Guest Post: Credit - The song of Roland

And again a guest post by Martin from Macronomics. I earlier posted a regular linkfest Thanks. Giving mostly on German bond auction, which was also covered extensively and commented by me on yesterday’s evening post. New page, About this blog is also online. And now over to Martin, the floor is yours!  

Markets update - Credit - The song of Roland

"In The Song of Roland, Roland carries his olifant (ivory hunting horns made from elephant tusks) while serving on the rearguard of Charlemagne's army. When they are attacked at the Battle of Roncevaux, Oliver tells Roland to use it to call for aid, but he refuses. Roland finally relents, but the battle is already lost. He tries to destroy the olifant along with his sword Durendal, lest they fall into enemy hands. In the end, Roland blows the horn, but the force required bursts his temple, resulting in death." - Source Wikipedia.

The recent developments in our ongoing European tragedy inspired me this time around to use this particular legendary reference namely "The song of Roland". It is an interesting analogy as Oliver (European leaders) are asking Roland (Germany) to use the Olifant (to unleash the unlimited resources of the ECB) to call for aid (ECB). In the end, Roland blows the horn...but is it already too late for Europe?

But yet again, I divagate in my thoughts. Time for a Credit Market overview as there are many items to discuss, some of our calls, as well as one of an earlier subject we previously discussed, namely the consequences of the disappearance of risk-free rates in Europe.

The Credit Indices Itraxx overview - Source Bloomberg:

New records across the board in an environment where: liquidity is dwindling and volatility higher still.
A market maker commented:

"Nobody wants to be short risk coming into year end and the European Council meeting. This market is really tough to trade."

Itraxx Financial Senior 5 year CDS index breaking a new record closing around 342 bps (Intraday range 304-339 bps), Itraxx Financial Subordinate 5 year CDS index getting close to 600 bps mark around 591 bps (intraday range 540 - 588 bps).
The same market maker added:

"SovX, Fins Snr and Fins Sub have now reached a new all time record as London is closing. And main (Itraxx Europe 5 year CDS index - investment grade gauge) is only a couple of basis points away from its March 2009 record of 214 bps. Will it be enough for Germany to change its mind and allow the ECB to come to the rescue? I don't think so as despite the move there is no real pain out there from clients or dealers. We need French OAT to sell off more or get a large European Bank to run out of assets to pledge to the ECB. We are going to put more hope on the Dec 9th meeting and at these levels of stress and where indices are trading I would not want to be short anymore. I am missing the capitulation leg to go long risk but we are not too far away from that level. "

Will we hear Roland's olifant?

As my good credit friend put it about today's moves:

"Very large widening of credit indices! Sub Financial is at the widest ever and there is no reason to expect any significant pull back as the global picture is terrible. The momentum is gaining steam and speed, and I suspect we will have a panic and a capitulation very soon. A Global Re-Pricing of all assets is on its way, so we could gap hard anytime. Fasten your seat belt!"

Here is an update from our previous post "Mind the Gap", finally the disconnect we mentioned on the 15th of November between the German Bund and the Eurostoxx has ended and the gap closed - source Bloomberg:

But interestingly there was no flight to quality this time around, given the very poor auction of the German debt agency today. Newedge Chicago had to say the following on the results:

"The German debt agency sold EUR 3.644bn of its new 10y Bund 2% Jan 2022 this morning. The Buba retained a massive EUR 2.356bn. Demand was very poor at EUR 3.889bn for a modest 1.1 bid/cover. Without the massive Buba's retention the auction would have been heavily undersubscribed."

It seems there is a buyer strike going on in Europe, courtesy of the disappearance of the failed notion of risk-free, which is at the foundation of the "Modern Portfolio Theory". We previously discussed this phenomena back in September in our post - "The curious case of the disappearance of the risk-free interest rate and impact on Modern Portfolio Theory and more!"

We argued at the time:

"Safe havens no longer exist. The game was based on confidence, on risk-free interest rates and fiat-money based on the trust we had in our governments."

and added:

"Confidence is the name of the game and the perception of the risk-free interest rates, namely a solvency issue is at the heart of the ongoing issues."

One of the indicator we have been following in our various credit conversations has been the spread between 10 year Swedish government yields and German 10 year government yields. It looks like this relationship is broken - source Bloomberg:

From March onwards German Bund yields had been moving in lockstep with 10 year Swedish government yields. The spread broke the 25 bps high level reached in August and widened significantly to close at 52 bps. A very significant move.

My good credit friend and I discussed the following points:

"Now that the concept of “risk free assets” is being removed from what some people call “modern finance”, there is a slow understanding that every investment bears a “credit risk”. So now comes “re-pricing time”! To be true to ourselves, there has never been such a thing as “risk free” investments, and there has never been such a thing as “modern finance” but only “modern products”, sophisticated ones created by mathematicians. Once more, the “modern finance” concept is just a “wording” to cover up human beings' fears and greed. How good and reassuring it is to invest without risk and make nice profits! But such a thing cannot last, as it does not really exist."

So, dear friends, welcome to a credit world! Where defaults can happen and repayment of principal cannot be taken for granted.

This is the current European bond picture with contagion now spreading to core Europe, not even the Netherlands or Finland were spared - source Bloomberg:

And our CPDO/EFSF is now closing towards the 4% yield - source Bloomberg:

The disturbing 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:


In his credit letter published in August, Dr Jochen Felsenheimer from Assénagon made the following valid points:

"Banks employ too much debt, because they know that they will ultimately be bailed out. Governments do exactly the same thing. Particularly those in currency unions with explicit - or at least implicit guarantees. It is just such structures that let government increase their debt at the cost of the community. For example, in order to finance very moderate tax rates for their citizens so as to increase the chance of their own re-election (see Italy). Or to finance low rates of tax for companies and at the same time boost their domestic banking system (see Ireland). Or to raise social security benefits and support infrastructure projects which are intended to benefit the domestic economy (see Greece). Or to boost the property market (Spain and the USA). This results in some people postulating a direct relationship between failure of the market and failure of democracy."

As we previously discussed in our September post about "The curious case of the disappearance of the risk-free interest rate and impact on Modern Portfolio Theory and more!" and relating to our assertion of moving to a credit world:

"The lower the confidence, the higher the rates issuers will have to pay to raise capital. Solvency of the issuer will ultimately determine the allocation of the capital."

To further illustrate the above, Credit Suisse published on the 23rd of November the following note entitled "Earthquake warning" and had to say the following:

"A more lasting source of despair is the lack of understanding of the issues in most key circles. It seems axiomatic that before a serious problem can be tackled, its nature has to be understood. If there’s a hole below the waterline in your boat and the water has caused engine failure, then tackling the leak becomes rather important as opposed to cursing the malign intent of the water while changing the plugs. Mapped to Europe, WHY are bond markets closing?
Of course; “evil New York hedge funds” and their CDS. How foolish of us to forget. That’s good, because we can ignore the correlation crisis.
Vetoes of the ECB as a lender of last resort are a case in point. It cannot be the lender of last resort because it is the lender of first resort, to the tune of €550 bio and counting (fast).
We risk excessive repetition but the accounting identity between a euro member state’s BoP deficit and the NCB’s balance at the ECB ensures that. So, to [editorialize] a recent comment from BuBa President Wiedemann, speaking on Italy and Spain: "In both cases, I am confident that these countries need no outside help but rather that they can comfortably help themselves [to limitless BoP funding at the ECB], and that the new governments will take the necessary measures [to ensure that they can continue to do so]". i.e., stay in the euro.
The Greek government had rumbled that ruse, as apparently had Sr Berlusconi; so both governments had to go, stat. But this particularly extreme form of the par pretence is on borrowed time. There is currently no exogenous constraint on the current account financing of any euro area member state. And if we accept that the present level of current account deficits is unsustainable, which has certainly been the view of private sector participants, then under “Stein’s law” ("If something cannot go on forever, it will stop") the only question is how it stops, and to a degree when.
This is the (currently binding) hole in the SS Euro."

In relation to EFSF Credit Suisse had to say the following:

"And, as with all the challenges in the euro area—anywhere--the key to managing a risk is to understand that it exists, for both buyer and seller. Relative to our analysis of the tranche structure of the euro area, we regard the observation that the EFSF has a tranche structure as being simple. Senior tranche, bond-holders; junior tranche, guarantor governments. As correlation rises, expected losses are transferred relatively to the senior tranches. So EFSF bonds will underperform in an environment where the risks systematize and outperform as they become more idiosyncratic. And the missed opportunity to restructure Greece in 2010 meant that an idiosyncratic crisis could not be tolerated—we always rejected the concept of a “Greek crisis”—so the underperformance of the EFSF is entirely accounted for conceptually, as well as more anecdotally in terms of France’s AAA rating and the like, which are manifestations of the same phenomenon."

Credit Suisse also made an important point in their recent note:

"European credit is wholly reliant on German credit. And of course, via the banking system and credit markets, German debt is very largely reliant on European. If we are heading, as we appear to be, where all non-German issuance is closed (and German not certain, for reasons we examine later, and as we saw on 23 November), then the whole structure turns on how much of the debt can be mutualized."

On a final note I leave you with Bloomberg Chart of the Day, showing the market positioning for a collapse of the euro:

"The CHART OF THE DAY shows options traders turned the most bearish ever on the euro on Nov. 16 and the currency fell to its least in more than a month against the dollar the following day. The euro, which traded at $1.3518 as of 7:16 a.m. in London on the 21st of November, probably will drop 4 percent to $1.30 by year-end, according the Nomura, Japan’s biggest brokerage. The lower panel shows wagers by hedge funds and large speculators on a euro decline, compared with bets on a gain, increased last week for the first time in a month after Italy’s 10-year bond yield rose to a euro-era record over Germany’s earlier this month."

"All enterprises that are entered into with indiscreet zeal may be pursued with great vigor at first, but are sure to collapse in the end."
Tacitus

Stay tuned!