12/1/2012: Q4 2011 Sovereign Bonds performance

Four charts covering Q4 2011 sovereign bonds (CDS) performance:

Data sourced from CMA Global Sovereign Risk Report Q4 2011

Economics 25/7/10: What lending markets tell us about EU policies

So the markets are not that enthused about the stress tests. After the initial bounce on the back of 'pass' grades, there are rising concerns about some 19 banks, including AIB, which were given 'all clear' with some serious stretch of assumptions.

But to see what is really going on behind the scenes, look no further than the actual interbank lending rates. In fact, the interbank lending markets provide a good reflection on the combined euroz one policies enacted since the beginning of the Greek debt crisis. Both euribor (the rate for uncollateralized lending across euro zone's prime banks) and eurepo (lending rates for collateralized loans between euro zone's prime banks) are significantly elevated on twin concerns about:

1. The quality of the borrowing banks (recall - these are prime banks); and
2. The quality of the collateral (with sovereign bonds being top tier quality, deterioration in sovereign debt ratings is hitting interbank markets hard).

Here are the usual, updated charts:

Chart 1Long maturities have been signalling extremely adverse effect of the Euro rescue package since its inception.

Medium-term maturities show severe deterioration since the euro rescue package. Steepest, and uninterrupted rise in 3 months euribor signals that the rescue package is faltering in delivering anything more than a buy-time for the euro… In other words, we have an expensive (€750 billion-sized) buy-in of short time.

The ECB claw back on longer term lending window did not help this process either. But the stress tests are doing nothing to stop the negative sentiment dynamics.

Chart 2Per chart 2 above, short-term maturities are showing that despite supplying underwriting to about a half of the full year worth of euro area bonds refinancing, the rescue package has achieved no moderation in the short-term risk perceptions of the market. In fact, the rise in euribor is more pronounced in the short term than in longer maturities, suggesting that short term risks of sovereign default remain unaddressed by the rescue package and are exerting a continuous pressure on interbank lending.

Introduction of the stress tests also did nothing to reduce overall cost of borrowing amongst the prime banks which were fully expected to pass the test even before the EU got on with setting test parameters.

In turn, all of this spells much higher costs of funding for the banks which have shorter term financing needs, such as the Irish banks. The implicit cost of taxpayers’ guarantee for Irish banks debt is therefore rising.

And panicked markets are not about to surrender their fears to the EU PR machine. With all the increases in the euribor, the volatility of the interbank lending rates also increased, across all maturities, as shown in charts 3 and 4 below.

Chart 3Chart 4As evident, in particular, from chart 4, in the longer term, credit markets are absolutely not buying the combination of the EU rescue package, ECB liquidity measures and the stress tests. Euribor trajectory for maturities of 6 months and higher firmly re-established and vastly exceeded volatility that preceded the pre-rescue panic. We are now worse off in terms of the cost of banks financing than we were before the Greek crisis blew up.


To remind you - eurepo is the rate at which one prime bank lends funds in euro to another prime bank if in exchange the former receives from the latter the best collateral in terms of rating and liquidity within the Eurepo basket. Eurepo rates have posted dramatic increases since mid-June 2010. The original effect of the June 2010 closure of the longer maturity (12 months) ECB discount lending was a temporary reduction in the rates, followed by a stratospheric rise two week later that has been sustained through the end of this week. This is especially true for shorter term maturities, suggesting that part of the adverse effect was due to the heightened uncertainty around the EU stress tests. Chart 5 below illustrates.

Chart 5Chart 6The u-shaped response in the interbank lending rates to ECB lending changes and to stress tests is even better reflected in the longer maturity eurepo rates, as highlighted in chart 6 above.

3-months and 12-months eurepo rates are now at the levels consistent with the height of the sovereign default crisis. There are significant differences in the rates by maturity group and vis-à-vis euribor due to the fact that the quality of collateral offered in the markets is now itself uncertain as sovereign credit quality continues to deteriorate both in terms of increasing probabilities of default and thus associated risk premia, but also due to the regulatory treatment of collateral that is being signalled by the stress tests.

As with euribor, eurepo rates are showing remarkable increases in volatility, for both shorter and longer term maturities.


Let us finally put the two rates side by side to compare evolution of euribor against eurepo, setting index for all at 100=January 4, 2010

Chart 7Chart 8
Some pretty dramatic stuff. To round off, recall that since the beginning of April 2010, the eurozone has undertaken the following measures to shore up its financial markets:

1. Set up a sovereign rescue fund worth more than €750 billion to underpin roughly 50% of the total borrowing requirement in the euro zone (which could have been expected to yeild an improvement in banks collateral and thus a reduction in overall systemic risks in the interbank markets as well);
2. Reduce maturity profile of ECB lending window (which was from the get-go equivalent to dumping more petrol on the forest fire);
3. Deploy aggressive quantitative easing by the ECB (again, this should have reduced uncertainty in the interbank markets as in theory improved pricing for sovereign bonds should have increased the quality of interbank collateral and improve banks own books);
4. Conduct an absolutely discredited stress test of the banks (designed to provide positive newsflow for the banks, especially for prime banks which should have seen their risk profiles reduced by a mere setting up of the test).

In short, none of the measures seem to be working, folks... May be, just may be, the real problem with EU banks is their unwillingness to come clean on loans losses and start honestly repairing their balancesheets?

Economics 15/7/10: European bailout fund - set up to fail?

I thought it is worth sharing few thoughts on a superb article by Satyajit Das"Debt shuffling will be a self-defeating exercise" in July 12 Financial Times (sorry - no link) concerning the European bailout fund. All quotes are from the article, with some of my additions/explanations etc.

European Financial Stability Facility (EFSF) “…structure echoes the ill-fated collateralised debt obligations (CDOs) and structured investment vehicles (SIVs). …In order to raise money to lend to finance member countries as needed, the EFSF will seek the highest possible credit rating – triple A. But the EFSF’s structure raises significant doubts about its creditworthiness and funding arrangements…”

The €440bn bailout fund created a SPV, “backed by individual guarantees provided by all 19 member countries. …The guarantees are not joint and several…”

This means that SPV – an insurance fund against sovereign defaults – is in the need of an additional insurance mechanism against the risk that one or more of the funders fail to pay up into the EFSF. This is achieved by “…a surplus ‘cushion’, requiring countries to guarantee an extra 20% above their ECB contributions.”

One point, not mentioned to Das is that this ‘cushion’ fund is itself subject to risk as a call on the ‘cushion’ will require some states near default to supply even more funding to the fund. In other words, to any of the PIIGS participating in supporting one of their fellow member states, the cost of the EFSF bears a 20% premium reflective of the ‘cushion’. Just how this is going to be feasible for severely financially stretched states remains to unknown. Take one example – for Ireland this would mean that our €5bn exposure to the EFSF is, in reality, a €6bn exposure.

Das focuses on the overall risk transfer within the EFSF arrangement, saying that the ‘cushion’ “is similar to the over-collateralisation used in CDOs to protect investors in higher quality triple A rated senior securities.”

Das puts some numbers on this: “If 16.7% of guarantors (20% divided by 120%) are unable to fund the EFSF, lenders to the structure will be exposed to losses. Coincidentally, Greece, Portugal, Spain and Ireland happened to represent around this proportion of the guaranteed amount. If a larger eurozone member, such as Italy, also encountered financial problems, then the viability of the EFSF would be in serious jeopardy.”

There are other problems with the EFSF. Das notes the issue of ratings migration – the situation where if one eurozone member state experiences problems, then the ‘cushion’ will suffer to the proportion of that member state contribution to EFSF, thus reducing overall insurance pool and adversely affecting overall EFSF ratings.

There is an added and much more severe problem here that no one dares to talk about. If one of the PIIGS experiences problems contributing to the EFSF, then other eurozone states with tight borrowing constraints might have an incentive to ‘run on the bank’, attempting to hover up EFSF funds before they are depleted while simultaneously withholding all contributions to IFSF. First mover advantage here will guarantee a payoff, while staying on the sidelines guarantees at least an up to 120% hit on the member state own funding.

As Das correctly points, “any ratings downgrade would result in mark-to-market losses to investors. …Given the precarious position of some guarantors and their negative ratings outlook, at a minimum, the risk of ratings volatility is significant. This means that investors may be cautious about investing in EFSF bonds and, at a minimum, may seek a significant yield premium. The ability of the EFSF to raise funds at the assumed low cost is not assured.”

So the problem then is that from a political standpoint, EFSF might be borrowing in the markets at 3.5-4%, while lending out to PIIGS at 5%. Should interest rates rise, or inflation tick up, or Euro devaluation continues, the net of costs safety band of 75-125bps can be exhausted very quickly. As the safety band is being eroded, the pressure on triple A ratings will rise, triggering the need for further insurance provisioning. Which can, in turn, put pressure on the troubled states to cut provisions for the EFSS. The EFSF will then turn into a loss-making subsidy generator to the PIIGS.

Germans won’t be too happy to see this. The noises from Germany – the main underwriter of the EFSF will put added pressure on the PIIGS to act fast, increasing a probability of a run on EFSF and triggering ratings pressures once again. Notice that to get to this point won’t require an actual run on the fund – a simple rise in the probability of a run will do the damage.

Das’ superb analysis comes at the end of his article (emphasis is mine):

“Major economies have over the last decades transferred debt from companies to consumers and finally onto public balance sheets. A huge amount of securities and risk now is held by central banks and governments, which are not designed for such long-term ownership of these assets. There are now no more balance sheets that can be leveraged to support the current levels of debt.

The effect of the EFSF is that stronger countries’ balance sheets are being contaminated by the bail-out. Like sharing dirty needles, the risk of infection for all has drastically increased.

The reality is that a problem of too much debt is being solved with even more debt.

The EFSF …may be self defeating and unworkable. The resort to discredited financial engineering highlights the inability to learn from history and the paucity of ideas and willingness to deal with the real issues.”

Of course, much of this criticism is pretty close to heart for Nama - an SPV with even lesser transparency, accountability and capability of management. Irony has it, the SPV has no insurance 'cushion' provisions and instead becomes a direct liability of the Irish state as its guarantor. Then again, we already know this much...