Thursday, 31 July 2014

Credit - Nimrod

"I made Nimrod great; but he built a tower in order that he might rebel against Me" (Ḥul. 89b). 

While looking at Spanish 10 year government bonds "Bonos" breaking the 2.50% level, a level not seen since 1789 and French OAT 10 year at 1.51%, a level as well not seen since 1746 in conjunction with the German bund 10 year making new record low at around  1.119%, it seemed to us a clear validation of the "japanification" process we have long been depicting in our numerous credit conversations namely of a deflationary process taking place particularly in the light of the recent print of the European CPI estimate YoY coming at 0.4% in conjunction with very weak CPI pointing towards outright deflation for both Spain and Italy.

The European bond picture and the "japonification" process - graph source Bloomberg:

While we have already used a reference to central bankers' deception tricks in our conversation "Deus Deceptor" (being an omnipotent "deceptive god" as posited by French philosopher René Descartes), we decided this week to venture towards a religious analogy in our chosen title. We already touched on the "Omnipotence Paradox" back in November 2012 when it comes to central bankers and the market's perception of their "omnipotence" in sustaining asset price levels. In fact, last week we mused around  the notion of "perpetual motion" and its physical impossibility. As far as deities and omnipotence go:
"1. A deity is able to do absolutely anything, even the logically impossible, i.e., pure agency.
2. A deity is able to do anything that it chooses to do.
3. A deity is able to do anything that is in accord with its own nature (thus, for instance, if it is a logical consequence of a deity's nature that what it speaks is truth, then it is not able to lie).
4. Hold that it is part of a deity's nature to be consistent and that it would be inconsistent for said deity to go against its own laws unless there was a reason to do so.
5. A deity is able to do anything that corresponds with its omniscience and therefore with its worldplan." - source Wikipedia.

In continuation to the past reference of "omnipotence" in regards to central bankers actions, we decided to venture towards the biblical character Nimrod when choosing this week's title as he is generally considered to have been the one who suggested building the Tower of Babel and who directed its construction to challenge the "almighty".

By birth, Nimrod had no right to be a king or ruler (such as central bankers). But he was a mighty strong man, and sly and tricky (such as Mario Draghi, Janet Yellen and her predecessor Ben Bernanke), and a great hunter and trapper of men and animals (in their relentless hunt for yield). His followers grew in number, and soon Nimrod became the mighty king of Babylon, and his empire extended over other great cities, but that's another story and we ramble again.

In this week's conversation we will look at the increasing risk in the much "crowded" credit market, namely investment grade and high yield which could be impacted by the rise in interest rate volatility as well as a rise in default rates. We will also look at the Banco Espirito Santo (BES) story which is a continuation of what we discussed recently in our conversation "The European Polyneuropathy":
"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.

When one looks at the "new credit Tower of Babel", which construction has no doubt been directed by our "omnipotent" central bankers reaching dizzying height (or spread compression that is), we wonder how long this mighty tower will continue to hold given the recent outflows in the High Yield ETF HYG and the disconnect with stocks as depicted in the below Bloomberg graph warrants caution we think for our "equities friend":
HYG and JNK are the two largest High Yield ETFs accounting for 80% of assets.

Given Investment Grade is a more interest rate volatility sensitive asset, whereas High Yield is a more default sensitive asset what warrants caution for both we think is, the risk of rising interest rates for the former and the risk of rising default rates for the latter. And, as we indicated in November 2012 in our conversation "The Omnipotence Paradox", zero growth should normally led to a rise in default rates, in that context, a widening in credit spreads should be a leading indicator given credit investors were anticipatory in nature, in 2008-2009, and credit spreads started to rise well in advance (9 months) of the eventual risk of defaults. What credit investors forget in this deflationary environment, is that, as we argued in November 2011 in a low yield environment, defaults tend to spike and it should be normally be your concern credit wise (in relation to upcoming defaults) for High Yield, not inflation.
(For a more in depth analysis on credit returns and valuation, please refer to our friend Rcube's guest post "Long-Term Corporate Credit Returns").

In relation to the outflows seen in the aforementioned High Yield segment of the market as illustrated by the above Bloomberg Graph, the recent note from Bank of America Merrill Lynch entitled "Greed Retreat" from the 24th of July indicates the largest weekly outflows from HY bonds since June 2013:
-source Bank of America Merrill Lynch

When it comes to our "new credit Tower of Babel" analogy, bonds ETFs in Europe have swollen as reported by Bloomberg by Alastair March on the 25th of July in his article entitled "Bond ETFs Swell in Europe as Debt Trading Slows":
"Bond buyers are pouring record amounts of money into exchange-traded funds in Europe that buy debt as central bank largess boosts demand and makes investors less willing to part with their fixed-income assets.
 Investors deposited more than $16 billion into ETFs that purchase debt from high-yielding corporate notes to sovereign bonds, almost quadruple the amount in the same period last year, according to data compiled by Bloomberg. BlackRock Inc., the world’s biggest provider of ETFs, estimates bond-fund inflows will climb to about $20 billion by year-end.
The unprecedented era of near-zero benchmark interest rates that’s fueling demand for debt shows no signs of abating in Europe, with European Central Bank President Mario Draghi pledging to keep borrowing costs at record lows for an extended period. Deposits into bond ETFs across the region are growing twice as fast as flows in the U.S. as Federal Reserve Chair Janet Yellen said rates in the world’s largest economy may rise sooner than it currently envisions if the labor market improves." - source Bloomberg

But, with volatility making a come back in the US Treasury space with US 10 year touching 2.59% following the better than expected US macro data as well as four-week average of jobless claims, considered a less
falling to 297,250, the lowest since April 2006, from 300,750 the prior week, given the spread compression seen in the Investment Grade space, there is no real buffer left to support a sudden rise in interest rate volatility, putting the YTD bond flows in Investment Grade at risk. As Bank of America put it in their flow report "quality" is a crowded trade:
"Quality-crowded: YTD bond flows show IG bonds (31 straight weeks of inflows) most at risk from crowding (Chart 2)
31 straight weeks of inflows to IG bond funds ($4.2bn)" - Source Bank of America Merrill Lynch

In true Japanese fashion, credit in a deflationary environment does indeed tend to outperform as we have previously discussed in our conversation from April 2012 entitled "Deleveraging - Bad for equities but good for credit assets":
"As volatility of credit is much lower than equities, investors could have taken a suitable amount of leverage on credit to convert this into high absolute returns"

As per our conversation "Deus Deceptor:
"The "japonification" process in the government bond space continues to support the bid for credit, with the caveat that for the investment grade class, there is no more interest rate buffer meaning investors are "obliged" to take risks outside their comfort zone (in untested areas such as CoCos - contingent convertibles financials bonds)."

When it comes to US default, the trend is up as indicated by Fitch's recent report on the matter in their note entitled "Another Jump in US HY Default Rate Looms"
"A potential bankruptcy filing from another struggling giant, Caesars Entertainment Operating Co., would propel the trailing 12-month US high yield default rate to 3.4% from its June perch of 2.7%, according to Fitch Ratings. With its $12.9 billion in bonds in Fitch's default index, the gaming company's impact on the default rate is pronounced - similar to Energy Future Holdings' (EFH) April bankruptcy. Caesars also adds to notable trends of busted LBOs and the exclusive camp of serial defaulters.

There have been 10 LBO related bond defaults thus far in 2014, compared with nine for all of 2013. The failed LBOs affected $21.8 billion in bonds this year and 26% of all bond defaults since 2008. Caesars would bring the latter tally to 29%. In addition, a Caesars filing would follow two prior restructurings via distressed debt exchanges (DDEs). Since 2008, 24% of issuers engaged in DDEs have subsequently filed for bankruptcy.

June defaults included Affinion Group, Allen Systems Group, MIG LLC, and Altegrity Inc., bringing the year-to-date high yield default tally to 20 issuers of $23.7 billion in bonds versus an issuer count of 19 and dollar value of $8.4 billion in first-half 2013. July defaults have so far included Essar Steel Algoma and Windsor Petroleum Transport.

Notwithstanding the likes of EFH and Caesars, the otherwise low default rate environment has some significant near-term support. Banks continue to ease standards on commercial and industrial loans, according to the Federal Reserve's Senior Loan Officer Survey, and they report stronger demand for such loans. The latter trend is an especially important gauge of economic activity and is consistent with the widely held view that GDP will improve in the second half of 2014.

At midmonth, approximately $33 billion in high yield bonds were trading at 90% of par or less - a relatively modest 2.9% of the $1.1 trillion in bonds with price data." - source Fitch Ratings-New York-29 July 201 - "Another Jump in US HY Default Rate Looms"

Given High Yield is a default sensitive asset class, no wonder the rising level of the default rate has triggered some outflows in the High Yield ETFs space as discussed above.

Our new Nimrod of the central banking world has no doubt pushed further down the line the day of reckoning as the "new credit Tower of Babel" continues to rise. For instance the recent CLO weekly report from Bank of America Merrill Lynch from the 18th of July entitled "Credit Outlook Benign Despite Loosening Lending Standards" indicates the following:
Credit Outlook Benign Despite Loosening Lending Standards
"Leveraged loan markets posted total returns of 2.6% and 2.9% in H1 in the US and Europe respectively, as compared to 5.4% for the HY markets. Up to the end of H1, institutional new-issue volumes totaled $242bn and €39bn in the US and in Europe. Repayment rates were subdued in the US in H1 with many deals having already refinancing in 2013, but hit a record high in Europe as many borrowers took advantage of favorable lending conditions to refinance their debt. If we look at the average leverage statistics for deals issued both in the US and Europe as well as the percentage of issuance that are cov-lite and second-lien, we clearly see that lending standards have loosened since the credit crunch. Despite this, the credit outlook for the loan markets remain benign largely due to a maturity wall that has been pushed out following all the refinancings that have taken place over the last two years and continued improvements in the economy." - source Bank of America Merrill Lynch

When it comes to illustrating our "new credit Tower of Babel" analogy we think that the below graphs from Morgan Stanley's Leverage Finance Chartbook from the 28th of July clearly shows our point:

- source Morgan Stanley

Moving on to the subject of Banco Espirito's woes, it is indeed the continuation of our 2011 prognosis, namely that weaker peripheral banks shareholders and bondholders would face further pain and losses down the line as reminded in our recent conversation "The European Polyneuropathy". The continuous widening in the CDS spread of Banco Espirito Santo illustrates the difficulties of the 2nd largest Portuguese lender:
- graph source S&P Capital IQ

The bank posted a €3.6 billion first-half net loss seeing its market capitalization falling to €1.2 billion. BES stock price - graph source Bloomberg:

Of course the junior subordinated bondholders were not spared either as it looks even more likely that a debt-to equity swap (in similar to what already happened to BES a couple of years ago) is in the pipeline - graph source Bloomberg:

Given the Bank of Portugal requires the lender to raise the money after it set aside 4.25 billion euros for bad loans in the first half, cutting its common equity Tier 1 ratio to 5 percent, below the 7 percent regulatory minimum, you can expect subordinated bondholders to face the Dutch SNS treatment, namely being wiped-out during the recapitalization process needed.

When it comes to the capital needed for the troubled BES, Bank of America Merrill Lynch in their note from the 28th of July entitled "Muddle, toil and trouble" put the capital needs at €6.5 billion but that was when the market cap was at €2.5 billion. Today it is 50% lower:
"Quantum of capital = substantial compared to market cap
BES’s capital needs are potentially substantial, we believe. First, there is the direct exposure to the Espirito Santo Group (GES) of up to €2bn. We think it would be best to adopt a ‘provide now, recover later’ strategy with this to be credible. Second, there is the Angola unit. This subsidiary is clearly in difficulty. Some relief came today with press reports that Angola would basically nationalise BESA but also repay the €3.2bn credit line BES had granted to its subsidiary ‘over time’ which we didn’t find that convincing. We think there is a world of difference between lending €3bn to a controlled subsidiary versus a Government-entity in Angola and would expect that to be reflected in the marks on the equity and debt exposures – perhaps at least another €1bn here at risk? Third, we are mindful of the large book of restructured loans for BES’s conventional lending and the low provisioning rate here which we think also is a risk ahead of the upcoming AQR. This is before we consider other third party risks, undeclared exposures or more contingent risk from investors who could claim that BES mis-sold them GES paper. We estimate a starting point of €4bn of potential capital needs, without the benefit of any tax effects. These compare with a €2.5bn market value today. In any case, a large recap number is required, in our view, for the market to turn the page on this affair."  - source Bank of America Merrill Lynch

What is of course of interest is that Junior Subordinated debt only represents €1.2 billion. When it comes to confidence, which is the name of the game in this credit story, a lot of investors believe that BES senior debt will be spared this time again as indicated in the Bank of America Merrill Lynch note:
Lots of people are telling us that in BES, senior is ‘the trade’. Many of our investor interlocutors also appear to have done well out of buying BES senior – even if it is based on the simple equation that ‘senior won’t be touched’ in any scenario. This facile assertion may or may not prove to be correct. In any case, the trade has worked – for those who bought at the lows. At current levels, senior is less compelling in any case, we think – there are cheap AT1 securities that offer the yield and the cash price appreciation but potentially with less headline risk, for example.
If the market really believed the ‘senior won’t get touched’ theme, we would not have, we think, the sharply inverted credit curve that prevails for cash senior bonds – if senior isn’t touched, the inverted curve doesn’t make sense. 
Our base case is that there will not be a rush to bail-in senior under most scenarios but that the capital needs of BES are potentially high which could test this proposition. We are not rushing to load up on ‘less risky’ senior as we still lack sufficient data to be confident about outcomes, even the ‘senior won’t get burned’ scenario. We are also concerned about senior in the context of what might be a less than convincing quantum of capital raised by the bank and what the bank will look like in the future. But clearly, the shorter-dated seniors would be the first port of call if we get clarity on the bank’s future." - source Bank of America Merrill Lynch

We think the only reason senior could be spared would be in a "Dexia scenario" with the government taking in effect control of the bank. If the solution has to remain "private", then we do agree with Bank of America Merrill Lynch's take that an inverted credit curve and a spiking senior CDS spread indicates trouble ahead in particular in the light of the capital needed to restore confidence in the ailing Portuguese lender. As a reminder, BES debt distribution as shown in our conversation "The European Polyneuropathy":
Subordinated bonds cushion is not material enough in the light of the capital needed. "Bail-in" for senior bondholders likely? Possible and probable outcome unless the state gets involved. So either the state gets involved or the senior bondholder gets it....we think.

On a final note, and as we stated recently, the much vaunted US "recovery" depends on an acceleration in wage growth. We have yet to see this trend coming to fruition as displayed by Bloomberg's recent Chart of the Day:
"Miserly pay increases for working Americans back Federal Reserve Chair Janet Yellen’s view that
inflation isn’t about to accelerate, making the case for continued central bank stimulus.
The CHART OF THE DAY shows wage growth remains stuck around 2 percent a year, where it’s been since the recession ended five years ago, even as the Fed’s preferred measure of inflation has recently picked up. Slack in the labor market, including people in part-time positions because they can’t find full-time jobs and those who have stopped searching for work because they are discouraged over prospects, probably means it will be difficult for earnings to accelerate.
“Inflation doesn’t happen with lots of slack and when wage growth falls behind,” said Jonathan Wright, an economics professor at Johns Hopkins University in Baltimore who worked at the Fed’s division of monetary affairs from 2004 until 2008.
Yellen told Congress today that the Fed needed to press on with monetary stimulus because “significant slack remains in labor markets,” while inflation is projected to be between 1.5 percent and 1.75 percent this year. The difference between the underemployment rate, which takes into account discouraged workers and part-timers who want to work a full day, and the unemployment rate was 6 percent in June, compared with a 3.8 percent average from 1994 through 2007.
Critics of central bank policy, such as Harvard University’s Martin Feldstein, have argued the Fed is already behind in fighting a coming surge in price gains. Feldstein, a former chairman of the White House Council of Economic Advisers, said in June “we are facing a problem of rising inflation” and the Fed is “probably going to respond too weakly, too slowly.”
“Martin Feldstein and others have been warning since 2008 that accommodative monetary policy would lead to a repeat of the 1970s,” said Wright. “This prediction has clearly been false.” - source Bloomberg.

"Do you wish to rise? Begin by descending. You plan a tower that will pierce the clouds? Lay first the foundation of humility." - Saint Augustine

Stay tuned!

Tuesday, 22 July 2014

Credit - Perpetual Motion

"Oh ye seekers after perpetual motion, how many vain chimeras have you pursued? Go and take your place with the alchemists." - Leonardo da Vinci, 1494
Looking at the continuous new highs registered by the Dow Jones, we reminder ourselves of the quest of many scientists for perpetual motion when choosing this week's title:
"Perpetual motion is motion that continues indefinitely without any external source of energy. This is impossible in practice because of friction and other sources of energy loss. A perpetual motion machine is a hypothetical machine that can do work indefinitely without an energy source. This kind of machine is impossible, as it would violate the first or second law of thermodynamics." - source Wikipedia
Given that by now it is fairly evident that the Fed's balance sheet extension has had a significant impact on the performance in risky assets in general and the S&P 500 in particular as displayed in the below graph from Société Générale's recent report entitled "20 charts to understand the fragile equilibrium of US financial markets" published on the 15th of July, we wonder if indeed our "omnipotent" central bankers do not think they have indeed surpassed Leonardo da Vinci and invented "perpetual motion" in financial markets:
But we reminded ourselves of Adam Smith's quote in relation to real "price" formation:
"Labour was the first price, the original purchase - money that was paid for all things. It was not by gold or by silver, but by labour, that all wealth of the world was originally purchased."
Despite the fact that successful perpetual motion devices are impossible in terms of the laws of physics, the pursuit of perpetual motion remains popular particularly in the US central banking space we think.
So we decided to "ramble" around the definition of perpetual motion in financial markets and the lack of "labor participation" in the current on-going Fed induced rally when carefully choosing our title and came up with this:
"The Fed's perpetual motion machine of the first kind produces "income" without the input of "labor". It thus violates the first law of "thermo economics": the law of conservation of labor." - Macronomics
In fact the Fed's conundrum can be seen in the lag in wage growth given nominal wages are only up 2% yoy whereas real wage growth remains at zero. Unless there is some acceleration in real wage growth which would counter the debt dynamics and make the marginal-utility-of-debt go positive again (so that the private sector can produce more than its interest payments), we cannot yet conclude that the US economy has indeed reached the escape velocity level.

If a country has 100% debt to GDP, it means that this country has roughly bought growth at a 2% rate for 50 years which is the case for France given the last time the books were balanced was 1974. 
In this week's conversation we will discuss around the risks of "hyper-deflation" happening as well as looking at the potential trajectory during the summer for US yields.
As we have argued in our conversation the "Molotov Cocktail":
When somebody has too much debt and cannot reimburse it, how do you bail him out? Obviously by restructuring his debts, which imply losses for his creditors.

But when one lends him more money in order for him to pay back what he owes, he is not bailing him out but rather pushing him in a bigger hole! The game until now has been to "print" more money and to add more debt on the shoulders on the indebted ones, to gain some time in the hope that growth will resume and reduce de facto the weight of the existing debt burden and the additional new debt issued to support the initial debt troubles.

This is a big misunderstanding of debt dynamics and its effects on the economy. When debt becomes too big, which it is now the case in many parts of Europe, the servicing drains all the available cash flows and reduces the growth potential."

Credit dynamic is based on Growth. No growth or weak growth can lead to defaults and asset deflation. We hate sounding like a broken record but: no credit, no loan growth, no loan growth, no economic growth and no reduction of aforementioned budget deficits and debt levels. 

What we are of course concern in this much vaunted "Perpetual Motion" infatuation in financial markets is that we are still sitting tightly in the deflationary camp. In fact we expected further yield compression on US Treasuries as discussed in our conversation "the Vortex Ring" back in May this year:
"The lack of "recovery" of the US economy has indeed been reflected in bond prices, which have had so far in 2014 in conjunction with gold posted the biggest returns and upset therefore most strategists' views of rising rates for 2014 (excluding us given we have been contrarian)." - Macronomics

In our conversation"The Coffin Corner" we indicated the following:
"We found most interesting that the "Coffin Corner" is also known as the "Q Corner" given that in our post "The Night of The Yield Hunter" we argued that what the great Irving Fisher told us in his book "The money illusion" was that what mattered most was the velocity of money as per the equation MV=PQ. Velocity is the real sign that your real economy is alive and well. While "Q" is the designation for dynamic pressure in our aeronautic analogy, Q in the equation is real GDP and seeing the US GDP print at 2.5% instead of 3%, we wonder if the central banks current angle of "attack" is not leading to a significant reduction in "economic" stability, as well as a decrease in control effectiveness as indicated by the lack of output from the credit transmission mechanism to the real economy."
So seeing the 1st quarter US GDP print shocker at -2.9% made us wonder about the control effectiveness of the Fed. We can relate to some of the interesting points developed by Shelby Henry Moore III in his Bell Curve Economics long post
"In a vicious feedback spiral, as the GDP shrinks, the private sector income shrinks and needs more debt (or government subsidies) to pay the interest on prior debt, but the additional government debt spending destroys more of the useful production and capital of the private sector. The only way to make the marginal-utility-of-debt go positive, is to decrease the debt load back to a level where the private sector can produce more than its interest payments. At this terminal phase, both increasing or decreasing M (debt), shrink the GDP, i.e. hyper-deflation." - Shelby Henry Moore III.
Of course this is why extended QE in the US and the launch of QE in Europe would be highly destructive we think and could potentially lead to "hyper-deflation". 

When it comes to deflationary pressures we have been tracking the events in the shipping industry with great interest and in particular the numerous prices increases in the Drewry Hong-Kong-Los Angeles Container Rates - graph source Bloomberg:
"Drewry publishes its weekly Hong Kong-Los Angeles 40-foot container rate benchmark on Wednesday mornings EST. The benchmark provides insight into the price to ship a container across one of the busiest trading lanes and is therefore used as a proxy for the market. It fluctuates with changes in liner supply-and-demand dynamics and rate surcharges." - source Bloomberg
Another shipping indicator we have been following is of course the Baltic Dry Index as oversupply of vessels keeps hire costs below break-even levels. The index dropped 29.4% on average in 2Q from 1Q and  is 69.8% lower than the 10-year historical 2Q average, yet is 8.8% higher than 2Q13 levels. Panamax vessels declined 40.1% on average sequentially, and were down 19.6% yoy in 2Q.- graph source Bloomberg:
"The Baltic Dry Index, which tracks the costs of moving dry bulk freight via 23 seaborne shipping routes, has averaged 32.5% higher yoy this year through July 16. The index is a barometer of the health of the dry-bulk industry, as well as the broader global economy. It has declined roughly 34.5% yoy and down 66.4% from the recent December peak. The index should begin to rebound as seasonal trends, such as grain exports out of South America, take hold." - source Bloomberg
For us shipping is a leading deflationary indicator as we have argued in March 2012: 
"He who rejects restructuring is the architect of default." - Macronomics.
As we have argued in our conversation  in September 2012 "Zemblanity" (being "The inexorable discovery of what we don't want to know"):
"By keeping interest low to promote investment, like the Fed is currently doing, full employment would therefore be "attainable". For Keynes, the velocity of money would move together with the level of economic activity (and the interest rate)."
 As a reminder:
Our core thought process relating to credit and economic growth is solely based around the very important concept namely the accounting principles of "stocks" versus "flows":
"We mentioned the problem of stocks and flows and the difference between the ECB and the Fed in our conversation "The European issue of circularity", given that while the Fed has been financing "stocks" (mortgages), while the ECB is financing "flows" (deficits). We do not know when European deficits will end, until a clear reduction of the deficits is seen, therefore the ECB liabilities will have to depreciate."
Credit growth is a stock variable and domestic demand is a flow variable. We always asked ourselves the following when it came to the Fed's policies:
"Does the end (lowering unemployment levels) justify the means (increasing M) or do the means justify the end (deflationary bust)?"
Back in our September 2012 conversation we came across this comment from a participant on a macro research forum from a prominent global research firm and we did find it very appropriate in relation to our past title analogy, namely "Zemblanity" and thought we had to share it at the time given we are at present discussing "Perpetual Motion" (which is impossible):
"Isn't QE3 in one sense a blow to the essence of America's prosperity, free markets and with that efficient capital allocation? Setting a target for unemployment rate by running the printing press sounds a lot like a planned economy. It might get us to the target (if not the drop in participation rate eventually will) but with that the economy risk be even more similar to Japan? Have we become so short sighted and spoiled that we can't face the hard facts of our previous reckless childish behavior? I can't think of any time in history when avoiding the truth ever was a sustainable choice. Only history will tell but FED, ECB, BOJ and BOE (soon BOC?) all being in the same boat makes you worried about unintended consequences.... I'm 100% long risk for the moment but long term I think this takes us further from a sustainable world."
And of course the credit "japonification" process has clearly been set in motion.
When it comes to our contrarian take on US yields since early January 2014 we argued the following in our conversation "Supervaluationism" back in May this year it comes from us agreeing with Antal Fekete's take from his paper "Bonds Defy Dire Forecasts but they are not defying logic":
"The behavior of the bond market has been consistent with Keynesianism. By his compassionate phrase “euthanasia of the rentier” Keynes meant the reduction of the rate of interest, to zero if need be, as part of the official monetary policy to deprive the coupon-clipping class of its “unearned” income. Perhaps it is not a waste of time to repeat my argument why, in following Keynes’ recipe, the Fed is acting contrary to purpose. While wanting to induce inflation, it induces deflation.
The main tenet of Keynesianism is that the government has the power to manipulate interest rates as it pleases, in order to keep unemployment in check. Keynes argued that the free market economy was unstable as it was open to the swings of irrational investor optimism or pessimism that would result in unpredictable and wild fluctuation of output, employment and prices. Wise politicians guided by brilliant economists − such as, first and foremost, himself  −  had to have the power “to prime the pump” (read: to pump up the money supply) as well as the power to “fine-tune” (read: to suppress) the rate of interest. They had to have these powers to induce the right amount of spending needed to put people to work, to entice entrepreneurs with ‘teaser interest rates’ to go ahead with projects they would otherwise hesitate to undertake. Above all, politicians had to have the power to unbalance the budget in order to be able to help themselves to unlimited funds to spend on public works, in case private enterprise still failed to come through with the money.
However, Keynes completely ignored the constraints of finance, including the elementary fact that ex nihilo nihil fit (nothing comes from nothing). In particular, he ignored the fact that there is obstruction to suppressing the rate of interest (namely, the rising of the bond price beyond all bounds) and, likewise, there is obstruction to suppressing the bond price (namely, the rising of the rate of interest beyond all bounds). Thus, then, while Keynes was hell-bent on impounding the “unearned” interest income of the “parasitic” rentiers with his left hand, he would inadvertently grant unprecedented capital gains to them in the form of exorbitant bond price with his right." - Antal Fekete

Capital gains in the form of exorbitant bond price? A game we have indeed played successfully given we have been learning a few tricks from our Keynesian magicians bankers as of late. We must confide we have indeed been playing this game and did in fact picked up some yield enticing junior financial subordinated bonds in late 2011 at a cash price of around 94.5, yielding around 14% at the time, to see the yield drop below 4%  these days and the cash price of our position rising by nearly 50% thanks to the generosity of our great "magicians" and given our observation of "Perpetual Motion" machine we decided at the time to buy this French Perpetual issue. We also suffered minimal volatility in the process as illustrated in the below Bloomberg graph:
Of course the main culprit behind our outsized gain is ZIRP (zero interest rate policy) given it has the effect of destroying capital. As the rate of interest is halved, the price of a long term bond is doubled.

Exorbitant government bond prices? The Core European bond market picture making new record lows such as the German bund 10 year yield at 1.14% and the French OAT 10 year at 1.56%, at the lowest level since 1746 - source Bloomberg:
"The continuing fall of interest rates in the 21st century, in the face of an unprecedented amount of Federal Reserve credit being created through bond purchases, is far from being illogical. Nor is the continuing bull market in bonds, now a third of a century old, is a conundrum to those of us who are not infected by the bug of Keynesianism. It is fully explained by the incentive to earn risk-free profits on a continuing basis, unconditionally offered to bond speculators by the policy of open market operations." - Antal Fekete, "Bonds Defy Dire Forecasts but they are not defying logic": 
In Europe of course, courtesy of our "Generous Gambler" aka Mario Draghi, ECB's president "whatever it takes" moment in July 2012 has indeed triggered the incentive to earn risk-free profits based on continuing "implicit" guarantees, a subject we discussed in our previous conversation last week.
Our dexterous "Generous Gamblerhas indeed been highly successful in propelling Spanish bonds gains above Germany. But what our "Generous Gambler" ignores is that generally hyper-deflation can lead to a deflationary spiral in which a deflationary environment leads to lower production, lower wages and demand, and thus lower price levels, which is continuing in Europe as far as we can see from the latest economic data releases.
Moving back to the important notion of the difference between stocks and flows we do agree with Antal Fekete's take in May 2010 in his article "Hyperinflation or Hyperdeflation" being akin to a Black Hole and the possibility of capital being destroyed thanks to ZIRP (as it is mis-allocated towards speculative endeavors) hence the risk of pushing to far the "Perpetual Motion" experience:
"Obviously, you need a theory to explain what is happening other than the QTM. I have offered such a theory. I have called it the Black Hole of Zero Interest. When the Federal Reserve (the Fed) is pushing the rate of interest down to zero (insofar as it needs pushing), wholesale destruction of capital is taking place unobtrusively but none the less effectively. Deflation is the measure of wealth in the process of self-destruction -- wealth gone for good. The Fed is pouring oil on the fire as it is trying to push long-term rates down after it has succeeded in pushing short term rates to zero. It merely makes more wealth self-destruct, and it makes the pull of the Black Hole irresistible.
But why is it that the inordinate money creation by the Fed is having no lasting effect on prices? It is because the Fed can create all the money it wants, but it cannot command it to flow uphill. The new money flows downhill where the fun is: to the bond market. Bond speculators are having a field day. Their bets are on the house: if they lose, the losses will be picked up by the public purse. But why does the Fed under-write the losses of the bond speculators? What we see is a gigantic Ponzi scheme. The Treasury issues the bonds by the trillions, and promises huge risk-free profits to the bond speculators in order to induce them to buy. Most speculators believe that the Treasury is not bluffing and they buy. Some may believe that the Fed is falsecarding doubts and they sell. But every time they do they only see foregone profits. What we have here is a rare symbiotic relation between the government and the speculators." - Antal Fekete

Of course, what the ECB has done as well is tame the speculators and prevented so far a deeper adjustment in the European banking space leading to an outperformance of financial bonds versus equities. But, as we pointed out last week, the continuous need to raise capital for the European banking sector is facing more margin calls, meaning more need to raise capital and the need for more sovereign supports to avoid a depreciation of the liabilities. This infernal "Perpetual Motion" is no doubt delaying a very painful adjustment which could lead the European sector to produce more than what is need just to make the interest payments of the ever rising debt burden!

Therefore it appears to us that deflationary environment in Europe is continuing leading to lower production, lower wages and lower demand, and thus lower price levels.

Moving on the trajectory of US yields during this summer lull, we agree to a certain extent with Nomura's recent take on US treasuries in their note from the 18th of July entitled "Bonds over-reacting or forward looking?":
"Summers aren't the time to burn carry and be short duration - wait for the Fall
We started out the year with a strategic call for lower rates and that has largely run its course. However, we have constantly said that investors should not expect a v-shape rise in rates just because the rally in duration wasn't expected. We have been slowly shifting our trading profile, and for now we have a tactical play on this bond rally to carve out a low this summer versus it just having a one-touch feel to it, where most have been hoping the May dip of 2.4% on 10s, for a brief second, was the low for year; we don't.
As seen in Figure 1, the market participants have been fighting the urge of getting dragged into the air pocket created last year post taper was let out of the bag. However, the path of least resistance and our call until the September FOMC (where there is a risk for more hawkish news around exits and growth/rate expectations) is for 10s to go towards 2.35% and 30s towards 3.10% during the balance of the summer. 
August traditionally is a seasonally strong bond rallying month, and Q2 data excitement can burn out soon (where we are watching if next week's CPI flares out and if at the end of the month wage inflation take off or not). Meanwhile, although investors are not as short, mentally most investors want higher rates and there are some groups underinvested.
Lastly as we mention in our mid-year update, once rates start to normalize, given the lower fixed income supply projections in the second half, bond markets will be supported even as Fed exits, in our view. In Figure 2 we highlight that the Fed has obviously been the biggest buyer during QE; however, in the past other investors would come in and fill the void. 
Recently there has been a focus on China buying USTs and how that was probably another force driving rates lower. However, bank buying in the US has been just as equal of a force while Japan hasn‟t been buying as strongly lately. So that can all change if yields back up and actors like GPIF allocate abroad." - source Nomura

On a final note and as we posited at the beginning of our conversation unless there is an acceleration in real wage growth we cannot yet conclude that the US economy has indeed reached the escape velocity level given the economic "recovery" much vaunted has so far been much slower than expected. But if the economy accelerates and wages finally grow in real terms, the Fed would be forced to tighten more aggressively. As reported by Anna-Louise Jackson and Anthony Feld in their Bloomberg article from the 22nd of July entitled "Higher Wages Signaled by More U.S. Employees Quitting", the jury is indeed still out there when it comes to confirming the "escape velocity" of the US economy:
"More than 2.5 million U.S. workers resigned in May, a 15 percent increase from a year earlier, based on seasonally adjusted data from the Labor Department. These employees represent about 56 percent of total separations, the highest since November.
Such departures serve as a proxy for consumer confidence because people are more likely to quit when they have a new position secured or are convinced that another is readily available, said Nicholas Colas, chief market strategist at ConvergEx Group, an institutional equity-trading broker in New York. The most-recent quits data were “very positive,” which suggests sentiment finally has turned a corner, he said. The report is one that Federal Reserve Chair Janet Yellen has said she uses to judge the strength of the labor market.
The share of Americans who say business conditions are “good” minus the share who say they are “bad” turned positive in June for the first time since January 2008: 0.2 percentage points, up from minus 3.5 points in May, based on data from the Conference Board, a New York research group.
Feeling Emboldened 

“Consumer confidence has been the last piece to come back in this recovery,” Colas said. This suggests wages also could go up because as employees feel more emboldened to switch seats, their bosses may be willing to offer higher compensation in an effort to prevent such turnover, he said.
People working in the private sector could see stronger salary gains ahead, according to Bloomberg BNA’s Wage Trend Indicator, designed to predict and interpret compensation trends. This forward-looking index rose to 99.12 in the second quarter from 98.92 in the first, marking the third consecutive increase and highest level since March 2009.
Pay for these employees could increase more than 2 percent by year-end, according to Kathryn Kobe, an economist at Economic Consulting Services LLC in Washington, who helped develop and maintains the indicator. Wages rose 1.7 percent in the three months ended March 31, near a post-recession low of 1.3 percent,data from the Labor Department show." - source Bloomberg

What of course could derail this very "fragile" recovery is a renewed jump in gasoline prices. The latest US core CPI climbed 1.9 percent from June 2013, after a 2 percent increase in the prior 12-month period. Gasoline costs jumped 3.3 percent, their biggest gain since June 2013, accounting for two-thirds of the increase in total prices, today’s report showed, something to watch closely we think.

"I can calculate the motion of heavenly bodies, but not the madness of people." - Isaac Newton

Stay tuned!

Monday, 14 July 2014

Credit - The European Polyneuropathy

"Politics is the art of looking for trouble, finding it everywhere, diagnosing it incorrectly and applying the wrong remedies." - Groucho Marx

Following up on our June conversation "Deus Deceptor" where we indicated our deep concerns relating to France's economic situation, we think it is time for us to revisit our negative stance on France. On a side note we share Charles Gave from Gavekal latest views on this very "French" subject. Given it is the 14th of July and France's national day, it is time, we think to look at the growing evidence of a slowdown and turmoil brewing in the quarters ahead.

In relation to our chosen title, with problems brewing at the core of Europe, in France in particular, and continuity in banking woes in the periphery, we thought our title should reflect the continuation of European woes using a medical analogy such as "Polyneuropathy" which is a damage or disease affecting peripheral nerves, which can be acute or chronic, but we ramble again...

In this week's conversation we will discuss France in general and peripheral European banking woes in particular. (we already discussed France in 2012 in our conversation "France's Grand Illusion").

As we posited back in June on our main subject France:
The story for  the remainder of 2014 in Europe is still France:
This is what we argued in January 2013 and this is still what we are arguing now. While French politicians are benefiting from low rates on French debt issuance courtesy of on-going Japanese support, but, on the economic data front France is increasingly showing signs of growing stress

France should be seen as the new barometer for Euro Risk. With Industrial Production at -3.7% (implying a negative GDP print, see below), the French government is seriously in denial when it comes to growth assumptions: 1% in 2014 (down from 1.2%) and 2% in 2015 is way over optimistic we think. 

A sobering fact, services in the French economy represent around 80% of the GDP versus 76% for the rest of the European union. the latest read at 48.2 for Services PMI is indicating contraction (the lowest level reached in February 2009  was at 40.2).

France appears to us as the weakest link if we take for example World Manufacturing PMI (50 = no change on prior month) as an illustration of the troubles brewing ahead as illustrated by our friends from Rcube Global Asset Management with France standing clearly at the bottom:

Another worrying trend illustrated by our friends at Rcube Global Asset Management lies in the growing financing gap between France versus Europe:
Or one could also look at the Corporate Financing Gap as a percentage of GDP in various European countries as displayed by Rcube Global Asset Management:
"Investment will keep plunging since French corporates' debt to value added ratio is so high. Furthermore, the French corporate financing gap is massive (as per above chart). It means that French companies' financing needs are extremely high, not only historically, but also compared to other countries in both Europe and the rest of the world. With France in such a difficult situation, the ECB will be under increased pressure to join the WE club

Corporate margins are thus decreasing, and are the weakest in Europe:

The high corporate debt to added value ratio suggest also that investment will soon turn negative

The French housing sector looks also mispriced compared to the rest of core EU:

We would like to add some more illustrations on France being the weakest link in Core Europe.

The recent evolutions of European house prices in some European countries seem to illustrate the start of a weakness in French real estate prices - graph source Bloomberg:
In blue: France
In red: United Kingdom
In yellow: Spain

Also, French industrial production (white line), French GDP (orange line) and French Services PMI (blue line, data available since 2006 only) tell the story on its own, we think - graph source Bloomberg:
An industrial production at -3.3% equals zero growth. With industrial production at -3.7% you can expect a negative GDP print for France.

As we argued back in June:
"If the Services PMI contracts, it doesn't bode well for France's unemployment levels. Services represent the number one employment sector in France (34% of total employment in 2010 according to INSEE).

Normally "entrepreneurial economy" can do that well as long when they are entrepreneurs in the picture but in the special case of France, given French civil servants have done their best to "kill" the entrepreneurs in France with great success, the economy will continue to linger.

A tight credit channel, high inventory levels vs. order books, depressed consumer sentiment and a forced fiscal tightening create a dangerous economic environment for an already weak economy."

We have also plotted France Consumer Confidence against GDP and the evolution of the French government debt to GDP (inverted) - graph source Bloomberg:
Deteriorating Debt to GDP level rising while French Consumer Confidence Indicator sliding, it doesn't bode well for growth and unemployment levels.

On numerous occasions we have discussed France and our growing concerns such as in our conversation "In the doldrums" where we touched the subject surrounding credit-less recoveries:
So for us, unless our  "Generous Gambler" aka Mario Draghi goes for the nuclear option, Quantitative Easing that is, and enters fully currency war to depreciate the value of the Euro, there won't be any such thing as a "credit-less" recovery in Europe and we remind ourselves from another conversation "Squaring the Circle" that in the end Germany could defect and refuse QE, the only option left on the table for our poker player at the ECB:
"The crux lies in the movement needed from "implicit" to "explicit" guarantees which would entail a significant increase in German's contingent liabilities. The delaying tactics so far played by Germany seems to validate our stance towards the potential defection of Germany at some point validating in effect the Nash equilibrium concept. We do not see it happening. The German Constitution is more than an "explicit guarantee" it is the "hardest explicit guarantee" between Germany and its citizens. It is hard coded. We have a hard time envisaging that this sacred principle could be broken for the sake of Europe." - Macronomics

The reasons for Germany's racing ahead have all been explained not only in the title of a previous post of ours "Winner-take-all" in February 2013 but also in the contents should you want to dig further on the subject:
"In similar fashion to the winner-take-all computational principle, when ones look at the growing divergence between France and Germany when it comes to PMI, in the pure classical form, it seems only the country with the highest activation stays active while all other see their growth prospects shut down

On the topic of France and the "overvalued"  Euro, French Industry Minister Arnaud Montebourg has most recently validated our Groucho Marx quote from above as indicated by his latest staunch attack on the ECB as reported by Mark Deen and Helene Fouquet on their July 10 article in Bloomberg entitled "France's Montebourg Hits Out at ECB in Campaign-Style Speech":
French Industry Minister Arnaud Montebourg hit out at the European Central Bank, calling on it to buy bonds and weaken the euro in order to boost growth.
“We have the most depressed region in the world with a currency that has appreciated the most globally and a European Central Bank that has not respected its mandate,” Montebourg told an audience of executives in Paris, citing the risk of deflation. “No one should leave the economy in the hands of moralists and accountants.”
The remarks were made against the backdrop of a screen reading “economic patriotism” and “fight for growth” in a packed and darkened room that resembled Montebourg’s campaign meetings in the Socialist primaries of 2011 in which he placed third. He pledged to run again after his defeat to Francois Hollande. France’s next presidential election is due in 2017.
With a French economy that has barely grown in two years and euro-area inflation that remains at less than half the ECB’s target level, Montebourg is taking aim at policies that he says are letting France and Europe behind the rest of the world. “Growth is a political problem that will be achieved through political action,” he said. “To allow unemployment to remain high is to help the National Front and destroy Europe.” The National Front, which led the European parliamentary elections in France, is an anti-euro, anti-immigration party. “I only have one enemy; it’s conformism,” Montebourg said. Conformism “is not a candidate, it is ruling” the country, he said.
Hollande’s approval rating at less than 20 percent is at a record low for a French president" - source Bloomberg

From our conversation  "Squaring the Circle" here is the simple answer to Arnaud Montebourg's euro concerns in a very self-explanatory diagram:
As pointed out previously by our friend Martin Sibileau (who used to blog on "A View From The Trenches"), here is a reminder from his work which we quoted in our conversation "The law of unintended consequences" in Macronomics on the 25th of January 2012:
"With a more expensive Euro, Germany is less able to export to sustain the rest of the Union and growth prospects wane. At the same time, the private sector of the EU looks for cheaper funding in the US dollar zone, which will eventually force the Fed to not be able to exit its loose monetary stance. - Martin Sibileau
Europe's horrible circularity case - Martin Sibileau

By tying itself to Europe via swap lines, the FED has increased its credit risk and exposure to Europe:
"If the ECB does not embark in Quantitative Easing, the Fed will bear the burden, because the worse the private sector of the EU performs, the more dependent it will become of US dollar funding and the more coupled the United States will be to the EU." - Martin Sibileau

As a reminder from our previous conversation  "Squaring the Circle":
As a side note and in relation to the EU private sector seeking USD funding as displayed in Martin's chart above, in 2012 over a third of the US Investment Grade supply (net issuance in $430 billions) was from non-US issuers up from 25% in 2011. In 2013 we have seen about a third of the new issuance from non-domestic issuers (estimated net issuance for 2013 $400 billions).

Arguably in recent months, thanks to the US Fed tapering, the 1 year/1 year forwards for the US dollar and the Euro have increasingly diverged as displayed in the below Bloomberg chart:
But it looks to us that what the market is pricing indeed is a trigger at some point of QE in Europe because when it comes to the European Polyneuropathy, we think our friend's Martin Sibileau's above diagram depicts clearly the situation particularly when ones take into account that a huge amount of euro denominated assets remain to be sold. For instance, Société Générale reported on the 7th of July reported in a specific report on European banks entitled "Rise of the "zombie" assets", non-core banking represents a €1.5 trillion industry:
"Non-core banking: A €1.5trn industry 
European banks have become highly skilled in separating off the unwanted, the unsellable, and the unexplainable. Across our coverage, there is now €1.5trn of non-core banking balance sheet, consuming €80bn of tangible equity. These operations have had a major impact on profitability, dragging a full 4ppts off sector ROTE in 2013. Cleaning up the non-core will have a major bearing on when profitability will creep higher for the sector, in our view.
The major operations 
Five banks account for €1trn of the non-core balance sheet currently. This is where we believe restructuring the “bad parts” of the book has the most potential to drive profitability higher. These banks are UBS, Barclays, CBK, ING, and UCG. We are seeing progress, with ING recently completing the NN Group IPO and CBK disposing of a block of assets.
Raising the bid for “bad” assets 
We believe that the combination of ECB liquidity, lower funding costs, and improving confidence should raise the level of attractiveness for noncore operations. We have seen more robust financials IPO deal flow, and decent returns for distressed debt funds. This should help banks to run down the “bad”, and focus on the
Further assets could become non-strategic 
We expect restructuring and consolidation to become a major theme for European banks after the AQR. This could bring further operations into question, particularly if the disposal process becomes easier (or even profitable). There is the potential for further restructuring at CS (CIB), DBK, and UCG (CEE)." - source Société Générale.

We can also point out that European banks need to sell another $795 billion worth of property assets as reported by Bloomberg by Neil Callanan and Patrick Gower on the 14th of July in their article entitled "European Banks needs $795 billion Problem Property Loan Solution":
"European banks and asset managers plan to sell or restructure 584 billion euros ($795 billion) of riskier real estate as they try to clean up their balance sheets, Cushman & Wakefield Inc. said.
The region’s lenders, asset managers and bad banks, such as Spain’s Sareb, sold 40.9 billion euros of loans tied to property in the first six months, 611 percent more than a year earlier, the New York-based broker said in a report today. Transactions including foreclosure sales will reach a record 60 billion euros this year, Cushman & Wakefield estimates.
Lenders such as Royal Bank of Scotland Plc are accelerating loan-portfolio sales as borrowing costs fall from a year ago and economic sentiment improves. Lone Star Funds and Cerberus Capital Management LP are among U.S. investors that are taking advantage as sellers opt to offer bigger groups of loans, making it more difficult for smaller firms to make purchases, Cushman & Wakefield said." - source Bloomberg

As we have argued in our conversation "Mutiny on the Euro Bounty" in April 2012:
"More downgrades mean more margin calls, more margin calls means more liquidation and more Euros being bought and dollars being sold, with a growing shortage of AAA assets, Europe is moving towards mutiny on the Euro Bounty ship..."

Unless of course Mario Draghi goes for the nuclear option, Quantitative Easing, that is.

And as indicated by Martin Sibileau from his note from the 17th of October "The EU must not recapitalize banks":
"The circular reasoning therefore resides in that the recapitalization of banks by their sovereigns increases the sovereign deficits, lowering the value of their liabilities, generating further losses to the same banks, which would again need more capital."

What would be a solution for the EU? We have repeatedly said it: Either full fiscal union or monetization of the sovereign debts. Anything in between is an intellectual exercise of dubious utility."

Of course it is! QE being the only card left but we have our doubt Germany will agree to play that card.

Moving on to the subject of lowering value of European peripheral banks liabilities generating further losses to same banks, needing more capital, the Banco Espirito Santo is a clear illustration once more of the above diagram. 
We already touched at length in our past credit conversations on the liability exercise management taken by many weaker peripheral banks in relation to raising capital to reach the 9% Core Tier 1 Capital target set up by the European Banking Association for June 2012 (see our conversations, "Peripheral Banks, Kneecap Recap", "Subordinated debt - Love me tender?" and "Goodwill Hunting Redux"):
"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.

In fact in our conversation "Peripheral Banks, Kneecap Recap", Banco Espirito Santo was prominently featured given October 18 2011 Banco Espirito Santo had announced a capital increase in effect via its bond tender which meant at the time a 83.5% dilution for shareholders. This was followed by another capital increase of 1 billion euro announced mid-April, to be completed by early May (see our conversation "All Quiet on the Western Front").

We argued at the time:
"We believe additional debt to equity swaps will have to happen for weaker peripheral banks, similar to what we witnessed with Banco Espirito Santo in October 2011, as well as for German bank Commerzbank ("Schedule Chicken" - 25th of February 2012)."

As our good credit friend said in November 2011: 
"The path will be very painful for both shareholders and bondholders."

The BES (Banco Espirito Santo) situation, is indeed a reflection of the European Polyneuropathy and is by no mean without "consequences" as shown in the above diagram from Martin Sibileau and the effect of "margin calls" given that Espirito Santo's board as not only appointed a new CEO but its largest shareholder was forced to sell a stake in the Portuguese bank to meet a margin call on loans as reported on the 14th of July in Bloomberg by Joao Lima: in his article entitled "Espirito Santo Owner Sells Stake to Meet Margin Call on Loan":
"Banco Espirito Santo SA’s largest shareholder was forced to sell a stake in the Portuguese bank to meet a margin call on a loan, heightening market concerns about the group’s finances. Espirito Santo Financial Group SA said today it sold 4.99 percent of the bank, reducing its holding to 20.1 percent, to meet the call on the loan taken out during the bank’s 1.04 billion-euro ($1.4 billion) rights offering in June. Banco Espirito Santo, Portugal’s second-biggest lender by market value, fell as much as 11.9 percent in Lisbon trading.
The sale came as Chief Executive Officer Ricardo Salgado, the 70-year-old great-grandson of the bank’s founder, was replaced by Vitor Bento after the Bank of Portugal urged the lender to speed up changes to its executive management. The Espirito Santo family’s hold on the bank slipped further as
Moreira Rato, 42, head of the government’s debt agency, was named as chief financial officer.
Banco Espirito Santo roiled global markets on July 10 after another parent company, Espirito Santo International SA, missed some payments on commercial paper. The stock plunged 36 percent last week and its credit rating was cut by Standard & Poor’s and Moody’s Investors Service on July 11. German Chancellor Angela Merkel said at the weekend the market turmoil caused by the Portuguese bank underlined the euro region’s fragility." - source Bloomberg.

Of course what has started in earnest is the application of "bail-in resolutions" of subordinated bondholders of weaker European financial institutions if one looks at the BES story - graph source Bloomberg:
"Banco Espirito Santo's June capital raise boosted its regulatory capital buffer to 2.1 billion euros ($2.9 billion), according to a press release from the bank. This buffer may be considerably smaller under the macroeconomic assumptions of the adverse scenario in the forthcoming ECB stress tests. Concerns will also mount on the application of bail-in rules for bank debt, suggesting that investors may re-examine reported capital and debt prices for periphery lenders." - source Bloomberg

It isn't only happening in Portugal if one follows the events surrounding Austrian Hypo Aldria issues given the first Chamber of Austria's parliament, the Nationalrat, has given the green light to wipe-out subordinated lenders despite the debt being guaranteed by the state of Carinthia. When the game changes, you can expect politicians to change the rules. This is what makes the difference between "implicit" guarantees from "explicit" guarantees (The German Constitution is more than an "explicit guarantee" as stated above). The rest of Hypo Aldria's network such as its Balkan banking network has been put on for sale. Yet another effect of "margin calls".

For now it seems subordinated bondholders and shareholders are getting the "kneecap" treatment to raise much needed capital with the surge of "margin calls". When one looks at the debt distribution of Banco Espirito Santo with a small cushion of perpetual subordinated debt, one can legitimately wonder if senior bondholders will not suffer at some point a similar "treatment" - graph source Bloomberg:
"The reopening of senior subordinated debt markets to many periphery banks and nations has alleviated funding and deposit-cost pressures since 2013, though recent discussions on bail-in rules and the ECB stress tests have damped investor appetite. Banco Espirito Santo's plummeting debt value and share price suggest the cost of refinancing its 2.76 billion euros ($3.76 billion) of senior subordinated notes maturing in 2015 will have risen, likely also driving up funding costs for peers." - source Bloomberg

It appears to us that the cost of maintaining "zombie" entities afloat is getting pricier by the day. On a final note given European Growth and Consumer Confidence go hand in hand, we think we have reached a plateau as per the below Bloomberg graph:

"If there must be trouble, let it be in my day, that my child may have peace." - Thomas Paine

Stay tuned!