Remainder Of Euro Sovereign Exposure, Just As European Primary Issuance Supply Surges

When we discussed the specifics of the ongoing European bank run, we cited from the NYT which noted the actions of a core Japanese mutual fund with European sovereign exposure, namely that "earlier this month, Kokusai Asset Management in Japan unloaded nearly $1 billion in Italian debt." The Nikkei has just reported that this was merely the beginning: "Kokusai Asset Management Co. has sold all Spanish and Belgian government bonds that were part of its flagship fund, Global Sovereign Open, The Nikkei learned Monday. As of Nov. 10, Spanish and Belgian bonds accounted for 1.8% and 3.1% of the fund, respectively. The share of the bonds in the fund's portfolio fell to zero as of Thursday." Just what prompted this drastic move and very loud slap in the face of the European confidence building exercise? "A Kokusai Asset Management official said the company sold off the bonds, amid widespread concerns about the outlook for Europe's sovereign debt crisis to avoid hurting the value of the fund, given volatile prices of the bonds. The mutual fund operator had already divested the fund of all its French government bonds in October and all Italian bonds in early November." It is safe to say that where one core asset managers has been (and no longer is), everyone else will shortly follow. For the simple reason that it is now if not cool to not have European exposure, it is certainly required by one's LPs to cut down on all European bonds. Kokusai is merely the canary: expect everyone else to go ahead and dump the €741 billion in non-domestically held Italian (and then all other European sovereigns) bonds. Good luck ECB buying these in the secondary market. And one market where the ECB can do nothing by charter, is the primary issuance one, where as the following update from Morgan Stanley shows, things are getting from from bad to worse.

Issuance between now and year-end

A near-term silver lining for many countries is that their 2011 bond issuance programmes are drawing to a close in many cases (see Exhibit 4). France, Netherlands and Portugal have all completed their bond issuance programmes. However, Germany, Italy and Spain still have a fair way to go. In 2012, of course, bond issuance will have to resume.

In the meantime, there is still quite a lot of T- bill and bond supply coming up before year-end (Exhibit 5). The week of the 28 November will be a heavy upply week; with issuance from Belgium, Italy, France and Spain. If the pattern of worsening auctions persisted, it would be very bad news for euro area sovereigns, in our view.

And if, IF, Europe somehow finds a buyer for all of this stuff even as all other prudent asset managers are mimicking the Tesoro and selling on their own...then we get 2012, where things go from bad to worse to truly surreal - sorry Jim O'Neill, but in this case your astonishment would be perfectly valid.

Super-Committee, Hello Stupor-Committee: It's Official - "No Agreement"

As if anyone is actually surprised by the headlines appearing from Bloomberg with regard the Super-Committee - which in retrospect is perhaps a little aggressively-named:

*SUPERCOMMITTEE SAID TO ANNOUNCE NO AGREEMENT REACHED

*U.S. DEBT SUPERCOMMITTEE ANNOUNCEMENT SAID LIKELY ON MONDAY

While not immediate, it would seem obvious that a ratings downgrade can't be far behind this event given the reasoning for the last downgrade and the clear indication by this lack of agreement that nothing-has-changed.

S&P recently said that a 'watered down' package from the Super Committee would put downward pressure on the rating. Moody’s said the outcome of the Super Committee would be informative but not decisive for its rating analysis.

We would also assume that Defense and Healthcare stock analysts will be bombarding inboxes in 3..2..1..with buy recommendations...

Who Is Stuck Buying Another €741 Billion In Italian Bonds

Spoiler alert: There will be no surprise "I see dead bondholders"-type ending here. Having suggested precisely what the BTP trading dynamics look like previously, we now get official confirmation. With everyone else dumping Italian bonds in the open market, there are only two parties on the bid side: the ECB, and Italian banks. That's it. The only question is "how much" in order to determine at what point the selling onslaught will overhwhelm both insolvent Italian banks whose Risk Weighted capital will soon become too high forcing them out of the market, as well as drag down Draghi's recently expanded bond buying desk (we would say trading, but that would imply a two way market). Here is Barclays with the full breakdown: "Italy’s government bonds, representing the largest bond market in Europe, or the third largest in the world, have been particularly unstable since the beginning of July. The sheer size of the €1.6trn outstanding stock, of which around €220bn of bonds and €120bn of bills are rolled over every year, begs the questions who will be the buyers going forward. We thus update the breakdown of Italian bond holders which we presented in July (see Who Owns Italy's Government Debt? July 29, 2011), and analysed who has been selling and buying between the beginning of July (when widening started) and end of September (as of the latest available data). ECB has been the main buyer since August 8th, and held 4% of the Italian bond market as of September. Domestic holders, mainly financial institutions (banks) have gradually increased their holdings, taking domestic holding from 55% to 56% of the total market. Foreign investors, consisting of European non-Italian banks and real money investors as well as international asset managers, have been the main seller of BTPs, reducing their holdings from 45% to 39%." As said earlier - nothing at all unexpected: everyone who can get out is getting out. The only buyers are those for whom selling equates to suicide. That said, we wish Italian banks and the ECB the best of luck as they seek to purchase the €741 billion in bonds that are still to be offloaded as Merkel persists in refusing to let the ECB even considering announcing monetization intentions.

Lehman, pardon Barclays, with the full Monty:

Summary

• We present the changes in the breakdown of Italian government bonds holders between end of June and September:
  • ECB’sSMPprogramhastaken4%of the market as of September
  • Domestic investors have been gradually increasing their holdings, by a total of 1%
  • Foreign investors have been the main sellers, reduced their holdings by 5%
• The funding risk for Italy and all other sovereigns remains critical, as shown by recent weak sovereign auctions. The funding issue is not only limited to sovereigns, banks have also been increasing their reliance on the ECB

ECB – Biggest But Not the Only Buyer in Town

Undoubtedly, ECB’s SMP program has been the biggest buyer of Italian debt since its re-activation on August 8th. The buying has been concentrated on 2-10y nominal BTPs. While the spread tightening effect has faded away, it has effectively absorbed a substantial portion of the Italian bond market, €67bn in notional size or 4% of the total market as of end of September, based on our estimate. This includes the €12bn of increased holding by the Banca d’Italia, which has risen proportionally as the share of Banca d’Italia’s contribution towards the ECB (17.86%). The size as of November 17th was €100bn, or 6.2% of the market.

Italians Banks – Supporting Italian Government Bonds

Domestic investors, who already held 55% of the market before the July widening (including Italian funds managed abroad), have gradually increased their holdings since July up to the end of September as data suggest, to 56% or an increase of €14bn.

In particular, domestic financial institutions (mainly banks) have been the main domestic buyers, increasing their holdings by €23bn to €267bn. This has been in line with our expectation that domestic banks should be the long-term potential buyer due to the tougher regulatory environment.

Other domestic financial institutions (investment funds and insurance companies) have reduced some of their holdings, by €13bn to €247bn, which may have contributed by the index rebalancing among the benchmark investors, as we expected.
Finally, domestic retail investors’ holdings (corporate, households and private wealth management) data is delayed, with the end of July remaining the latest point, which remains stable at €214bn. We expect such holdings to stay stable if not higher, as the incentive for domestic households holding government bond is higher than for other assets due to lower capital gains taxes from January 2012 (12.5% vs 20%).

Selling Emerged from International Investors

The data for foreign investors’ holdings is also lagged; however, given the increase in holdings by domestic investors and the SMP’s purchase, it is reasonable to assume that the main sellers of Italian government bonds have emerged from international investors, by as much as €80bn – within which we estimate that non-Italian European banks and real money investors (insurance and mutual funds) have sold €40bn in total over the period. The remaining portion of the liquidation of €40bn has likely come from international asset managers who have been rebalancing their index to either reduce their exposure to Italy or have moved towards some type of AAA or GDP weighted index in the first few months of the widening.

Ongoing Sellers?

Continued selling post September, evidently prompted by SMP’s increased purchases and Italy’s rising yields since then, has more likely been due to deteriorating confidence beyond the initial index rebalancing. Foreign holders, especially non- European investors, who currently hold €271bn (17%) of Italian bonds, are likely to be on the front line of sellers going forward if the bearish outlook continues. The European banks and real money investors, who hold €344bn (21.6%), may be relatively stronger hands due to the large portion of Italian government bonds present within the European bond market (24%) as well as the regulatory regimes. However, this will depend on investors’ willingness to refinance the ongoing selling of Italian bonds by the government itself, with bond gross issuance €220bn a year and another €130bn of T-Bills.

Who Will Be the Buyers?

While it is encouraging to see that domestic investors have been stepping up their holdings, in line with our expectation, the move has been gradual. The slow path has also been overshadowed by the selling flows on the back of deteriorating confidence. Although it remains our key assumption that domestic insurance companies [ZH: got ASSGEN and ZL CDS yet?], will be the potential long-term buyer, the interim uncertainty and volatility certainly calls for a more urgent buyer.

The SMP, which has achieved some rebalancing role during the initial underperformance, has failed to backstop the Italy yield level or provide sufficient confidence for investors to retain their holdings. Nevertheless, the capacity of the SMP is not limited by any technical constraints: the ECB’s balance sheet can expand without limit while the sterilization process is ensured as long as there is ample excess liquidity in the system. The constraint only depends on the ECB’s willingness, both politically and their willingness to be exposed to sovereign credit risk.

Funding Risk for Sovereigns and Banks

The formation of the new Italian government has been welcomed by the market. However, our economists highlight the very poor growth outlook and implementation risks related to fiscal consolidation. The ongoing funding worries for a number of sovereigns and the banking system also stand as a key risk, especially going into year-end as balance sheet constraint amplifies.

This week we have had a failed Belgium 3-mth and 12-mth T- bill auction, an uncovered 2y German auction and a very weak Spanish 10yr auction – all pointing to the increasing worry over funding events for sovereigns, even for very short- dated T-bill issuance. The funding crisis is not only limited to sovereigns, but their close link, banks, are also facing increasing short-term funding difficulties and countries that have relied less on the ECB have now been catching up (Exhibit S2). Italy, Spain and France in particular in the last few months have ramped up their borrowing from the ECB as funding dries up in the market.

In addition, this week’s MRO saw a sharp rise in usage by €35.5bn, which has coincided with last week’s increase in initial margin for BTP repo positions by leading clearing houses. The increase in margin has likely had a negative impact on funding position of banks holding BTPs, especially domestic banks. We estimate banks would have to find an extra €5-16bn to fund this additional haircut for their BTP repo positions in CCPs, and this is not to mention the volatility of BTPs since then, which could have had additional impact on margin calls

European Black Swan Sighted

While everyone's attention was focused intently on peripheral European bond spreads last week and the incessant call for ECB intervention, a dramatic (and contagiously panic-worthy) move occurred in the European Investment Bank (EIB) bonds.

For those unfamiliar, the EIB is the EU's IMF-equivalent and is the largest international non-sovereign lender and borrower. Technically, it is defined as "the European Union's long-term lending institution established in 1958 under the Treaty of Rome. It supports the EU’s priority objectives, especially European integration and the development of economically weak regions."

5Y Euro-denominated AAA-rated EIB bond spreads crashed wider, blowing past the 2009 record highs and clearly indicating that European capital flight is in full swing.

The IMF-like entity, supported by a small capital base of deposits backed by promises of huge capital injections by sovereign nations, has massive exposure across Europe (and elsewhere). EUR382.4bn of senior unsecured debt and (according to Bloomberg - chart below), EUR2.5bn of deposits (admittedly backed by supposed promises to make whole loan commitments) does not make for a sound AAA-rated firm in our humble opinion.

Clearly investors think the same this week and are starting to worry about the same self-referencing, self-supporting house-of-cards that caused the EFSF to be written off as unworkable.

It is clear that the contagion is spreading as Bund yields start to underperform (no capital flight to safety within the Euro-zone) and furthermore, as the chart above shows, the stress on the EFSF has now spread to the EIB's publicly tradable debt.

It is no wonder given the size of their loan portfolio and who it is being lent to:

Spain, Italy, France, Portugal, and Greece all in the Top 10 with simply enormous outstanding debts relative to the capital in-house to cover potential losses (let alone any MtM or economic risk budgeting).

The debts outstanding, much as with any major investment bank, are denominated in multiple currencies and the yield curves below show the differentiation of those curves by major currency.

The next few months/quarters/years has huge supply from the EIB as it rolls its major debt load and while it maintains its AAA-rating - and therefore appears very attractive from a carry-per-regulatory-risk-capital perspective, we suspect the professionals are already unwinding their exposure very rapidly.

The next few months have over EUR20bn in maturities (and EUR6bn in interest payments) and so we will get plenty of opportunities to judge how new issue premiums will adjust secondary markets.

The following chart (of the USD-denominated EIB debt yields) should be enough to prove that both systemically (yield curve shift higher) and idiosyncratically (potentially speculative-driven negative bets as bear flattening is occurring) the AAA-rated EIB is facing some significant stress and should it need to make capital calls (to maintain its AAA-rating), is Spain, Italy, France, and Greece going to step up to their promises...

There are no CDS trading on this reference entity (yet) but given the still-relatively-tight nature of the bond spreads, we suspect specialness is not an issue and borrow is possible. The 2s5s bear-flattener looks the lowest vol trade but at such low costs of carry, outright is perhaps just as attractive on a reduced size trade. The compression in the EFSF-EIB trade also looks attractive.