Remember how prohibiting the use of naked sovereign CDS was supposed to make the CDS market tame as a docile lamb? Well, as it turns out, the bulk of the marginal moves were not CDS driven, but simply basis traders putting on, and taking off hedges. Ignoring the fact that many desks have experienced "Boaz Weinstein" like events in the past month (perhaps even Mr. Basis "$4.7 billion AUM" Trade himself), it seems that CDS is now simply tracking moves in cash. And those moves, if you are France, are not pretty. As the chart below shows, French CDS have just hit 88 MPH and are about to go back to a calmer, more peacful time, when everyone could buy and sell stuff using the French Franc...
UPDATE: EFSF is denying it bought its own bonds. We suspect semantics as the denial is very specifically worded and EIB or ECB involvement is possible and frankly just as incredible. Perhaps the ECB really is the lender of ONLY resort.
We earlier discussed the desperate actions that occurred surrounding the EFSF self-aggrandizement this week and Peter Tchir, of TF Market Advisors, notes that the whole situation was bizarre and is becoming more and more Enronesque every day. But the lack of demand for EFSF debt is simply, as we have repeatedly pointed out, a factor of their own design and a symptom of the actions that a bloated lobbying IIF and the feckless politicians have taken. One of the obvious consequences of the EU and IIF decision to pursue this restructuring is they cannot fully rely on CDS, and markets will treat net exposure numbers with skepticism.
So banks will sell bonds/loans and unwind their CDS positions and manage their exposure the old fashioned way, by adding or reducing to their bond/loan position. That impact seemed obvious to everyone other than the EU and IIF. So the pseudo-private money (EU banks, EU pension funds, and EU insurance companies) are reluctant to buy EFSF bonds because they already have too much sovereign exposure, and the EU is likely to force "voluntary" changes on EFSF debt before it would on actual outright sovereign debt. Real private money is confused by the structure. Who does that leave? Only sovereign wealth funds and other supra-national entities.
EFSF is the bond only a mother could love.
The spike in yields on sovereign debt of Italy was attributable, only in part, to the Italian political turmoil we are witnessing. The other aspect dealt with CDS on Italian debt. Those holders thought they had one type of CDS protection. They realized from the events in Greece that they had something else.
Remember Austria: that "other" AAA-rated country, whose megabank Erste recently made headlines for covering up its sovereign CDS exposure? It appears that AAA rating, which means Austria is still eligible to fund the EFSF, may soon be cut, putting even more pressure on Germany and, of course, France, and thus concerns for ratings downgrades there, to bear the brunt of what is an increasingly impossible bail out plan for Europe. It also means that the market will now be fearing not only a kneejerk reaction to the perpetual French downgrade terror threat courtesy of S&P and Moody's, but can now add not only Hungary and Belgium but also Austria to the list of countries due for some inverse rating agency love trim. As for the catalyst: "In two weeks, Moody's analysts to come to Vienna to assess the situation on the ground. Felderer considers it possible that Austria would put on negative outlook in this review." Alas, it appears that the Grinch is about to steal AAAustria's vaunted rating for Christmas, and push the direction of contagion into a whole new direction.
This morning brings the latest, or the third, in the ongoing pitch book of Italian bonds by Goldman's Francesco Garzarelli, in which the strategist hopes that third time will be the charm for calling the bottom to the BTP collapse (sold to you, Goldman client). What apparently has Goldman confused is how its former employee Mario Draghi has let BTP spreads hit the record and unsustainable levels they did yesterday. To wit: "We were actually quite surprised not to see more forceful intervention by the central bank in secondary markets after the LCH announced it would raise initial margin requirements (and wrong in assuming it would have helped keep the Italy vs. AAA spread close to 450bp – it closed yesterday at 500bp over, but is now back at 450bp)." Here Goldman confirms what we suggested on Monday: that the ECB is now nothing but a policy enactment and dictator overhaul tool: "In this context, Italy still has to comply fully with the ECB’s ‘requests’ dated August 8, while Greece’s commitment to more austerity in exchange for financial support has continued to sway (at the time of writing, news that former ECB no. 2 Papademos would take the helm is encouraging)." Even so, the future to Goldman is quite cloudly :Granted, one positive collateral effect of market tensions has been to precipitate a political shakeup in Italy. But the collateral damage created by the price shock in Italian bonds to the stability of the EMU project (aggravated by explicit talk of countries being expelled from the single currency) is high and quite lasting. It will probably take a leap forward into deeper forms of fiscal risk-sharing (Prof Monti is a long-time proponent of Eurobonds) to get the market properly functioning again." OTOH, Barclays has done the math, and as we pointed out a few days ago, is not surprised.
Earlier today, Jefferies made it all too clear that anyone found holding any PIIGS sovereign debt exposure, net AND gross, will be promptly punished by the market all the way down to the circuit breaker halt, until such party promptly offloads its GROSS exposure to some other greater fool, in the process gutting its entire flow trading desk. Courtesy of Bloomberg we may now know who the market will focus its attention on next: "Barclays has $12.5 billion sovereign risk, $20.1 billion of risk to corporations and another $10.2 billion to financial institutions. It also has $66.6 billion of exposure in its retail business, 86% of which is to Spain and Italy. Group and corporate-level risk mitigation (sovereign CDS, total return swaps) may reduce these exposures." Or, as the Jefferies case study demonstrated so vividly, it may not, and the only option will now be for Barclays to post daily releases with CUSIP breakdowns which will achieve nothing until Barclays follows in Jefferies footsteps and liquidates (at what is likely a substantial loss) all or at least half of its gross exposure. Thank you Egan Jones for starting a hot-potato avalanche that will keep banks honest. And woe to the last PIIGS sovereign debt bagholder.
Back To European Sov Exposure: Moody's Will Downgrade Austria's Erste Over Attempt To Hide Billions In Sovereign CDSSubmitted by Tyler Durden on 11/04/2011 10:09 -0400
Before MF Global went bankrupt due to European sovereign exposure, the smart money was that Austria's Erste would be "it." After all, recall from our October 10 post "that Erste disclosed some major losses on its €5.2 billion CDS portfolio, consisting of "EUR 2.4 billion related to financial institution exposures, and EUR 2.8 billion related sovereign exposures". Why is this a surprise? UK-based financial advisory Autonomous explains: "The fact that Erste had a sovereign CDS portfolio which was not marked-to-market has left many investors scratching their heads. As a reminder the EBA stress test data showed Erste to have zero sovereign CDS exposure within its sovereign mix compared to the €2.8bn it now appears to have ‘fessed up’ to (taking a cumulative €460m hit). They also have €2.4bn exposure to banks via writing of CDS. The bulk is non-PIIGS but banks spreads have moved in the same manner as sovereigns (albeit wider and more volatile)." And there you have it: the bogeyman that everyone has been warning about, yet nobody has seen, CDS written (as in sold) in bulk against other sovereigns and other banks which up until now were only mythical, as they, to quote the EBA (which had Dexia as its safest bank) simply did not exist. Oh, they exist all right, and what they do is create a toxic spiral of accentuating losses whenever the risk situation deteriorates, creating positive feedback loops of ever increasing losses until the next Dexia appears... and then the next... and the next. Expect the market to latch on to this dramatic revelation like a rabid pitbull once the hopium high from today's EURUSD short covering squeeze wears off." Of course, the market ignored this loud warning bell, and next hting you know MF was under. This time it won't be so easy, especially since Moody's just announced it is about to downgrade Erste precisely for this reason. This move also explains why the market is suddenly rife with rumors of a broad Austria downgrade.
Following this morning's busted issuance, it seems appropriate to take a deeper dive into the first-loss insurance that EFSF issuance may provide. There are still a lot of details to be worked out, but the €250 - €275 billion EFSF first loss insurance facility is starting to take shape. The amount of exposure that the EFSF can take in any form and retain the AAA rating is capped at €452 billion Euro – the amount of guarantees provided by the AAA entities. It looks more and more like the EFSF guarantees will be used in 3 different ways. A portion will be used to raise money to meet commitments already made to Greece, Ireland, and Portugal. Another portion will be allocated to provide additional capital to banks. Finally, a portion will be used to back first-loss insurance and we note that the EFSF First-Loss Insurance Program is like Nothing We Have Ever Seen Before. Why we have wound up at the stage that issuing binary options on sovereign debt is a good solution, I don’t know, but since we are there, it might as well be done as well as possible.
The first three CDS ban attempts have failed. So has the coordinated ISDA attempt to make sovereign CDS a product with absolutely no functionality. The fourth time will be the charm though. The EFSF guarantees it! On the other hand, think of the massive EPS profit that Italy will post this quarter as a result of today's CDS blow out courtesy of the DVA accounting gimmick. Surely Dick Bove will imminently upgrade it to Dodecatuple Turbo Buy.
The duration of the European bailout was 48 hours give or take. And now reality is back in the form of the following headlines:
- Italian 10 Year BTP Yield surges to all time high 6.153% before ECB intervention takes it back to ... 6 122%
- Expressed in price, they have dropped to a record 90.697
- Italian-German 10 year yield passes 400 bps
- Italy CDS soar 22 bps to 427 bps
- Italy 5 Year yields bonds join drop, yield rises to over record 5.91%
See a trend? The one thing Europe was trying to avoid, contagion spreading to Italy, has happened.
With tonight's multi-year record CNY fixing and trillions being flushed at maintaining an arbitrary JPY line in the sand, it seems appropriate to re-consider how to hedge a China hard landing and what probabilities various asset classes are assigning to it occurring. While many are pointing to what seems an entirely capricious level of 79.20 JPY to the USD as the 'new normal' being defended, we were curious at the strange coincidence that the CNYJPY cross implied by tonight's CNY fixing and the 79.2 JPY was exactly the average CNYJPY level during the QE2 period. It seems the Japanese are hedging their tail-risk against the Chinese and a recent note by Morgan Stanley points to how various asset class traders might consider hedging their own version of a hard-landing scenario and notably they agree with us that China sovereign CDS remains among the 'best' hedge.
Your one stop, comprehensive summary of the main bullish and bearish events in the past week.
With the EFSF, Italian and Spanish debt all creeping higher in yield today and a disappointing Italian auction, we take a deeper dive into the mechianics of the EFSF and the paradoxically weak impact it may have as sovereign risk deteriorates. The [EFSF] idea works well when people aren’t thinking there is a real chance of default, but as that increases, the EU may wish they had stuck to their original plan of having raised 440 billion of cash that they could lend directly. Basically, if the markets deteriorate, the first loss protection, is worth more, but provides less leverage.
The reason why the EURUSD took a big step lower in the past minutes is because Fitch has come out with a note in which it has assigned an AAA rating to the amended EFSF program. That in itself is not an issue, what is however, to the market is the announcement that a 50% Greek haircut would be an event of default. That said this is not to be confused with an ISDA determinations committee ruling that CDS has been triggered: we now know this will never happen and is the reason why basis trades across the board are exploding as all sovereign CDS is effectively being unwound. Regardless, the market does not seem to be liking the fact that someone's head is not stuck in the sand. Fitch also adds that it is critical that ECB carry on bond purchases, something which neither the ECB nor Germany have agreed to. It also adds that Greek PSI deal is a necessary step, and that the effectiveness of the summit deal depends on details. This is important considering Greece was barely able to get 85% acceptance in its 21% proposed haircut. The 50% will be even more interesting. Fitch concludes that the market is likely to see further market volatility. That is a given.
It has been long in coming but finally the credit market is noticeably refocusing its attention to the two countries that are supposed to carry the burden of bailing out the world on their shoulders: Germany, and, that perpetual placeholder for global rescues, China. As noted yesterday, while following today's anticipated ISDA decision to effectively make price discovery in CDS null and void, and in the process also put the whole premise of sovereign debt insurance into doubt, CDS still provides a very useful metric courtesy of the DTCC, namely open interest, or said otherwise, gross and net notional outstanding in the CDS. And while we will reserve the observation that not only did ISDA kill sovereign CDS, but in the process it also ended bilateral netting effectively pushing up net CDS to the level of gross, we will highlight that as of the last week, net notional in both German and China CDS has hit a record, of $19.6 billion and $9.3 billion, respectively. This is occuring as notionals in the two most active countries to date, France and Italy, have been declining. In essence, what the CDS market is telling us is that while the easy money in French and Italian default risk has been made, it is now finally the turn of China and Germany to defend their credit risk and sovereign spreads. We expect that if China is indeed confirmed to be the backstopper of Europe through funding the EFSF in whole or in part, that while its CDS may or may not surge, net notionals will continue to increase as it means that ever more are laying insurance, as hobbled as it may be, on the country which recently was forced to bail out its own banking system, let alone Europe. Keep a close eye on China, which while the bulk of the market is taking for granted as the global rescuer of last resort with hard money, the smart money is already positioning itself for the next big disappointment.