Tag Archives: Spain

The Spanish Banking Reform And The Devil’s Alternative

Global Economy, On the cover, Sin categoría,
(This article was published in Cotizalia on May 12th 2012)

There is hope and doubt among investors following the announcement of the Spanish financial reform. And like it or not, investors are the only real solution to help finance the so-called “property management agencies” (bad bank), the term used for the entities that will house the toxic assets of Spanish banks, generated after a decade of real estate bubble.

There is hope because it is the first reform that looks real. But there are doubts, especially because it is not clear which will be the discount to be applied to the valuation of toxic loans, or what will be the formula to finance the gap between loan value and real asset value. The answer, in my opinion, is that if the discount is not strong funding will be complicated.Investors told the government in many meetings that they will only accept an “American” solution, a bailout (TARP) and a complete clean-up of the toxic mess created by real estate. However, the Spanish government does not want to take such a high a political cost, by undertaking a massive bailout that previous administrations failed to undertake. The policy of “pretend and extend” has been incredibly damaging both for the country and for financial institutions. The interventionist regulation of the Bank of Spain and lousy management of the loan portfolio of some entities, not all, made the financial crisis deeper and longer.

The true liberal solution would have been to let the bad banks fail, auction their assets, and let the solid banks emerge stronger. The problem is, and was, to allow publicly managed entities (the savings banks) go under, and the political cost that it would entail.

The other solution would have been to create a giant debt-to-equity swap program that would take care of the toxic loans and re-capitalize the banks. Two problems there as well. One, the size of the problem, more than €170bn, and two, the contagion effect on the holders of that debt, mostly European banks and domestic entities, which would face the dilution with a domino effect of re-capitalization needs.The Spanish government faced the devil’s alternative, remembering Frederick Forsyth’s novel about a situation in which all options entailed huge challenges. Allowing bad banks to fail, or a “USA TARP solution” or a “Swedish solution”, buy the loans at once at real market price. But the cost to the taxpayer would be enormous, between 17 and 30% of GDP, and it could mean bankruptcy for many public institutions, which would have a greater political cost yet. The devil’s alternative.

All the options to solve the mistake of “waiting until it clears” and denying the bubble of the last four years are financially complex and politically difficult. That is why the government in Spain is hoping that the solution will include foreign investors. But these will not allow another half-baked solution, but immediate and total cleaning. And the risk is that this new reform is perceived as courageous, but with unresolved issues, and probably too long -two to five years- to implement.In 2008 we were told that the maximum exposure to troubled real estate loans of the banking system in Spain was €25 billion. Today, four years later, the figure many of us had in mind is now official. Nearly €184 billion in troubled non-performing loans. And someone should be held accountable for the loss of credibility of the enormous amount of incorrect and half-clear information that was provided to markets in the past years to try to “reassure” investors.

At least, the Government puts the problem on the table . The solution is less obvious. But the alternative of the devil tells us to be drastic. It may hurt in the short term, but it cuts the gangrene . Leaving the solution in the hands of the same regulator and the same managers which extended and masked the problem “while markets recover” can cause Spain a major problem. Because credibility is lost in a day and it does not recover in years. And it’s an urgent matter.

In Spain, which prided itself of having no sub-prime crisis – these are things of the evil Americans- no less than €73 billion of the total €184 billion in toxic loans correspond to “land”. This is important because one of the things that separates Spain’s real estate bubble from others in the OECD is that some banks and cajas (savings banks) had the brilliant idea of ​​giving loans to land before urbanization. This has to be completely written-off. Because finished properties can be sold, maybe at 40%, 50% or 60% discount, but credit to land is worth almost nothing. The real estate adjustment cost other countries between 20% and 40% of GDP and massive dilutions in banks. In Spain it will probably be similar. But it’s the beginning of the solution.In 2004, a good friend, a professor at a prestigious business school, told me how surprised he was to see such a “diverse” professional profile in the new Spanish bankers attending his course. Politicians, trade unionists, philosophers, among others.”That’s what free money does, everybody is Rothschild until the music stops” he said. And it stopped. The problem is not that it stopped, but that many of these financial entities, mostly public-owned savings banks, waited for years hoping that the music and the party returned… Spanish real estate only fell 22% from the top while unemployment soared to 24% and the economy tanked because most of the inventory of unsold houses was kept “until prices recovered”, to avoid large mark-to-market losses, through troubled loans.

It is worth noting that the creation of real estate management vehicles (bad banks) and public capital injections will not increase credit immediately to the real economy, because the problem of Spain remains a public and private debt of 350% of GDP, and the deleveraging process is unavoidable. In addition, banks, once they have tried to put out the fire of the real estate hole, face a challenging economic environment. And with expectations of a fall of GDP also in 2013, according to the EU, the bad loans (NPLs) remain a problem. It is impossible to increase credit in an economy where credit expansion was close to 8% pa for a decade, leveraged more than three times its gross domestic product, where the return on assets of many banks is less than its cost of capital.

. If the State is involved in funding the bad banks, but the country accepts bubble-time valuations, the need for constant injections will keep Spain in unsustainable debt ratios. In fact, the government deficit would increase (including state guarantees)  from 87% today to 110% .

. Injections of public money are short term loans and would not affect the taxpayer only if the market valuations are realistic and don’t require additional injections.. Of the €310 billion that we mentioned earlier, €184 are already considered within the category of problematic (delinquent). Of these, €44 bn are already provisioned, ie about 25% of the value of the credits. The remaining amount of real estate loans considered “healthy” and not yet provisioned (€122 bn) are not all fine and secure. As the economy worsens, a part of these will also become non-performing. Let’s face it. Because it can cost between 1% -2% of GDP over three years if the country allows more “hide, pretend and extend”.

. Spain should not try to hide the difficulties of bad banks, those are already sentenced. It should ensure and enhance the situation of the good banks -very good, some of them- and not allow a contagion from a lack of credibility and perception of mismanagement that is not, nor can be generalized . The country cannot allow a capitalization problem -serious, but solvable at market prices- to become a problem of solvency of the system.

Who funds the gap between loan value and true market value of the real estate exposure?

According to the different alternatives considered, the market supports an ECB or EFSF credit line. The problem would come from the demands on tax hikes and additional cuts that such aid would entail. And it’s the same old problem . Debt with more debt that is financed with taxes anyway.

On the other hand, a public funding solution also seems remote because of the need to increase borrowing at a time when spreads to the German Bund are at all-time highs (480bps). And with the system’s credibility into question, forget about Eurobonds to finance real estate bad loans clean-up.

Of course, the most logical is to attract the participation of foreign capital , through partial debt-to-equity swaps, IPOs or placements of convertibles, which will only succeed if the market perceives that valuations of the assets are really discounted and attractive. A 20% -30% discount after a peak-to-current drop of only 22% would not easily create enough investor appetite.

The worst of past mistakes made by banks, regulators and government, is that through our stubbornness of maintaining that nothing was a real problem we have risked the discredit of our financial system, which could spread the problem from the weak banks to the good ones, and from bad managers to solid ones.

It is good to read that some bank rule out any resort to state funds and may make all provisions against operating profits. To separate the bad from the good is much better than the previous policy of infecting healthy assets mixing them with toxic assets, because the risk does not dissipate, it is contagious. Let us separate everything, and show actual market prices. And the solution will be in front of our noses. After four years of evident crisis, this is the opportunity to be realistic.To watch my interview in Al Jazeera about the Spanish banking issues go: (Quicktime or Oplayer required) http://dl.dropbox.com/u/62659029/iv_daniel_lacalle_250512_0.mpg

Further reading:

Eurobonds? No Thanks. Debt Isn’t Solved With More Debt: http://energyandmoney.blogspot.co.uk/2011/11/eurobonds-no-thanks-debt-isnt-solved.html#

What happened to put Spain on the verge of intervention?: http://energyandmoney.blogspot.co.uk/2012/04/what-happened-to-put-spain-on-verge-of.html

Why Italian and Spanish CDS can rise 40%… and Greece is not to blame:

What happened to put Spain on the verge of intervention?

Global Economy, On the cover, Sin categoría
Spanish 10 year

(This article was published in Cotizalia on April 7th 2012)

“Italy is not Spain”. This is the most repeated sentence in Italy this past week. However, along with Spain at 430bps, Italian bond spreads against the Bund rose to 400bps. Does this remind you of anything? Rewind to July 2011. When we heard “Spain is not Greece”, “we don’t have a problem of public debt”, “we are doing our homework.”. Anyway … time puts everything in context. We talked about it here months ago (read).

However, after the announcement of Spain’s budget, the Ibex (at the close of this article), plummeted to 7,500 points, reaching the lows of 2009, while the risk premium exceeded 430 basic points. We have spoken many times about the Ibex’s troubles. An ultra-leveraged index, the most heavily subsidized in Europe, with very poor earnings growth expectations, to which we must add a tax measure that aims to raise 5 billion euros from an index that reported a net income of 30 billion euros in 2011.

But what really intrigues me is what is happening in the debt market. I am optimistic and believe this government is willing and open to listen, so here’s my contribution.

We do not want to admit it, but in the bond market there are three major challenges:

a) The risk premium and as such, the cost of borrowing, will continue to grow if no capital is repaid, 
b) The effect of deleveraging, ie the decreased amount of money available to invest in sovereign debt, is accelerating and…
c) The crowding-out predator effect of massive public debt and giant state refinancing requirements on the availability of credit and financing for the private sector, the one that pays taxes and generates GDP growth, undermines the prospects for recovery.

The spread with Bunds at 430 bps is a problem. Because it shows that massive injections of liquidity do not work. As well as being a disastrous measure that takes money from the pockets of taxpayers and savings to give it to the overgeared inefficient zombies, these liquidity injections support and rescue those who have done wrong, and moreover, the placebo effect has a lower impact each time. It shows that default risk does not change. As we explained here, debt is not solved with more debt (Read here)

The fact that state bond auctions cannot even be absorbed by the underwriters is a big problem. We have been saying it for months. There is no relevant international institutional demand for government debt and auctions are gobbled between European central banks, local financial institutions and citizens, either through the Social Security or other public entities.

But … Why? If the Spanish budget was “very tough” and the government is doing the right thing, why does the market run in the opposite direction?.

First of all, it is worth highlighting a very important thing. The market does not want Spain to do badly. No way. Because Spain is not Greece. Spain is the 4th economy of the Eurozone and several times the size of Greece and as such it can not be “rescued”. If Spain falls, goodbye friends, nice to meet you. Say goodbye to the S&P 500, the Eurostoxx, Germany and the EU.

So if the market does not want Spain to fall and the budget is very conservative helping Spain to reduce the deficit … What’s the problem?

That neither the one nor the other. Investors of sovereign debt by definition are the most conservative investors in the market, and they are not convinced by the budget, either on the side of the revenues, which seem very optimistic, nor on the side of the expenses. On the revenues, the Spanish government expects to increase revenues in 2012 by 4.7% from the income tax (73 billion versus 69.8 in 2011). However, in the first two months of the year, revenues in this item have fallen 2.8%. Even in February, with the tax increase already in place, revenues from this item only grew by 1%. In an article, in Spanish, my friend Juan Carlos Barba points out the challenges of the budget and the differences of estimates, which could lead to a deficit that actually reaches 7% versus the target of 5.3% (Read here). The Laffer curve in all its glory. More taxes, less revenues. That is why I believe that the government has to be harder and more aggressive on expenditures, which is the lion share of the problem in Spain. They can.

2012021796a1(chart above shows regional communities’ debt, which is not accounted as state debt)

The problem of the budget for investors is that it does not reduce the weight of the state in the economy, which is already way above 50%, the debt to GDP rises to 78%, which is almost 120% including private debt, autonomous regions and state-guaranteed debt, tariff deficit, unpaid bills etc. The total saving that the Spanish budget targets, 27 billion euro, is equivalent to the amount that Spain will spend on paying interests from the massive debt, not more. So, if the total debt continues to rise, budget cuts and tax increases only to pay interests the big elephant in the room, the big problem, is unsolved. An unsustainable and hypertrophied public sector and the massive burden of the regions, seventeen “small kingdoms” that have already increased their expenditures in the middle of “austerity measures” in 2011 by 10%, and will increase spending yet again in 2012. In some regions the public sector is larger than 55-60% of the region’s GDP, for example in Andalucia or Extremadura. This would all be fine if the expenditure had generated growth or jobs. But it has been the opposite. Money has been wasted in vast quantities and employment has plummeted. This is not austerity, it is keeping public spending orgy. Only a radical change on this point would improve Spain’s credit rating.

Investors make their numbers. Just a deviation in the estimated income of 3-5% down, could make the deficit skyrocket to between 8 and 10% above the government target.I assure you that markets have high hopes that this government, with absolute majority at the national level and in almost all regions, would be reducing total debt and the weight of the public spending, not to reduce its growth, cut subsidies and worthless megalomaniac expenditures and repay capital, stop capitalizing interests constantly. And the disappointment is greater when there is trust and hope placed but the government maintains the status quo. But they still have time to rectify. A hundred days are a hundred days.

Politicians are ignoring the effect of deleveraging of financial institutions on demand for sovereign bonds, not least because banks, their advisers, do not comment it. The Norwegian investment fund just reduced further their exposure to Europe. Not only governments have to do the right things, curtail political spending and encourage private job creation, which is the one that pays taxes, the public sector consumes taxes… States must take account that the pie of money available to invest in sovereign bonds continues to decline. And that makes what we consider “our rights”-unlimited access to debt, and cheap- unaffordable unless we change radically the structure of public spending.

The funds available for European debt have been reduced by an average of 20 billion euros a year every year since 2007, according to our own studies. Not only the cake has reduced, but competition is fierce, as no country has reduced its debt-issuing voracity. And of course, by increasing the money supply by 6% pa, we only have placebo effects. Because the increase in money supply is clearly inadequate compared with the increase of public and private indebtedness, but in addition it generates stagnation, deflation in the goods, products and services from our economy and much higher inflation in raw materials and imported foreign goods. In fact, most of the inflation generated in the EU between 2007 and 2011 is from commodities and foreign goods. The states are still in debt, but practically nothing of the additional money supply goes to the real economy, industries or households. It stays in zombie banks that purchase sovereign debt with ECB funds (paid by current and future citizens in taxes) and use the difference to keep zombie companies alive “until it stops raining.”

Of the 200 billion taken by the Spanish banks of the ECB all have been consumed in bond buying, cover the fall of deposits (-7.5% in 2011) and cover their own debt maturities, but neither the state’s nor private balance sheets have improved. Many investor are surprised at why very few companies and banks have taken the injection of Draghi liquidity and the “placebo effect – stock market euphoria” to raise capital and cut debt. Why? Better to be a zombie among zombies than victim of the greed of the of the hunger of the undead. Like Japan, but with a difference. A private and public debt that no one has reduced “because the recovery is coming.” UBS recently commented “the banking stresses are not yet addressed: We see the system as undercapitalised, poorly-funded and badly reserved …”.

No wonder that many companies do not generate free cash flow in the IBEX. Because when you generate it, it is seized by the governments in taxes. At least when the company generates no free cash flow it enters the list of “rescue-able”. And they keep as much income as possible in tax havens. I always say that there are no tax havens, there are tax hells.

But the problem is that Spain can not be rescued. The cost would exceed 500 billion euro and that cannot be afforded by the EU. Especially because as we talk about Spain, France is also close to the territory of danger, with a debt to GDP that will reach 100% soon.

A bond investor cannot accept just 5.9% for a 10-year bonds of a state+region apparatus that will swallow + 10% of expected revenues, because as we review the growth rates to more logical levels (-2 % in 2012 and -0.4% in 2013) the investor asks himself “where will the money come from?”.The Spanish institutions, constantly talking of acquired rights, seem to think that money is free and that we deserve it “at any cost”. It seems that public spending (political, not public) that is advocated so insistently by the political parties was not paid through taxes and borrowed money at an interest rate. And those who lend money have a nasty habit of expecting to receive that money back.

The investor asks only that expenses match revenues. Those who decide to cut essential services like education and healthcare but maintain more advisers than Obama, more official cars than the UK and France together, countless regional TV stations and zombie semi-state owned companies, 17 separate governments, regional embassies, grants and 5% of GDP in subsidies are those that we voted to manage these resources. All an investor asks is that resources be managed based on a reasonable income and based on the demand for bonds that the country can take. Spain can not be, even if it wanted, more than 30% of the European supply of bonds. And let’s see when we start implementing zero-based budgeting. Budgets that can only grow are a fallacy of “bull market”.There is, of course a solution. Curtail political spending and zero based budgeting. With courage. Adjust expenses to income.

Bill Gross, from PIMCO, said “Greece is a Zit, Portugal a Boil, but Spain is a Tumor”.Spain is the bridge between recession and the Euro recovery. Spain is much more important than we think. I am a Spanish citizen and I cannot believe that we can not reduce a bloated state. It’s time to raise awareness and decide where we go. History will not forgive us.Here is an excellent blog that details the Spanish debt evolution at regional and state level:

http://javiersevillano.es/BdEDeuda.htm#BCE

and the Economist:

http://www.economist.com/node/21551520

This from Ahorro Corporacion, one of the best Spanish brokers:

Spanish public debt sales by foreign investors (€53,538Mn since November) have been offset by the resident sector’s purchases, especially by domestic banks (€71,965Mn during the same period). However, the pace of public debt purchases by domestic banks (€25,000Mn/month) doesn’t appear sustainable over the long term (especially without expectations of additional ECB liquidity injections). As a result, the key factor for a sustainable decline in Spanish interest rates appears to be the recovery of foreign demand, which is only likely to occur if there are deeper structural reforms and the government meets public deficit targets.‬
Without any recovery of foreign demand we don’t foresee a sustainable downtrend in Spanish interest rates albeit the impact of carry trade deals and possible secondary market purchases by the ECB could help set a cap. Assuming a scenario without purchases of new Spanish debt issues by foreign investors in 2012e and renewal of only 50% of their Spanish debt positions which mature in 2012, the resident sector would need to purchase 100% of the Spanish Treasury’s net issues this year (€38,826Mn) plus maturities not renewed by the foreign sector of €24,635Mn (total Spanish public debt maturing in 2012 of €149,300Mn * 33% held by foreigners * 50% non-renewal hypothesis). In total, the resident sector would need to finance €61,461Mn, which we believe is possible given liquidity provided to domestic banks by the ECB’s two 3-year LTROs (Spanish banks received around €250,000Mn from the two LTROs, which should be used for: meeting banks’ 2012 debt maturities of €106,100Mn, meeting 2013 maturities of €79,900Mn, and purchasing public debt to take advantage of carry trade opportunities).‬

‪ More: ABC in Spain reports here that:

The cost of the public sector in Spain exceeds 200 billion euros a year . That’s the cost structure to hold the public sector in Spain as: central government, regional and local communities, municipalities, county councils and town councils and the long list of public companies, agencies and entities linked to them all. More than three million public employees from all levels of government and its agencies and public enterprises. In keeping with the extensive machinery of its public sector, Spain spends right now almost a quarter of its Gross Domestic Product (GDP). Just to pay the salaries of public employees, this year Spain will spend about 100 billion. The figure includes not only officials but also the long list of political appointees and consultants , temporary workers and contractors in the extensive network of public companies and agencies. The bulk of all that spending on salaries is for the autonomous communities, some 60 billion euros, with nearly two million workers on the payroll.

To watch my interview in Al Jazeera about the Spanish banking issues go: (Quicktime or Oplayer required) http://dl.dropbox.com/u/62659029/iv_daniel_lacalle_250512_0.mpg

The Market Doesn’t Attack, It Defends Itself. Spain, Short Positions And The Lost Decade

Global Economy, On the cover, Sin categoría

Here is a link to my analysis of the Spanish elections on CNBC http://video.cnbc.com/gallery/?video=3000058799(The following article was published in Cotizalia on November 19th)If there is a chilling fact of this past week is the result of last week’s Spanish Treasury auction. There was no institutional demand. The market is scared seeing again how on Tuesday the government revised downwards the expectations of GDP growth for 2011, no less than about 40% less from +1.3% to +0.8%. € 180 million less of GDP every time they revise it, and there have been six times, while expenditures are not trimmed. So one can understand the reaction of the markets in a country which shall spend 3% of GDP in financial expenses, issues debt to pay interests and each year spends between 1 and 2% of GDP in subsidies. How is Spain going to pay that debt?

Amid all this, the media in Spain constantly mentions “attacks against the country debt” without realizing that the only thing the country has done has been to introduce risk and uncertainty for investors.Regulatory uncertainty, planning and legislation swings and turns. There is no attack. Because no one wants to invest. The market is closed. Imagine that the management of any listed company that has breached its own estimates for years demanded more funding and more support, and think how much its shares would fall. That’s the situation.

The elections have been a first step towards the solution. At least the new government has absolute majority not only at the State level, but also in 95% of the regional communities, which have been responsible for a very large part of the spending binge of 2004-2010, multiplying their budget by 3x.

Part of the solution is the famous “confidence” that the popular party advocates, and that is nothing more than credibility. Give the real figures of expenditure, deficit and exceed targets. Stop the ostrich policy of “pretend and extend”, which has been the country’s economic policy since 2008, hoping that people forget the announced estimates and forgive the mistakes.

A serious problem is the brutal installed overcapacity generated in the orgy of stimulus plans and expenditure. Ghost-airports in every region, ghost towns, a giant real estate bubble, billions in energy infrastructure and renewable subsidies optimistically estimating annual growth of 2-3% … In Spain there is little to do in the field of infrastructure for a few years. The scissor on civil works is unavoidable. Spain has invested in infrastructure like an emerging country, but with the demand of a mature country. Now it has massive spare capacity and the country has to digest, and pay, the debt created by the construction of unnecessary assets.

The good news: some companies are doing their homework and, as always, the private sector will rescue the economy. We’ve spent too much time attacking the capital markets and investors, scaring them with constant revisions of the legal framework, changing regulations in the middle of the period and looking for patch solutions to long-term problems. And while public saving has fallen by 12 percentage points of GDP, private savings reached 11 points. This saving is essential, added to a policy to attract investment capital, to boost the economy.

Well, now that the Ibex has lost all its gains in the “lost decade”, in part because many companies have spent the last ten years looking away, it is worth focusing on companies that can benefit from a situation that on one side will be incredibly complex, without growth, but in which the country and investment risk is lower.

The table below shows the companies in Spain with the largest short positions.

The first surprise is that, contrary to what people in Spain think, short positions in the IBEX are nothing special compared to other global indices. Not much of an “attack” then, even if we look by sectors. But the interesting thing is to look at the ones with the highest short interest and understand why it remains so high.

When media and banks say that stocks are cheap, the key to understand this table lies in something that no one is looking at. Namely, the outstandingly high short interest (look in the table at the ones with more than 1-1.5% of market cap) is due to a massive deterioration of working capital. The reason why hedge funds increase their short positions in some of these companies even when the stocks go up is because the cost of “survival” of these companies is rising as working capital deterioration accelerates. With a ratio of annual working capital to sales that in cases exceeds 20%, those stocks ​​are called “living dead” (it costs more to maintain the activity than to stop it).

But there are three important points to argue:

a) In spite of strategic errors, especially those damn “acquisitions to diversify” that have destroyed so much value, several of these companies are demonstrating that their core business is being managed very well. Therefore, if they manage to stop working capital deterioration and focus on the areas where they have real competitive advantage, the market will reward them.

b) Companies should not fall back into the mistake of “diversifying” and growth for growth sake. Reducing size and being a cash machine is more attractive in the medium term, leaving the balance sheet breathing. The small, focused and efficient companies are worth more than the inoperative conglomerates.

c) No one appreciates debt reductions if they are due to financial engineering, changing of accounting parameters and other tricks.So do not try. The short covering will happen only when margins, cash and balance sheet is restored. Not because of changes in accounting.

There is nothing I like more as an investor than a stock where there is a large short interest, recommendations of analysts are neutral or negative but the company is in the process of recovering quickly and efficiently. These are treasures stocks. And nothing I like more as a short than stocks where the working capital is soaring, returns plummet but have many Buy recommendations. These diamonds are the “short on strength” stocks that gave us so much joy in 2009 and 2010.

While many executives and directors are blinded by accumulating many Buy recommendations from sellside and are pleased with themselves adding revenues purchased in acquisitions at massive multiples, they should realize that the market values ​​organic cash generation, margins, and balance sheet. Not imperialistic adventures. I was head of investor relations for several years in public companies. There is nothing better than to win the interest of bears on your stock and to prove the company is delivering and exceeding expectations of ROCE (return on capital employed) and balance sheet strength. Companies should focus their communication efforts on those investors that currently do not want to buy their shares or are short, not those who already have them, as these are the first to sell in this market. They will learn a lot.

Companies can continue blaming their share price on attacks and justifying themselves, depending on subsidies and grants, or revive. “Shrink to Earn”. It is in their hands.

Why Italian and Spanish CDS can rise 40%… and Greece is not to blame

Global Economy, On the cover, Sin categoría, ,

(Published in Cotizalia on 5th Nov 2011)The peripheral European sovereign risk premium and the role of CDS (credit default swaps) have focused the debate this week with my Twitter followers. Despite the enormous stimulus measures and bailout packages, the CDS of the peripheral countries remains at historic highs. It falls one day and rises quickly the next. That is because, despite all the stimulus plans,  the risk increases.

On the issue of credit default swaps there are many myths that often hide the desire of governments to mask reality. We’re used to hear that every time the premium rises they say that it is because of Greece, the Fed, or any other excuse.

The CDS market is about $ 24.1 billion gross. Insignificant compared with the impact of the ECB and public institutions. The European Union itself in 2010 analyzed the potential impact of CDS positions on the cost of debt and concluded that there was no effect. Nevertheless, the EU has banned CDS without collateral, a cosmetic measure as not even 0.3% of the CDS market transactions are negotiated without coverage.

The main positions in CDS are in Italy ($ 22.8 billion), Germany ($ 13.1), Spain ($ 13.1), Brazil ($10.6) and Greece ($ 8.7), but for those who support the the theory of an “attack from Anglo-Saxon institutions” against Europe, the figures don’t even compare remotely with the U.S. CDS positions, or, more tellingly, General Electric, Bank of America, JPMorgan and Goldman Sachs that, combined, surpass the CDS exposure to Italy and Spain together. The biggest exposure to corporate CDS is … Berkshire Hathaway with $ 4.8 billion, far more than Deutsche Telekom, Telefonica, and France Telecom, all below $ 4.0 billion.

. Those buying CDS do not expect that countries or companies go bankrupt because in that case the “credit event” would make these CDS worthless. What they expect is to cushion the impact of default risk. In fact, when one buys a CDS, one seeks to mitigate the probability of bankruptcy when it is between 20 and 65% (Spain is now at 29%, Italy 35%). From 65% chance of default, the CDS does not protect.

. While Euro governments persist in the mirage metric of debt to GDP, false because what matters is free cash flow generation, bond investors looks at the percentage of income to interest expense, the acceleration of debt and deterioration of the accounts, calculating the difference between the actual cost of it, artificially manipulated by the ECB buying, and the real one if it was traded in the open market, given the fundamentals of the economy and the type of interest that institutions would demand.

By that calculation, unless things change, the Spanish CDS, for example, could rise 40% in the next twelve months (519 basis points if the deficit reaches 12.5% ​​and the financial costs exceed 35% of income). Since it is very likely that the next government sees a real deficit of 8% instead of 6% due to lower income than expected (uncollectible bills of autonomous regions) and see higher non-computed costs, the probability is not small. in Italy, the deterioration of the accounts has made the 10 year government bold yield 6.595%, its highest since 1997. And the deterioration of the accounts is visible while refinancing needs take 20% of all Euro supply. Italian CDS rising by 35-40% is also likely as spending cuts are proving less and less evident.

. 96% of the sovereign CDS market is absorbed by the financial institutions (many semi-state owned) that accumulate billions of European sovereign debt (€275bn) and know they have to “pitch-in” and buy more when countries need to refinance € 5.9 billion from 2011-2015.

. Many of the new CDS are “quant CDS”, a simple long-short strategy in which the investor buys protection against sovereign risk using CDS, buying in dollars and selling in euros, which “insulates” the sovereign risk and covers the two parts with no “speculative” impact to the country risk premium.To understand the rise of risk premium spreads we must analyze the lack of institutional demand, as the demand-supply analysis explains perfectly why the CDS up despite aid packages to Greece, bailouts and injections of debt.

The first major problem for peripheral debt is institutional investors do not demand it because the price and interest does not match the risk .

If we look at official figures, Spanish debt seems well placed between residents and non-residents (62% -38%). The Treasury boasts that 38% of sovereign debt is placed “between non-resident investors”, however this figure conceals the fact that the vast majority are European central banks, which support each other in the orgy of public debt, EU institutions and underwriters. In Italy it’s the same. Institutional demand is all but nonexistent. Very active buyers are the European central banks, government agencies and the Social Security, which can go to the primary market and is filling its reserve fund, up to 80%, with sovereign bonds . In other words, almost 45% of the debt is bought by the issuing country and the rest by the EU entities.

On Thursday’s Spanish auction there was not a single final customer order, I have been told by several banks. The same since July 2011. And in 2012, Spain has €150 billion more to refinance. Italy has €361 billion maturities in 2012. Therefore it is essential to attract capital and to stop placing the debt in a false cocoon market buddied between the ECB, public entities, social security and underwriters. Countries have to show that this investment is attractive for foreign capital. And that can only be achieved regaining confidence in public accounting, commitment to re-pay, providing transparency and allowing the investor to receive an interest on that debt that is right, not manipulated.

The fundamental reason for the rise of the CDS is not the absolute debt level, religiously repeated by politicians, but the acceleration of expenses and the deterioration of cash flow.

The other reason why CDS are not down is the huge refinancing needs. Between 2011 and 2015, European governments must refinance € 5.9 billion and European companies another €1.1 billion, all while GDP and stagnates and spending does not drop substantially. Italy, especially the Czech Republic and Spain are the biggest risks.

It seems normal that bond investors will continue to demand a premium over the German bund of at least 150 basis points rising to 400 if the deterioration of the income statement of Europe SA continues. The sovereign debt risk premium of peripheral countries is at risk of rising in a scenario in which the supply of debt in the market far exceeds the possibilities of investors to buy it. Spain can not expect to reduce their risk premium when their refinancing needs account for 8% of European supply in 2012, because it is simply impossible to bear weight by investors. The same with Italy, which accounts for a staggering 20% of European refinancing requirements in 2012.