Eurozone's banks cutting dollar businesses

As predicted back in February, European banks are beginning to exit their dollar businesses. They've reduced dollar denominated loans and sold dollar assets.

MarketWatch/Business Wire: This reduced appetite for MMF funding has likely contributed to a significant dip in Eurozone bank lending to project and trade finance, sectors that historically have largely been USD-denominated.

That in turn has led to a reduced need for the Fed's dollar swap facility, which has fallen off sharply.

Fed Liquidity Swap Facility

It is important to note that the decline in the Fed's Liquidity Swap Facility does not necessarily mean an improvement in the strength of Eurozone's financial institutions. It is simply an indication that European banks will never again rely on US money market funds to this extent to finance their dollar operations. Neither does it point to Eurozone's banks obtaining alternative dollar funding sources such as unsecured bonds. Trying to issue unsecured dollar paper may be a difficult task indeed for these firms for years to come.

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The "London Whale" is likely hedging JPMorgan's own bonds

The financial media has had a field day with the recent story about the so called "London Whale". Apparently a trader out of JPMorgan's office of the CIO has been a seller of the Investment Grade (IG) CDX (an index of investment grade corporate CDS).

WSJ: Mr. Iksil has taken large positions for the bank in insurance-like products called credit-default swaps. Lately, partly in reaction to market movements possibly resulting from Mr. Iksil's trades, some hedge funds and others have made heavy opposing bets, according to people close to the matter.

According to the story these trades have been so large that they are distorting the market. A few comments on this situation:

1. The story of large sales of protection are in fact true as evidenced by the recent divergence of the IG CDX and the HY CDX spreads which are generally highly correlated. The selling pressure from the "Whale" or whoever has tightened IG spreads disproportionately to HY CDX.

IG anf HY CDX spreads (Bloomberg)

Note that the spike in both spreads today is due to the relatively bad employment numbers out of the US, as we continue to see more negative economic surprises.

2. The story about hedge funds taking the other side is probably true as well, simply because hedge funds use IG CDX as a general hedge against negative market events. And given the relative divergence here, they saw this index as a fairly cheap hedge/market short. But they clearly have not traded enough to bring the two indices back in line.

3. As IG CDX widened today, it is premature to conclude that JPMorgan has taken a large loss. Let's just put some numbers on it. Let's say JPM is short $5bn of  IG CDX protection. The index has widened 15bp from the lows (85 to 100). That translates into $37mm of losses, barely a blip for JPM's earnings.

4. In general JPM would not do an outright trade like this. Most likely they have something on the other side of the trade that the market doesn't see. It is in fact highly possible that the bank is hedging the volatility in its own bonds. Well publicized accounting rules have banks mark their own debt to market. In difficult times their debt drops in value, and because the bank is effectively short its own debt, it records a gain. What JPMorgan may be doing is protecting itself from the rise in its debt value, which would force them to record a loss. If JPMorgan's credit spread tightens, the firm takes a loss on its own bonds but would make a gain on the bank's IG CDX position as an offset. IG CDX is highly correlated to the CDS of financial companies and is liquid enough for JPMorgan to execute in size. It is well known that Goldman for example has been quite active in hedging its bonds, and is therefore not unreasonable to assume that JPMorgan is doing the same using IG CDX.

Reuters: ... Morgan Stanley reported $3.6 billion worth of debt valuation gains in the last half of 2011, as its credit default swap prices more than doubled. The bank is likely to report a charge of hundreds of millions of dollars in the first quarter if its bond and CDS prices remain stable, analysts said. Goldman hedges its debt valuation risk, so its gains and losses are smaller and harder to predict.

For those interested in this topic, here is a great detailed write-up on the IG CDX recent dynamics and a discussion of the infamous London Whale from Lisa Pollack .

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The ECB has completely lost control over the monetary policy for Greece

The Bank of Greece balance sheet has expanded sharply this year. This of course is part of the ECB's balance sheet expansion on a consolidated basis. But the Greek central bank's balance sheet by itself is now almost €200 billion. That's an unprecedented amount for Greece and represents over 65% of the nation's annual GDP. It is also close to a 50% increase year-over-year.

Bank of Greece balance sheet ( €mm, source: BoG)

One would expect at least some impact on the monetary aggregates from such a dramatic expansion. Yet the money supply measures, both narrow and broad have collapsed. We've seen this before with other periphery nations such as Italy. But nothing on this magnitude.

Greece contribution to Eurozone's money stock year-over-year growth (source: BOG)

This trend shows a massive drain of liquidity out of the system that will result in a total seizure of credit. How can the ECB claim any control over the monetary policy when a 50% increase in the Greek central bank's balance sheet results in a 16% decline in M1 and nearly a 20% decline in M3 money stock?  Greece is now in a  permanent state of extraordinarily tight monetary conditions no matter what the central bank does. In such an environment there is absolutely no hope for any growth, let alone fiscal consolidation. It seems the only possible solution for Greece may be to take control of its own monetary policy, which would require abandoning the euro. An ugly outcome, but given the ECB's inability to stabilize Greece's rapidly shrinking money supply, there may be little choice.

Update: see some insightful comments below from Kostas Kalevras on the topic.

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Sarkozy gains in the polls but Hollande risks remain

With the Eurozone recession comes the possibility that by taking a wrong turn, France could easily migrate from the core to the periphery. That is why the upcoming French election is critical to the direction of the euro area nations. France has to start moving rapidly toward a balanced budget before the market begins to view it the same way it views Spain. Sarkozy is quickly positioning himself as a fiscal conservative ready to tackle the problem.

The Washington Post: Sarkozy, a conservative, said balancing the budget by 2016 is “an absolute imperative,” and promised a balanced budget law this summer.

He said he would do that by cutting €40 billion ($52 billion) in public spending and raising €13.5 billion ($17.6 billion) in new taxes.

The strategy is to tell the voters that if they don't vote for him, France will indeed move toward the Eurozone periphery.

FT: [Sarkozy -] “The situation which our Spanish friends are experiencing, after what our Greek friends experienced, remind us of the realities,”

Some have accused Sarkozy of causing France's relatively high budget deficit to begin with. Others point out that the opposition is not necessarily going to make the budget problems worse. Whatever the case may be, it looks like the opposition from the left is still ahead in the polls, a development that could be destabilizing for the Eurozone. Since the last post on the topic however, Sarkozy has gained some ground. The chart below shows the latest polling trend for the second round of elections (head to head) which is widely expected to be between Sarkozy and Hollande (the Socialist opponent).

Source: BNP Paribas

In spite of this trend, BNP Paribas' analysis still projects Hollande to be the winner. In spite of Sarkozy's one point advantage in the first round of elections (28.4 to 27.4), the believe that Hollande will be able to capture the bulk of France's left. In particular he is expected to keep 90% of Melenchon's Leftist's Party, which commands 13.4 percent in the first round. Sarkozy on the other hand is not expected to capture a significant majority of Le Pen's supporters (a somewhat scary group) on the right nor the bulk of the centrist Bayrou's supporters.

Hollande's victory is not necessarily a disaster for France, but it will create a great deal of uncertainty and may unsettle the financial markets. Hollande basically has no real experience governing. It is in fact possible he will take France on a spending spree as Sarkozy keeps insisting (France's public spending is already 56% of the GDP). But the most dangerous step at this juncture would be for Hollande to push in a different direction with respect to the latest Eurozone treaty and the ESM. That is why Angela Merkel has effectively said she will "campaign" for Sarkozy. Germany is clearly worried about the Hollande risks and so should the rest of the Eurozone.

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Foreigners rattling Spanish debt again

Spanish government debt volatility is spooking global markets. As much as the world wanted this problem to go away, it hasn't and Spanish bond spread to Germany is on the rise once again.

Spain to Germany 5y spread (Bloomberg)

What's driving this sell-off? Clearly a poor performance in the latest bond auction was the catalyst.

WSJ: A miserable Spanish bond auction Wednesday highlighted fraying investor confidence in the country's economy, with unemployment rampant, the debt burden climbing and the government's ambitious budget cuts likely to further crimp already weak growth.

But other factors are contributing as well. The Eurozone economic fundamentals are continuing to deteriorate, with Spain at its epicenter. As discussed earlier, Spain's regional debt problems create additional risks to the nation's fiscal consolidation effort.

WSJ: Spain expects the ratio of the country's debt to gross domestic product to climb to 79.8% in 2012 from 68.5% last year. A stuttering economy could push debt levels even higher, while there are still question marks over the government's ability to reduce debts in the face of rising public anger at austerity measures.

Technical factors however are also responsible for the volatility in Spanish Government debt. As discussed recently, Spain's banks have been by far the largest buyers of this paper (at the "request" of the central government of course). And as foreigners sold Spain's debt, the Spanish banks bought (see chart below). As the government issued new paper, Spain's banks were there to buy more. In fact while the ECB did much of the buying in the second half of 2011, that buying got transferred to the banks via the 3-year LTRO program, giving these banks the liquidity they needed to finance their indebted government.

Net financing of Spain's central government debt (Source: Barclays Capital)

But Spanish banks have limitations in how quickly they can absorb that nation's new debt hitting the markets as well as paper sold by foreigners - even with the LTRO financing in place. In the mean time foreigners will continue to swing Spain's sovereign debt. As an example, the chart below shows hedge funds' trading volumes with Barclays relative to the bank's overall trading volumes in major sovereign markets. Some 30% of all trading in Spanish debt and CDS is done by hedge funds. There is no reason to believe that this ratio is much different at other dealers. And as the previous post shows, net CDS outstanding on Spanish debt is substantial relative to Italy for example. And unless Spanish banks step up to the plate to buy more, the volatility will continue.

 (Source: Barclays Capital)

Going forward, expect more downgrades of Spanish debt by the rating agencies given the horrific economic fundamentals. In and of itself another downgrade won't mean much except that it may provide a pretext for the Eurozone core NCBs to reject Spanish paper as collateral. It will also increase haircuts on collateral for ECB financing as well as raise the amount of regulatory capital (increase RWA) the banks would need to hold against these bonds. That in turn could be a major catalyst for further sell-offs as foreign traders get in on the action.

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Sovereign CDS notionals - an update

Here is a quick update on sovereign CDS net notional outstanding. The chart below shows the net for SovX (index of sovereign CDS) and its components. The notional for "single name CDS" (the components) has been on a decline. Part of that decrease was the Greek CDS going away, but some represents a decline in trading. Less "excitement", less volume - for now.

CDS net notional  (Source: Credit Suisse)

Here is what the notional looked like recently as a percentage of total debt outstanding for Western European nations. As expected, Ireland and Portugal are at the top. The Scandinavian nations are up there as well, but the ranking is a bit skewed because the overall amount of debt of these nations is low on a relative basis.

CDS net notional /debt (Source: Credit Suisse)

This shows again how low the CDS notionals are relative to the overall sovereign debt outstanding. But it's important to track these rankings as an indicator of where the market participants are placing bets.

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Oesterreichische Nationalbank follows Bundesbank in refusing some periphery collateral

As discussed earlier, Bundesbank may have started a trend. Other Eurozone core central banks are starting to refuse accepting collateral from troubled periphery nations. Austrian central bank made the announcement this morning.

FxStreet.com: Spokesman for the Austrian central bank said: "we will do that as well , we are talking about minimal amounts. It will have little impact on overall collateral" the ECB on March 23 said members are no longer obliged to accept bank bonds guaranteed by governments whose credit assessments do not comply with the benchmark for mimimum requirements of high credit standards This leaves Greece , Portugal and Ireland unable to use such bonds to get funding from subsidiaries in Germany and Austria.

The impact on current collateral is insignificant but it is sending a massage of an increasing rift within the Eurozone. It also opens the possibility that the "restricted list" may be broadened to include other, much larger periphery nations.

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Performance persistence in hedge funds

A fascinating report from Barclays Capital is shedding some light on what's known as "performance persistence" in hedge funds. If a hedge fund had a great year, what's the likelihood that its performance will be above average next year? Alternatively if a fund had a terrible year, what should the expectation be for the following year? Another way to ask the question is whether hedge fund performance could be modeled as a "martingale" with each year's performance completely independent from the previous year (similar to the way a stock price would be modeled).

It turns out that hedge fund performance in a particular year is very much dependent on how that manager did the previous year. The two charts below compare how funds in the lowest (Q1) and the highest (Q4) one year performance quartile fare over the the following year. With no exceptions the "losers" in year one performed below the mean in year two and the "winners" performed above the median. This is true for each year since 1997 and for all major strategies.

Source: Barclays Capital

What this means is that the "losers" (poor performers) are much more likely to be stuck being "losers", while the "winners" will probably continue to do well. The table below is a transition matrix, showing  the frequency of funds moving from one quartile to another or staying in the same quartile from one year (t) to the next (t+1). A loser has only a 13% chance of being a winner the following year and a 38% chance being a loser. The result for the winners is very similar.

Hedge funds performance transition matrix (Source: Barclays Capital)

Hedge funds that had either a very good or a very bad year are in effect "trapped" in their performance bucket. This explains why when hedge funds have severe underperformance relative to their peers, redemptions kick in quickly. Investors don't want another bad year and know that it is in fact the most likely outcome. The opposite is true for funds who had an exceptional year.

Value stock investors often look to invest in stocks that underperfomed their peers in hope that these stocks would bounce back next time, outperforming peers. But here is the lesson from the "performance persistence" study: unlike value stocks, loser hedge funds are likely to stay that way.

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