Previously
on MoreLiver’s:
Credit - The Sleepwalkers
"Those who have compared our life to a dream were right... we were sleeping wake, and waking sleep."- Michel de Montaigne
As 2014, marks the anniversary of probably one of the greatest human
tragedy, namely the start of the First World War, we thought our title
would reflect one of the greatest book written on the subject on how
Europe went to war, "The Sleepwalkers: How Europe Went to War in 1914"
by Christopher Clark. In his masterpiece, Christopher Clark analyses
what caused the spark that led to the Great War. In similar fashion, we
think that there is a possibility some future historian will write an
opus on how in 2014 Europe went into deflation but, we ramble again.
In his book, Clark asserted that the Great War was an entirely avoidable
and unnecessary tragedy. "Unintended consequences" of the most colossal
sort led to the outbreak of the Great War. In similar fashion the
"credit crunch" that plunged Europe into a very deep recession and
soaring unemployment levels, we have long argued, was as well an
entirely avoidable and unnecessary tragedy.
What accelerated the "credit crunch" was the EBA's decision for banks to
reach a certain capital threshold by June 2012 (for the EBA June 2012
core tier one capital target of 9%, banks needed to raise at least 106
billion euros according to the EBA's calculations):
"If banks cannot access term funding, given the deleveraging they
ambition to do, it could put additional pressure on bank lending, in
effect reducing access to credit for the economy, namely triggering
another credit crunch in the process." - Macronomics, November 2011
We have been sitting in the deflationary camp for a while and while last
week, we argued that we could not see a significant drop in the Euro
versus the dollar unless the ECB resorted to more "unconventional
policies" such as QE. One of the main reasons we cannot fathom a rapid
depreciation of the euro comes from the current account balance of the
Euro Zone in % of GDP which continues to rise as displayed in recent
study done by French bank Natixis in a report published on the 14th of
January:
As described in Natixis note, the appreciation of the euro drives a fall
in import prices which therefore lowers inflation levels in the Euro
Zone. This does increase the deflationary pressure on the Euro zone.
Given 73% of the turnover from companies pertaining to the Eurostoxx is
coming from outside Europe, this can in turn explains the relative
underperformance of European stocks versus the S&P 500 or Nikkei
index. European stocks, in similar fashion to Emerging Markets, have as
well been the victims of the on-going "currency war".
Looking at the recent discussions surrounding the capital requirement
favored by the ECB in the upcoming stress tests, it seems it favors 6%
of retained capital, slightly above the 5% used in 2011 during the EBA
(European Banking Association) stress tests. Of course, this 6%
benchmark must been agreed by the EBA which will coordinate the exams.
The slight increase in capital requirement is still below the
Comprehensive Assessment (balance sheet review), where the ECB will be
using a minimum capital requirement of 8% to evaluate the 130 euro-area
lenders under review. The ECB will only become a full member of the EBA
when its starts its supervision role later in 2014.
Still on the regulatory front, the Basel Regulators recent ease of the
leverage-ratio rules for banks have not improved financial stability for
the near future as reported by Jim Brundsen in Bloomberg on the 13th of
January in his article "Basel Regulators Ease Leverage-Ratio Rule for Banks":
"Banks such as BNP Paribas SA, Bank of America Corp. and Citigroup
Inc. called for amendments to the draft leverage rule published last
year, saying it would adversely affect economic growth and job creation,
make it more expensive for governments to sell their debt and give
banks incentives to invest in riskier assets." - source Bloomberg.
We touched at length the subject of banks equity buffers in March 2013 in our conversation "Dumb buffers":
"Back in September 2011, we quoted Dr Jochen Felsenheimer from asset management company "assénagon" now called "XAIA", we would like to quote him again looking at the current context:
"Banks employ too much debt, because they know that they will ultimately be bailed out. Governments do exactly the same thing.
Banks have fought bitterly against increasing equity buffers which is
the cheapest and easiest way to recapitalize banks. Why? Because
allowing high payouts to shareholders, namely bank employees in many
cases, allows financial institutions to raise their leverage: "Focus
on ROE is also a reason bankers find hybrid securities, such as debt
that converts to equity under some conditions, more attractive than
equity." - Anat R. Admati."
And if leverage is the issue, when it comes to providing loans to the
real economy, although there has been some improvement in the euro-zone
fragmentation in lending rates between core Europe and the periphery,
resolving this divide has yet to be achieved as displayed by Spanish
loan rates which have been jumping up as of late:
"ECB President Mario Draghi noted, in comments following November's
rate cut, that while euro-zone fragmentation had been improving since
mid-2012, progress had foundered since late summer. The latest data on
Spanish loan pricing, often cited as a measure of the North-South
divide, paint a dark picture. The two-month jump is the biggest increase
in more than a decade and will likely stoke fears about this divide,
potentially prompting talk of a rate cut." - source Bloomberg.
This fragmentation can as well be ascertained from this graph displaying
the interest rate on MFI loans to non financial corporations (1-5 year
maturity,
As far as we can see the European "Sleepwalkers" can either provide
sufficient ammunitions via the carry trade for banks to rebuild their
capital and deleverage, increasing in the process and not severing their
fate with their sovereigns, but cannot provide at the same time the
necessary credit support to boost economic growth sufficiently in the
periphery, therefore not reducing the solvency issue.
For the time being, the situation is one of stability as indicated by
the improving sentiment indicator in the Eurozone and Eurozone Real GDP
which should improve at least in the short term - graph source
Bloomberg:
Due to the fragility of this "recovery", for a change, the less
restrictive approach regulatory attitude in relation to banks is
supportive of the macro picture.
We do agree with Bank of America Merrill Lynch Alberto Cordara when it
comes to Italian banks from his recent note from the 15th of January
entitled "Rules & Recovery":
"Sovereign spreads on a normalisation trail
Italy was hit hard by the crisis, suffering from the malaise spread
by the Greek debacle, the collapse of the Spanish real estate market and
in our view, the political quagmire of mid-2011. Italy, the
third-largest Eurozone economy, has a strong and diversified industrial
backbone, individual wealth is high and households are underleveraged.
So far, the Italian government has seemed reluctant to implement
structural reforms, which have come under fire from the traditional
lobbies. In our view, the recent change of guard in the Democratic Party
bodes well for reforms, in particular for the labour market, which is
in need of modernisation. We think this may lead to further tightening
of Italy’s spreads (still higher than in mid-2011).
A punitive regulatory attitude would be plainly ineffective
As we highlighted in Breaking with tradition 18 October 2013 Italian
banks’ lending businesses are currently loss-making and are thus
subsidised by profits from elsewhere (AM, product placings, sovereign
carry trades). Banks have been damaged by i) high sovereign spreads
affecting their ability to issue term funding, and ii) low ECB rates
which destroyed their ability to extract margins from depositors. Both
variables are exogenous to banks (i.e. not related to their credit
worthiness). We do not believe an increase in capital requirements would
help address these issues.
Domestic authorities set out a favourable backdrop
We believe that the best way to reactivate the lending cycle is to
allow banks to extract more profits, loosen capital requirements and (to
a degree) front-load future losses. Recent steps by Italy’s authorities are supportive allowing full tax deductibility of credit losses,
a shortening of the DTA amortisation cycle (from 18 to five years), and
turning existing IRAP goodwill DTAs into tax receivables, while AFS
sovereign losses will continue to be sterilised. Further, banks may
ultimately be allowed to benefit from the revaluation of BOI stakes. On
the other hand, it stands to reason that banks will be pushed to a
credit clean up in 4Q13 as part of the AQR." - source Bank of America Merrill Lynch
When it comes to Italy Bank of America Merrill Lynch makes the following important points:
"In contrast with the rest of the Eurozone, Italy remained in
recession in Q3 with unemployment at 12.5% and GDP growth contracting by
0.1% (-1.9% yoy) albeit at a softer pace (Q2: -0.3%; Q1: -0.6%). The
overall framework for recovery remains fragile but signs are emerging.
Business confidence is improving steadily and industrial production
turned positive in November (+1.4% after 26 consecutive months of
decline). On latest available data (June 2013), household gross wealth
declined by 1% mainly as a result of a fall in house prices, but this
was also counterbalanced by a fall in financial debt that currently
stands at around 65% of disposable income compared with about 80% in
France and Germany and 120% in Spain. Only 25% of Italian households
have financial debt and the share of financially vulnerable households
is low (3%). Italy’s historically high saving rates have contributed to
the formation of a relatively high stock of wealth and a high degree of
wealth dispersion among the population." - source Bank of America Merrill Lynch
In relation to Italian banks, the situation is much more different than
the poor lending standards and risky loans and real estate exposure
which decimated the Irish and Spanish banking sector as pointed out by
Bank of America Merrill Lynch's note:
"Capital not the answer although politically appealing
In theory, more capital may help reduce funding costs for those banks
that are issuing at a premium to sovereign spreads and potentially
reactivate lending to the economy. However, experience suggests that the
end result may be exactly the opposite. Higher capital requirements
mean that banks are pushed to enforce stricter lending criteria and will
adopt suboptimal practices to satisfy the regulator and avoid
shareholder dilution. This goes beyond the check dates outlined by the
regulator as there is always the risk that the regulator may come back
asking for more (this has happened every time…).
The Italian case is very telling: in early/mid-2011, most Italian
banks (BP, UBI, ISP and MPS) carried out massive recapitalisations,
which proved completely ineffective as funding costs skyrocketed when
the price of Italy’s sovereign bonds hit the skids in July 2011. In other words, banks
are price-takers and are impacted by Italy’s sovereign – probably a
different situation to in Spain and Ireland where poor lending standards
and the collapse of the real estate markets were the very epicentre of
the crisis. This is also very different from the US situation
where TARP was introduced and is often cited as an example of
regulatory foresightedness, a panacea for all ills. Italy’s
problem resides with the country’s high level of public debt and
disappointing ruling class, not with bad banks’ underwriting nor obscure
asset values (subprime, etc.)." - source Bank of America Merrill Lynch
While the "stabilisation" is a welcome respite in the Euro-zone, our
European "Sleepwalkers" should not take this recovery for granted and
continue to push forward for some additional much needed structural
reforms, in particular for France which as of late has been
significantly lagging its European peers. Nevertheless the increase in
European Consumer Confidence has been reflected as well in the EU27 new
passenger car registration increases - graph source Bloomberg:
Credit wise, the correlation between the US, High Yield and equities
(S&P 500) since the beginning of the year is back on track. US
investment grade ETF LQD is more sensitive to interest rate risk than
its High Yield ETF counterpart HYG - source Bloomberg:
What caught our attention is Credit Indices, when one look at the
positioning of credit investors, as displayed in a recent note from
Morgan Stanley entitled "The Future of the CDS Market", US investors are
net long credit risk in the US, particularly in Investment Grade via
the CDX IG index:
"In terms of positioning, investors are net long credit risk in the
US, particularly in IG (via a net short position of $40 billion in CDX
IG). As such, there is some demand from index users to be simply long
the market in an unstructured form via the indices." - source Morgan Stanley.
2014, is indeed a continuation of 2013, namely that the liquidity
backstop continues to provide ample support for a continuation of carry
trades, releveraging and an increase in the search for yield in the
riskier part of the credit space as indicated by Lisa Abramowicz in
Bloomberg on the 15th of January in her article entitled "Firms Tripling Junk Returns Lure Most Since '07":
"Firms that use borrowed money to lend to the smallest and riskiest
companies are attracting cash at the fastest pace since before the
crisis, wooing buyers with returns that are triple those of the broader
junk-debt market.
Investors from retirees to wealthy individuals plowed $4.1 billion
into publicly traded business development corporations last year, the
most since 2007, as the firms known as BDCs gained an average 16.4
percent. The entities are juicing returns by borrowing about 50 cents
for every dollar raised from equity investors, up from 36 cents in 2011,
as Keefe, Bruyette & Woods predicts average gains of as much as 13
percent this year.
BDC shareholders are wagering that an accelerating economy will
bolster earnings for companies that are the most vulnerable to default,
even as the Federal Reserve starts scaling back the unprecedented
stimulus that suppressed borrowing costs. After shunning funds that used
derivatives and leverage in the years after the 2008 credit crisis,
buyers are returning to pad yields that reached record lows last year
while seeking shelter from bonds that face losses as rates now rise." - source Bloomberg.
So we wonder if investors are not indeed indulging themselves into
"sleepwalking", although generally sleepwalking cases consist of simple,
repeated behaviours, there are occasionally reports of people
performing complex behaviours while asleep.
On a final note, and in relation to our European Sleepwalkers, the
recent surge of the EONIA and Euribor, seems to point to some additional
concerns when it comes to credit supply in the Euro area as shown in
this Bloomberg graph highlighting the rise of the EONIA index and
Euribor:
"The decline in excess liquidity in the euro region, driven by a
decision by southern European banks to repay LTRO cash early, is raising
key short-term interest rates, threatening the supply and cost of
credit to Europe's struggling small- and medium-sized companies. A near
doubling of one-month Euribor and EONIA since late November poses a
growing threat, even though the ECB has pledged to do whatever
necessary, including further rate cuts, to defend the euro zone's
recovery." - source Bloomberg.
Let's hope Mario Draghi is not sleepwalking towards the deflationary slippery slope.
"Each man should frame life so that at some future hour fact and his dreaming meet." - Victor Hugo