European Black Swan Sighted

While everyone's attention was focused intently on peripheral European bond spreads last week and the incessant call for ECB intervention, a dramatic (and contagiously panic-worthy) move occurred in the European Investment Bank (EIB) bonds.

For those unfamiliar, the EIB is the EU's IMF-equivalent and is the largest international non-sovereign lender and borrower. Technically, it is defined as "the European Union's long-term lending institution established in 1958 under the Treaty of Rome. It supports the EU’s priority objectives, especially European integration and the development of economically weak regions."

5Y Euro-denominated AAA-rated EIB bond spreads crashed wider, blowing past the 2009 record highs and clearly indicating that European capital flight is in full swing.

The IMF-like entity, supported by a small capital base of deposits backed by promises of huge capital injections by sovereign nations, has massive exposure across Europe (and elsewhere). EUR382.4bn of senior unsecured debt and (according to Bloomberg - chart below), EUR2.5bn of deposits (admittedly backed by supposed promises to make whole loan commitments) does not make for a sound AAA-rated firm in our humble opinion.

Clearly investors think the same this week and are starting to worry about the same self-referencing, self-supporting house-of-cards that caused the EFSF to be written off as unworkable.

It is clear that the contagion is spreading as Bund yields start to underperform (no capital flight to safety within the Euro-zone) and furthermore, as the chart above shows, the stress on the EFSF has now spread to the EIB's publicly tradable debt.

It is no wonder given the size of their loan portfolio and who it is being lent to:

Spain, Italy, France, Portugal, and Greece all in the Top 10 with simply enormous outstanding debts relative to the capital in-house to cover potential losses (let alone any MtM or economic risk budgeting).

The debts outstanding, much as with any major investment bank, are denominated in multiple currencies and the yield curves below show the differentiation of those curves by major currency.

The next few months/quarters/years has huge supply from the EIB as it rolls its major debt load and while it maintains its AAA-rating - and therefore appears very attractive from a carry-per-regulatory-risk-capital perspective, we suspect the professionals are already unwinding their exposure very rapidly.

The next few months have over EUR20bn in maturities (and EUR6bn in interest payments) and so we will get plenty of opportunities to judge how new issue premiums will adjust secondary markets.

The following chart (of the USD-denominated EIB debt yields) should be enough to prove that both systemically (yield curve shift higher) and idiosyncratically (potentially speculative-driven negative bets as bear flattening is occurring) the AAA-rated EIB is facing some significant stress and should it need to make capital calls (to maintain its AAA-rating), is Spain, Italy, France, and Greece going to step up to their promises...

There are no CDS trading on this reference entity (yet) but given the still-relatively-tight nature of the bond spreads, we suspect specialness is not an issue and borrow is possible. The 2s5s bear-flattener looks the lowest vol trade but at such low costs of carry, outright is perhaps just as attractive on a reduced size trade. The compression in the EFSF-EIB trade also looks attractive.

Charts: Bloomberg