Threat of $100bn hit if US top rating lost

Investors in the US government bond market could face losses of up to $100bn if the largest economy loses its triple A rating, according to a research arm of McGraw-Hill, the parent of Standard & Poor’s.

A ratings downgrade that results in higher bond yields and lower prices could also mean the US Treasury paying $2.3bn-$3.75bn a year more in interest on financing a $1,000bn annual budget deficit.

More

ON THIS STORY

• Setback for government bonds
• Flight from money market funds exposed to EU banks
• On Wall Street Banks lose out
• Treasury yields signal deflation risk
• In depth US budget

“If Standard & Poor’s or any of the other major rating agencies downgrade the US, Treasuries would likely drop in value, possibly by as much as $100bn,” said analysts at S&P Valuation and Risk Strategies, a research team separate from the agency.

Currently, Treasury yields do not reflect concern about the US losing its top rating. The yield on 10-year Treasury notes fell to 2.85 per cent on Friday, a low for the year. Investors are concerned about a weaker economy and financial contagion from the euro debt crisis. Yields on four-week Treasury bills have been driven below zero.

While the threat of a US downgrade is remote, it remains a possibility given the projections of large long-term deficits and the impasse over raising the $14,300bn Treasury debt ceiling.

In April, S&P affirmed its US rating but revised its outlook to negative because of the deficit and the risk that it will not be cut meaningfully by 2013.

Moody’s has said it could place the US government on review for downgrade if there is no resolution of the impasse over raising the Treasury debt ceiling before the August 2 deadline.

Many in the bond market say it is unthinkable that the US would actually default over the debt ceiling and expect a deal before the deadline.

But prominent bond investors such as Bill Gross at Pimco have warned about the US’s long term fiscal position for some time. Earlier this year, Mr Gross eliminated Treasury holdings in the total return fund that he manages.

Michael Thompson, managing director at S&P Valuation and Risk Strategies and one of the three authors of the report, said the analysis is based on the debt ceiling being resolved and focuses on whether Congress addresses the long term fiscal outlook.

The S&P analysis calculates a reduction in the rating to double A or single A would spark a decline of 2 per cent and 3.2 per cent respectively in the price of the 10-year Treasury note, sending yields higher.

The price of the 30-year bond would drop by 3.9 per cent and 6.3 per cent under these scenarios. The analysis focuses on Treasury debt with a maturity longer than two years as this sector is least affected by the Federal Reserve’s near zero interest rate policy. As such, the estimate of costs associated with a downgrade is considered conservative.

A ratings downgrade applied across all Treasury maturities could raise the cost of financing an annual budget deficit of $1,000bn by an additional $20bn

A psy-QE-logical problem

Posted by Tracy Alloway on Oct 01 15:14. 2 comments | Share

David Rosenberg thoughts on QE v2.0 are complex indeed.

Though he’s detailed at length why quantitative easing will flatten the yield curve —this time — he’s rather dubious of its actual effects on the US economy, at least in terms of mortgages.

In his Friday ‘Breakfast’ missive, the Gluskin Sheff analyst says:

New home sales are at their second lowest level on record despite record low 4% long-term mortgage rates. So if QE2 brings rates down to 3%, who cares? And with 11 million U.S. households upside down on their mortgages, refinancings have failed to boom and add cash flow to pocketbooks as was the case in 2003-04.

At the 2006 bubble peaks, households were engaging in mortgage equity cashouts to the tune of over $80 billion per quarter. That provided the thrust for the spending binge even as the jobs cycle lagged behind, similar to what we had seen in the past as the economy continued to adjust the vagaries of the post-dotcom bubble bust. Today, cash-out refinancing activity is running at one-tenth that good ol’ pace of five years ago. Indeed, attitudes towards “being in debt” have shifted so radically that nearly 1 in 4 households are now “cashing in” and paying down their mortgage debt. Nearly 1 in 3 upon refinancing are doing the most un-American thing of all; choosing to accelerate their paydown by reducing their amortization terms! This means maintaining or increasing the same monthly payments in a lower rate environment, which in turn helps explain why spending intentions on other things are going down. What can Dr. Bernanke do when the shift in attitudes is so profoundly psychological?

Right now debt is, quite simply, distasteful?

It’s certainly one way — together with tighter bank lending — to explain the breakdown in some of the historical associations between rates, refinancing and home sales in the below charts.

They — along with the extra commentary — come from RBC Capital Markets’ US economics team, led by Tom Porcelli.

Exhibit 1: We have been saying QE2 will have little impact on the economy aside from perhaps more refi activity. But an increase in refis and the commensurate savings would be a drop in the bucket. If the level of refi originations matched the all-time highs seen back in 2003 and mortgage rates fell another 50bps we would see an injection of $5bn to consumer pocketbooks in one year – or 0.05% of nominal PCE. Miniscule.

Exhibit 2: Furthermore, getting back to the record level of refi’s seems highly unlikely. Keep in mind that we’ve already seen rates fall 200bp from nearby highs (which is 2/3 the decline seen during the boom). The response to this decline in rates this time around has been muted thanks to, among other things, incredibly tight lending standards.

Exhibit 3: Low rates have done nothing to stimulate home sales and the relationship between mortgage rates and sales, since the bubble peaked in mid-2006 has decidedly broken down…

Exhibit 4: …those that say lower mortgage rates will motivate buyers clearly have not done their homework.

Over to you, Bernanke.

Related links:
Historic lows in mortgage rates fail to motivate buyers, owners – USA Today
Get ready, get set, deleverage! With one notable (US) exception - FT Alphaville
Quixotic QEasing - FT Alphaville

‘Japan’s brewing fiasco’

Posted by Joseph Cotterill on Mar 08 11:40. 6 comments.

No, there hasn’t been an explosion in the Asahi Super Dry factory. But it might be almost as bad. SocGen’s Dylan Grice has a note out on Japanese government bonds (JGBs) – and fears their maturity dates presage an imminent blow-up. More…

No, there hasn’t been an explosion in the Asahi Super Dry factory. But it might be almost as bad. SocGen’s Dylan Grice has a note out on Japanese government bonds (JGBs) – and fears their maturity dates presage an imminent blow-up.

The canary in the mineshaft? As Grice explains (emphasis his) :

The biggest JGB holder on the planet – the Government Pension Investment Fund (GPIF) – which has already admitted it’s no longer able to roll maturing bonds, has announced that it will open credit lines so it doesn’t have to sell them to fund its obligations…

… Japanese debt markets have been stable for such a long time it’s difficult to imagine anything different, so we don’t imagine anything different and predict that the future will look like the past. Now, Japan’s debt markets may well remain very stable in the future and I’m very open to the strong possibility that I’m barking up the wrong tree. But logic like that outlined above is lazy indeed.

It’s a big canary, by the way. GPIF’s portfolio is bigger than India’s GDP. Two-thirds of that is piped into JGBs. But what about Grice’s own logic?

It’s a scary story – but scarier for pointing out how little we really know about Japan’s debt fundamentals, rather than for Grice’s own bearishness.

Grice’s starting point is the obvious one of how household savings can continue to fund government debt and start retirement spending as Japan’s ageing crisis bites.

This is usually the point at which the editorial pages weigh in with some bullish counters on the low cost (1.3 per cent) to Japan of servicing its debt, plus the luxury – denied to Greece – of having almost all of it held by home investors.

But Grice says that may be the entire problem – there’s little evidence that corporate savings rates are large enough to take over from households, or that government assets would really be fungible in a crisis, given their domestic entanglements – such as the non-privatisation of Japan Post Bank.

Pause for thought.

And it all makes Japan’s relatively short debt maturity (six years, compared to the UK’s fourteen) rather uncomfortable. Ten trillion yen rolls over this month alone.

As it is, JGB futures far from predict any impending crisis. Indeed, they jumped to a two-month high last week, on the back of a good 10-year bond auction – although that tells us relatively little about the early maturity problem. And at any rate, the high has receded this week, as investors shift to the stock rally.

Boring stuff. But is it the calm before the storm? Last word goes to Grice (emphasis his again):

To spell that out: we are going into a year in which the government has ¥213 trillion of bonds to roll over… and the biggest holder of JGBs is openly admitting he has no new inflows of money.

And if he’s right, drop the weak beer. Make it a stiff shōchū.

Related links:
JGB update: Is Japan the next Greece? – FT Alphaville
Is Japan preparing to intervene? – FT Alphaville
Japan’s debt woes are overstated - FT

Corporate bonds: The rot sets in as gold shines

Posted by Gwen Robinson on Feb 12 09:29. 4 comments.

It’s happening… corporate bond markets are already in the grip of that “massive case of indigestion” that commentators were warning about last month. But the mounting risk aversion to sovereign debt, More…

It’s happening… corporate bond markets are already in the grip of that “massive case of indigestion” that commentators were warning about last month. But the mounting risk aversion to sovereign debt, amid contagion fears over the Greek debt crisis, could be providing a (very mild) panacea.

From Bloomberg on Thursday:

Investment-grade debt sales are drying up and returns on high-yield bonds have turned negative for the year as investors wait to see whether European leaders can contain Greece’s budget crisis.

Borrowers in the US and Europe sold $5.96 billion of high-grade securities this week, the least this year and about 90 percent less than the average $52.9 billion, according to data compiled by Bloomberg. Speculative-grade, or junk, bonds in the US have lost 0.09 percent in 2010 after gaining 1.52 percent in January, Bank of America Merrill Lynch index data show.

While relative borrowing costs in the US remained steady [on Wednesday] and prices to insure against defaults fell, Huntsville, Alabama-based telephone service provider ITC Deltacom Inc canceled a $325 million bond sale, citing “current market conditions.”

But fears over the “Greek factor” in sovereign debt has this week helped narrow the extra yield investors demand to own corporate bonds instead of Treasuries. As Bloomberg reports, that spread narrowed 1bp to 170bps on Wednesday – having widened from this year’s low of 160bps on Jan 14, after narrowing from 443bps a year ago.

Meanwhile, as the FT reported on Wednesday:

European bond investors believe that the worst is still to come for sovereign debt and are more gloomy about the sector than any other fixed income category, according to a survey to be released by Fitch Ratings on Tuesday.

Of 63 of Europe’s top 100 fixed income fund managers surveyed, 70 per cent expect fundamental credit conditions to deteriorate for sovereign debt and 55 per cent forecast that spreads will widen further.

In fact, notes the FT report, the expected performance of sovereign credit “stands in stark contrast to just about every other debt instrument where investors foresee strong improvements in categories such as emerging markets corporate debt and investment grade corporate bonds”.

But in the view of CLSA’s Christopher Wood, investors should be piling into gold, gold, gold – oh and Asian assets or currencies. In his weekly investor newsletter Greed&Fear, Wood says:

A sovereign debt crisis in the West is coming sooner or later though it is probably not right now. This is why the recent correction in gold is an opportunity to buy more bullion and more gold mining shares.

Gold, in Woods’ view, remains the best hedge against the “almost inevitable Western currency debasement which will be the consequence of the increasingly untenable welfare states and related social security systems”.

The next best hedge, he adds, is Asian currencies and Asian assets. While many would broadly agree with his point about gold and even Asian currencies, some may question his confidence in Hong Kong property. However, he reasons, the recent correction is a buying opportunity in relevant stocks while the continuing supply crunch is a “reason to remain fundamentally bullish on Hong Kong residential property”.

As we noted recently, when it comes to Hong Kong (and mainland China) property prices, it really depends on who you want to believe.

Related links:
For corporate bonds, a week is an eternity – FTAlphaville
China: “It’s simply because people are rich now” – FTAlphaville
Faber lashes out, again- FTAlphaville
Gold backwardisation fears revisited – Oh! Oh! – FTAlphaville

Goldman asks, is sovereign strain Europe’s subprime?

Posted by Tracy Alloway on Feb 12 09:21. 5 comments.

We’ll spare you the suspense.

The answer, according to Goldman Sachs analysts Ben Broadbent and Nick Kojucharov, is no, it probably isn’t. Or, at least it won’t be as long as defaults stay below a certain threshold. More…

We’ll spare you the suspense.

The answer, according to Goldman Sachs analysts Ben Broadbent and Nick Kojucharov, is no, it probably isn’t. Or, at least it won’t be as long as defaults stay below a certain threshold.

Here’s the thrust of their (brief) analysis:

That the authorities say they will take such action is no surprise, and we believe they’ll be successful in safeguarding stability— should the need arise. Nevertheless, as was the case after past financial crises, government debt is rising sharply as the private sector de-levers, and history shows that incidences of sovereign default increase after financial crises. As a result, sovereign spreads have widened and, with a share of that debt held by banks, some have wondered if this could be ‘the European subprime’.

Needless to say, the ramifications of an outright default anywhere in Europe would be considerable. But, in scale at least, the problem looks considerably smaller than subprime. European banks’ exposure to sovereign debt is half that of US banks to mortgages in mid-2007. We find that, under some reasonable assumptions, it would take the default of nearly half of non-German Euro-zone government debt in order to replicate the hit to banks’ balance sheets that was inflicted by the US mortgage crisis. To us, that seems a very tall order.

So the first point is really that European banks are less exposed to government bonds than US banks were to mortgages in the year before the subprime crisis.

The government bond market itself is smaller in Europe, according to Goldman. It’s equivalent to roughly 65 per cent of GDP versus the nearly 80 per cent of the mortgage market and US GDP.

Plus, the European banking sector’s share of the government debt market is also smaller, at 25 per cent, than the US banks’ share of mortgages, as the below chart should show:

There’s a bit of a caveat here:

This is not to say that other owners [of sovereign debt] wouldn’t react adversely to asset write-downs. In response to an explicit sovereign default that triggers a formal accounting loss and a hit to capital, European insurers—who own around €1trn of government bonds (our estimate)—might have to raise more capital and reduce holdings of other, risky assets. This would depress equity prices and tighten financial conditions. There might also be wealth effects on spending by households, who probably own over €1trn-worth of sovereign debt.

But the US mortgage crisis has taught us that it is the leveraged institutions that play the most important role in transmitting and amplifying the original shock through the rest of the economy (see ‘More Thoughts on Leveraged Losses’, US Economics Analyst 08/10, March 7 2008). The distribution of the at-risk asset, and in particular the proportion held by banks, therefore matters.

Back to the question at hand then — possible European bank losses on sovereign debt.

The US mortgage crisis inflicted first-round losses equivalent to about 4 per cent of GDP, according to Goldman, half of which fell on the banks. By Goldman’s estimates the hit for Europe’s banks shouldn’t be as high — in fact it should be something like losses equivalent to 0.3 – 0.7 per cent of GDP.

Here then is Goldman’s heavily-conditioned conclusion:

Even for economists happy to accept approximation, this is an uncomfortably imprecise exercise. We are also reluctant to offer ranges of our own. While we think noncommercial funding for the most at-risk sovereign (Greece) will probably be required, our central expectation is that such funding will eventually be forthcoming and that the chances of outright default are very low, particularly across the Euro-zone as a whole. But the uncertainties involved are considerable.

It’s also true that we have restricted ourselves to only a very limited comparison and that, even without outright default, changes in the perceived risk of it can still tighten financial conditions. Notably, there has been a clear cross-country correlation in the past three months between changes in sovereign CDS and the performance of banks’ equity prices (Chart 6). As sovereign debt cheapens, funding costs go up for everybody, inflicting immediate damage on the most leveraged institutions . . .

As a summary comparison it’s helpful to think of what’s required to match the two. We’ve estimated that the initial hit from US mortgage losses was worth 4% of GDP, of which a half fell on leveraged-sector balance sheets. To get the same aggregate impact from Euro-zone sovereign losses, assuming losses-given-default of 35% (the baseline assumption in the CDS market) and remembering that debt is around two-thirds annual GDP, you’d have to expect a default rate of 18% (over whatever horizon you think is relevant).

If we assume that German sovereign debt is essentially risk-free, that means a 24% expected default rate in the rest of the Euro-zone. If you believe that what matters is the losses borne by the banks—and there’s no doubt that the leveraged sector played a key role in the amplification and propagation of the original hit in the US mortgage market—that threshold rises to close to 50%.

Could this be the European subprime? Yes, but only if Europe suffers a wave of sovereign defaults unprecedented in scale and at significantly lower levels of debt (relative to revenue) than those of the past.

So this shouldn’t be Europe’s subprime as long as defaults and correlations stay within an expected range.

Where have we heard that before?

Related links:
Bank Grεεkery – FT Alphaville
US banks have $176bn in exposure to troubled Europe, BarCap says – FT Alphaville
Banks, insurers and sovereign debt - FT Alphaville
Next up for Europe, covered bond catastrophe? – FT Alphaville

Bond on bonds – disaster ahead

Posted by FT Alphaville on Feb 11 19:05. 16 comments.

By the FT’s Chris Flood

Government bond markets are facing a decade of “disastrous returns”, according to Tim Bond, head of asset allocation at Barclays Capital.

Bond reckons unfavourable demographic trends mean long term-yields in the US and UK will double from current levels over the next ten years, More…

By the FT’s Chris Flood

Government bond markets are facing a decade of “disastrous returns”, according to Tim Bond, head of asset allocation at Barclays Capital.

Bond reckons unfavourable demographic trends mean long term-yields in the US and UK will double from current levels over the next ten years, moving up to around 10 per cent by 2020.

In its 2010 Equity Gilt Study, Barclays said its analysis of the interaction between demographic trends and bond yields suggest the era of low and stable long-term interest rates is over.

Effectively, the models are suggesting that the shrinkage in the high savings population cohorts and an expansion in the retired population will alter supply demand dynamics in the debt capital markets in a profoundly negative manner.

Ageing populations will lead to an explosion in government debt over the long run:

The unfavourable shift in dependency ratios, combined with sharply increased spending on pensions and healthcare is likely to cause a sustained deterioration in primary fiscal balances and a continuous increase in government debt to GDP ratios.

IMF and OECD projections suggest that the effects of ageing alone will increase debt ratios by 50 percentage points of GDP over the next 20 years:

For the advanced G20 economies, the government debt/GDP ratio is projected to rise from 100% in 2010 to 150% in 2030. Over the subsequent 20 years, debt ratios for these countries are anticipated to rise further, increasing to 275% of GDP by 2050.

And of course the deterioration in government finances — as a result of the credit crisis — has worsened the starting point for the future path of rising indebtedness due to demographic factors:

The deterioration in budget deficits has also provided a notable setback to many countries’ strategies for dealing with the long-run effects of aging. Although fiscal discipline has been weak in the US and UK over the past decade, the larger European economies had certainly been following fiscal policies designed to reduce deficits in the short run and thus clear the decks for the anticipated increase in borrowing over the long run. This strategy has now been de-railed by the widening of deficits stemming from the credit crisis.

Mr Bond says it is difficult to avoid the conclusion that national savings within the advanced economies will be insufficient to meet domestic requirements:

The common assumption that future savings flows from the large developing economies will be a ready source of finance for the ageing advanced economies is most probably flawed. The projected trajectory for old age dependency ratios in countries like Brazil, China or Russia are as severe as in the US. It is highly implausible to believe that Africa, the Middle East and India will be capable of funding the rest of the world’s growing population of retirees.

Because the rise in old age dependency ratios is common to virtually all significant economies, the idea that a redistribution of global savings flows from surplus to deficit nations might mitigate the impact of ageing on bond markets is a false comfort.

Barclays also says the risk premia embedded in nominal bond yields is likely to rise, as history shows that higher inflation – sometimes hyperinflation – can be the end result of unsustainably high debt/GDP ratios.

Although such an outcome is by no means an historical inevitability, it is certainly the case that high debt ratios increase the temptation for policymakers to engineer higher inflation as a soft option for containing debt/GDP ratios.

Pragmatically, we can take the view that when investors focus on the nearubiquitous trend for substantial increases in debt burdens, they will demand a higher longterm inflation risk premium.

Mr Bond admits that a decade of rising bond yields as forecast by Barclays demographic models appears unlikely from our present, deleveraging, post-crisis perspective, and notes that past few years have been characterised more by an abundance of savings relative to productive investment opportunities.

However, it is likely that this phase represents a high-water mark, to be followed by an inexorable turn in the demographic tide. Over the next two decades, the boomer generation will age into retirement and run down their accumulated savings. An era of capital abundance will gradually turn into an era of capital scarcity. Government debt burdens will rise sharply, with the risk premium demanded for financing these debts increasing as private sector net savings flows dwindle. Given the broad international context for these trends, with similar developments afflicting almost all the world’s major economies, the means by which the government debt burdens are eventually curtailed is unclear. As a result, government bond yields are likely to require a significant rise in risk premia to cover the eventuality of default, either outright or through inflation.

Sovereign debt crises 2010, an RBS sapling

Posted by Tracy Alloway on Jan 04 16:44. 3 comments.

What is the `Tree of Truth’?

According to RBS, it is a Binary Recursive Tree Approach aimed at selecting explanatory variables and critical threshold levels that best discriminate between sovereign debt crisis and non-sovereign debt crisis states. More…

What is the `Tree of Truth’?

According to RBS, it is a Binary Recursive Tree Approach aimed at selecting explanatory variables and critical threshold levels that best discriminate between sovereign debt crisis and non-sovereign debt crisis states.

In basic terms it’s a flow chart, showing which countries in Central Eastern Europe, the Middle East and Africa, the bank (using criteria from a 2005 IMF working paper by Nouriel Roubini and Paulo Manasse) thinks are potentially vulnerable to a sovereign debt crisis.

And RBS has just updated its Tree of Truth chart for 2010.

The result is below, click to enlarge.

If you want to compare and contrast with the 2009 version, created in June, the chart is here.

We can tell you that the model identified 14 economies at risk in 2010, compared with 13 for 2009. In the words of RBS’s CEEMEA specialists Tim Ash, Imran Ahmad and David Petit-Colin, that means that “… despite the general improvement in global sentiment, the analysis suggests a more lasting impact from problems faced by the global economy over the past year or so.”

Specifically, Hungary, having dropped off the list of vulnerable credits in CEEMEA in 2009, re-enters in 2010, along with Romania. Having added some new states to the model mix for 2010, RBS also identifies Bahrain, Iceland, Lebanon and the UAE as crisis-prone this year.

The majority of at-risk states are still, however, within emerging Europe.

Here are some select excerpts:

* The results are broadly in line with current market risk perceptions as in recent years Emerging Europe has generally suffered from wide current account deficits and excessive foreign borrowing and hence large external financing requirements/relative to FX reserve positions. Rigid exchange rate regimes, predominant through the region, add an extra vulnerability, suggesting a very hard landing for these economies, with pass thru to banking sectors via rising [nonperforming loans].

* None of the major EM economies in Asia and Latin America surveyed appear vulnerable to crisis as per the IMF definition/methodology. The latter two regions’ much better external financing positions, particularly reflect the maintenance of current account surpluses and relatively light external debt burden while the accumulation of healthy stocks of FX reserves during the “good years” provide an added degree of insulation.

* The analysis clearly has its limits as it only reveals “ability to pay”. As recent debt crises (e.g. Argentina and Ecuador) in Latin America and perhaps even Dubai in CEEMEA, in particular, have shown, “willingness to pay” is also critically important, but difficult to model. Countries could perhaps use the “cover” of the global crisis to manage their external liabilities lower by restructuring liabilities.

Full paper in the usual place.

(H/T the FT’s Chris Flood)

Related links:
`Rules of Thumb’ for Sovereign Debt Crises - IMF working paper
Moody’s sees sovereign states a suffering – FT Alphaville

Consolidating the US, UK gov’t bond sell-off

Posted by Izabella Kaminska on Jan 04 14:00. 2 comments.

With the holiday season finally over, it’s probably a good time to contemplate the period’s more excessive and illiquid market moves. Among them the rather sudden and acute sell-off in US and UK government bonds. More…

With the holiday season finally over, it’s probably a good time to contemplate the period’s more excessive and illiquid market moves. Among them the rather sudden and acute sell-off in US and UK government bonds. Was it rational?

As the following charts depict, British government bonds ended 2009 with their worst monthly performance since the start of the year.

US Treasury notes, the 10-year yields of which were approaching their highest level since June on Monday, registered the worst sovereign debt performance of 2009 according to Bloomberg:

As far as the UK is concerned, even upbeat manufacturing and lending data was unable to reverse the sell-off in any decisive fashion on Monday. As Reuters reported:

LONDON, Jan 4 (Reuters) – British gilt prices were little changed on Monday despite upbeat manufacturing and lending data as investors assessed the sustainability of sharp price falls during thin trading over the Christmas period. At 1247 GMT the March long gilt future was flat at 114.45 in thin trade on the first trading day of 2010, when most dealers were back after two weeks of thin markets due to the Christmas and New Year holidays.

Meanwhile, Pacific Investment Management, aka bond-fund Pimco, fuelled further jitters after announcing it was planning to cut its holdings of US and UK debt due to the countries’ record borrowing levels.

According to Bloomberg:

Pimco is “more cautious” on corporate bonds and holds fewer mortgage-backed securities than the percentages in the benchmarks it uses to gauge performance, wrote Paul McCulley, a portfolio manager and member of the investment committee, in his 2010 outlook.

The company is also underweight Treasury Inflation Protected Securities, according to the report on Newport Beach, California-based Pimco’s Web site. “This all leaves us with portfolios that appear, more than at other times, to be hugging the benchmarks with no bold positioning,” McCulley wrote. “We’re making a very active decision to run light on risk.”

Which presumably suggests the bond sell-off was justifiable after all?

Related links:
After the decade of debt: A course to chart- FT
Our wall of gilts is casting a long shadow over 2010 - FT

Nakheel bondholders are having a ‘temper tantrum’

Posted by Izabella Kaminska on Dec 10 10:55.

The UAE’s English language newspaper The National put out a snippy editorial on Wednesday, lecturing about the perils of moral hazard and the like.
In short, it told Nakheel bondholders to get over themselves, summing up their reaction to Dubai’s standstill on Nakheel obligations as nothing short of a hissy fit:Dubai World’s creditors responded with a temper tantrum in the international media. To read the coverage of Dubai’s announcement, one might think Dubai and the companies it controls are ready to miss payment on their entire $85bn in estimated debts.
Stupid investors.
The National goes on:
Investors mistook being government owned with being government backed. Governments in emerging economies end up starting and controlling much of the corporate scene. Eventually, if all goes well, they privatise those companies to eliminate the conflict of interest.Until then they are major shareholders, with limited liability, like Richard Fuld was the largest shareholder at Lehman Brothers. He walked away from that wreck. Much of the coverage of Dubai’s predicament has been from the perspective of its creditors, not from that of the Government trying to figure out which businesses are worth saving and which aren’t. Little wonder: the Government has been cryptic(隱祕); investors vociferous (喧嚷的).
As for the restructuring process:
Clearly, the Dubai Financial Support Fund, which is in charge of disbursing, and making sure it is paid back, the $10bn in rescue funds Dubai borrowed from the Central Bank in February, took a hard look at Nakheel’s business prospects and decided that paying off its bonds at par might not be the smartest use of the money. Electing not to bail out Nakheel, after all, would leave more cash to help out more promising businesses. This is the way debt restructurings work. They are like divorces –messy. Debtors threaten to default. Sometimes they do. Creditors threaten to foreclose. Sometimes they do.
In all, according to The National, Dubai’s government is doing a very sound thing indeed.
Above all, it’s not encouraging the sort of bailout-associated moral hazard the West has partaken in, a process which might otherwise have led to:
… try this scenario for size: imagine that every debt for whatever project, no matter how extravagant, was guaranteed. If companies couldn’t come up with the cash, the Government would, even if it had to fork over barrels of crude oil. Try to picture the pandemonium that would cause.Anyone with any hare-brained investment scheme could borrow as much as they wanted. Secure in the knowledge that their debt was guaranteed, they could build edible skyscrapers of Swiss chocolate reinforced with candy canes, so high that on a clear day you could see Riyadh. They could cool them with icebergs towed from Greenland or just let the whole thing melt in summer into a big pile of delicious chocolate-mint rubble. It wouldn’t matter. Creditors could be certain that no matter how ridiculous the project, they would be paid.

Statement From Sheikh Ahmad Bin Saeed Al Maktoum

Posted by Neil Hume on Dec 14 06:34.
14 December 2009

The Government of Dubai, acting through the Supreme Fiscal Committee (”SFC”), today announces a set of actions in relation to Dubai World:
Sheikh Ahmad Bin Saeed Al Maktoum, Chairman of the Dubai Supreme Fiscal Committee said: Like other global financial centers, Dubai has faced recent market challenges driven by global economic slowdown and severe real estate market correction.
Recently, Dubai World announced that it might not be able to commercially support its obligations. Since that time, the Government of Dubai has worked closely with the Abu Dhabi Government and the UAE Central Bank addressing and assessing the impact of Dubai World on the UAE economy, banking system and investor confidence. The following provides comprehensive set of actions: First, the Government of Abu Dhabi and the UAE Central Bank have agreed to provide important support.
Specifically, the Government of Abu Dhabi has agreed to fund $10 billion to the Dubai Financial Support Fund that will be used to satisfy a series of upcoming obligations on Dubai World.
As a first action for the new fund, the Government of Dubai has authorized $4.1 billion to be used to pay the sukuk obligations that are due today. The remaining funds would also provide for interest expenses and company working capital through April 30, 2010 – conditioned on the company being successful in negotiating a standstill as previously announced.
In addition, the Government of Dubai is particularly focused on addressing the concerns of Dubai World trade creditors within the Emirate of Dubai. To help address these concerns, today the Government of Dubai is announcing that the remainder of the funds provided will be used for the satisfaction of obligations to existing trade creditors and contractors. Discussions with affected contractors will begin in short order.
Next, the central bank is also prepared to provide support to local UAE banks.
Finally, today the Government of Dubai will announce a comprehensive reorganization law, a framework that is based upon internationally accepted standards for transparency and creditor protection. This law will be available should Dubai World and its subsidiaries be unable to achieve an acceptable restructuring of its remaining obligations.
Today’s actions, taken together, demonstrate our strong commitment as a global financial leader to transparency, good governance, and market principles. There will certainly be challenges periodically, just as there are challenges in other major financial centers around the globe. We believe today’s actions will best serve the interests of all stakeholders.
We are here today to reassure investors, financial and trade creditors, employees, and our citizens that our government will act at all times in accordance with market principles and internationally accepted business practices. Dubai is, and will continue to be, a strong and vibrant global financial center. Our best days are yet to come. The Government of Dubai remains committed to its high standards and its obligations. We are confident in our economic model, and we are confident in the long-term health and outlook for our economy.
The actions taken today are consistent with our market development, and we believe they are the actions that will best serve the interests of all stakeholders.”

Related link:Nakheel says it will pay/ Abu Dhabi rides to rescue – FT Alphaville

Dubai - Saving the day

Dec 14th 2009From Economist.com
Abu Dhabi rescues Dubai after all

DUBAI, one of seven members of the United Arab Emirates (UAE), is now in the middle of its international film festival, which includes “City of Life”, a film set in Dubai and directed by a local. But the most gripping cliff-hanger is playing out in Dubai’s debt markets. On Monday December 14th Abu Dhabi, the wealthiest member of the UAE, arrived on the scene at the last moment to rescue its neighbour from the brink of default.
It provided $10 billion to Dubai’s government, more than enough to repay the $4.1 billion due on Monday to holders of a sukuk, or Islamic bond, issued by Nakheel, a prominent developer. Nakheel belongs to Dubai World, a holding company owned by the Dubai government, which less than three weeks ago requested a standstill on repayments of $26 billion of debt, perplexing investors and panicking global markets.
Just as every film-goer knows that the damsel in distress will be saved in the end, so Dubai’s creditors had long assumed that the emirate would be saved by its oil-rich neighbour. But the standstill announced on November 25th departed from this script, creating genuine suspense.
Investors knew Abu Dhabi could not let its neighbour fail without damaging its own economic interests. They assumed that Abu Dhabi knew this too. Therefore when it let Dubai walk to the edge, it was deeply unsettling. Either Abu Dhabi's policymakers did not know the damage this would do, or they did not care. The announcement on Monday suggests that Abu Dhabi did care. It just did not anticipate quite how badly creditors would react.
Nakheel’s creditors can now be repaid, but Dubai’s credibility cannot be repaired so easily. Its solvency rests on a relationship with its neighbour that is impossible to fathom. At least this latest handout dropped the fig leaves that disguised Abu Dhabi’s previous gestures of support. It was given directly from one government to the other, unlike the $10 billion routed through the UAE’s central bank in February and the $5 billion lent in November through two commercial banks partly owned by the Abu Dhabi government.
Even now, Dubai’s creditors cannot expect every claim to be redeemed in full. The money left over after the Nakheel sukuk is repaid will go to Dubai World’s suppliers and contractors, who endured a standstill on payments long before the company asked the same of its creditors. The money will service Dubai World’s other debts only if the group is “successful in negotiating a standstill as previously announced,” the statement says.
If those negotiations falter, Dubai World’s fate will be governed by a brand new “reorganisation law”, unveiled on Monday. The UAE already has a bankruptcy law, but almost no one uses it. Any creditor foolhardy enough to test the regime can expect to recover just ten cents on the dollar, the World Bank calculates.
The new decree instead appoints three judges from the Dubai International Financial Centre (DIFC), a 110-acre “free zone” with its owns laws, written in English and based on common-law principles. The judges include one who formerly sat in the High Court of England and Wales and a Singaporean who previously served on his country's Supreme Court. They will apply DIFC law, with some tweaks, including a provision to allow for an automatic stay on creditors’ claims.
Their expertise will not be needed if Dubai World’s creditors now come to terms. The chances are good that they will. The shock they have suffered over the past three weeks may have softened them up. And the underlying case for a restructuring of Dubai’s debts has some merit, even if the government has so far handled it abysmally. Dubai, one might say, has had one life. Now it must make a success of its second.

S&P and Fitch to Dubai: ‘not so fast…’

Posted by Miles Johnson on Dec 14 15:34.

Ratings agencies Standard & Poor’s and Fitch have issued responses to Dubai’s surprise repayment of the now infamous $4.1bn Nakheel sukuk.
And just in case the emirate was labouring under any misconceptions, both make it clear that the $10bn chucked its way by Abu Dhabi will have no impact on the ratings of any Dubai Government-Related Entities (GREs).
Standard & Poor’s Ratings Services considers this announcement as a step towards rebuilding confidence in Dubai’s policy-making environment. In particular, we believe the intention to strengthen the laws governing the Dubai World restructuring is an opportunity for the Dubai government to demonstrate the workings of its legal system in dealing with such events. Moreover, we view the intervention of Abu Dhabi as an indication that it stands ready to safeguard the stability of the UAE economy and financial system.
However, we believe uncertainty remains as to the Dubai government’s general ability and willingness to provide timely extraordinary support to its government-related entities (GREs), as well as the transparency and predictability of such support. The remaining financial obligations of Dubai World and Nakheel, amounting to around $22 billion, remain the subject of a restructuring. Therefore, we will continue to monitor the situation closely, and any ratings action we take on Dubai-based GREs based on the question of potential government support will be grounded in clear and publicly stated policy that is supported by appropriate laws and/or instruments.
The subtext here is clear. Dubai cannot hold its fate in its own hands. As such, nothing is certain about its credit risk.
Investors will continue to make wagers on Abu Dhabi’s continuing support for its financially challenged cousin. But the grounds for this argument – that the damage to the richer Emirates’ reputation if Dubai were default serves as a implicit guarantee – is hard to quantify.
Judging from the opacity(不透明)of the bailout and Nakheel repayment, both emirates will need to work harder to restore confidence in the region.
Legal and procedural transparency is key for international investors and rating agencies alike, as is a move towards international bankruptcy standards.
Dubai has said it will begin a “comprehensive reorganisation law”, a boon to investors exasperated by the emirate’s primitive bankruptcy laws.
This would, as Fitch note, make doing business in the region less of a hair-raising prospect for creditors.
While questions remain on how this change will practically affect creditors, this action is clearly aimed at facilitating easier corporate restructuring. In turn, this has the obvious ancillary benefit of making it simpler for future corporate debt obligations to be addressed through court-based restructurings, rather than through a sovereign bail-out, reducing the pressure on Dubai to continue offering financial support to corporate entities, and on Abu Dhabi to accede to further financial pressures in the neighbouring emirate.
But Monday’s statement provides little clarity on how these reforms will work in practice. Fitch expect the changes to be based on the code currently employed by the Dubai International Finance Centre, Dubai’ financial free zone. S&P also welcome the move, but argue that the remaining uncertainty overpowers any positive impact this could have on the ratings of Dubai-related companies.
Abu Dhabi’s surprise largesse will not erase the disasters of the last month – throwing money at problems doesn’t always make things better. At best the bailout is a palliative(緩和的) for the emirate’s ills; at worst a further example of a region that views itself above the norms of international finance.
Until the workings of the region’s financial system become clearer, the stink of Nakheel incident will linger like a stagnant(停滯的) water in a 75 km Arabian canal.

Related links:
Statement From Sheikh Ahmad Bin Saeed Al Maktoum – FT Alphaville
Abu Dhabi steps in to bail out Dubai – FT

S&P downgrades Mexico

Posted by Stacy-Marie Ishmael on Dec 14 20:42.

Standard & Poor’s, following in the footsteps of rival rating agency Fitch, on Monday downgraded Mexico’s sovereign rating, but left its outlook for the country at “stable”.
S&P cut the foreign-currency sovereign credit rating on Mexico to ‘BBB/A-3′ from ‘BBB+/A-2′ and the local-currency rating to ‘A/A-1′ from ‘A+/A-1′.
From the statement accompanying the dowgrade:
Despite recent tax increases and steps that could bolster growth prospects, we expect that Mexico’s fiscal challenges will persist over the coming years.
In addition, the prospects for substantial fiscal reform or other measures to enhance GDP growth in the second half of the Calderón Administration are, in our view, diminishing.
The stable outlook reflects fiscal and external indicators that are consistent with the ‘BBB’ median, the absence of macroeconomic imbalances in the Mexican economy, and the Mexican government’s longstanding commitment to macroeconomic stability.
“The downgrades reflects our assessment that Mexico’s recent steps to raise non-oil revenues and improve efficiencies in the economy will likely be insufficient to compensate for the weakening of its fiscal profile,” explained Standard & Poor’s credit analyst Lisa Schineller. “This weakening stems from a combination of modest GDP growth prospects and diminished oil production over the coming years.” The revenue measures approved in the 2010 budget should address immediate concerns about fiscal vulnerability to volatile oil revenues. However, the inability to widen the tax base substantially, along with a low likelihood of major tax reform in the next several years, suggest that Mexico’s debt profile will remain more in line with that of its ‘BBB’ peers.

Related links:US problems still flowing down Mexico’s way – FT Alphaville
Mexico’s new ‘C’ for commodity banker – FT Alphaville
Mexico buys $1bn insurance policy against falling oil prices – FT Alphaville

How do you say vicious circle in Greek?

Posted by Tracy Alloway on Dec 08 15:53.

Here’s a useful chart from UBS given recent events concerning the Hellenic Republic:
The chart shows funding from Europe’s Central Bank on a relative basis (against banking assets) at July 2009. You can see that Greece was the biggest user of ECB liquidity on that basis. On an absolute basis, we should note, Germany, was the ECB’s biggest customer at the time, followed by Ireland.
UBS analysts John-Paul Crutchley and Alastair Ryan wrote back in September:
Given that the Greek banks, like their German counterparts, do not have a liquidity problem as their balance sheets are typically 60-80% funded by deposits and L/Ds are at a maximum of 120%, we think the reasons [for the high use of ECB funding] are:
The banks were invited to receive low-cost ECB funding and took the opportunity by repoing sovereigns, also making a lucrative carry trade (Greek sovereign yields at c.4-5%, ECB funding at 1% = net spread of 3-4% or 2-3% if hedged for IR risk). On a near-€50bn position, that equates to €1.5-2bn of incremental profit for the Greek banking system. The Greek banks see this as a “natural hedge” against abnormally low rates which have harmed their core deposit profitability.
The Greek bank support plan was sovereign-bond based, i.e. the €4bn of prefs and €6bn of short-term liquidity were provided in the form of Greek Central bank loans to banks accounted for 9.6% of total assets of the Greek financial system sovereigns which banks could then repo with the ECB for liquidity (seignorage, in a way). So around €10bn out of the €45bn is related to this.
Weaning off from the ECB should be feasible, given that the repoed assets (Greek sovereigns and securitised loans) are also potentially repoable on the interbank market. As a matter of fact, for durations of up to 4M the interbank market is now cheaper than ECB’s 1% base rateIn addition, it is important to note that in 2009 the Greek banks are likely to be making 3-5% of NII (and a larger proportion of earnings) from the ECB carry trade. As a result, there is an underlying revenue/earnings risk associated to the eventual withdrawal of excess ECB funding.Underlying revenue/earnings risk indeed. But there’s another point touched on in that bit of (albeit dated) commentary.A downgrade of Greece’s long-term ratings to BBB+ — much of which had to do with the difficulty of the country weaning itself off ECB liquidity in the first place — could strike a further blow for the Hellenic Republic in terms of its ability to repo assets to the ECB.
As FT Alphaville has mentioned previously, under the original terms of its funding operations, the ECB would only accept bonds rated A- and above. Under emergency collateral rules issued in October 2008, those securities must be at least BBB, with anything rated BBB- subject to an additional haircut.
The issue then, is how long the emergency rules will apply for — and if you’re thinking a) `not that long’ and b) Greek banks might not be able to repo their bonds so easily/cheaply on the interbank market afterwards — then those Greek government bonds really aren’t looking so good.
And who’s been the biggest buyer of Greek sovereign debt?
The Greek banks of course:To get an idea of the relative scale of these purchases, it is instructive to compare the increase in national banking system bond purchases with the total level of issuance by the respective sovereigns.
Using this metric, the increase in Spanish bank holdings of government debt corresponds in volume to 73% of the Spanish sovereign issuance over the same period. The relative proportions for France and Italy are in fact much lower at 28% and 13% respectively. We emphasise, however, that our data refers to bank holdings of all government debt, and not only that of the particular country in which the banks operate.
Irish and Greek financial institutions are also punching above their weight, with increases of €15.4bn and €11.5bn in government debt holdings since July 2008. In absolute volume terms, this represents 62% and 20% of their respective sovereign’s issuance over the same period.

Greece, the not-so-expected impacts

http://ftalphaville.ft.com/blog/2009/12/09/87871/greece-the-not-so-expected-impacts/

Posted by Tracy Alloway on Dec 09 09:05.

While Greek banks are the obvious losers in Fitch’s decision to downgrade Greece to BBB+ on Tuesday, there are some less obvious impacts.
For instance — Belgian insurance subsidiaries:
FITCH AFFIRMS AG INSURANCE AND FORTIS HOLDING COMPANIES;OUTLOOK REVISED TO NEGATIVEFitch Ratings-London-08 December 2009: Fitch Ratings has today affirmed AG Insurance’s Insurer Financial Strength (IFS) rating at ‘A+’ and Long-term Issuer Default Rating (IDR) at ‘A’. Fitch has also affirmed the Long- and Short-term IDRs of the five Fortis holding companies: Fortis SA/NV, Fortis N.V., Fortis Brussels, Fortis Utrecht and Fortis Insurance NV., at ‘BBB+’ and ‘F2′ respectively. The Outlooks on the IFS ratings and on all the Long-term IDRs are revised to Negative from Stable. A full rating breakdown is provided at the end of this comment.Milleniumbcp-Fortis operating entities and Fortis Insurance Company (Asia) Ltd ratings are unaffected by today’s rating actions.The change in Outlook to Negative reflects the concentration risk of AG Insurance’s investment portfolio to certain Euro-zone sovereign issuers, particularly Greece, whose sovereign IDR was downgraded by Fitch to ‘BBB+’ from ‘A-’ today (for further information, please see the 8 December, 2009 comment, entitled ‘Fitch downgrades Greece to ‘BBB+’; Outlook Negative’, which is available at www.fitchratings.com.). However, the agency understands that the company’s management will closely monitor its exposure to Greece . . .
And Italian property companies. Via JP Morgan’s latest European property forecasts:
The last key theme for 2010 is potential sovereign credit risk, in our view. In the next chart we multiplied the CDS spread for every country with the companies’ country mix in order to come up with an overall credit risk estimate: [Greek property developer] Babis Vovos and [Immobiliare Grande Distribuzio SA] are most exposed, while the market believes that the Germans have the least potential sovereign credit risk.

Greece’s spartan samurai bonds

http://ftalphaville.ft.com/blog/2009/12/09/87901/greeces-spartan-samurai-bonds/

Posted by Izabella Kaminska on Dec 09 13:25.

With all eyes on Greece’s credit quality, it’s useful to take a closer look at the type of debt the sovereign has been issuing.
For instance, Greece — like a number of other fiscally strapped European sovereigns – has of late been issuing a fair amount of foreign currency-denominated bonds, particularly yen denominations. The measure is no doubted intended to guarantee as much demand for Greek bonds as possible.
Indeed, as Financial News reported back in March, 2009:
The Greek government is eyeing the private placement of dollar- and yen-denominated bonds, a senior finance ministry official said Monday, following a successful multibillion euro placement last week, says Dow Jones Newswires.“The 2009 borrowing plan envisions raising funds through private placements and that includes the likely placement of dollar and yen-denominated bonds,” the official said. Analysts said the potential move would give the issuer much-needed flexibility in tapping the market in a generally volatile environment, without committing itself to a pre-announced schedule.“Now is definitely the time to tap all sources of financing, especially for the weaker credits in the euro zone, so the decision of the Greek Public Debt Management Agency is positive and warranted,” said David Schnautz, strategist at Commerzbank AG in Frankfurt.Dow Jones Newswires stresses that the move recalls a practice used occasionally by Portugal. Portugal΄s Treasury and Government Debt Agency last year conducted several government bond auctions which were limited to primary dealers and hadn΄t been announced to the auction publicly in advance.
Consequently, as Citi analyst Akane Enatsu noted on Monday, there has been a lot of Japanese interest in Greek fiscal developments:
Credit implication 1) — Developments in Greece have recently been a focus of attention in the sovereign credit default swap (CDS) market. Recent developments have also attracted attention in Japan because the Republic of Greece and Hellenic Railways (guaranteed by Republic of Greece) have issued samurai bonds. However, there was no particular reaction by credit spreads for sovereign CDS and samurai bonds to the latest citations by the European Council.
The following screen shots from Bloomberg, meanwhile, provide an indication of how much Greek yen-denominated paper currently remains outstanding:


To apply some values to those numbers, according to the Hellenic Republic’s latest public debt bulletin, as of September 30 2009, the government had €298bn worth of outstanding debt. The report noted 0.4 per cent of that debt was denominated in non-euro zone currencies, which equates to just over €1.2bn worth of bonds.
And while there may have been no reaction in the Greek samurai market on Monday, following Tuesday’s Fitch downgrade of the sovereign the July 2015 yen-denominated issue reacted as follows:
It’s worth noting, however, that most of these yen-denominated Greek bonds are highly illiquid having been privately placed directly with investors and banks.
Carlo Ciabuschi, who oversees government bond investments at Eurizon Capital in Luxembourg, told FT Alphaville most of these bonds would be held in the same hands until maturity, with many not trading in the secondary market at all.