Mark To Market
One of the problems with the Hispanic Pandora's box unleashed by a now insolvent Bankia, which as we noted some time ago, is merely the Canary in the Coalmine, is that once the case study "example" of rewarding terminal failure is in the open, everyone else who happens to be insolvent also wants to give it a try. And in the case of Spain it quite literally may be "everyone else." But before we get there, we just get a rude awakening from The Telegraph's Ambrose Evans-Pritchard that just as the bailout party is getting started, Spain is officially out of bailout money: "where is the €23.5 billion for the Bankia rescue going to come from? The state's Fund for Orderly Bank Restructuring (FROB) is down to €5.3 billion."... And in an indication of just how surreal the modern financial world has become, none other than Bloomberg has just come out with an article titled "Spain Delays and Prays That Zombies Repay Debt." We can only surmise there was some rhetorical humor in this headline, because as the past weekend demonstrated, the best zombies are capable of, especially those high on Zombie Dust, or its functional equivalent in the modern financial system: monetary methadone, as first penned here in March 2009, is to bite someone else's face off with tragic consequences for all involved. What Bloomberg is certainly not joking about is that the financial zombies in Spain are now everywhere.
Europe continues to fight the wrong battle, and continues to spread contagion risk. It is clear that Greece has had a solvency issue now for over 2 years. The ECB and Troika chose to treat it as a liquidity problem. Maybe, they could have argued that in early 2010, but by the summer of 2011 it was obvious to any credit observer that the problem was solvency, yet they continued to treat it as one of liquidity. That is scary because if they fail to see the problem correctly now, they will fail miserably. Not only is the problem clearly solvency, but now forced currency conversion has been added to the mix. Any "solution" from the EU must now address that risk, and it is not the same as solvency. Programs that can protect against solvency may do nothing for the redenomination risk. We keep playing with scenarios and find it hard to find out where a Greek exit doesn't result in a steep sharp decline in the market. We could go through more ideas of ECB intervention, but in the end most will have flaws. Dealing with currency conversion risk is huge. Dealing with the contagion risk that has been created by the EFSF is huge. Will Europe force Greece out thinking they have a plan; that fails miserably and sparks the miserable series of consequences we’ve outlined? Sadly, yes.
Bank Regulatory Capital has been in the news a lot recently - between the $1+ trillion Basel 3 shortfall, the Spanish banks with seemingly their own set of capital issues, or JPM's snafu. There has been a lot of discussion about Too Big To Fail (“TBTF”) in the U.S. with regulators demanding more and banks fighting it. After JPM's surprise loss this month, the debate over the proper regulatory framework and capital requirements will reach a fever pitch. That is great, but maybe it is also time to step back and think about what capital is supposed to do, and with that as a guideline, think of rules that make sense. Specifically, regulatory capital, or capital adequacy, or just plain capital needs to address the worst of eventual loss and potential mark to market loss. Hedges are once again front and center. The only "perfect" hedge is selling an asset. This "hedge" is also a trade. The risk profile looks very different than having sold the loan and the capital should reflect that.
It would seem, just as during the crisis in 2008/9, that now might be an opportune time to push for 'improvement' in how banks are regulated (and more importantly how the instruments they trade in colossal size are priced and marked-to-market). Rick Santelli believes now has never been a better time but as his guest Tim Backshall of Capital Context notes, regulation of the CDS market can be summed up in one sentence "Get Them On Exchange". Something we have been saying for years (and has been tried before) but with dealers holding all the keys (to market-making) and exchanges cowering for fear of losing clients, we remain less optimistic. Santelli and Backshall critically address the complicity of banks, regulators, analysts, and The Fed in giving 'banks the benefit of the doubt' with regard their use of the bottomless pit of capital they implicitly have but what is more important is for the hordes of sell-side analysts and buy-side sheeple to understand just what this JPM debacle exposes about bank risk (VaR is useless), bank transparency (mark-to-model or worse is widespread), and bank valuation (traditional Price/Book metrics have no merit anymore).
The ECB seems to be quite happy to comment on Greece, and most of the comments seem to say that Greece isn’t doing their part. Well, what about the ECB? What have they been doing for Greece? So far, not very much and I think they need to start to play nicely with their holdings. If the ECB just plays nicely, at no cost to the ECB, the situation in Greece would improve quickly and dramatically. The ECB must go from being a lender of last retort to a bona fide contributor to Greece and a true lender of last resort. Maybe the ECB should “Ask not what Greece can do for you, but what you can do for Greece”?
The question for investors is how likely Draghi unleashes some new money and gives the market another brief relief rally? I’m not sure he is able to do anything meaningful and right now I believe the market will fade over the course of the day as realization sets in that not much can be done. I’m not quite ready to put this trade on, but am looking closely at going long Spanish stocks versus short German stocks. The belief that Germany will be fine while Spain is a disaster seems too common and priced in. I’m not quite there on that trade, but it is only that am looking at very closely.
First we got Italy telling the world quietly it would not meet its deficit target for 2013, and will in fact experience debt/GDP growth in all outer years, and now we get the Bank of Spain, also taking advantage of today's market rally to dump its own set of bad news, namely that Spanish banks will need to provision another €29.1 billion, and will have higher core capital requirements of €15.6 billion (this is fresh capital). 90 banks have already complied with the capital plan, 45 have yet to find the needed cash. Putting this into perspective, the amount already written-down is €9.2 billion. So, just a little more. And this assumes there are no capital shortfalls associated with any impairment from the YPF -> Repsol follow through, which as Zero Hedge already showed, would leave various Spanish banks exposed. In other news, there is one more hour of trading: we suggest every insolvent entity in the world to quickly take advantage of the interim euphoria, as tomorrow may not be so lucky. Of course, in the worst case, Japan will just bail everybody out.
By now everyone is aware of Argentina's disturbing plan to nationalize YPF over the protests of Spain, and soon EU. And as we noted yesterday, the equity value of YPF is essentially a doughnut as BofA stated, if somewhat more correct politically. YPF continues to be halted on the NYSE as per a T2 halt (aka "The news has begun the dissemination process through a Regulation FD compliant method(s).") and there is little availability for price discovery at the first derivative level. However, where discovery is ample is at the second degree, namely Spanish Repsol-YPF which is a majority owner of YPF, whose CDS continue soaring, and hit a whopping 391 earlier today, well over 100 bps compared to the Friday closing spread. For a massive energy production company this is a big move and we can only hope its Spanish bank shareholders are well insulated from mark to market losses, although somehow we doubt it.
There are relatively few natural buyers of Spanish long dated bonds here. Fast money is likely caught long, and it will take a potentially reluctant ECB and some already overly exposed Spanish institutions to step up and stop the slide. It may happen, but many of the policies that “bailed out” Greece created very bad precedents for bondholders, and some of those are coming home to roost, as is the understanding that LTRO ensures that banks can access liquidity, but does nothing to fix any problem at the sovereign level.
With ZIRP and LTRO it is hard to get a good read on the Spanish yield curve and what anything means. Spanish 10 year yields have risen 9 days in a row, 5 year yields have moved higher 8 out of 9 days, and the 2 year has been much more mixed, until recently. The 2 year yield is out 19 bps in those 9 days, but 18 bps of that move has occurred the last 2 days. The 2 year bond fits the sweet spot of LTRO, is likely to be held by banks in non mark to market accounts, so it has been stable, but it has even started to leak a little. The move is small, almost trivial, yet with all the things working to support 2 year bonds, it is curious that it is able to widen at all, let alone 18 bps in 2 days.
One of the big stories of the week was that Morgan Stanley “reduced” its exposures to Italy by $3.4 billion mostly by unwinding some swaps they had on with Italy. Morgan Stanley booked profit of $600 million on the unwind. The timing couldn’t have been worse coming on the heels of the “Darth Vader” resignation at Goldman Sachs, attracting more attention to profits on derivatives trades was the last thing the investment banks need. Much of the outrage seems misplaced though. In this case, don’t blame Morgan Stanley, blame Italy, and be very afraid of what else Italy has done.
As gold loses its 200DMA once again (along with Silver weakness) as the USD rallied post FOMC and stocks were starting to limp lower, Jamie saved the day and the stock market had that most embarrassing of affliction - premature exuberation. While it seemed to have come as a shock to some that banks passed the stress test, the market's reaction (given only recently markets were worrying over NIMs, trading revenues, and real estate) was incredulous. The US majors were all up 6-7% (apart from Morgan Stanley which managed a measly 3.8% on the day!). With XLF now up more than 37% from its Oct11 lows, financials remain the major outperformers in this rally and we note that credit markets are missing the fun - the last time JPM stock was here, its CDS was trading 25bps tighter. Credit and equity moved in sync and tore higher on the JPM news. Gold (and Silver) which had been falling managed a decent bounce into the close while the USD closed at its highs post FOMC as did Treasury yields as for the first time since the 2011 bubble popped, the NASDAQ closed above 3000 (thanks in large part to AAPL's 3% rally over $568).
CDS is once again (still) in the spotlight. We have moved on from debating whether or not a Credit Event has occurred in the Hellenic Republic, to concerns about whether the CDS market will settle without a problem. There is a lot of talk about “net” and “gross” notionals and counterparty risk. What I will attempt to do here, is build a CDS world for you. We will look at various counterparties, the trades they do, and the residual risks in the system. It will be loosely based on Greek CDS but some liberties will be taken. None of the institutions are real world institutions (in spite of how much they sound like some people we know). It is a simplification, but to make it useful, it has to be robust enough to give a realistic picture of the CDS market/system.
While AIG FP often made the contracts look like insurance products, the banks were very careful to make sure that the products were “credit derivatives” because they needed the regulatory capital relief provided by them. Didn’t the Fed at some point get concerned about the counterparty exposure to AIG FP? Isn’t counterparty risk something that the Fed is responsible for monitoring (or the ECB in the case of foreign banks)? When the Fed let MS and GS become bank holding companies and get the ability to use Fed lending programs, didn’t they ask about the AIG FP exposure? Goldman, which always claimed it was hedged, must have had a massive short position in AIG CDS to be hedged – again, no one at the Fed noticed this? CDS may be unregulated, but when virtually every big financial company in the world has large notionals on with AIG, huge mark to market gains on those positions, no collateral from AIG, and big shorts in AIG CDS, couldn’t someone do their job? This should have been noticeable in 2007!