callable

The Fed’s zero lower bound policies have dislodged credit risk as the primary concern for investors, only to replace it with a major technical headache: interest rate risk. If rates remain too low for too long, financial stability suffers as investors reach for yield, companies lever up, and lending standards decline. The greatest of financial stability risks is probably the least discussed among those that matter at the Fed: the deterioration in trading volumes. As such, we suspect that the longer low rates persist, the worse the unwind of QE may be. And it may, in fact, already be too late. As events in the past two weeks have shown, credit markets also appear vulnerable to a rise in rates that occurs too quickly or in a chaotic fashion. Moreover, to the extent that issuers sense demand may be waning for bonds, there’s a distinct possibility the pace of supply increases precisely at the same time that demand decreases. Invariably, it’s this sort of dynamic that ends in tears.

Do you need a break from public policy buzzwords? Are you happy to go back to the days when cliffs were discussed occasionally on the National Geographic channel but not analyzed ad nauseum on CNBC? Are you tired of reading about austerity, austerians, anti-austerians and austeresis? You’ve come to the right place. “How long have we been deleveraging?” – I’ll answer “zero years.” As in, what deleveraging? We haven’t even gotten started yet.

S&P futures are bleeding back down again after-hours (and EUR -30pips) as Moody's announces the downgrade of the EFSF and ESM from AAA to Aa1. "Moody's decision was driven by the recent downgrade of France to Aa1 from Aaa and the high correlation in credit risk which Moody's believes is present among the ESFS' and ESM's entities' largest financial supporters." Of course, this is nothing to worry about as we are sure that some Middle East sovereign wealth fund will still buy their bonds? Or China? Or Supervalu?

• *MOODY'S DOWNGRADES ESM TO Aa1 FROM Aaa, EFSF TO (P)Aa1 FROM Aaa

Not entirely surprising given the underlying rating moves - but yet more AAA-rated collateral bites the dust.

Europe just can't catch a break these days. While French Fitch naturally came out earlier with a AAA rating and a stable outlook, it is Moody's, which has yet to follow through in S&P's footsteps 14 months later and tell the truth about America's AAA rating, that moments ago spoiled the ESM "inauguration" party by branding it AAA, but with a Negative outlook. So much for the most 'supersecure' CDO on earth: looks like we are not the only ones to assign comical value to the ESM's €80 billion first loss "Paid-in" tranche. Because that 12% in buffered protection can disappear very quick if and when the central planners lose control.

Now that the ESM has been officially inaugurated, to much pomp and fanfare out of Europe this morning, many are wondering not so much where the full debt backstop funding of the instrument will come from (it is clear that in a closed-loop Ponzi system, any joint and severally liable instrument will need to get funding from its joint and severally liable members), as much as where the equity "paid-in" capital will originate, since in Europe all but the AAA-rated countries are insolvent, and current recipients of equity-level bailouts from the "core." As a reminder, as part of the ESM's synthetic structure, the 17 member countries have to fund €80 billion of paid-in capital (i.e. equity buffer) which in turn serves as a 11.4% first loss backstop for the remainder of the €620 billion callable capital (we have described the CDO-like nature of the ESM before on many occasions in the past). The irony of a country like Greece precommiting to a €19.7 billion capital call, or Spain to €83.3 billion, or Italy to €125.4 billion, is simply beyond commentary. Obviously by the time the situation gets to the point where the Greek subscription of €20 billion is the marginal European rescue cash, it will be game over. The hope is that it never gets to that point. There is, however, some capital that inevitably has to be funded, which even if nominal, may prove to be a headache for the "subscriber" countries. The payment schedule of that capital "invoicing" has been transformed from the original ESM document, and instead of 5 equal pro rata annual payments has been accelerated to a 40%, 40%, 20% schedule. And more importantly, "The first two instalments (€32 billion) will be paid in within 15 days of ESM inauguration." In other words, October 23 is the deadline by which an already cash-strapped Spain, has to pay-in the 40% of its €9.5 billion, or €3.8 billion, contribution, or else.

A long period of economic mediocrity is the most likely outcome.

Despite the ongoing barrage of pronouncements out of Europe on a weekly if not daily basis, discussing the imminent launch and even more imminent success of the ESM, the reality is that many questions remain: such as will Germany just say nein again today, in the constitutional court's verdict, especially after the President asked Merkel over the weekend why it is that Germany has to keep bailing out Europe, a proposition which no longer impresses about 54% of the German public. More importantly, even though the debate over the explicit subordination of the ESM may be resolved (it never will be as the bailout funding will always be implicitly senior to general bondholders no matter how many pieces of paper are signed), a bigger debate now emerging is just who will guarantee the bank losses. Below, we answer that question, and virtually every other outstanding one, courtesy of this DB analysis, which removes most of the lack of clarity surrounding the European bailout mechanism. Yet the main axis of inquiry in our opinion is different: what is the timetable of funding rollout. Because as DB explains, "It follows that from July to October, the ESM can only lend about EUR 100bn. If that is committed to Spain, there is nothing left in the ESM until October. Any other intervention before October would have to be under the EFSF." In other words, assuming a smooth acceptance of the ESM today by the German court, and no further glitches, the best case scenario is one which provides for funding to Spain... and there is no other cash until virtually the end of the year under the ESM, whose implementation is staggered as the chart below shows.

Just this week we had: TVIX, MF Global & “customer money”, CPDO, Greek CDS auction, BATS.... I’m all for some complexity and innovation, but it does seem after a week like this, that the financial markets have become too complex, and some real effort should be made to simplify things and put everyone on an even playing field.

Over the weekend, we commented on Dylan Grice's seminal analysis which excoriates the central planning "fools", who are perpetually caught in the "lost pilot" paradigm, whereby the world's central planners increasingly operate by the mantra of “I have no idea where we’re going, but we’re making good time!” and which confirms that in the absence of real resolutions to problems created by a century of flawed economic models, the only option is to continue doubling down until terminal failure. Basically, the take home message there is that once "economists" get lost in trying to correct the errata their own models output as a result of faulty assumptions (which they always are able to "explain away" as one time events), they drift ever further into unknown territory until finally we end up with such monetary aberrations as "liquidity traps", "zero bound yields" and, soon, NIRP (which comes after ZIRP), if indeed the Treasury proceeds with negative yields beginning in May under the tutelage of the Goldman-JPM chaired Treasury Borrowing Advisory Committee. Today, it is Bill Gross who takes the Grice perspective one step further, and looks at implications for liquidity, and the lack thereof, in a world where one of the three primary functions of modern financial intermediaries - maturity transformation (the other two being credit and liquidity transformation) is terminally broken. He then juxtaposes this in the context of Hyman Minsky's monetary theories, and concludes: "What incentive does a US bank have to extend maturity to a two- or three-year term when Treasury rates at that level of the curve are below the 25 basis points available to them overnight from the Fed? What incentive does Pimco or banks have to buy five-year Treasuries at 75bp when the maximum upside capital gain is two per cent of par and the downside substantially more?" In other words, Pimco is finally grasping just how ZIRP is punking it and its clients. It also means that very soon all the maturity, and soon, credit risk of the world will be on the shoulders of the Fed, which in turn labor under a false economic paradigm. And one wonders why nobody has any faith left in these here "capital markets"...

Isn’t it meaningless to look at the inverse floaters in isolation? To assess risk, shouldn’t we look at the entire portfolio held by Freddie Mac?

While sounding just a tad preachy in his February newsletter, Bill Gross' latest summary piece on the economy, on the Fed's forray into infinite ZIRP, into maturity transformation, and the lack thereof, on the Fed's massive blunder in treating the liquidity trap, but most importantly on what the transition from a levering to delevering global economy means, is a must read. First: on the fatal flaw in the Fed's plan: "when rational or irrational fear persuades an investor to be more concerned about the return of her money than on her money then liquidity can be trapped in a mattress, a bank account or a five basis point Treasury bill. But that commonsensical observation is well known to Fed policymakers, economic historians and certainly citizens on Main Street." And secondly, here is why the party is over: "Where does credit go when it dies? It goes back to where it came from. It delevers, it slows and inhibits economic growth, and it turns economic theory upside down, ultimately challenging the wisdom of policymakers. We’ll all be making this up as we go along for what may seem like an eternity. A 30-50 year virtuous cycle of credit expansion which has produced outsize paranormal returns for financial assets – bonds, stocks, real estate and commodities alike – is now delevering because of excessive “risk” and the “price” of money at the zero-bound. We are witnessing the death of abundance and the borning of austerity, for what may be a long, long time." Yet most troubling is that even Gross, a long-time member of the status quo, now sees what has been obvious only to fringe blogs for years: "Recent central bank behavior, including that of the U.S. Fed, provides assurances that short and intermediate yields will not change, and therefore bond prices are not likely threatened on the downside. Still, zero-bound money may kill as opposed to create credit. Developed economies where these low yields reside may suffer accordingly. It may as well, induce inflationary distortions that give a rise to commodities and gold as store of value alternatives when there is little value left in paper." Let that sink in for a second, and let it further sink in what happens when $1.3 trillion Pimco decides to open a gold fund. Physical preferably...

So the ESM is going to be implemented ahead of schedule.  Or at least that is the current plan, although it seems that Finland is insisting that it retains unanimous voting and most (all?) countries still need to ratify it. The ECB will oversee the ESM and EFSF, which is good as they have more market experience than the EFSF head, but does mean they will be reluctant to print which is what the market really wants. The ESM will have an effective lending capacity of €500 billion.  That document states that the lending capacity of €500 billion includes any capacity being used by the EFSF.  The EU statement confirms that.  So between EFSF and ESM, the combined lending capacity is €500 billion.   “The ESM will use an appropriate funding strategy so as to ensure access to broad funding sources”.  So the ESM has paid in capital but it will continue to try and raise money based on guarantees and commitments.  I know this is a detail that people want to ignore in the rush to proclaim “paid in capital” but the reality is that the ESM is not so dissimilar from the EFSF... On a side note, Europeans seem to love night clubs much more than Americans.  Maybe that is why they make all these announcements at 5 am?  They are used to "table service" shutting down around that time and having to make a decision of what to do next.  I can count how many good decisions I've made at 4 am after an all-nighter on one hand.  Why will this be any different.  It feels to me like at the end they shrugged their shoulders and decided to settle because it wasn't going to get any better and they didn't feel like saying the night had been a waste.

Update: And it gets better. Now Dow Jones:

• Euro-Area Countries Ready To Provide IMF With Bilateral Loans, According To Draft Seen By Dow Jones

Yet earlier today, none other than Mario Draghi said that loans to the IMF to purchase European bonds would be legally unworkable. Brilliant

With just 30 minutes until the close we were cutting it close to a rumorless, headlineless session. So here is Reuters to the rescue:

• ESM BAIL-OUT FUND TO BE GIVEN BANKING LICENCE - DRAFT
• EU DETERMINED TO STRENGTHEN BAILOUT MECHANICS - REUTERS

And from earlier:

• ESM BECOMING A BANK "OFF THE TABLE"

Have fun

The only quote worth noting from the just delivered speech by ECB executive board member José Manuel González-Páramo is the following: "We cannot completely delegate governance to financial markets. The euro area is the world’s second largest monetary area. It cannot depend solely on the opinions of ratings agencies and markets. It needs economic governance arrangements that are preventive and linear. This underscores my central point that a much more comprehensive approach to economic governance is now the priority for the euro area. And this means more economic and financial integration for the euro area, with a significant transfer of sovereignty to the EMU level over fiscal, structural and financial policies." In other words, in order to protect people from the "stupidity" of rating agencies which after years of lying have finally started telling the truth, and the market which does what it always does, and punishes those who fail, Europe must be prepared to give up "significant sovereignty" (sounds better than Anschluss) to Europe's "betters" which is another way of saying 'he who pays the piper calls the tune." And "he" in this case is, of course, Germany. In other words, courtesy of one failed monetary experiment Germany will succeed, without sheeding one drop of blood, where it failed rather historically some 70 years ago.

Yesterday's divergence/convergence in HYG/HY17 was another example of the interplay between various instruments in the credit market space and how they can be traded profitably. Taking a step up from the trees to the forest, unlike Mr. Fink's earlier comments on the cheapness of equities relative to any and every other asset class, we note that in fact - were you to have a bullish perspective on the world - then HY spreads are far cheaper (i.e. priced for much more of an Armageddon-like scenario) than equities and offer more upside if things work out. However, the bond ETFs have their own set of technical flows and idiosyncratic risks and Peter Tchir, of TF Market Advisors, sees growing concerns in this increasingly active area of the market.