Credit - Fears for Tears
"A person's fears are lighter when the danger is at hand." - Lucius Annaeus Seneca
In continuation to our musical title analogies and given we have been
revisiting old classic "New Wave" music from the 80's while enjoying the
quiet daily commute, looking at the continuation of the build in risk
(US equities making new highs using margin debt, the great return of
covenant-light loans, etc.), we thought this week, we would use a
somewhat veiled reference to UK group Tears for Fears for our chosen
title, given this year was the 30 year anniversary since the release of
their first debut album "The Hurting"
(released on the 7th of March 1983). Looking at the increasing risks of
a Fed "Tapering" and the poor liquidity experienced in the secondary
space during the previous bout of bond volatility, we thought using
"Fears for Tears" as a title would conveniently illustrate our growing
"fears" concerns that could no doubt led to "tears" and to large
inflicted "hurting" in risky assets.
Of course, some will describe us as being outright "bearish" given
everyone is vaunting the much improved economic data in the US as well
as in Europe. As we pointed out last week, there are indeed a few clouds
gathering on the horizon thanks to rising "forced correlations" which
could lead to some additional repricing, and not only in the equities
space.
In this week's conversation, we will focus on these risks as well as
what capital shortfalls entails in the credit space for subordinated
bond holders, which have become again quite complacent on the matter.
We have been tracking with interest not only the rise of the S&P
index (blue) versus NYSE Margin debt (red) but we also added S&P
EBITDA growth (yellow) as well as the S&P buyback index (green)
since 2009 - graph source Bloomberg:
Of course this only telling half the liquidity induced rally courtesy of
our "omnipotent" central bankers and their wealth effect strategy,
leading to the use of leverage of any kind, which, leading to some "risk
parity" strategic users to rediscover with much "hurting" the inherent
risk in too much leveraged risk piled into interest rate sensitive asset
which our friends at Rcube Global Macro Research have been discussing as of late. We will touch more on liquidity further in our conversation.
Some argue that concerns on the record amount of borrowing for US stocks
are misplaced because, lower interest rates have made the borrowing
much less expensive, as illustrated by Bloomberg in a recent Chart of
the Day (15th of August):
"Concern that a record amount of borrowing to buy U.S. stocks
foreshadows an end to the current bull market is misplaced, according to
Michael Shaoul, chairman and chief executive officer at Marketfield
Asset Management.
The CHART OF THE DAY illustrates why the issue has emerged in the top
panel, which compares total margin debt at New York Stock Exchange
member firms with the value of the Standard & Poor’s 500 Index.
April’s debt was a record $384.4 billion, according to the exchange.
Lower interest rates have made the
borrowing much less expensive -- and less significant -- than it was
when the last two bull markets concluded in 2000 and 2007, Shaoul wrote
in an e-mailed note yesterday.
Investors are paying about 72 percent less interest than they were at
the 2007 peak, as displayed in the chart’s bottom panel. This estimate
was calculated by multiplying margin debt by the broker call rate,
charged by banks on similar loans to securities firms, as Shaoul did in
his note.
Companies’ rising earnings also suggest borrowing is far from
excessive, the e-mail said, because they have made stocks more valuable.
By this yardstick, the amount of margin debt has to climb 40 percent to
reach an equivalent to the two previous market peaks, even if S&P
500 company profit stays unchanged.
“Margin debt expansion will remain in place until corporate earnings
falter” or the Federal Reserve raises its target interest rate
significantly, the New York-based investor wrote. “We do not expect to
see either of these take place for a number of quarters.”" - source Bloomberg.
But corporate earnings are, we think exposed, and the rally has been as
well sustained by multiple expansions and very significant stock
buy-backs.
Reading through CLSA's weekly Greed & Fear note from the 15th of
August, written by Christopher Woods, we could not agree more with his
comments, where he indicated that risks on the S&P 500 are rising:
"What does all this mean for the American stock market? Well in one
paradoxical sense if growth in the US is not as robust as hoped for,
that means quanto easing continues which should support the equity
market. Still at some point common sense
takes over and a lack of growth is plain bearish for equities, most
particularly in the context of an American stock market which in recent
months has been driven far more by multiple expansion rather than
earnings growth. Thus, the S&P500 trailing PE has risen from 15.6x in late December to 18.4x" - source CLSA - Greed & Fear, 15th of August 2013.
For illustrative purposes, we have been plotting the growing divergence
between the S&P 500 and trailing PE since January 2012 - graph
source Bloomberg:
On top of that multiple expansion and the induced rally by central banks
liquidity injections have been boosted as well by a reduction in
denominator via stock buy-backs. The complacency in the equity space is
starting to raise our "fears" for "tears" as displayed by Deutsche
Bank's US equity strategist at Deutsche Bank graph indicating the
price-earnings ratio for the Standard & Poor's 500 with the VIX:
"Investors are becoming overly content about the prospects for stocks
after more than four years of gains, according to David Bianco, chief
U.S. equity strategist at Deutsche Bank AG.
The CHART OF THE DAY shows how Bianco reached his conclusion: by
comparing the price-earnings ratio for the Standard & Poor’s 500
Index with this quarter’s average close for the Chicago Board Options
Exchange Volatility Index. The latter gauge, known as the VIX, is based
on S&P 500 options.
Bianco’s P/E-VIX ratio closed yesterday
at 1.20. At that level, a lack of concern that share prices may fall
starts to supplant “realistic and disciplined” investing, he wrote in an Aug. 9 report.
“This complacency signal may pertain more to the derivatives market
than the equity market,” he wrote. This quarter’s closing VIX average as
of yesterday was 13.59, just above the first-quarter figure of 13.53.
The latter reading was the lowest since 2007, when a five-year bull
market came to an end, according to data compiled by Bloomberg.
While stocks have room to extend their advance since March 2009,
increased volatility is likely to accompany any further gains, he wrote.
This would allow stocks to rise relative to earnings without sending
another warning sign, the New York-based strategist wrote.
Bianco expects the index to end next year at 1,850, which is 9.2
percent higher than yesterday’s close. His projection for the end of
this year is 1,675, in line with the average among 17 strategists in a
Bloomberg survey." - source Bloomberg.
Whereas the volatility in the fixed income space has remained elevated
as displayed by the recent evolution of the Merrill Lynch's MOVE index
falling from early May from 48 bps towards the 87 bps level, the VIX,
the measure of volatility for equities has remained fairly muted - graph
source Bloomberg:
MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.
CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.
Of course when ones look at European government yields and in particular
peripheral yields, both Italy and Spain are trading towards the lowest
level since 2011 relative to German government yields - graph source
Bloomberg:
While the German 10 year government bond has moved in sympathy with the
10 year US treasuries breaking its 1.60% - 1.70% range towards 1.90%,
Spanish and Italian yields have so far remained fairly muted.
In relation to our "Fears" for "Tears", we share the same views as
Morgan Stanley, from their Credit Strategy note from the 16th of August
entitled "Working Through Our Worries", namely that Europe remains on
our top concern list:
"Why Europe is the risk we’d stay focused on
We’re relatively relaxed about higher rates and the EM slowdown, but
it’s the risk of renewed volatility in the eurozone that causes us the
most discomfort. This may sound odd, given that Spanish sovereign
spreads are at their year-to-date tights, but is based on a couple of
factors unique to this risk.
First, it enjoys especially high uncertainty: One can look to
Fed speeches and US data to inform a view of ‘tapering’. One can follow
EM currencies or commodity prices to get a sense of regional stress. No
similar metric exists for measuring the cohesion of the Italian
government or the likelihood of a rating agency downgrade.
Second, it can strike with high intensity: The large rate move
since May has so far been weathered well. No more than a handful of
European corporates are experiencing serious credit trouble from a
sharper China slowdown.
Sovereign weakness, in contrast, has repeatedly shown the ability to drive severe, broad-based weakness in our market.
Third, while it is not our base case, there are plausible reasons why a eurozone crisis could re-emerge:
Improving economic data in Europe are encouraging. Yet the ratings of
nearly all eurozone sovereigns remain on negative outlook. Debt/GDP will
likely rise and unemployment should stay high well into 2014, even if
growth ‘improves’ to ~1%. The eurozone’s ability to backstop a crisis
remains hamstrung by the continued lack of a banking union, an OMT
programme that our economists believe will be difficult to activate, and
a continued reluctance by the ECB to use QE." - source Morgan Stanley
Yes, we all know that Mario Draghi's OMT "nuclear deterrent" has yet to
be tested. But what we are concerned about is, as we indicated in our
conversation "Cloud Nine", is the lack of credit growth in peripheral countries which are most likely to be exacerbated by the upcoming AQR
As a reminder: AQR = Asset Quality Review, planned for 1st Quarter 2014
as a prelude to the ECB becoming the Single Supervisor for large euro
area banks in 2H 2014. The AQR's intent is to review banks challenged
loan portfolios and the need for capital increase.
"Until the AQR is completed and capital shortfalls identified and remedied, you cannot expect a significant pick up in lending."
One of main reason of the relative calm in the European government bond market has been the "crowding out" of the private sector.
"Although, the intention of European politicians has been to severe
the link between banks and sovereigns, in fact what they have
effectively done in relation to bank lending in Europe is "crowding out" the private sector. Peripheral banks have in effect become the "preferred lender" of peripheral governments"
It is fairly simple, in effect while the deleveraging runs unabated for
European banks, most European banks have been playing the carry trade
and in effect boosting their sovereign holdings by 30% since 2011 to
record as displayed in the below table by Bloomberg:
"Euro zone financial institutions'
sovereign holdings totaled 1.78 trillion euros in June, up from 1.4
trillion euros in December 2011. In efforts to maintain asset
values and lower auction costs, banks have increasingly supported their
sovereigns by purchasing sovereign debt, which may stop their own
associated CDSs and funding costs from rising aggressively.
Over-exposure to sovereign debt (and loans) can threaten solvency should
conditions deteriorate enough." - source Bloomberg.
In that sense the European Banking Union is more akin to a Government/Bank Union when it comes to sovereign bonds holdings.
As we indicated back in our conversation "Cloud Nine",
indeed the government is the preferred borrower when it comes to
lending as displayed in Bloomberg Chart of The Day from the 13th of
August:
"Italian banks are increasingly using liquidity to buy more
profitable sovereign debt, reducing loans to companies and households,
as Italy’s longest recession in 20 years makes lending more risky.
The CHART OF THE DAY compares the banks’ purchase of Italian government bonds and loans made to the private sector.
Italian banks increased their holdings
of the country’s debt by almost 100 billion euros ($133 billion) in the
12 months ended June 30 to a record 402 billion euros. In the same
period, loans decreased by 55 billion euros, or 3.3 percent, to 1.63
trillion euros.
“There’s a crowding-out effect,”
said Carlo Alberto Carnevale Maffe, professor of business strategy at
Milan’s Bocconi University. “The public debt is soaking up resources
from the private sector, offering higher yields on capital and a lower
investment risk, at a time in which companies and families are struggling to repay their debt.”
Italian banks, which have borrowed more
than 255 billion euros from the European Central Bank’s longer-term
refinancing program, are investing part of the liquidity obtained at
lower interest rates in short-term government bonds that offer higher
yields. That’s favored by Italy’s government, which is
seeking domestic buyers to replace lower purchases from foreign
investors so it can cover a monthly average issuance of 40 billion
euros in securities to finance its $2.7 trillion debt. At the same
time, banks are more reluctant to lend as a recession saddles them with
mounting bad loans." - source Bloomberg
Should Mario Draghi feel the urge to trigger is "nuclear" device, it will have to be "Brighter than a Thousand Suns", to quote, J. Robert Oppenheimer...
Oh well...
So when it comes to our "Fears for Tears", liquidity has always been our top concern, credit wise.
As we posited in "The Unbearable Lightness of Credit":
“Liquidity is a backward-looking yardstick. If anything, it’s an indicator of potential risk, because in “liquid” markets traders forego trying to determine an asset’s underlying worth – - they trust, instead, on their supposed ability to exit.” - Roger Lowenstein, author of “When Genius Failed: The Rise and Fall of Long-Term Capital Management.” – “Corzine Forgot Lessons of Long-Term Capital“
“Liquidity is a backward-looking yardstick. If anything, it’s an indicator of potential risk, because in “liquid” markets traders forego trying to determine an asset’s underlying worth – - they trust, instead, on their supposed ability to exit.” - Roger Lowenstein, author of “When Genius Failed: The Rise and Fall of Long-Term Capital Management.” – “Corzine Forgot Lessons of Long-Term Capital“
The recent surge in the fixed income space of May and June have indeed
been very stark reminder of the importance of liquidity. On that subject
we came across a Risk.net article entitled "The great unwind: Buy-side fears impact of market-making constraints" which struck as a perfect illustration of Roger Lowenstein's quote:
"At the start of May, as prices for US agency bonds reached what
would later prove to be a peak, one New York-based hedge fund decided to
sell its portfolio of roughly $100 million in AAA-rated mortgage-backed
securities. The fund’s senior trader
expected to be out of the position in a day, or even less. If it had
gone to plan, it would have been beautifully timed, but it didn’t go to
plan.
“You’re talking about AAA agencies – OK, with some callable features –
and you don’t expect there would be no liquidity for that kind of
instrument. The only reason I allowed us to carry that position is that,
in my mind, you should be able to blow out of it in basically a day, or
even an hour for that kind of size. But the reality was it took us a
month,” he says.
The fund initially turned to a single dealer, which bought less than
$10 million of the bonds upfront, promising to take the rest as and when
it could find bids from other clients. Over the course of the next four
weeks, the position shrank slowly, and the price of the bonds steadily
slipped. The trader declines to say how much value was given up, but he
admits the fund’s hedges did not work perfectly, and says it lost money
on the portfolio during the month. Eventually, losing patience, the fund
brought in a second bank to speed up the process.
“Effectively, there was no liquidity for that stuff. The discrepancy
between the expectation and the actual liquidity was one of the largest
I’ve ever experienced,” he says.
This fund was one of the lucky ones, selling the bulk of its
portfolio before bond market jitters turned into a full-scale rout in
the last week of May. The sell-off was triggered by the fairly innocuous
statement from Federal Reserve chairman, Ben Bernanke, that the central
bank might rein in its programme of quantitative easing. As
fixed-income investors sought to pare back the huge positions they have
built up in recent years, prices moved dramatically, triggering further
waves of selling – yields on 10-year US Treasury bonds leapt 80 basis
points in six weeks to close at 2.73% on July 5, but everything from
emerging market sovereign debt to corporate bond exchange-traded funds
(ETFs) was hit.
“I’ve never seen markets move so far on so little news,” says one
senior, London-based trader – a sentiment shared by many other market
participants.
Some banks, plus buy-side firms including BlackRock, Deutsche Asset
& Wealth Management and Fortress Investment Group, now explain this
episode in the same way: the problem was illiquidity, and the cause was
bank regulation.
New capital, liquidity and leverage rules are making it more
expensive to carry inventory, they say, meaning banks have less capacity
to take principal risk. The consequence is that market-makers were not
initially willing to absorb the supply of securities: orders were broken
into smaller clips, bid-offer spreads exploded, in some cases even
enquiries had the power to move markets. Once prices had collapsed,
demand strengthened, enabling bank trading desks to match up buyer and
seller more rapidly, and stabilising the market.
Or so the argument goes, and there is a lively debate, particularly among dealers, about how important these factors were. But the
bigger question is what happens next. As interest rates normalise,
investors that have gorged on fixed-income securities will all be trying
to cut their exposure – a prospect the chief risk officer at one US
bank’s asset management arm calls “the great unwind”. With
market-makers unable to provide the kind of liquidity many investors
are used to, he predicts a period of sustained, savage volatility, and
the head of rates distribution at one UK bank agrees: “We’ve just had a 30-second trailer for the full movie.”
For now, there is little science to back up these scary predictions,
but there are anecdotes, intuition, a lot of first-hand experience – and
some numbers.
“There’s never been a wider gap between the amount of overall product
out in the market versus dealer balance sheets. When you start looking
at the size of the institutional market and daily turnover as a function
of the dealer balance sheet, you get some pretty horrific stats,” says
Richard Prager, head of trading and liquidity strategies at BlackRock in
New York.
Others see it the same way. “There is a pent-up mismatch that has
been built as real-money asset managers have swelled in size while
dealers have reduced their inventories, and there is a real risk that
some investors may not understand the effect this structural imbalance
has on the underlying liquidity of some of those portfolios,” says Randy
Brown, co-chief investment officer at Deutsche Asset & Wealth
Management in London.
According to data compiled by the Federal Reserve Bank of New York,
the inventory of corporate bonds held by primary dealers plunged from a
high of $235 billion on October 17, 2007 to just $55.9 billion as of
March 27 this year. An even bigger drop has been seen in holdings of
agency debt, which fell from a high of $69 billion in May 2008 to $6.8
billion by March 27 – a decline of 90%.
The same trend has been seen in corporate bonds, according to Peter
Duenas-Brckovich, global co-head of credit flow trading at Nomura in
London. “If, 10 years ago, the Street was willing to hold 4.5 to 5% of
the outstanding debt, that number is now only 0.5%,” he says.
Constraint
The major constraint has been the introduction of the Basel Committee
on Banking Supervision’s new trading book capital rules – known as
Basel 2.5 – which has forced dealers to hold more capital against
trading book assets through the use of a general market risk charge
measured using a 10-day value at risk at a 99% confidence interval, a
stressed VAR charge and, for banks that model specific risk, an
incremental risk charge (IRC) (see box, The roots of the problem). But
banks also face a new leverage ratio and structural restrictions on
their ability to take proprietary trading positions – however those are
defined.
“Post-crisis, the proportion of inventory held by dealers has
diminished dramatically; collectively, dealers’ inventory is a tenth of
what it once was,” says Chris Murphy, global head of rates and credit at
UBS, and a member of the bank’s investment bank executive committee.
“Banks were complacent about housing inventory in the pre-crisis years,
and balance sheets were out of whack with the industry’s real
risk-bearing capacity. That has been corrected by the Basel capital
overlay, where warehousing credit products in the lower-rated space –
like high-yield or emerging markets – is extremely punitive. And banks
also have to comply with leverage ratios, which act as a major
constraint on balance sheet size.”
Large asset managers agree on both the cause and the effect. “Holding
securities longer term has always been challenging for dealers. Today,
constraints on funding cash inventory are even more pronounced because
of new regulations, lower credit ratings for most dealers, and
mark-to-market concerns if credit spreads widen. Dealers will assume
positions temporarily while trying to place bonds elsewhere, but I would
not expect them to offer significant additional longer-term capacity,”
says Hilmar Schaumann, chief risk officer of Fortress Investment Group
in New York.
What this means, simply put, is that
markets are likely to move further and faster when clients are selling –
and traders say the reaction to Bernanke’s comments is the perfect
example.
“He basically said, ‘At some point in the future, there is a
possibility we might think about maybe – maybe – not doing quite as much
bond buying’. And we still had a complete meltdown. That’s a lot of
movement for not a lot of news. Imagine if they’d actually changed
rates,” says the London-based head of European fixed-income trading at
one large European bank.
Another example is the reaction to the July 1 resignation of the
Portuguese finance minister. By July 3, the country’s 10-year bonds had
jumped from 6.38% to 7.46%. The price of the bonds fell around five
points – or 5% of par.
“It’s a peripheral credit that is expected to have problems, but a
five-point drop? I’ve been doing this for 20 years – the news does not
justify the move. This is not a corporate where the head of accounting
quit because of accounting fraud. This is highly suggestive of poor
liquidity in the market,” says Nomura’s Duenas-Brckovich." - source Risk.net
Moving on to the subject of complacency in the subordinated bond space,
we eagerly await the results of the AQR tests which will be conducted by
the ECB and we agree with CITI's take from their credit note from the
13th of August:
"European Union finance ministers recently reached an agreement on
several topics which should form the backbone of the European bail-in
legislation (expected to be implemented from 2015): e.g. the priority of
payments in the event of a bail-in and the creation of national based
resolution funds. Essentially, the agreement specifies a list of
liabilities which will not be bailed-in (e.g. guaranteed deposits); this list excludes equity, sub and senior debt, i.e. they are “bail-inable”.
According to our interpretation of the draft directive, national
authorities will only have the ability to inject “public” money into a
bailed-in bank once losses of 8% of total assets have already been
absorbed. In other words, for sub or senior debt not to be
bailed-in, other (presumably more junior obligations like equity)
securities would have to have already absorbed (i.e. bailed-in) 8% of
the total liabilities of the bank. What does this mean (to us at least)?
-If the equity to total liabilities
ratio in a bank were more than 8%, there would be a chance that sub debt
may not be bailed-in. However, the average equity to total liabilities
ratio in European banks is 5% and very rarely exceeds 8%, which means
that sub bail-ins appear very likely.
-The ratio of equity plus subordinated debt to total liabilities for
the average European bank is around 7%, which means that national
authorities would pretty much be forced to “fully” bail-in equity and
subordinated bondholders. Figure 4 shows the distribution of the
ratio of equity plus subordinated debt to total liabilities across
European banks.
In many cases, the ratio is below 8%. Even if the ratio is above
8%, sub debt would likely be bailedin if losses are above that level
and/or national authorities want the post “bailined” bank to have a
meaningful capital base
-What about senior debt? In the average European bank, equity plus
subordinated debt will make up around 7-8% of total liabilities, which
means that national authorities will likely have discretion not to
bail-in senior debt.
National authorities will, in our view, make use of bail-in legislations when dealing with distressed banks going forward.
We expect that bail-ins will trigger restructuring credit events in
current CDS contracts, as was the case in SNS and Bankia, and “bail-in”
credit events in the new CDS contract." - source CITI
Of course we have long voice our "Fears for Tears" for the subordinated
bond holders and it has been a recurring subject in our numerous credit
conversations. It support our long standing views expressed in our post "Peripheral Banks, Kneecap Recap, Kneecap Recap":
"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." - Macronomics - 20th of November 2011.
Back in our conversation "The Week That Changed The CDS World",
we indicated that the recent SNS case has derailed the auction process
and the validity of the current CDS subordinated contract. In the case of
SNS, because the auction used senior bonds, the recovery was around
95.5 for the bucket at 2.5 years and 85.5 for other maturities segment.
Given the payout equates to par minus recovery, a CDS subordinated
bondholder only received 14.5 (100-85.5)....so much for taking a CDS in
the first place...
"Fears for Tears"...
On a final note, German exporters should start to have as well their
"Fears for Tears" given the Chinese slowdown will continue to weigh on
German output as indicated by Bloomberg Chart of The Day:
"China’s credit squeeze is signaling a downturn in German manufacturing, according to ING Groep NV.
The CHART OF THE DAY shows that
Germany’s factory output as gauged by a manufacturing
purchasing-managers’ index has mirrored Chinese bank-lending growth
since a credit boom that began in 2008. As China’s Communist Party seeks to rein in lending on concern that wasteful investment will threaten
longer-term growth, Germany’s export-oriented manufacturers are poised to suffer.
“China’s economy is shifting from domestic investment to more of a
domestic consumption model,” said Martin van Vliet, senior euro-zone
economist at ING in Amsterdam. “If you’re a German exporter
selling machinery, that’s bad news.” China will start a nationwide audit
of public-sector debt this week as the government pressures banks to
better manage their balance sheets after the record surge in credit. The
nation’s economic growth slowed for a second quarter to 7.5 percent in
the three months ended June and the government has set a target of 7
percent a year for the five years through 2015. China hasn’t expanded at
a slower than 7.6 percent pace
since 1990.
A reduction in debt-fueled Chinese investment spending may hurt
German machinery orders in particular. Machinery sales to China last
year were valued at 16.9 billion euros ($22.5 billion), accounting for
more than a quarter of total shipments to the country, according to the
Federal Statistics Office in Wiesbaden.
German exports to China have increased at an average rate of 15.8
percent a year since 1995, more than twice as fast as the total gain.
That’s helped Germany weather the effects of the euro-area’s sovereign
debt crisis, now in its fourth year." - source Bloomberg.
"Prosperity is not without many fears and distastes; adversity not without many comforts and hopes." -Francis Bacon
Stay tuned!
The issue was that the auction could not operate due to lack of deliverable, it reminds us of a similar case with Delphi Automotive when a market maker had squeezed the market and cornered the bonds which had led to a higher recovery rate and smaller payout to the CDS holders. The markets then moved towards cash settlement to avoid some players to rig on purpose the auction process.
In the case of the SNS expropriation, the CDS mechanism has derailed somewhat the auction process, hence the need to ensure with the new contracts a smoother payout mechanism. Obviously going forward Sub CDS protection should trade wider.