Please, click here to read this article in pdf format: april-12-2010

This was a “busy” weekend, and we are left with no alternative but to write about it on a Sunday night…
First, we offer our deepest condolences to the people of Poland on the tragic deaths of their President, Mr. Kaczynski, First Lady Maria Kaczynski, and those who were traveling with them, on the 70th anniversary of the Katyn massacre.

Europe was also on the front pages, with the announcement of a EUR45BN rescue package, consisting of EUR30BN by European Union members and EUR15BN by the IMF. Of course, this money is at below-market interest rates. We suspect that Greece shorts will be squeezed this morning, although much of the rally we saw at the end of last week was on the speculation of this outcome. Personally, we believe this is only buying time for the European Union and we fail to understand the logic behind this package, if it is real. To us, it looks more like a threat, for it seems Greece’s Finance Minister, Mr. Papaconstantinou, said the government still plans to issue debt, without taking up the offer for aid. Another relevant point here is that from now on, we should expect the same kind of response to other worsening fiscal deficits, as in the case of Spain or Portugal. Will the Union be there for them? If so, what kind of exit policy can the European Central Bank (ECB) undertake?
On this note, in our last letter (Thursday, April 8th) we had assumed the graded haircut schedule announced by the ECB was going to include government debt. We were wrong. Details were subsequently released and the program will exclude government debt.

Thus, one more act has closed on the European theater and we have no choice but to think the world can only print its way out of this crisis. This is the reason why we turned bullish on gold last week, for as our market thesis states (refer: www.sibileau.com/martin/2009/04/21 ), every major central bank has now to face internal unique problems that prevents a global coordination in monetary policy. Gold therefore will increasingly play a role as the common denominator for all fiat currencies.

As central banks are (unsuccessfully) seeking to structure their respective exit strategies, governments are looking for a way to build the next line of defense against a future liquidity crisis. Sometimes, the line looks like the Maginot line…

On Saturday, Canada’s National Post reported that Ms. Julie Dickson, Canada’s chief bank regulator, prefers a scheme whereby banks could insure themselves against failure with debt that converts to equity (refer: “OSFI offers conversion as bank shield”, at : http://www.financialpost.com/story.html?id=2785584 ).  If correct, we think Ms. Dickson may be referring to contingent notes, similar to those recently issued by Rabobank. On March 12th, Rabobank issued a EUR 1.25 billion, benchmark 10-yr Senior Contingent Note, at an annual coupon of 6.875%. These notes are contingent on Rabobank’s capital, as a percentage of assets. If this ratio falls to less than 7%,  the notes will be written down to 25% of face value. Therefore, the bank will record a gain on the issue, which increases its capital.

We have no view on this particular debt issue. But we believe that encouraging this type of financing as a buffer against a liquidity crisis is absurd. We cannot mince words here. In fact, the widespread use of this type of debt will only help precipitate a crisis, in a self-fulfilling dynamic.

No investor in any part of the capital structure of a financial institution should feel any safer with this scheme. As soon as an event triggers only the mere likelihood of a liquidity squeeze, noteholders will dump the notes with the proverbial violence. The transfer of wealth from noteholders to shareholders will only be temporary, for immediately after this event, the capital gain will never, ever, offset the liquidity costs financial institutions will face to remain going concerns. Depositors will feel at risk and a serious run against those financial institutions will trigger a swift downward spiral.

Indeed, with senior contingent notes, financial institutions are buying a put from the note holders. However, believing that these notes constitute a solid cushion against systemic risk equals to ignoring the leveraged and correlated nature of financial institutions under a fiat currency system.

Martin Sibileau

Please, click here to read this letter in .pdf format: may-4-2009

Finally, Friday came with the data on the ISM Index, which was at 40.1 vs. expected of 38.4. On an absolute basis, main street still looks awful, but everyone makes the case that the so called “second derivative” is signaling there is light at the end of the tunnel. As I have been repeating since March 18th, the positive news relies on the Treasuries, GSE debt and securities purchases by the Fed. On Friday, the sell-off in Treasuries continued. The yield on the 30-yr Tsy is now above 4%. And yield, agency and credit curves have steepened considerably during last week. The news on Chrysler and the delay in the release of the stress tests results have left stocks on a wait-and-see mode. The S&P500 at 877.52pts is up a bit over 1% in the week. The inflationist policy in April has pushed a lot of short-covering in the credit space. The CDX IG12 ended at 163/165bps. But High Grade, High Yield, Loans, Convertibles and Mortgages have all tightened significantly too.

May 1st, 2009: 30-yr Treasury (white) vs. S&P500 (orange)

Source: Bloomberg Analysis: Tincho’s Letter

Some brief comments on 3 issues the markets have lately been paying attention to:

1. Steepened credit curves: Most analysis on this is either descriptive or focused on the specific fundamentals. This is short sighted. The steepening is the natural outcome of the inflationist process. It could also be called re-leverage. The different degrees of steepening and liquidity points we see are another proof of the non-neutrality of inflation, which is also impacting correlation in structured credit. Think of this: Without central banks, the only inverted curves you would ever see would be at the single-name level. But we do have central banks…
2. Sovereign CDS: The recent tightening in this space is purely technical. Like any other spread, the sovereign spread should compensate for expected losses: spread = prob. of default x loss given default. In the case of developed sovereigns, the probability of default would be that of systemic collapse, after which huge inflation surges, resulting in a considerable currency debasement (=loss given default or loss given systemic collapse). Now, this probability has not yet fully disappeared, while the currency debasement is just starting. Thus, from a fundamental perspective, sovereign spreads should be widening. And they are, but this is only taking place in the bond market (i.e. Treasuries), where yields keep climbing.
3. Banks stress tests: The US Govt. wants well capitalized banks. This is all idiocy. In our leveraged world, it is a mistake to think that the banks’ capital’s task is to allow the redemption of funds, when clients have lost confidence in their banks. The confidence that banks and the loans they have issued enjoy is indivisible. No risk management policy or capital requirements adopted on the banks’ initiative or forced upon them can remedy this. Given the ongoing inflationist policy, regurgitating this issue only brings unnecessary political risk to the table = If the Fed will keep bidding on assets and print our way out of this, they should shut up and just do it! Asking for more capital or more lending or even targeting an inflation rate is hypocrisy and it only adds expensive noise (volatility) to a trend!

This week is heavy in Treasury supply: $35bn 3-yr auction (Tues), $22 bn 10-yr (Wed), and $14 bn 30-yr (Thur). With Transmission spreads (LIBOR, LIBOR-OIS and Comm. Paper) collapsing, what could bring a reversal (lower lows in stocks, wider wides in credit)? POLITICS! Behaviour like the one shown in the chart above, between 10:30am and 2pm, when govt. debt and stocks enter or exit for the same doors AND the outlet valve of foreign exchange acts as a thermometer, MUST BE AVOIDED. (What happened on Friday between 10:30am and 2pm, AND AFTER?)