Credit Suisse

We have lived through a long period of financial management, in which failing financial institutions have been propped up by emergency intervention (applied somewhat selectively). Defaults have not been permitted. The result has been a tremendous build-up of paper ripe for burning. Had the fires of default been allowed to burn freely in the past we may well have healthier financial institutions. Instead we find our banks loaded up with all kinds of flammable paper products; their basements stuffed with barrels of black powder. Trails of black powder run from bank to bank, and it's raining matches.

As forecasts for peripheral macro data continue to deteriorate and core to strengthen modestly, there is little real comfort available from the European situation aside from the 800lb gorilla that all headlines are focused on today. Credit Suisse describes it as "a case of the outlook being less bad than expected, rather that it being better" and notes that post the Greek situation, despite the ongoing rally in the ever-thinning sovereign bond market, that risk premia (that were dangerously forgotten for the first decade of the Euro) will remain at elevated levels. CS sees three scenarios beyond Greece with even the best-case leaving questions of sustainability, trust, and continued negotiations yet the market's willingness to follow along the path of inevitably ruinous policies seems writ large with today's credit, equity, and FX strength.

• German president resigns in blow to Merkel (Reuters)
• China central bank in gold-buying push (FT)
• Germany Seeks to Avoid Two-Step Vote on Greek Aid, Lawmakers Say (Bloomberg)
• Eurozone central bankers and the taboo subject of losses (FT)
• Bernanke: Low Rates Good for Banks in Long Run (WSJ)
• Cameron and Sarkozy to test rapport at talks (FT)
• Chinese Enterprises encouraged to invest in US Midwest (China Daily)
• Goldman Sachs Group Inc. and Morgan Stanley have reduced their use of "mark-to-market" accounting (WSJ)
• Regulators to raise trigger for rules on derivatives (FT)

A week ago we presented an excerpt from Credit Suisse's most excellent piece "The Flaw" - merely the latest in one of the best overviews of the neverending Greek soap opera by William Porter. Yet every soap opera eventually ends. Although when it comes to Nielsen ratings, the denouement is usually a whimper. In the case of Greece, it will be anything but. Yet listening to the daily cacafony of din from Europe's leaders, who are likely more clueless than the average reader as to what is really going on, one may be left with the impression that there is a simple solution to the problem, and Greece may be "saved... in hours." It can't. In fact, as of today, Porter's s conclusion is: "we are left with a sense that the probability of delivering the largest default loss in history in a disorderly way on or before 20 March has increased relative to doing so in an orderly way."

If the ECB switches 50 billion of old bonds for 50 billion of new bonds, what does Greece get?  No notional reduction. Possibly a reduction in interest payments but that depends on the coupons on the bonds the ECB owns. The new bonds allegedly have some covenants and possibly other projections for the bond holders. That is a negative for Greece - they can default on these old bonds and the ECB can't do much about it. Maybe the reporter is wrong, but this is a good deal for the ECB, marginal for Greece, but does make it easier to jam holdouts. They can default on old bonds or retroactively CAC old bonds and the ECB won't be affected. This announcement is either marginally good or marginally bad depending on the details. It is not great or a game changer - except maybe the money printing angle.

A number of headlines from Bloomberg, via Die Welt, that the ECB will undergo a bond swap on their greek government bonds and the 'profit' will flow to governments. This is absolute delusion. The ECB claims EUR50bn nominal value of GGBs - so likely took a EUR20-30bn loss on this given the prices they bought at under the SMP and the current market price. We explained last week (must-read) the delusional nature of these profits (given the losses that occur once the new bonds break) and assume this is yet another attempt to make market participants believe they wil help with PSI. However, there is more to this in our humble opinion. Since the ECB says they will distribute profits (which we know are illusory) to governments - it is nothing but a covert attempt to funnel money (think printing) to local government central banks - and the illusory profits here are simply giving away free money. Perhaps the loud screaming over the pain associated with even an 'orderly' Greek default is enough that the ECB needs to placate them with some new freshly printed money? For now, the PSI remains in limbo for the hold-out blocking stake reasons we have discussed at length - if the ECB were to step into the market and buy/swap with hold-outs all of their UK-law bonds at Par (for huge gains to the hedgies) then perhaps we get a deal done - but this would be astounding and leave the rest of the European sovereign debt market disabled as investors pushed for the same deal and vigilantes drove Portugal and then Spain to this point...

Is it perhaps cheaper for the Troika to fund the ECB's EUR30bn loss (and let Greece default) than pay the EUR130bn for them to stay?

Two formal requests to Mr. Draghi - please show where the profit is booked on your balance sheet and also explain how a notional swap (no debt reduction) in any helps the Greeks?

Now everybody's bank bashing, of course the reason to bash the banks is 4 years old, despite Bove-like analysis to the contrary. I will discuss this on CNBC for a FULL HOUR tomorrow from 12 pm to 1pm.

The long-term link between demographic supply-demand shifts and the dynamics of asset price changes is hard to quantitatively dismiss and while it is just as difficult to trade these long-term shifts, as Credit Suisse notes, it is a useful context for considering tactical and strategic asset allocation. Based on projections of two interesting ratios (Middle-/Old-age ratio for equity multiples and Yuppie/Nerd ratio for bond yields), they find that US and European equity P/E multiples are set to structurally fall for the next decade (while Japan may see expansion) and similarly Japan is expected to see bond yields continue to structurally fall while US and European yields will rise (with US yields rising only modestly - though still painfully for governments - and UK quite significantly). While, of course, significant differences exist in the equity and debt market participation level and demand and supply mechanics of foreign investors, the relationships have stood the test of time and should warrant concern for the medium-term in both US and European markets as perhaps monetary policy's extreme experimentation is fundamentally fighting these trends that are exaggerated in the short-term by the cyclical-to-secular end of the leverage super-cycle.

The good people at Knight put together a comprehensive list of potential ratings for banks in Europe after Moody's came out with their outlooks. We agree that banks getting shifted to non-investment grade is a big deal.  We saw the impact for Portugal once it got taken out of the indices, and we think for banks it will be an even bigger deal to lose that investment grade status.  Sure, they can still go to the LTRO, but it is hard to function as anything other than a zombie bank once you lose that rating...

While these pages have been warning for about a month that a Greek default is precisely what Europe wants, a self-deluded market has been ignoring this reality. That is no longer the case as the default (pardon the pun) thought is now one of Greek default. As for the assumption that "it is all priced in"... that too is being scrapped as revisionist histories of Lehman come to mind. As a result the EURUSD is drifting ever lower, and has been trading with a 1.29 handle for the first time in weeks. Needless to say, Europe is on the verge of panic as the nearly 2-month impact of the LTRO is now truly gone, and with unmistakable stigma (sorry Jernej Omahen - read this) associated with LTRO banks, we shudder at the thought how many banks will voluntarily subject themselves to being seen as desperately needing European Discount Window access in two weeks. Moody's downgrade of key insurance companies and threat to cut most banks, has not helped. Finally, some unpleasant news out of China, where commerce ministry said that the trade outlook is "grim" while a research with the Chinese Academy of Sciences said that Chinese EFSF contribution should be capped at Spain's €92.6 billion, rounds out the rout. So while we wait patiently as reality in Europe truly seeps into risk prices, here is Bloomberg with a summary of overnight catalysts.

Last week we discussed the gradual unraveling of a topic we had been following for the past 3 years, namely the brazen and criminal manipulation in the Libor market, which directly and indirectly impacts a stunning $350 trillion worth of securities (and thus, their implied risk, and hence, prices). Today we are delighted to learn that the retribution against these banks who have been artificially representing to the market that they are in better condition than in reality (courtesy of Libor's "strict" self-reporting approach), are beginning to see lawsuits filed against them, with Schwab merely the latest out of the gate. And just as fraudclosure was the litigation topic of 2010 and 2011, sit down and watch as Li(E)borgate explodes into the biggest litigation pain for banks, with litigation expenses that could easily surpass both the robosigning scandal (and its robo-settlement) and the escalating banks Reps and Warranties scandal. Because as recent evidence confirms, there are likely emails proving manipulation exists black on white, as discussed last week. Which means that the case of Schwab, noted last summer by Reuters, is about to become a pandemic.

We have posted various extracts from this piece from Credit Suisse previously. We will post from it again, because, to loosely paraphrase Lewis Black, it bears reposting... especially in the context of the latest and greatest Greek "bailout" (of Europe's bankers), which incidentally, will achieve nothing and merely bring the country one step closer to a military coup and/or civil war.

Earlier in the week we began discussing the stigma that would likely be attached to the banks that decide to borrow from the ECB via the LTRO. Many talking heads including Mario Draghi himself, arbiter in chief of all risky collateral in Europe, dismissed this - reflecting back at the compression in credit spreads in the market-place as evidence that all was well and confidence was returning. In the last week our (senior unsecured debt) index of LTRO-ridden banks has underperformed non-LTRO-ridden banks by 23bps to a 75bps differential. This is the largest divergence since the LTRO began and corrects off mid-Summer tight levels of difference as the critical flaw that we also pointed out earlier in the week (that of the implicit subordination of bank assets via ECB's LTRO collateralization). Credit Suisse agrees with us and expounds on 'the flaw' in the LTRO scheme noting that the market is fickle and self-sustaining at times (as we have seen) but over time (and that time appears to be up this week), the market will weigh the liability side of the balance sheet versus the asset side, less haircuts (which implies haircuts will become the de facto capital requirements) and inevitably (given bank earnings potential) reflect this huge differential - most specifically in the senior unsecured debt market. With few shorts left to squeeze, spreads back at pre-crisis levels and financials having dramatically outperformed even large gains on sovereigns, the weakness in senior financial debt in Europe this week is more than just a canary in the coal-mine, it should become the pivot security for risk appetite perception.

It seems our discussions on sovereign litigation 'arbitrage' and blocking stakes among foreign-law Greek bondholders is gathering some consensus among the smarter sell-side research shops. In a note today, recognizing the differences between Greek international-law bonds, Credit Suisse applies their rigorous game theory perspective to the EUR18bn of foreign-law bond holders and the implications on the PSI negotiations. As we have pointed out, and has been successfully traded in  the last few weeks, they expect foreign-law bonds to trade at a premium to Greek-law government bonds (just as we also noted we see increasingly in Portuguese bond dispersion) not just for blocking stake possibilities but also as better hedge-protected CDS positions. CS points out that if CACs were introduced into Greek law bonds, this blocking stake in foreign-law bonds will create a much higher chance of a hard default credit event and while UK law bonds won't be protected from a hard default they will at least have CDS trigger protection. Finally, the hope of creating a true Prisoner's Dilemma (where standing alone/holding-out singularly is a sub-optimal strategy) fails dismally as each participant is aware that others (blocking stake foreign-law bond holders) will for sure not participate. Adding to this threat is the current low stress environment, set up by the ECB and its LTRO, which could encourage more 'aggressive' behavior by any player in the game creating higher chances of a hard default by Greece as Troika-deal confidence increases the bargaining power for heavier haircuts and thus - fewer willing participants. What a mess!

The last time the Fed tried to dump Maiden Lane 2 assets via a public auction in a BWIC manner, it nearly crashed the credit market. This time, the FRBNY, headed by one ex-Goldman Sachs alum Bill Dudley, has decided to go back to its shady, opaque ways, and transact in private, with no clear indication of the actual bidding process or transaction terms, and sell $6.2 billion in Maiden Lane 2 "assets" to, wait for it, Goldman Sachs, the same firm that would benefit in the first place if AIG's assets imploded (remember all those CDS it held on AIG which supposedly prevented it from losing money if AIG went bankrupt?). One wonders: does Goldman have a put option on the ML2 portfolio if the market experiences a sudden and totally impossible downtick some day? But all is well - we have assurance from the Fed that the sale happened in a "competitive process." Luckily, that takes care of any appearance of impropriety.