European Financials: A Line in the Sand

Nov.29.10 | About: iShares MSCI (EUFN)

Well we have the bailout plan, cue the usual items from your chosen bailout drama:

  1. Protests (check)
  2. Breakdown of government consensus (check)
  3. Inevitable question of who’s next

Team Macro Man is coming to the conclusion that the drama in Europe is getting fairly predictable, and the big question – Spain – is only just starting to be asked by the market.

In a cruel twist of fate, Iceland – (remember that one? Mid-Atlantic Lehman on volcano?) – now trades about 30-40 bps tighter for 5-year sovereign CDS than Spain. Let it never be said that the gods don’t have a sense of humor; it’s just that they are as cruel and capricious as they were in The Iliad.

Team Macro Man at this point is looking for slightly more nuanced trades than the obvious “it’s all gonna end innit?” ones, and this has caused us to turn to none other than CDS indices.

The chart below is of the Itraxx financials senior and sub indices, which have diverged more than a bit recently:

(Click to enlarge)

The reasons are pretty clear: the EU and any bailout packages now expect junior creditors to take the pain along with equity holders, whereas decisions have been made by the great and the good that senior lenders should be made whole so that banks don’t get into a collective crisis due to a ramp in funding costs.

The objective here is clearly to force the weak to dilute and cram down junior creditors, while keeping senior whole and not pushing a wholesale exodus of the bank paper market. So is this what the market is pricing right now? Not really, and frankly, not even close.

Team Macro Man is feeling lazy and thought we’d take a snap of both a 5-year deal on European senior financials versus sub financials and equalize the default probabilities (assuming cross default provisions, naturally) and see what we got:

(Click to enlarge)

As can be seen, it's abundantly clear that you have to set recoveries on senior really low to get these spreads to line up, assuming the kind of sub haircuts we are looking at here (0-25%). Now, maybe European financial leaders are joking and maybe this will get so bad that senior will get impaired, but right now Team Macro Man can’t help but feel the senior/sub trade has more than a bit of a way to go.

While we're onto nuanced trades, it seems to Team Macro Man that it's worth having a punt on 10-year Ireland. A quick back-of-the-envelope job suggests that at 71.89c on the euro, if you assume that Ireland restructures with a 30% haircut when the EFSF runs out in 2013, you get a loss-adjusted yield of 5.3% - or 255bps above Bunds.

Now, Team Macro Man reckons that once Ireland has a "Number Two" of 30% it will be on a sustainable debt path, and that 255bps above Germany *post-restructuring* in such a scenario comfortably prices the risk premium.

In fact, that looks like fantastic loss-adjusted real yield with the added bonus of the wildcard option that they manage to pull this beast off. As with all the subprime trades, the key to finding support in prices of toxic waste under-priced illiquid assets is for there to be a decent enough unleveraged yield. Well in the New Normal world this looks to be a key candidate.

And finally, a happy announcement to make. With the increase of local denials of any peripheral problems, it would appear that the Eurostrich has spawned lots of baby peripheral Eurostriches. Aren't they sweet! Arrrrhhh.

Going "cheep" to a good home ... ( groan)

Disclosure: No position