Tuesday, 12 June 2012

Buyer’s Remorse in Time Lapse

Meet the Shortest Relief Bounce Ever… On Monday morning we were still musing over whether the markets might celebrate the latest euro area bailout maneuver or not, noting that 'doubts were creeping in already'. A little while after we had written these words European stock markets opened with a big gap up – which turned out to be the selling opportunity du jour.

Apparently a few market participants were considering the implications of the bailout thoroughly. For one thing, it is not quite the 'no strings attached' loan Spain's government tried to portray it as. However, that is actually not necessarily a bad thing.

What is however bad is that all existing bondholders of Spain suddenly find themselves subordinated to whatever public sector entity will be chipping in. Moreover, it has apparently not even been decided yet which of the euro area's bailout vehicles will provide the funds. Apart from possible timing issues, this is not without consequence as Alphaville mentions here.

Spain after all is one of the guarantors of the both the EFSF and ESM – to the tune of 12.75%. Anyone borrowing from the EFSF no longer guarantees anything of course – and the share of the other guarantors increases accordingly.  The ESM rule book apparently looks slightly different, in that the ESM treaty does not provide for a 'stepping out' clause. So in case the ESM ends up as the vehicle for financing the bailout, Spain would literally be bailing out itself, while continuing to bail out others as well.

EFSF contributions as per the most recent presentation (pdf) - click chart for better resolution.

The market that registered its consternation first was Spain's government bond market. After all, Spain will be liable for the money – the fact that it is given to Spain's FROB (the agency dealing with bank bailouts) and used for recapitalizing the banking system is not altering the connection between the sovereign and the banks – it is not severing the link between the banking crisis and the sovereign debt crisis at all, it is in fact strengthening it further. This realization evidently dawned on bond traders within a few minutes of the opening of trading on Monday. From the bond market this conclusion was then swiftly transmitted to the stock market.

After incongruously dipping slightly at the open, the 10 year government bond yield of Spain explodes - click chart for better resolution.

Spain's IBEX, intraday on Monday (5 minute candles) -  after opening with a 5.3% gap up, the index declines more than 400 points from its high - click chart for better resolution.

As the day wore on, the voices of the doubters were given a hearing.

“What all the fancy-sounding acronyms in the world can’t obscure is the fact that Spain will effectively be on the hook itself for whatever sum is borrowed to bail out its banks. As Morgan Stanley economist Joachim Fels put it in a client note Sunday, “a loan by the EFSF or ESM to the Spanish bank restructuring fund, FROB, hardly counts as a circuit breaker as it raises the Spanish government’s contingent liabilities.”
And €100 billion is no chump change. It amounts to nearly 10 percent of Spain’s gross domestic product; the country last year was already running a deficit of about 9 percent of GDP.
It isn’t clear how much of this sum will be borrowed up front, but it is clear that increasing Spain’s debt load at a time when its recession is still deepening is hardly a way to shore up investor confidence in the nation or the broader euro zone. In fact, such a transfer of private-sector debts to the public sector (which then triggers further austerity measures) has perhaps been one of the biggest missteps of the crisis; it hardly seems prudent now to double-down. A Pyrrhic victory it will certainly be if Spain’s banks get help at the cost of further eroding the solvency of the sovereign or the sustainability of the euro zone.”

(emphasis added)
That seems indeed how the markets are seeing it at the moment.
As John Hussman once again pointed out, it is incomprehensible why it is held that the people and institutions that voluntarily took the risk of providing capital to the banks – i.e., their shareholders and bondholders – continue to get bailed out at the cost of taxpayers. Hussman writes:

„Every major bank is funded partially by depositors, but those deposits typically represent only about 60% of the funding. The rest is debt to the bank's own bondholders, and equity of its stockholders. When a country like Spain goes in to save a failing bank like Bankia – and does so by buying stock in the bank – the government is putting its citizens in a "first loss" position that protects the bondholders at public expense. This has been called "nationalization" because Spain now owns most of the stock, but the rescue has no element ofrestructuring at all. All of the bank's liabilities – even to its own bondholders – are protected at public expense. So in order to defend bank bondholders, Spain is increasing the public debt burden of its own citizens. This approach is madness, because Spain's citizens will ultimately suffer the consequences by eventual budget austerity or risk of government debt default.
The way to restructure a bank is to take it into receivership, write down the bad assets, wipe out the stockholders and much of the subordinated debt, and then recapitalize the remaining entity by selling it back into the private market. Depositors don't lose a dime.“

(emphasis added)
So why have the rules of capitalism been suspended for banks? In the US it can probably be said that the banking establishment has simply enormous political influence. Partly this is also true in Europe, but there are other considerations at work as well. Every time the banks of one European country get bailed out, the aim is actually to bail out banks elsewhere concurrently (and  surreptitiously). It is the cross-border interdependence between the banks that is a motivating factor. Moreover, banks are the biggest buyers of government debt. We have already seen after the ECB's LTRO funding rounds that the banks don't regard their de facto insolvency as an obstacle to buying more dodgy sovereign debt.

This is a chief reason to expect even more LTRO funding in the not too distant future, although slowly but surely, the banks are running out of unencumbered and eligible collateral. However, the ECB probably still has some room to tinker further with collateral eligibility requirements – it has already established itself as the biggest 'bad bank' in Europe (and probably on the planet), so further expansion in this direction should not pose too big a difficulty. Not least when a widely admired money printing charlatan like Adam Posen lately argues that the BoE should monetize 'small business loans' in order to see 'cash pumped into the economy'.

Of course, economic activity is not funded by 'cash' – it makes absolutely no difference to the pool of real funding how big the money supply is. In fact, as Mises pointed out, any size of money supply is as good as any other. Money is the only good an increase in the supply of which confers no social benefit whatsoever – on the contrary. Increasing the money supply does of course have a plethora of effects (all of them negative), as money is not neutral.  

They range from redistributive effects (earlier receivers profit at the expense of later receivers) to the furthering of capital malinvestment as the distortion in relative prices draws funding into lines of business that would normally not be considered profitable. Economic calculation is falsified and that can not possibly be a good thing. Posen is evidently unaware of all of this, or rejects it for reasons we cannot fathom. Anyway, our main point is that in view of the advice dispensed by such a well-regarded 'expert' to a neighboring central bank, the ECB will certainly not shy away from discounting even more garbage.

Finland has decided to add its two cents to the Spanish bank bailout, and given that the Fins are going to end up as net payers, their attitude toward such efforts has a somewhat conservative bent:

„Finland doesn’t want any of Spain’s bailout to prop up unhealthy lenders and expects some troubled banks to be split up as the northernmost euro member outlines the conditions it understands are attached to the rescue deal agreed on June 9.
“The unhealthy banks should be brought down or some banks should be possible to chop up” so that the healthy parts continue and the rest ends in a so-called bad bank, Finnish Prime MinisterJyrki Katainensaid in an interview in Norway today. “There must be a possibility to restructure the banking sector because it doesn’t make sense to recapitalize banks which are not capable of running.”

(emphasis added)
Well, all of this does emphatically not require a bailout, since by definition, it is not necessary to bail out healthy lenders. 'Bringing down' unhealthy ones does not require any fresh funding. It only requires someone waving good bye to them, and not even that is strictly necessary. So we're not quite sure what the Fins are getting at. Don't they know that banks are no longer allowed to fail in this day and age?

A daily chart of the IBEX – early buying turns into relentless selling - click chart for better resolution.

It is remarkable that the markets are nowadays reassessing new bailout announcements so quickly. In the past, bounces on bailout news tended to last for at least the day of the announcement and often for longer. However, as the  charts below courtesy of Scott Barber from Reuters show,  generally all bailout announcements except that of Ireland turned into 'sell the news' events eventually. The difference this time is that the markets were already quite oversold going into the announcement.

Euro area bailout announcements and the Euro-Stoxx index - click chart for better resolution.

Euro area bailout announcements and 'PIIGS' 10 year yield spreads over German Bunds - click chart for better resolution.

Euro area bailout announcements and European bank stocks - click chart for better resolution.

All in all it doesn't appear that news of bailouts are particularly market-friendly events – and why should they be? In the case of Spain let us not forget that this is the bailout that was never supposed to happen.  If anything, it demonstrates that the cart is well and truly stuck in the mud.

Italy Threatens to Grab the Spotlight Next

It didn't take long for questions about Italy to be raised – this is not surprising, given that Italy guarantees a full 22% of the EFSF and ESM respectively. Bloomberg reports that Italy is now in the 'market's crosshairs':

“The 100 billion-euro ($126 billion) rescue for Spain’s banks moved Italy to the front line of Europe’s debt crisis, as the country’s bonds and equities slumped on concern it may be the next to succumb. Italy’s 10-year bonds reversed early gains today in the first trading after the Spanish bailout. Their yield rose by the most in a day since Dec. 8, adding 27 basis points to 6.04 percent. Shares of UniCredit SpA (UCG), the country’s largest bank, had their steepest decline in five months.

“The scrutiny of Italy is high and certainly will not dissipate after the deal with Spain,” Nicola Marinelli, who oversees $153 million at Glendevon King Asset Management in London, said in an interview. “This bailout does not mean that Italy will be under attack, but it means that investors will pay attention to every bit of information before deciding to buy or to sell Italian bonds.”

Italy has 2 trillion euros of debt, more as a share of its economy than any developed nation other than Greece and Japan. The Treasury has to sell more than 35 billion euros of bonds and bills per month — more than the annual output of each of the three smallest euro members, Cyprus, Estonia andMalta.”

(emphasis added)
As we have mentioned yesterday, a bailout of Italy would clearly be one step too far. €2 trillion in debt of which euro area banks reportedly hold €1.2 trillion certainly harbor the potential to sink the the whole ship without a trace. Incidentally Italy's economy -  which has stagnated for a decade – is estimated to contract by 1.7% this year.

10 year bond yields of Spain, Greece, Italy and Portugal – keep the different price scales in mind - click chart for better resolution.

The intra-day move on Monday in Italy's 10 year bond yield (to the right hand side of the chart) - click chart for better resolution.

5 year CDS on Portugal, Italy, Greece and Spain  – CDS on Italy and Spain have reversed back up - click chart for better resolution.

Led by an 8.8% decline in the shares of Unicredito, the country's biggest bank, the MIB index also reversed sharply from an early gap up:

Italy's MIB index – another ugly daily candle - click chart for better resolution.

The intra-day action in the MIB on Monday – selling intensified by the close - click chart for better resolution.

However, as noted above, all of this is happening as 'risk assets' of all sorts are alread oversold to varying degrees, which can inter alia be gleaned from the chart of crude oil, the most heavily traded industrial commodity:

WTI crude looks extremely oversold by now - click chart for better resolution.

One has to remember though that the fact that markets look technically 'oversold' is by no means a guarantee that a rally will commence soon – sometimes oversold markets just panic. The downtrends persist until they don't anymore, so second guessing the likely stopping point of the various falling knives may not be fruitful. That said, the extremely large  speculator net short position in euro futures shows that most market participants are already leaning heavily in the same direction. In light of this it may not be advisable to chase weakness in the short term, regardless of the fact that the medium to long term outlook seems quite bleak. Doing nothing (except taking out insurance) may not be the worst decision.

There was one sector of the markets that appeared happy with the announcement – our CDS index of European banks as well as euro basis swaps both traded somewhat better. This is probably no surprise given that banks are the recipients of this latest bout of bailout largesse, although Fitch kept downgrading Spanish banks in the wake of its downgrade of Spain's government debt last week.

Our proprietary unweighted index of 5 year CDS on eight major European banks (BBVA, Banca Monte dei Paschi di Siena, Societe Generale, BNP Paribas, Deutsche Bank, UBS, Intesa Sanpaolo and Unicredito) – a sharp short term pullback - click chart for better resolution.

Three month, one year, three year and five year euro basis swaps – the bounce in the longer dated ones has continued since late last week - click chart for better resolution.

It is noteworthy that CDS spreads on Germany's debt streaked to a new interim high, in spite of the strength in Germany's bond market. The markets correctly perceive that the risks to Germany's creditworthiness are increasing further with every new bailout announcement.

5 year CDS on Germany (white line), the US (orange) and the Markit SovX index (yellow) of CDS on 19 Western European sovereigns - click chart for better resolution.

The SPX intra-day on Monday – the index roughly mimicked what happened in European markets. So much for decoupling - click chart for better resolution.

A chart showing the euro area crisis spiral that reportedly comes from David Einhorn of Greenlight Capital –  these days it seems we are going from 'champagne party' to 'solution won't work' in one day - click chart for better resolution.

Finally an interesting chart on an unrelated matter: China's best one year deposit rate, the real interest rate (measured vs. CPI) and the bank deposit reserve requirement - click chart for better resolution.

Charts by: Bloomberg, bigcharts, stockcharts.com, EU, Scott Barber/Reuters, Greenlight Capital

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