Notes From Underground: Looking Backwards … Again

It is hard to believe that NOTES FROM UNDERGROUND is approaching its 1,000 blog post. Many of the themes touched in my analysis have had an echo effect. Certain themes have continued to provide trading opportunities over and over. 1. The European financial crisis; 2. The Fed’s destruction of the bond market; 3. The ECB‘s destruction of European sovereign debt markets in an effort to preserve the Maastricht strait jacket. 4. Russian geo-political moves on a timely basis to affect Putin’s desire for an increased role for Moscow on the world stage; 5. Japanese desires to fabricate an inflationary backdrop to ease the burden of debt overhang; 6. Too much or too little growth in the emerging market economies; 7. China’s desire too have an enlarged impact on the global financial system in fact and fiction; and oh so many more.

Presently we are saddled with an important financial problem that I wrote about in August 2013. The reason for republishing is not to blow my horn but to allow ourselves to understand how problems swept to the side by the algo headlines still remain a problem. The European bank stocks are the heavy drag on the markets. Today’s trading activity was a perfect example. The Asian markets were higher last night as the Chinese foreign reserve data was far more sanguine than the market had feared but once Europe opened this morning the downward pressure on European financials began a selloff of global equities, a rally in GOLD and BONDS and an eventual selloff in the DOLLAR.

The issue plaguing the European banks is the vast amount of COCO bonds that were sold in 2012, 2013 and 2014 in an effort to shore up bank balance sheets with contingent convertibles (or CoCo bonds). In a yield-starved world the large EU banks were raising capital by selling higher-yielding notes but the catch was that if a bank’s tier-one capital dropped below a certain level (5%) the bank had the RIGHT to convert the bond to equity, the worst possible outcome for investors. This has the property of a convertible bond except it is the borrower making the decision rather than the investor. The forced conversion of debt-to-equity is an investor’s worst nightmare as it loses a credit position to become an equity shareholder in a badly weakened institution.

I issued many warnings to personnel friends to avoid these instruments as all the large institutions were pushing yield-starved clients into these toxic instruments. It seems that banks such as DEUTSCHE BANK are being sold as investors try to keep ahead of the tsunami of equity issuance. Again, I reissue the previous piece  in an attempt to explain the present situation and even the opening geo-political piece has relevance.

The Russians are now firmly implanted in the Middle East negotiations and been able to secure a position in both the Sunni Arab camp and well as the Shia Iranian group. Russia is siding with the Sunni Arabs and is leaving the Erdogan Turks for the U.S. but at some point Putin will push the envelope to find how far NATO powers will go to aid Turkey. This will continue to be a theme for I think that President Putin will try to demolish NATO by seeing how far Western powers will go in defending Turkey. Putin will choose his time and place to embarrass Erdogan and provoke him into another ill-advised action. I would advise dusting off the Franco-Prussian War of 1871 to see how Bismarck so successfully baited Napoleon III into a war he didn’t want. I’m just hypothesizing but it’s worth watching, especially as the world will be distracted by refugees, the Olympics, debt crises and U.S. politics. Never a dull moment.

Notes From Underground: Who’s COO COO For CoCos?!?!?

The SECOND key story was in the weekend Financial Times by one of my personal favorite financial journalists, John Dizard. In the piece, “The Pricing of COCO Bonds is Proving too Good to Be True,” he challenges the calm currently presiding in the European financial system. COCO is an acronym for CONTINGENT CONVERTIBLE debt instruments. It is a bond issued by a bank with a higher rate than market interest rates because it has a “reaction function” that causes it to convert to equity if a bank’s capital falls below a certain level, thus it acts to BAIL IN bondholders to become equity owners and ease the debt burden of the troubled institution. (It’s making sure that the private sector is the first line of defense in any banking crisis.) These COCO bonds are not callable and therefore act as perpetual financial instruments. In comparison, the preferred stock issued by financial institutions is callable and as I can attest much of the high yield preferreds issued during the debt crisis to shore-up financial institutions balance sheets has been called. Even my AIG preferreds have recently been called.

The difference is that Europe is now creating more of this high-priced debt just as the U.S. is paying down the high yields that the debt crisis demanded for institutions to rebuild their capital base. As Mr. Dizard asks: “Who is going to pay the revenue needed to support this expensive paper?” The European banks will continue to be saddled with high capital costs and it is just another peek behind the curtain of financial uncertainty. Why do sound institutions have to pay so much to rebuild their balance sheets and a European-wide nominal GDP growth of 0.5% is just not going to provide the economic strength to repair the financial system and the debt to capital ratios being demanded by financial regulators. Nothing is as it seems, which is why 2+2=5.

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21 Responses to “Notes From Underground: Looking Backwards … Again”

  1. Sabdy Robideau Says:

    Looking forward to a 1,000 more, Yra.

    • yra Says:

      Sabdy–thanks and hope I have it in me—it does get exhausting but I have hoped to provide insight and incite into the world of global macro.If you have time and inclination read,Inside the House of Money by Steve Drobny

  2. Richard H Papp Says:

    Is it any wonder the gold is at a recovery high with High Yield Bonds the HYG and the US Preferred Index Fund (PFF) at a new closing lows. The latter finally gave it up after a year of sideways trade

    • yra Says:

      Richard–nice catch on that and thanks for it is what makes this blog a constant flow of quality information–a true dialectical group and most posters are high quality for there is no reason to troll here

  3. the american limey Says:

    OUTSTANDING fear 1000 clues to a better life for those who chose to follow the trail. Here’s to 10^9 more.

    I “thought” the Chinese numbers were smack in the middle of the goldilocks zone and therefore no one believed them?

    The jobs number seemed to reflect the bump in minimum wage the chief buffoons hoisted on us active in Jan 1.

    Today I was pondering, with my chums, the wonders of SWF selling equities en masse and the effect such selling might have on the market both bonds and shares.

    I suppose these considerations are due to my ignorance of this macro world I am exploring BUT it seems to me that the vast majority of pundits seem to have their head up their…

    Do COCO’s mean that a SWF could end up owning DB ? that would be a giggle and a half.

    Again GREAT work Yra and here’s to the next 10^9

  4. Frank C. Says:

    Deutsche Bank is now everyone’s problem. As you stated the Coco’s may get put and if you own them the hedges are being placed by shorting the common and buying the CDS. Both pushing the stock into a self fulfilling downward cycle. Who knows what lies in DB’s ENORMOUS derivative’s portfolio but remember it was the derivative contracts AIG sold on MBS that took them down.

    I have always wondered how TBTF Banks can cover their overhead with negative interest rates. The Net Interest Rate Margins become more compressed and the ability to cover operating costs is compromised. That is why over the weekend bankers are now coming out against ZIRP. DB is a prime example of ZIRP effect on profitability. (Granted DB legal troubles and payouts have been a big factor.)

    My great concern is the ECB has pushed rates on excess reserves to negative rates to promote lending. So therefor banks lend to each other overnight at a slightly positive rate so they don’t have to pay negative rates to deposit their excess funds at the ECB.

    As DB and Credit Suisse and other banks weaken their CDS prices increase and the counterparty risk increases. While this may not be this month, but when banks stop lending overnight to each other because of the counterparty risk a liquidity crisis develops. It is always amazing how fast money can go out the door.

    Which begs the question of if DB goes south all the other Italian, Portuguese and Spanish banks go further south ( and their CoCo’s also get put). And if depositors are being charged negative interest rates to keep money in the bank you can bet there will be a run to get the money out when the bank is no longer consider safe and money good.

    I don’t know what kind of bazooka Draghi has but he better have Janet Yellen on speed dial.

    • yra Says:

      Frank c—what a great add and believe me Draghi doesn’t have a bazooka —he is spent and should fear the demise of Merkel.Most of Europe is hoping that Germany implodes so that Schaeuble and Weidmann will acquiesce to a massive fiscal stimulus program —the road to heaven is paved with bad intentions and we will probably hear from the modern day Napoleon ,Juncker very soon—interesting that the Junckers harken back to the days of large landholdings in Feudal Germany–guess Jean Claude is aptly named.Yellen will be silenced by the fragility from Europe and the sovereign debt market today revealed the fright taken place—when will the ECB unload some of its 60 billlion euro monthly allowance to aid the beleaguered peripherals—oh well time to dust off the PIIGS acronym and time to purchase the rotten heart of heart by Bernard Connolly

      • GreenAB Says:

        thanks for bringing CoCo to our attention, Yra! makes a lot of sense. are there any quick numbers out there like the amount of CoCo bonds of DB (to compare it to their equity market cap)? thanks!

        “Most of Europe is hoping that Germany implodes so that Schaeuble and Weidmann will acquiesce to a massive fiscal stimulus program”

        actually, we have a nice little stimulus program already in place. involuntary though. the refugee crisis is forcing our government´s hand to spend. 1.1 million refugees came to Germany (a country of 80 million) last year. these people need shelter, food, clothing, medical assistance etc. i guess the economic activity associated with those people is what is keeping our domestic economy on track while exports (China…) crumble.

      • yra Says:

        Green AB–nice to hear your voice.The desire for a massive larry Summers inspired fiscal stimulus is what the Spanish and italians are crying for—the refugee stimulus is nothing –we are looking at a global package in the trillions and Draghi is hoping Germany implodes because he has nothing to offer

      • SacredReich Says:

        I can’t sincerely comprehend what they are doing here.

        Perhaps those wise, most intelligent justices in German Constitutional Court may have an answer to some questions next week.
        “You Can’t Handle the Truth,” I hear.
        “I Want to Believe” — the poster, I see.

        As Goethe put it in a letter to Wilhelm von Humboldt:
        “Verwirrende Lehre zu verwirrtem Handel waltet über die Welt…”

      • yra Says:

        Reich–glad to hear from you.We have gone back and forth over the years about the German situation but I believe that Chancellor Merkel has overplayed her hand with the refugee situation.The AfD while fringe does have some interesting powerful voices and Otmar Issing seems to always be at the ready to poke at Merkel.Wiedmann quiet for the moment but I think his disdain for Draghi will keep him busy as the ECB President is also playing a poor hand–he seems to be about jawboning and acquiescing to “everybody else is doing it”—-Germany will have the best situation for awhile as it is the creditor of the entire EU project–just as De Gaulle wanted it–but can the house of straw last.I wonder if the German electorate will push for a referendum on the Lisbon treaty after the Brits—the only positive for Merkel is that Hollande and Cameron are such lightweights

      • SacredReich Says:

        Many West Germans are arrogant –the more thrifty parents were, the more lavish kids are. The Easteners are hit and hard bitten — what often-mentioned Connolly has to say on their fate is correct (at least the irresponsible socio-econ earthquake of 90s raised my interest in macro matters).
        A ship broker told me yrs ago, that Westeners are tired of eating kebab all week. Over past 12m, the penny’s dropped–der Groschen ist gefallen (=10 Pfennig, haha).
        Easteners got a wicked sense of humor — similar to that what we’re hearing from Czechs, and alienating the (Western) media, state TV anyway. (an ex-anchor is govt spox: bed affair press/state also a taboo,huh, Yra)
        Many thanks Yra for your great outputs. Love yld curve talks here. Schöne Grüsse to the Windy City.

      • GreenAB Says:

        “The AfD while fringe does have some interesting powerful voices”

        Sorry to disagree with you Yra. In case you missed it – the AfD has split up in 2015. Many of the founders including the chairman (Euro sceptics, professors, hard money advocates) have left after the party was pretty much hijacked by right wing elements. Sorry, but there´s no other word for it. Peolple with extremist agendas find their new home in a party once painted as serious. Open and hidden racists, former NPD members. I might sound paranoid and there´s no immidiate danger yet. But for the first time ever I am scared that once the situation is bad enough (recession/depression) really dangerous people could take over this country. Some of them are in upper positions already. Imo there´s no doubt that the current leader Mrs. Petry would be gone in a minute once radical voices like Mr. Hoecke would reach for the power. So please be very careful what you make of the AfD! Thank you!

        As for Merkel – she´s just doing what the German law require´s her to do. Everybody has the right to apply for asylum. There´s no upper limit to that. The administration is trying hard to bring the number down, e.g. excluding all kind of countries of origin. Asylum seekers from the Balkan, Northern Africa and even Afghanistan are going to be sent back home. What´s making the situation so hard to handle is the escalating war in Syria and the lack of solidarity across Europe. Everybody´s shutting their borders, so Syrians come to Germany.
        There´s no doubt that this crisis will be felt in upcoming elections. Ironically voters migrating from all parties towards the AfD only makes the situation more stable. The big parties CDU and SPD can´t form a coalition with their former minority partners. Therefore they need each other and the Grand Coalition should be the status quo for the foreseeable future. (Which is a good thing, imo.)

      • yra Says:

        Green AB–you are of course correct.The Tea Party was certainly hijacked by many of the fringes attaching themselves to a successful host and the original sound message of the economic reasons for the Tea Party get drowned out—I am aware that the same happened as you note to the AfD

  5. Chicken Says:

    Another case of bankers sticking it to their shareholders, what a surprise! Nobody goes to jail, of course.

  6. Chicken Says:

    Nice knowing in advance, which was perfectly timed as always.

  7. Sophocles Sophocleous Says:

    Thank you Yra for sharing your work and thoughts.

    It’s already game over for the US market as I outlined in this article:
    Many (mostly retail) investors are trapped into the logic that this is short term due to oil. Once the European Bank problem re-appears it will be the final catalyst to push markets into a bear market and this time there are no bazookas or bullets left…

  8. asherz Says:

    Let me add my kudos to the outstanding past 1000 and wishes for your good health and stamina to continue your edifying thoughts on financial and geopolitical issues with super clear thinking.

    Two comments on the latter. Bismarck in the Franco Prussian War succeeded in unifying Germany into a nation state. Putin has said that the breakup of the Soviet Union was the great tragedy of the 20th century. NATO could go after the Serbs 20 years ago, but there is no stomach to confront the Russians today. The Lady or the Tiger will reveal a pusillanimous damsel emerging from behind the door. Putin is testing the West with a jab here and there until he is confident he can move ahead. Turkey will be the great test as you intimate. Erdogan is afraid of this and that is why he is cozying up to two of his objects of previous animosity, Israel and Egypt. Watch for Russian jets “accidentally” straying over Turkey, testing the Turks mettle.
    A replay of a tired post WW l League of Nations with no stomach for a fight allowed another tyrant to come to the fore. With a collapsing global banking system, the oracles will give the bare chested leader the propitious time to fix the results of the “tragedy” of a quarter century ago. Baltic states be afraid.

    • yra Says:

      Asherz–thanks and I am in agreement with your analysis.The Baltic states are in discomfort as they have awoken to the fact they are the new trip wire and as Bismarck might have said —the baltics are not worth the “healthy bones of a single Nato infrantryman”—-first as tragedy and then as farce.And by the standards of Juncker and others ,putin may be at the top of the list of the least autocratic

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