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Rotten Contagion To Make Landfall In Denmark: CDS Set To Soar As Hedge Funds Target Country zerohedge.com
Tyler Durden on 12/07/2011
Misquoting Shakespeare before the market open may seem like blasphemy but in a follow-up confirmation of a thesis we proposed back in July, Luxor Capital expands on the idea that something rotten is ahead for the state of Denmark. As with many of these crises, the heart of the Danish problems lie in a commercial and residential real estate boom and looming bust and with the capital/equity remaining so low in the Danish banking system (and a pitiful funding profile), it seems increasingly evident that public balance sheet support will become necessary (and perhaps not sufficient). How ironic that we pointed out, back in July, the probability that Germany will need two insolvency funds, a South-facing and now a North-facing one. Having traded in the mid 20s during H1 2011, CDS now stands at 106bps (off its September peak of 158bps) and given the interest we are seeing from hedge funds in this relatively lower cost short, we suspect this week's modest decompression will accelerate.
After dedicating 20 of the 21 pages of its Q3 Letter (courtesy of ValueWalk), Luxor's conclusion in its Death to Denmark thesis is as follows:
In summary, we believe a housing crisis is looming in Denmark. Whether Danes grow into current home prices over an extended period of time (as the Danish central bank predicts) or home prices violently correct downward will determine the fate of the banking sector and with it the market’s estimation of the sovereign’s solvency. Our experience with levered assets is they tend to re-price on the downside much quicker than they appreciated on the upside.
Denmark could be particularly susceptible to this in the wake of the upcoming contraction in private credit in Europe. We find the senior bonds in the Danish banks to be among our best risk-adjusted shorts in the portfolio. The Danish regulators have already exercised their authority to impose losses on senior bank creditors in the recent bank failures; we would expect them to do the same in the future should a banking crisis emerge. In our estimation, the senior bonds are the de facto equity in the Danish banking system and they are trading at 3-4% yields.
Given the paltry equity in the Danish banking system and the reckless funding profile of the banks, we fear the government will eventually be saddled with much of the banking systems’ liabilities in the event of a full blown housing crisis. Given the size of the bank liabilities to the sovereign and the acceleration the sovereign would be facing in its own leverage saddled with such an economy, this outcome would lead to considerably wider credit spreads, if not an ultimate default on the sovereign.
While we would stress that none of these negative outcomes are probable, we believe they should be of reasonable concern to bondholders of sovereign and bank debt in Denmark. For this reason alone, we find the current trading levels of these securities materially over-priced.
As a reminder, back in July we made a special prediction about precisely a day like today:
S&P said that "In our base-case assumption, we estimate the gross loss due to additional bank failures to be Danish krona (DKK) 6 billion-DKK12 billion over a given three-year period. If the losses are larger than we expect, we would have to reassess our ratings on individual Danish banks, based on the impact of the fallout on each. Eleven banks have failed in Denmark since 2008. Although the banks were small by international standards, it is nevertheless an unusually high number for a developed market where bank defaults are generally rare events and extraordinary government support mostly averts losses to senior creditors. While the Danish regulatory authorities accept the concept of systemically important institutions, they have so far given no formal indication of which institutions fall under this definition. In our opinion, the banks we rate would be considered systemically important and therefore may receive extraordinary government support, beyond that defined in the country's established bank resolution scheme." So according to the rating agency any country that dares to avoid the Paulson-Summers TBTF doctrine is in prompt need of annihilation if we read this right. Either way, this latest black swan means that the crisis is creeping ever closer to Germany, which now has to fund two insolvency fronts: a southern and a north one. And when S&P finally puts France on downgrade review, the time to panic will have come and gone.
France is now on downgrade review... and the market refuses to accept reality.
Denmark sovereign CDS remain notably rich to their recent wides and well below peers from a cost of carry perspective offering a relatively low cost long vol position that is yet to be crowded out. |
