You would have expected the spread to decompress in the widening but it did not even blink. The only real explanation for this, is because nobody feels like buying Sub protection at these levels; which is fair if you don't think LT2 will get haircut and believe CDS will go to zero one day (post Basel III)."

In relation to LT2, as a reminder from our September credit conversation "Credit - Crash Test for Dummies":

"Typically, in subordinated CDS single names, the bond reference is a Lower Tier 2 bond (LT2), and not Tier 1 (T1) bonds or Upper Tier 2 bonds (UT2), as coupon payments can be deferred in these structures. For Tier 1 bonds and UT2, missing a coupon does not constitute a credit event, therefore they cannot be used as a reference for a single name financial subordinate CDS, so no CDS on these bonds."
In our September post we discussed:
"If a financial entity is able to buy back its LT2 debt below par, it generates earnings and then Core Tier 1 capital. It's a kind of magic...because this way a bank's total capital base goes down (by retiring LT2 debt) and given regulators care most about the Core Tier 1 ratio, everyone is happy (probably note the subordinate bondholder)."
We would have to disagree with the market maker in the sense that we could go wider still on the Itraxx Subordinate 5 year CDS index, given the market doesn't fathom the possibility of getting haircuts on LT2 subordinate bonds. It has happened and will happen again for weaker financial institutions in the peripheral countries.

Tracy Alloway in FT Alphaville on the 22nd of October described what happened in Ireland, for Anglo Irish Bank subordinate bondholders in her post - "Anglo Irish’s burden-sharing template":

"The bank is offering holders of some of its outstanding sub-debt to swap their notes for new Irish government guaranteed bonds that will be due in 2011 with a coupon of three-month Euribor plus 3.75 per cent. Holders of the €1.57bn worth of three Lower Tier 2 (LT2) bonds will receive just 20 cents on the euro. Investors in about €377m of perpetual junior debt will get even less — 5 cents on the euro."
And Tracy also reminded us what happened in 2009 in the UK in relation to the Bradford and Bingley precedent:

"In 2009, the nationalised British bank enforced burden-sharing on both LT2 debt and perpetuals — offering 45 pence for every pound of LT2, and 25 pence on perpetuals. That was a premium of about 10 to 12 points at the time.

Bradford and Bingley burden-sharing, however, also came with a ‘special resolution regime.’ The UK government went ahead and changed the terms of outstanding Bradford & Bingley subordinated bondsallowing the bank to defer coupon and principal payments."

And Tracy concluded at the time:
"The future is here, and it bites for bondholders."

We already know the score given the flurry of bond tenders which we had seen coming fast and furious following Spanish bank Santander's bond tender. Given the wall of refinancing for banks in 2012 we detailed previously, we would therefore disagree with the current credit market assumption that LT2 haircut will not happen again and Itraxx Financial Subordinate CDS index could go wider still. This time is different? Probably not, given the European Banking Association's willingness to ensure European banks reach 9% Core Tier 1 capital ratio by 2012.

"Something has gotta give" - subordinated bondholders or shareholders, or both, we argued recently.

It seems Moody's Investors Services is confirming our September assumption given it is considering lowering debt ratings for banks in 15 European nations to reflect the potential removal of government support. This will likely help banks quietly retire their LT2 bonds at even more discounted levels, shoring up in the process somewhat their Core Tier 1 capital. According to Jacob Greber and Chitra Somayaji in their Bloomberg article - Moody’s Considers Bank Debt Downgrade in 15 European Nations published on the 29th of November:
"All subordinated, junior-subordinated and Tier 3 debt ratings of 87 banks in countries where the subordinated debt incorporates an assumption of government support were placed on review for downgrade, the ratings company said in a statement today. The subordinated debt may be cut on average by two levels, with the rest lowered by one grade, it said.
Lenders in Spain, Italy, Austria and France have the most ratings to be reviewed as governments in Europe face limited financial flexibility and consider reducing support to creditors, the rating company said. Moody’s has said that a “rapid escalation” of Europe’s sovereign debt crisis threatens the entire region."

The difficulties for banks to issue term funding debt have been a recurring theme in our conversations. The two journalists from Bloomberg also added:

"Banks will cut bond sales by 60 percent in Europe next year as the sovereign debt crisis drives up issuance costs, Societe Generale predicts. Lenders will sell 50 billion euros ($67 billion) of senior notes, down from a euro-era low of 121 billion euros so far this year, according to the French bank.
The extra yield that investors demand to hold European bank bonds is the highest since May 5, 2009, widening to 424 basis points on Nov. 25 from 336 on Oct. 31, Bank of America Merrill Lynch’s EUR Corporates Banking index shows."

In the great European bank deleveraging process, not even German bank Commerzbank is immune according to Bloomberg journalists Nicholas Comfort and Aaron Kirchfeld - Debt Crisis Puts Commerzbank Back to Drawing Board Fighting Aid:

"Commerzbank AG Chief Executive Officer Martin Blessing spent the last three years trying to free Germany’s second-largest lender from the shackles of government aid needed to survive the 2008 credit crunch. Europe’s debt crisis may put him right back where he started.
Blessing, 48, this year pulled off a capital increase of 11 billion euro($14.6 billion), among the biggest ever in Germany.
The stock sale, a conversion of shares held by the government and excess capital enabled the Frankfurt-based lender to repay 14.3 billion euros of government aid in June. Blessing has pledged not to accept state funds again, even as Commerzbank comes under pressure to boost capital to meet tougher requirements.
European leaders are demanding banks bolster their capacity to withstand losses after financial firms agreed to accept losses on Greek sovereign debt. Commerzbank, told by the European Banking Authority last month that it may need 2.94 billion euros in fresh capital, may have to raise as much as 5 billion euros in a worst-case scenario, people familiar with the situation said last week. “If the bank’s capital requirements rise significantly, it would be very hard for Commerzbank to reach them with the traditional measures they have to hand,” said Michael Seufert, an analyst with Norddeutsche Landesbank Girozentrale in Hanover. “Taking state aid again would be the very last option they’d try as it would be seen as a signal of weakness.”

So subordinate bondholders beware as the article added:
"Commerzbank is exploring options including buying back hybrid bonds and placing sovereign holdings in an external entity, or bad bank, one of the people said. The goal remains to avoid taking state aid. The bank already announced plans to scale back risk-weighted assets and new loans, and to sell non-strategic businesses.
The bank may have to seek assistance from Germany’s Soffin bank-rescue fund, which the government plans to reactivate, if the EBA significantly raises its capital requirements, one person said last week.
Commerzbank’s consideration of putting sovereign debt into a bad bank was reported by the Financial Times on Nov. 25, while the Financial Times Deutschland said yesterday the bank is weighing buying back as much as 1 billion euros of hybrid bonds in exchange for new shares."

In our conversation "Goodwill Hunting Redux", we were expecting this eventuality of debt to equity to materialise:
"First bond tenders, then we will probably see debt to equity swaps for weaker peripheral banks with no access to term funding, leading to significant losses for subordinate bondholders as well as dilution for shareholders in the process."

As for mortgage insurer PMI we mentioned in our post "Credit Terminal Velocity", in August, where we discussed the future for the mortgage insurance business, it is indeed goodbye PMI.
By Mary Childs and Sapna Maheshwari, November 29 (Bloomberg):
"Bondholders are unlikely to recover as much as PMI Group Inc., the guarantor of U.S. home loans that filed for bankruptcy protection last week, indicated in its Chapter 11 petition, debt-market trading shows.
PMI, which pays lenders when homeowners default and foreclosures fail to recoup all of the mortgage debt, reported $225 million of assets and $736 million of debt as of Aug. 4 in its Nov. 23 filing. That means senior bondholders would get about 30 cents on the dollar. Credit-default swaps on Walnut Creek, California-based PMI signal a recovery expectation of 20 cents on the dollar for its senior bonds, according to data provider CMA. The company’s $250 million of 6 percent senior unsecured notes due in September 2016 traded at 22.75 cents on the dollar on Nov. 23
The insurer’s assets may have deteriorated since August, according to analysts at debt researcher CreditSights Inc. They said in a Nov. 27 note that the assets in the filing were higher than they are now and the company likely would be liquidated."

The Bloomberg team interviewed a fixed-income strategist on the subject:
"“The fundamental question behind whether a company can restructure or must liquidate in bankruptcy is whether that company has a viable business model,” Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott LLC in Philadelphia, said in an e-mail. “Whether PMI is able to restructure or ends up in liquidation is essentially a referendum on the mortgage insurance industry as a whole.” Mortgage insurance may not be a sustainable business because home prices have proven to move in sync, making it difficult for providers to diversify, he said.
If mortgage insurance pricing rebounds, PMI’s liquidation would reduce competition and allow for better conditions for those who remain such as Radian Group Inc. and Genworth Financial Inc., LeBas said."

Survival of the fittest...PMI 5 year CDS in upfront price, indicating the recovery for Senior bonds will be in the region of 26 cents to the dollar, definitely less than the assumed 40% recovery rate in the senior CDS - source Bloomberg:

On a final note I leave you with Bloomberg Chart of the day, showing that "Investors are shifting haven demand out of core Europe and in to foreign markets as the region’s debt crisis reaches its most fiscally sound nations, according to UBS AG."

"The CHART OF THE DAY shows the 120-day correlation coefficient between French and German 10-year yields and the euro-dollar has fallen from highs earlier this month. The correlation between U.S. Treasuries and the currency pair continues to increase as the common currency is sold to buy debt outside the euro zone. The measure for 10-year U.K. gilts also remains stronger than Germany and France."

"The only safe ship in a storm is leadership."
Faye Wattleton

Stay tuned!