Pese a las apariencias, los países periféricos de Europa continúan padeciendo una crisis de deuda

Posted on 2 May 2013 by Mike Riddell

This article appeared in English on 26 April.

A comienzos de esta semana, las rentabilidades de la deuda española a 5 y 10 años cayeron hasta los niveles más bajos desde el cuarto trimestre de 2010. No cabe duda de que esta recuperación fue estimulada por los comentarios de Mario Draghi relativos a que el BCE haría « todo lo necesario para salvar el euro» y posteriormente alentada por la mejora de los datos económicos de la zona euro registrada durante el segundo semestre de 2012 la cual, probablemente, se debió en parte a las palabras de Draghi. No obstante, la recuperación de los países periféricos ha continuado durante este año a pesar del importante deterioro que han sufrido los datos económicos en los últimos meses. Actualmente, los fundamentales económicos y las valoraciones avanzan rápidamente en direcciones opuestas.

Lo anterior queda reflejado en el siguiente gráfico: el eje izquierdo representa el diferencial de rentabilidad entre la deuda italiana y alemana a 10 años, y el derecho representa el índice Citi Eurozone Economic Surprise (de forma que si la línea verde asciende implica que los datos económicos son más débiles de lo previsto).

Sigo manteniendo mis dudas respecto a la solvencia de España donde, por insolvencia, me refiero a la situación en la que la ratio de deuda pública sobre el PIB aumenta de forma indefinida. Sí, el BCE puede inyectar liquidez en España para posponer el pago de la deuda y sí, podría decirse que hay muchos otros países desarrollados que se encuentran enla misma situación—la ratio de deuda pública sobre el PIB de Japón se acerca rápidamente al 300%, lo que hace que la deuda pública española parezca relativamente raquítica. Pero como ya hemos visto en el caso de Grecia, la deuda soberana de la zona euro puede ser y será reestructurada si se considera que un país es insolvente y, como ya comentamos anteriormente en una entrada de 2010, parece que España se dirige hacia tal situación.

Centrándonos en la dinámica de la deuda española a largo plazo, es preciso recordar que la ratio de la deuda pública sobre el PIB de un país cambia en funciónde las siguientes tres variables:

La diferencia entre los costes de financiación de la deuda y el crecimiento nominal como porcentaje del PIB. Si el coste de financiación es mayor que el PIB nominal, aumentará la ratio de deuda pública sobre el PIB.
El cambio en el balance primario de un país como porcentaje del PIB (donde balance primario es el balance presupuestario antes del pago de intereses). Un mayor déficit presupuestario equivale a un aumento de la ratio de deuda pública sobre el PIB.
Variaciones en el ajuste deuda-déficit. Normalmente este ajuste es relativamente pequeño, pero si un gobierno recapitaliza un banco, la ratio de deuda pública sobre el PIB aumenta (más información).

La ratio de la deuda pública sobre el PIB de España se ha disparado como consecuencia de estas tres variables. Analizando a su vez cada una de estas variables, en el siguiente gráfico representa el crecimiento del PIB nominal de España comparado con su coste de financiación nominal a 6 años (en sentido estricto, el dato incluido en la fórmula debería ser el promedio de los costes en concepto de interesesque, en el caso de España, en la actualidad es próximo al 4% —en este caso he utilizado la rentabilidad de la deuda española con vencimiento a 6 años en su lugar). Un coste de financiación del 4% estaba bien entre 2001 y 2007, cuando España aun podía generar un crecimiento del PIB nominal de entre el 7 y el 9%, pero dada la situación actual no es una cifra tan positiva.

Dado que los costes de financiación de España son superiores a su tasa de crecimiento nominal, necesita acumular un superávit primario para poder estabilizar su ratio de deuda pública sobre el PIB (tal como se ha indicado en el punto 2). Pero en la actualidad España presenta un enorme déficit presupuestario (del 10,2% de media desde 2009) y por tanto tiene un enorme déficit primario. En el siguiente gráfico mostramos cómo el FMI ha aumentado de forma constante sus previsiones para el déficit presupuestario español desde 2011.

En parte el FMI ha previsto déficits cada vez mayores debido a que sus previsiones de crecimiento han sido excesivamente optimistas. En el siguiente gráfico se muestra como en el 2011 el FMI pensaba que España estaría actualmente creciendo a un ritmo estable del 2%, mientras que la realidad es que se encuentra todavía inmersa en una crisis (recientemente se ha confirmado una tasa de desempleo del 27.2% para el primer trimestre del ano, una cifra récord). La mayoría de las estimaciones de crecimiento a largo plazo elaboradas son simples promedios históricos a la larga, pero dados los elevados niveles de endeudamiento tanto público como privado de España, así como el deterioro de su demografía, la tasa de crecimiento potencial a largo plazo puede ser de tan solo el +1% anual.

¿Y qué sucede con el tercer punto relativo a la ratio deuda/PIB: los ajustes deuda-déficit? Nuestro analista de banca española, Ed Felstead, considera que no es impensable que incluso algunos de los bancos que ya han sido recapitalizados por el estado necesiten serlo nuevamente, a pesar de haber transferido sus activos y préstamos inmobiliarios más tóxicos ala Sareb, el «banco malo» español. Las ratios de préstamos morosos de los bancos ya «saneados» siguen siendo elevadas y la generación de ingresos se mantiene baja debido a la reducción de los márgenes de beneficio. Si se produjera un mayor deterioro de préstamos no-inmobiliarios, los bancos tendrán que hacer mayores provisiones, lo cual generará pérdidas, sin que haya forma de sustituir el capital perdido. Es probable que dicho deterioro se produzca dada la frágil situación de la economía española, junto con el hecho de que las ventas de activos por parte de la Sareb ejercerán presión sobre los precios de los mismos, y la posibilidad de que se introduzca una nueva legislación en materia de ejecuciones hipotecarias y las deudas en mora más favorable para los prestatarios.

Por ello, si no se consigue reanudar el crecimiento en España, los gastos de financiación seguirán superando la tasa de crecimiento, continuarán existiendo grandes déficits presupuestarios y posiblemente veamos la necesidad de realizar nuevas recapitalizaciones bancarias. El FMI ya no prevé una estabilización de los niveles de endeudamiento españoles, al contrario,cree que continuarán aumentando en un futuro próximo, y esto es con unas expectativas de crecimiento del PIB que pueden considerarse todavía algo optimistas. La deuda de los países de la Europa periferica, sobre todo la española, parece todavía vulnerable a sufrir a una venta masiva.

Peripheral Europe is still facing a debt crisis, despite appearances

Posted on 26 April 2013 by Mike Riddell

Earlier this week, 5 and 10 year Spanish yields fell to the lowest levels since Q4 2010. The rally was no doubt kick started by Mario Draghi’s “do whatever it takes to preserve the euro” comment, and was given further fuel by the improvement in Eurozone economic data over the latter half of 2012, which was probably due in part to Draghi. However, the peripheral rally has continued this year in the face of a significant deterioration in economic data in recent months. Economic fundamentals and valuations are currently moving rapidly in opposite directions.

The chart below illustrates this – on the left axis is the Italian 10 year yield spread over Germany, and on the right axis is Citi’s Eurozone Economic Surprise Index (so if the green line moves up, data is coming in weaker than expectation).

I continue to doubt whether Spain in particular is solvent, where I’d define insolvency as being where a country’s public debt/GDP ratio increases indefinitely. Yes, the ECB can throw liquidity at Spain to keep the debts rolling over, and yes, many other developed countries are arguably in the same boat – Japan’s public debt/GDP ratio is quickly rising towards 300%, which makes Spain’s public debt burden look relatively puny. But as we’ve seen with Greece, sovereign Eurozone debt can and will be restructured when a country is deemed insolvent, and as previously argued in a comment in 2010, this is where Spain appears to be heading.

Focusing on Spanish long term debt dynamics, it’s worth recapping that the change in a country’s government debt/GDP ratio is a function of three variables, namely:

The difference between debt interest costs and nominal growth as a % of GDP. If interest costs are greater than nominal GDP, then this leads to a higher public debt/GDP ratio
The change in a country’s primary balance as a % of GDP (where a primary balance is the budget balance before interest payments). A larger budget deficit equals a higher public debt/GDP ratio
Changes in the stock-flow adjustment. This adjustment usually relatively small, but if a government recapitalises a bank, the public debt/GDP ratio increases (see here for more information)

Spain’s public debt/GDP ratio has been soaring because of all three of the above variables. Taking each of these variables in turn, the chart below plots Spain’s nominal GDP growth against its 6 year nominal borrowing cost (strictly speaking it should be the average interest cost that goes into the formula, which for Spain is currently about 4% – I’ve taken the yield on Spain’s 6 year maturity as a proxy). A borrowing cost of 4% was fine from 2001 to 2007, as Spain was able to generate nominal GDP growth of between 7 and 9%. It’s not so fine now.

Given that Spain’s borrowing costs are higher than its nominal growth rate, it needs to run a primary surplus if it is to stabilise its public debt/GDP ratio (as per point 2). But Spain is actually running a huge budget deficit (averaging 10.2% since 2009), and is therefore running a large primary deficit. The chart below shows how the IMF has steadily increased its forecast for Spain’s budget deficits since 2011.

Part of the reason why the IMF has forecast larger and larger deficits is down to its growth forecasts being hopelessly optimistic. The chart below shows how in 2011, the IMF thought Spain would be growing at a tidy 2% by now, when instead Spain remains mired in a slump (yesterday it was announced that the unemployment rate hit a record 27.2% in Q1). Most forecasters’ long term growth estimates are simply countries’ long run historical averages, but given Spain’s high private and public debt levels, as well as deteriorating demographics, Spain’s long run potential growth rate may be as little as +1% per annum.

What about the third point about the debt/GDP ratio, namely stock flow adjustments? Our Spanish banks analyst Ed Felstead believes it isn’t inconceivable that even some of the banks that have been recapitalised by the state will need additional recapitalisations, despite the transfer of their most toxic real estate developer loans and assets to Sareb, Spain’s ‘bad bank’. Non Performing Loan (NPL) ratios at the now ‘clean’ banks remain high and revenue generation remains low on falling margins. Any further deterioration in asset quality on non-real estate developer loans will result in the banks having to take more provisions, which will lead to losses, with no way to replace the lost capital. This deterioration is likely given the state of the Spanish economy mentioned above, along with Sareb asset sales putting pressure on asset prices, and potential new borrower-friendly legislation on foreclosures and arrears.

So in the absence of a miraculous return to growth, Spain’s borrowing costs will continue to exceed its growth rate, large budget deficits will remain a feature, and it’s easy to see how further bank recapitalisations will be necessary. The IMF is no longer forecasting that Spanish debt levels will level off but will continue rising for the foreseeable future, and that’s even with what appears to be over-optimistic mean reverting GDP growth assumptions. Peripheral Eurozone bonds, and Spain’s in particular, look vulnerable to a sell off.

I predict a CypRIOT: Three major implications for the European and UK banking systems

Posted on 20 March 2013 by Ben Lord

Stefan blogged earlier this week about the landmark sovereign bailout occurring in Cyprus, and about some of the interesting issues this raises. Sure enough, the parliament did not approve the package in the form talked about at the weekend. The reason? The taxes were felt too painful for the poor and too lenient for the more wealthy. This harks back to a blog I wrote about a couple of years ago, and goes to reiterate the issues we discussed then. However, for now I wanted to highlight some of the issues that this raises more specifically for the European banking system at large.

Firstly, depositors were presumed to be guaranteed by governments up to at least €100,000 in Europe. Last weekend, that notion was dealt a brutal blow by the Cypriot situation. However, it feels to us as though the main reason for the parliamentary delays is that deposit guarantees could and should remain in place – or at least to a greater extent than was implied in the original bailout package. This package stated that those people with deposits of less than €100,000 would pay a 6.75% tax, whilst those with more than this amount would be taxed 9.9%. The politicians that have delayed the approval of the rescue package want to see greater amounts of the burden borne by the wealthier (those with more than €100,000, and perhaps an even higher rate borne by those with greater amounts than, say, €500,000 in deposits), and so lesser amounts of the burden borne by those with small amounts of deposits.

My guess is that this is the key issue here. If the tax rates are not changed, then I would expect to see some significant moves in Spanish, Italian and other peripheral deposit flows and movements. As a risk, this must not be underestimated by the Troika. Why not maintain the deposit guarantee and generate the amount raised by the taxes, through taxing more on those with more than €100,000, more still on those with more than €250,000, and more still on those with more than €500,000?

Secondly, subordinated debt bail-in is a key part of the package, and without it one senses the Troika will not part with the bailout funds needed. We have expected weaker banks in weaker regions to have to use this as a necessary tool to break the sovereign-bank link for some time now. It is now official, and being used. I would expect more of these to come.

Thirdly and finally, sovereign bailouts of banking systems where the sovereign is already in an over-levered position will no longer be tolerated. It is time to break the sovereign-bank feedback loop (as we previously wrote about here). This has to be through bail-in and burden-sharing. However, the most unpalatable part of the proposed package to us (and I guess to many riotous Cypriots) is this: up until 2007 it was believed that senior bank bondholders ranked pari passu with depositors in the event of a bank failure. And now in 2013 we learn quite vividly that in actual fact in Cyprus depositors are likely to be subordinated to a bunch of wholesale and institutional (ie banks and insurance companies) investors?

The capital stack has been turned on its head in this regard. No one used to buy senior unsecured bank debt because they thought that depositors would take losses before them. Rather, it was because the markets believed 100% in the government guarantee of depositors. The pari passu relationship of depositors and bondholders supported high valuations on senior bank bonds. Thus to be pari passu with depositors, senior bank bonds need to take the same losses as depositors are. In my opinion, this part of the proposed deal is the most disgraceful.

So, I find myself wondering how on earth a deposit tax found its way into the package. The answer to me seems to be quite simple: contagion, or the avoidance thereof. We all know that in Europe and the UK in the future (as in the US already), senior bank bonds will be bail-in-able or writedownable if a bank fails or gets into difficulty. We were originally told that the date for senior bank bond bail-in in Europe would be 2018, although there has recently been much talk about bringing this forward to the beginning of 2015. It has long struck me that this should be the favoured route out of the bank-sovereign interconnectedness problem in Europe: continue to promote and enable senior issuance in Europe by banks, and then implement a higher level piece of legislation that at some date in the future makes all debt in the Eurozone and UK writedownable.

No matter how small Cyprus is relative to the rest of the Eurozone, if the Troika had forced senior bank bondholders to accept losses before 2018 – or is it 2015? – senior bank debt spreads would have suffered significantly across Europe. Given that this is the most attractive funding market for banks at the moment, as it is still cheap to issue from a bank’s perspective, and as sovereigns do not want to have to (or cannot, in the Cyprus case) step in to take on more liabilities on behalf of their banks, the Troika has ripped up the rule book and done the insane.

I think parliamentarians in Cyprus should force a rethink on the sovereign-bank feedback loop, as well as forcing a more palatable (ie Robin Hood) sharing of the burden between smaller and larger depositors. After all, can anyone truly imagine the French, German or any core European government accepting losses for their depositors whilst a bunch of international senior bank bondholders get made whole? Our view is that depositors should be protected (at least to the guaranteed amount) over and above all wholesale creditors, whether senior or subordinated. This is the first step to break the sovereign-bank loop. The second step, only to be used in cases where there is not enough senior and subordinated debt to prevent the sovereign, and so tax-payers, from having to bail out the failed institutions, is to look at forcing losses on depositors, but with preserving the preceding guaranteed amounts of deposits. The final, most radical, and rarest, step is to have to renege on that deposit guarantee amount, so as to avoid tax-payer bailouts and increased probability of sovereign default.

Depositors across Europe are already watching Cyprus carefully. My guess is that many are starting to check the amounts they keep with any one institution or in any region. Subordinated bondholders are already aware of the risks if those banks get into difficulty, but senior bondholders in my opinion are not. These investors must ask whether the Cyprus package is likely to be copied in future cases. And they must also start to wonder if they still have until 2018 before senior bonds can be bailed in, or if it is significantly sooner.

RBS – The Goodwin Lottery?

Posted on 13 February 2013 by Richard Woolnough

Vince Cable has suggested that the government’s shareholding in Royal Bank of Scotland should be parcelled off to UK citizens. The UK government’s ordinary shareholding in RBS Group (A shares) today stands at 65.29%, which goes up to 81.15% including B shares (shares with priority over dividends).

Assuming the UK government would distribute A shares only, this would give us roughly 63 shares each that would be worth £222 based on yesterday’s closing share price of £3.54. This very simplistic way to dispose of the government’s ordinary stake could well be described as fair, though it would leave lots of individual holders and create administration and system chaos. Is there a better way? How can you reduce this administrative nightmare, make the give away more popular, or improve RBS’s future prospects?

How about simply having a lottery, as opposed to the shares being split? We could have a lottery based on the electoral roll for example. However, winners would get substantially more shares each, say 300,000, which at £3.54 a share would be worth just over a million pounds each. We could in effect create more than 13,000 new millionaires. It could maybe even be marketed as the Goodwin Lottery!

A second alternative would be to actually embrace free choice and the market economy via selling tickets for the lottery. This could not only create the same amount of millionaires, but would raise extra revenue for the government. The use of the existing Camelot lottery network would make that relatively efficient.

A third alternative would be to basically “de-mutualise” it. This would involve an open offer for sale of the government’s share holding to individuals, with all proceeds raised contributing to new equity for a new invigorated bank. This would act as a deeply discounted rights issue with the government stake being 100% diluted, and their huge loss being the new investors’ gains.

The ideal solution for the UK economy is to have a thriving competitive banking sector, at a minimum cost to the taxpayer. If the politicians decide the best way to do this is to simply give the shares away then hopefully they may improve their plan to get some of the potential benefits outlined above.

Going Dutch – SNS nationalisation

Posted on 4 February 2013 by Richard Woolnough

We have been talking about the emergence of, and the effects of, the financial crisis in our blogs for a number of years now. However, more than 5 years into the crisis even we can be surprised. On Friday the Dutch government nationalised SNS, as capital injections from the private sector failed to appear. This action was undertaken to maintain the stability of the Dutch financial system.

This legal manoeuvre involved a confiscation of all SNS equity and group and bank level subordinated debt by the authorities, and an injection of cash into the bank. The holders of the aforementioned equities and bonds quite simply no longer have these securities. To paraphrase Monty Python, they are ex securities. Investors have lost all legal rights. Instead, they have been offered potential compensation based on the value that the Dutch government ascribes to the securities. However, their judgement of what that amount may be is highly likely to be zero.

We have examined many times the potential weakness embedded currently in financial issuers and how the tiering of debt is becoming more significant for investors. Before the financial crisis, senior and subordinated debt from the same bank were seen as equal under all circumstances except an event of default, in which case the senior bonds would see better recovery values. The fact that for systemic reasons the authorities wouldn’t want the bank to stop operating meant that subordinated debt benefitted from the halo effect of the perceived need to sustain the bank for the benefit of the financial system. However, since 2008, countries all over Europe have been putting in place legislation, in the form of so called “resolution regimes”, to allow them to deal with failing banks, without necessarily having to keep the whole bank going. This use of these recently introduced new laws in the Netherlands allowed the authorities to separate the claims of subordinated bond holders from those of other, more senior, bond holders. This is something we have not encountered before in this form (for example, while the UK government did nationalise the preference shares as well as the equity of Northern Rock, it didn’t actually nationalise the subordinated debt, whereas in Denmark a different approach was followed, leaving bondholders on the wrong side of a good bank/bad bank split). This Dutch approach allows for the quick and efficient bailing in (writing off) of subordinated debt and allows the bank to continue operating, thereby protecting the financial system.

‘Going Dutch’ is an expression used when you agree to share a restaurant bill. However, going Dutch SNS style means subordinated bond holders pick up the tab, as they have been eliminated, losing all the capital value of their investment. They have explicitly provided 1 billion euros of capital to help the ongoing health of the Dutch financial system.

Early intervention of this sort to protect the financial system is obviously bad news for subordinated bond holders, with their status becoming more equity and less bond like. It will be interesting to see what the market and the rating agencies think of this new approach in the ongoing battle to support the financial system. Is it a one off, or something we are going to come to see as common practice?

Contingent capital notes – bank equity’s best friend?

Posted on 15 January 2013 by Stefan Isaacs

As investors, the majority of our time is spent pricing risk with an increasing amount of that spent trying to value optionality. We’ve always had to price the optionality inherent in owning certain bonds. For instance what’s the likelihood of a call option sold to a bond issuer being exercised? What’s the likelihood of an early refinancing, or perhaps a change of control? These and other options are both risks and opportunities that credit investors will regularly have to consider and reconsider.

Some of the more recent options that credit investors have been forced to consider are those embedded within contingent capital notes or CoCos. These aren’t entirely new securities with Lloyds having exchanged bonds for CoCos back in 2009. Simplistically these ‘first generation’ CoCos are designed to behave like a traditional bond until a pre-defined trigger is breached. When triggered, first generation CoCo holders are forcibly converted into equity at pre-determined pricing, aiding the bank with its recapitalisation efforts. These instruments have found favour with the regulator not least because traditional subordinate capital instruments proved themselves almost entirely ineffective in providing loss absorbing capital.

However, since the issuance in 2009 the market has moved on somewhat and a new breed of CoCo has since emerged. Many of these newer instruments (see chart above) are designed to be written off entirely in the event of a trigger without the conversion into equity discussed above. This optionality has two obvious implications. Firstly, given that investors are written down to zero without equity conversion, any prospect of participating in a future recovery becomes null and void. Secondly (with the caveat that the quantum of issuance remains small for now), the prospect of a bond essentially performing the role of a non dilutive emergency rights issue has to be positive for all other stakeholders in the bank, not least common shareholders. And don’t forget that the majority of these instruments will see their coupons paid before tax, further enhancing the relative value of said issuance.

Selling all this optionality does have its price, as do most things in life, but the current exuberance in credit markets may yet see CoCo investors fail to exact an adequate premium.

Central Bank Regime Change: an update following the Fed last night, and Carney the day before

Posted on 13 December 2012 by Jim Leaviss

Last night’s move by the Federal Reserve to change its approach to US monetary policy to effectively reduce the focus on the inflation target was just the latest step in an accelerating project by the world’s monetary authorities. In a world where unemployment rates are well above pretty much anyone’s estimate of the natural rate, and in many geographies well above 10%, the need for growth is seen as much more pressing that the fear of missing the 2% inflation targets. So at the latest FOMC meeting the Fed decided that inflation would be tolerated if it nudged higher to 2.5% as long as unemployment remained too high (above 6.5%). You can read the text of the Fed’s statement here.

We call this move by the world’s authorities away from the old idea of 2% inflation targets Central Bank Regime Change. We wrote this blog about it in March. The chart is worth showing again.

The chart from the IMF shows us that in the period post Paul Volcker’s appointment to the US Fed in 1979 (the orange line), the monetary authorities kept interest rates higher than the rate of inflation (they were reacting to the damage that inflation caused in the 1970s). As a result inflation steadily fell – and as well as high “real” rates, the rhetoric was all about inflation (inflation targets, the Bank of England’s Inflation Report, independent central banks). It’s been an awesome 30 years (on the whole!) to be a government bond investor, as yields fell in response to inflation fighting credibility. However, I’ve added another line to the IMF chart (blue), showing how central banks have behaved since Lehman went bust, and the credit crisis was followed by the sovereign debt crisis. It’s a very different story, with sharply negative real yields. Nominal interest rates are near zero in much of the developed world, yet inflation has been sticky above 2%. This is deliberate central bank policy – negative real rates are designed to make it attractive to borrow to invest and stimulate growth (and to deliver gains to indebted consumers), and also to encourage risk taking as investors reach for yield (government bond investors buy credit, investment grade investors buy high yield etc.).

Negative real rates also have an impact which we’ll discuss in more detail another time – debt reduction for bust governments. There are a few ways to reduce debt burdens: strong real growth (seems out of reach for the foreseeable future), austerity (unproven and probably counter-productive, although some point to Canada and Sweden as success stories), default (will be necessary for some Eurozone economies without their own currency to depreciate) and inflation. It’s the last that’s likely to be effective – and as the red line on that chart shows, it’s the method by which the western economies reduced the war debts following WWII.

So whilst we don’t believe the world’s central bankers and finance ministers are sitting high in some Swiss cable car complex, stroking white fluffy cats and cackling maniacally, plotting to generate super high levels of inflation, this is becoming the pragmatic (only?) response to a world without other policy responses (no fiscal flexibility left). Now the Fed’s latest move to target both inflation AND unemployment rates is very interesting – when I was a young student of economics, the idea that you could chose BETWEEN inflation and unemployment was discredited. To quote, er, Wikipedia on that idea, known as the Philips Curve “while it has been observed that there is a stable short run tradeoff between unemployment and inflation, this has not been observed in the long run”. So the idea that you can choose both is probably even more far fetched.

Anyway, what does the Fed’s action mean? Well watching Bernanke’s press conference last night it struck me that in changing the Fed’s guidance away from the “no hikes until 2015” towards the unemployment and inflation numerical targets should actually be seen as a potential monetary TIGHTENING. After all, we are exceptionally bullish on US housing as a driver for growth in 2013 and 2014, so if things go well we could end up with the Fed raising rates ahead of the old 2015 date.

So I’ve asserted that Central Bank Regime change is taking place, but I thought it would be worthwhile to put together a brief list of the evidence so far. Here it is.

Evidence for Central Bank Regime Change

The level of real rates set by the Central Banks: the best evidence is obviously shown on the graph itself. Are central bankers hitting inflation targets? Not really – for example the Bank of England has only had CPI at or below the 2% target for 6 months in the last 5 years, and for much of that period it’s been above 3% (and above 5% at one point!). On latest data the UK, the Eurozone and the US all have negative real rates of 1.75% or higher. Western central banks are even considering setting negative NOMINAL interest rates. Only Japan of the major economies has positive real rates at the moment – although we think this might change dramatically, as I’ll discuss below.
The US refocus on the dual mandate: after three decades of inflation targeting, the Fed has been moving towards this new objective for a year or so now. First Charles Evans of the Chicago Fed started floating the concept of an unemployment target, then Janet Yellan (Bernanke’s probable successor) of the San Francisco Fed joined him, leading up to last night’s actions. This was pushing on an open door for Ben Bernanke who has written the following in his previous academic life…
Bernanke’s 4% inflation target for Japan: in this paper, Japanese Monetary Policy: A Case of Self-Induced Paralysis, written whilst he was at Princeton in 1999, Bernanke argues that the solution for an economy like Japan with a burst property bubble, broken banks, sluggish growth and deflationary pressures should be to target inflation of between 3% and 4%. Looks similar to the US situation, so why wouldn’t Bernanke think that this is the correct response from the Fed for the US?
Mervyn King’s softening stance on the inflation target: I guess actions speak louder than words, and the lack of actual inflation targeting in the UK for the last 5 years should tell you more than any speech, but I’d never heard the Governor soften his rhetoric until these words in this speech Twenty Years of Inflation Targeting this October. “There may be circumstances in which it is justified to aim off the inflation target for a while in order to moderate the risk of financial crises”.
New Bank of England Governor Mark Carney talks about a new regime of nominal GDP targeting rather than pure inflation targets: in a speech to the CFA Society of Toronto this week, Carney (who takes over at the BoE next year) suggested that when policy rates approach 0% (the “zero bound”), targeting nominal growth might be more effective than targeting inflation rates. He even used, for the first time from a central banker (?) the term “regime change”. “Under Nominal GDP targeting, bygones are not bygones and the central bank is compelled to make up for past missed on the path of nominal GDP.” Of course, targeting nominal GDP is a very effective way of reducing debt levels in an economy too.
Japanese regime change, the “Abe Trade”: this weekend Japan goes to the polls with opposition leader Shinzo Abe of the LDP favourite to emerge as the new Prime Minister. Japan has yet to recover from its bust, decades ago, and Abe wants to aggressively target growth. With deflation of 0.4% in Japan despite the BoJ’s 1% inflation target, Abe wants the central bank to do MUCH more. This would include raising the inflation target to 2% (or even 3%) and doing whatever it takes (more QE, currency intervention) to achieve that. This is a manifesto commitment that might get watered down at a later date – but having seen a BoJ member in Tokyo recently I get the feeling that a hike in its inflation target is inevitable.
Europe: hard evidence is more difficult to find, but with hawkish German ECB members like Axel Weber and Juergen Stark both resigning in 2011 (“It’s generally known that I’m not a glowing advocate of these (bond) purchases” – Stark) the ECB has been much more open to extraordinary balance sheet expansion (LTRO, SMP, OMT). And to more “traditional” Quantitative Easing at a later date?

So with all of this evidence that the authorities are changing how they think, and act, on inflation, you would expect that bond markets would have reacted badly right? If Ben Bernanke thinks 4% is an appropriate level for inflation in the US, you wouldn’t be lending money to the government at 0.65% for the next 5 years would you? And with Mark Carney taking over at the BoE next year, breakeven inflation rates (i.e. market inflation expectations) would be overshooting the 2% inflation target over the next few years too? Well 5 year Treasury yields are still well below 1% (helped by QE buying of that sector, announced last night) and UK breakeven inflation rates on a CPI basis are below the 2% inflation target. In both cases it feels as if state intervention in these markets (financial repression through QE, capital requirements etc.) will keep yields low despite high inflation. And this is entirely necessary – with half the US Treasury market maturing in the next 3 years or so, if yields ever did adjust higher then western governments, with marginal solvency in any case, could go bust quickly.

Don’t call us we’ll call you

Posted on 1 November 2012 by Richard Woolnough

We have opined on many occasions about the call features on bank debt and have long argued that investors and issuers should price these securities on economic rather than emotional grounds (for more detail, see Jim’s blog on Deutsche Bank being the first not to call a Lower Tier 2 bond in 2008).

However, even we were surprised late last week when Intesa SanPaolo decided to amend the terms of some of its callable subordinated debt by removing the call option for each of the bonds.

The terms of a security are sacrosanct to bond investors. We obviously fear the terms of a contract being amended as this reduces our legal rights and the value of our securities. Therefore bond documents are carefully written, and a trustee generally acts as an arbiter to protect both the issuer and the investors’ interests. How can Intesa be allowed by the trustee to unilaterally change the terms of the bond?

The simple removing of the call option from the bond terms and conditions is not detrimental to bond holders. If someone has an option against you and cancels that option the text books and simple logic states that you can be no worse off, and the only party whose position is weakened is the one who has cancelled the option they had against the other party. So in theory as a bond investor you’re better off, so why complain?

The reason investors in these types of securities are concerned is that they were hoping that for reputational reasons the bonds would be called to keep them happy. In many cases that long term care of reputation with regard to funding has been deemed an appropriate call (excuse the pun) for the bank issuer of these callable securities to make.

The companies that have generally not called securities in the past have been led by the likes of JP Morgan, Deutsche Bank, and US Bancorp. But none of them decided to remove the call option as that would be potentially detrimental to them. Indeed this week US Bancorp’s subordinated bonds matured due to them exercising an economically efficient call. These non-callers continue to be able to fund and interact with the investors whose expectations were not met regarding their bond holdings.

In these difficult times it appears that banks are now more willing to act on a purely economic basis, which takes some of the hope out of the valuation of callable securities. The investor relations department of banks used to have a mantra of ‘don’t call us we’ll call you’. That is looking increasingly out of fashion.

5 years on

Posted on 10 October 2012 by Richard Woolnough

On the 9th October 2007 the totem pole of capitalism, the S&P 500, peaked at 1,565. Last night it closed at 1,441. So, five years into the crisis, where are we in terms of clearing up the banking crisis?

There’s good news in the US. We have commented on the initial driver of the crisis in the world’s largest economy – the boom and bust of the housing market – on many occasions. Recently, we’ve noted that we’re beginning to see improvement here. This is an important sign that the US is moving on from the financial crisis. Although unemployment remains stubbornly high, it is moving in the right direction and the financial system is looking sound once again. The government’s combination of supportive measures – such as taking equity stakes in banks – and allowing some pain to occur – in the case of Lehman Brothers and housing repossessions – seems to have been largely successful.

The UK economy and financial system have not yet returned to the same state of health and the government still holds legacy stakes in some of the bigger banks. It appears that the problems the country faced five years ago remain, even though they are not as severe as they were. These difficulties are highlighted by today’s Financial Times where the two headline stories relate to the FSA easing bank rules further to encourage lending and help the financial system, and the governor of the Bank of England’s speech at my old university last night where he talked about giving central banks greater flexibility with their inflation targets to help avoid financial crises.

Europe, the third major western financial system, faces its own particular problems. Five years on from the peak we had the strange situation of the German chancellor being taken in a convoy of cars through Athens past illegal demonstrators to try to sort out the continued funding of the Greek state. We have written many times about the questionable sustainability of a politically motivated single currency and the funding of states, individuals and corporates remains difficult in many parts of this system.

We believe financial systems need to be mended by a combination of government intervention and private sector responsibility. The US has led the way in this regard and the UK is trailing, hopefully successfully, behind it. However in Europe the problems have been exacerbated by the single currency regime, where the need for political intervention to solve the problem is relatively large versus the need for private sector adjustments. We are still concerned about whether the necessary political intervention will occur. So, five years on, it appears that the western world is still coming out of the credit crisis, albeit at different speeds and with different levels of success.

The “safety race”: the systemic implications of the bank asset grab

Posted on 26 April 2012 by Jeff Spencer

Anyone monitoring the risks in the global financial system knows that those of us who lend to banks are increasingly asking for some kind of security in order to do so. Issuance volumes for covered bonds have increased and more countries have recently passed covered bond laws or are in the process of debating legislation. Andrew Haldane, Executive Director for Financial Stability at the Bank of England, raised greater asset encumbrance at banks as a serious concern in a recent speech.

The speech outlines three “arms races” that banks have been or are now engaged in. One of these is a “safety race” in which investors all want to be first in the queue in case of liquidation. It is true that this “race” to the front of the queue has intensified in the past several years, but many forms of bank lending or trading have only been done on a collateralised basis for some time in the form of repo or derivatives trading with collateral posting requirements. The race for safety has only intensified as many banks have been forced to substitute collateralised central bank funding for other sources of funding that have been more difficult or too expensive to access. In the speech, the topic of pledging assets to receive central bank funds – in many countries the biggest reason for higher and higher encumbrance – is referred to. Repo, derivatives and covered bonds are not mentioned by name, but are implicitly involved in the “safety race”.

Certainly the thesis that investors are less and less willing to provide unsecured financing to the banking system is not new or controversial. That said, if you ran a poll as to the reasons investors have on balance pulled back, we strongly suspect the average investor would cite bail-in proposals and resolution regimes as being at least as important as encumbrance, since under the pre-Lehman assumption of state support the question of asset encumbrance and recovery rates didn’t really come up: the expectation (made explicit in ratings pre-crisis) was that the liquidation of systemically important banks was almost purely hypothetical.

Haldane proposes in the speech that, along with sensible macroprudential measures to curb systemic leverage and risk-taking as well as the speed of trading, regulators look to limit the amount of asset encumbrance at banks. How that sits with a central bank’s liquidity provision against collateral makes for an interesting thought experiment, but the more serious implication is that the real limits on pledging collateral could (if they emerge as policy proposals) be found in the new attempts to bring the repo market out from the shadows, which will form the subject of discussions being carried out by the FSB, EU, IOSCO and other bodies over the course of 2Q and 3Q 2012. Another area limitations may emerge is in covered bond regulations, which are constantly evolving. (Note that the US and Canada, both with longstanding deposit insurance arrangements, already limit the amount of covered bonds that banks can issue, even though neither country has a legislative covered bond framework yet.)

It’s worth thinking about whether limits on asset encumbrance actually benefit senior unsecured bank bond investors. There is at least a case to make that more of the benefits would accrue to shareholders, since leverage without asset pledges should still, all else being equal, increase returns to them, whereas senior unsecured investors, even having potentially better recovery prospects, would have to resort to pushing harder for faster implementation of the Basel III leverage ratio in order to gain protection. Current covered bond issues, at the margin, may be relatively more attractive than they already are, if there were to be a possibility of regulatory limits on issuance.

Finally, what about creditor bail-ins? Discussion continues about how this will be implemented in the EU. If it turns out that new “senior” debt, that explicitly allows write-downs, has to be issued to meet a bail-in debt requirement, it’s hard to argue that any investor would buy it without significantly more information on asset encumbrance. Investors would have to stand a chance of attempting to work out a recovery rate on their debt if they were to commit to automatic write-down in the event of resolution. The paradox is that the more serious regulators have become about bail-in, the more counterparties and lenders have grabbed collateral. The only obvious pressure valve is pricing, which makes it logically very difficult to argue that unsecured bank debt will see a significant rally in the near future.

Asset encumbrance remains a topic to watch, certainly, and it presents more evidence that bank balance sheets remain in a state of flux, so talk of a recovery in the senior unsecured market remains premature.

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