Thursday, November 17, 2011

Another Global Banking Crisis?

Dakin Campbell of Bloomberg reports, U.S. Banks Face Contagion Risk From European Debt:

U.S. banks face a “serious risk” that their creditworthiness will deteriorate if Europe’s debt crisis deepens and spreads beyond the five most-troubled nations, Fitch Ratings said.

“Unless the euro zone debt crisis is resolved in a timely and orderly manner, the broad credit outlook for the U.S. banking industry could worsen,” the New York-based rating company said yesterday in a statement. Even as U.S. banks have “manageable” exposure to stressed European markets, “further contagion poses a serious risk,” Fitch said, without explaining what it meant by contagion.

The “exposures” of U.S. lenders to major European banks and the stressed nations of Greece, Ireland, Italy, Portugal and Spain, known as the GIIPS, are smaller than those to some of the continent’s larger countries, Fitch said.

The six biggest U.S. banks -- JPMorgan Chase & Co. (JPM), Bank of America Corp. (BAC), Citigroup Inc. (C), Wells Fargo & Co. (WFC), Goldman Sachs Group Inc. and Morgan Stanley (MS) -- had $50 billion in risk tied to the GIIPS on Sept. 30, Fitch said. So-called cross-border outstandings to France for all except Wells Fargo were $188 billion, including $114 billion to French banks. Risk to Britain and its banks was $225 billion and $51 billion, respectively.

Europe’s debt crisis has toppled four elected governments, with the last two, in Greece and Italy, falling last week. Italian bond yields remained at about 7 percent -- the threshold that led Greece, Portugal and Ireland to seek bailouts -- and shares of French banks, including BNP Paribas (BNP) SA and Societe Generale (GLE) SA, dropped amid concern they’ll need more capital.

Stocks Slump

U.S. stocks slumped yesterday after the Fitch report was released. The Standard & Poor’s 500 Index slid 1.7 percent and the 24-company KBW Bank Index declined 1.9 percent. U.S. index futures fell earlier today as Spanish and French borrowing costs rose.

The Fitch report is a worst-case scenario and is "oddly out of step" with the rating company’s previous reports, analysts at HSBC Holdings Plc said today. U.S. banks may even benefit as investors shift money to the U.S. from Europe, HSBC said.

Investor demand for the relative safety of Treasuries during the European debt crisis has sent the difference between U.S. short-term yields and bank rates surging to levels not seen in more than two years.

The gap between the London interbank offered rate and the overnight index swap, or what traders expect the Federal Reserve’s benchmark to be over the term of the contract, widened to 38 basis points today. It was the highest level since June 2009.

Swap Spreads

U.S. five-year swap spreads climbed to 45 basis points, the most since August 2009. Investors use swaps to exchange fixed and floating interest rates. The spread, the gap between the fixed component and the yield on similar-maturity Treasuries, is a measure of bank creditworthiness.

The TED spread, the difference between what lenders and the U.S. government pay to borrow for three months, widened to 47 basis points today, or 0.47 percentage point, the most since June 2010.

Yields have yet to reach the levels seen three years ago when credit markets froze and the U.S. economy was in a recession. The TED spread was as wide as 4.64 percentage points in October 2008.

Hedging Risk

While U.S. banks have hedged some of their risk with credit-default swaps, those may not be effective if voluntary debt forgiveness becomes “more prevalent” and the insurance provisions of the instruments aren’t triggered, Fitch said in the report. The top five U.S. banks had $22 billion in hedges tied to stressed markets, according to Fitch.

Disclosure practices also make it difficult to gauge U.S. banks’ risk, Fitch said. Firms including Goldman Sachs and JPMorgan don’t provide a full picture of potential losses and gains in the event of a European default, giving only net numbers or excluding some derivatives altogether.

Guarantees provided by U.S. lenders on government, bank and corporate debt in Greece, Italy, Ireland, Portugal and Spain rose by $80.7 billion to $518 billion in the first half of 2011, according to the Bank for International Settlements.

Also yesterday, Moody’s Investors Service downgraded the senior debt and deposit ratings of 10 German public-sector banks, citing its assumption that “there is now a lower likelihood” that the lenders would get external support.

Meanwhile, over in Europe, Nigel Davies and Alexandria Sage of Reuters report, Spanish, French borrowing costs climb as contagion worries build:

Spain and France struggled with government bond auctions on Thursday, throwing into sharp relief the threat of larger euro zone economies succumbing to the debt crisis that began in Greece and is already lapping at Italy's shores.

Madrid was forced to pay the highest borrowing costs since 1997 at a sale of 10-year bonds, with yields a steepling 1.5 points above the average paid at similar tenders this year, drawing descriptions from the market ranging from "pretty awful" to "dreadful."

The euro fell on the foreign exchanges in response.

Paris fared a little better, but again had to pay markedly more to shift nearly 7 billion euros of government paper. Fears that the euro zone's second largest economy is getting sucked into the maelstrom have taken the two-year debt crisis to a new level this week.

"The euro zone has got to deliver something which is going to calm markets down and at the moment markets feel like they are being given no comfort whatsoever," said Marc Ostwald, strategist at Monument Securities.

Italian Prime Minister Mario Monti outlined a broad raft of policies including pension and labor market reform, a crackdown on tax evasion and changes to the tax system in his maiden speech to parliament ahead a confidence vote to confirm backing for his technocrat government.

With Italy's borrowing costs now at untenable levels, Monti will have to work fast to calm financial markets given Italy needs to refinance some 200 billion euros ($273 billion) of bonds by the end of April.

Ireland, which has been bailed out and gained plaudits for its austerity drive, will also be forced to do more.

Dublin will increase its top rate of sales tax by two percent in next month's budget, documents obtained by Reuters showed.

But no amount of austerity in Greece, Italy, Spain, Ireland and France is likely to convince the markets without some dramatic action in the shorter-term, probably involving the European Central Bank.

Many analysts believe the only way to stem the contagion for now is for the ECB to buy up large quantities of bonds, effectively the sort of 'quantitative easing' undertaken by the U.S. and British central banks.

France and Germany have stepped up their war of words over whether the ECB should intervene more forcefully to halt the euro zone's debt crisis after modest bond purchases have failed to calm markets.

Facing rising borrowing costs as its 'AAA' credit rating comes under threat, France has urged stronger ECB action but Berlin continues to resist, saying European Union rules prohibit such action.

"If politicians think the ECB can solve the euro crisis, then they are mistaken," German Chancellor Angela Merkel said, adding that even if the ECB assumed a role as a lender of last resort, it would not solve the crisis.

Investors and euro zone officials hope that if Merkel and others find themselves staring into the abyss, the unthinkable will rapidly become thinkable.

"The Germans have made some remarkable changes to their position over the past few months, you have to give them credit for that, it just takes rather a long time. It's Chinese torture," one euro zone central banker told Reuters. "They are not drawing lines in the sand as clearly as they were."

The ECB's policy of buying Italian and Spanish bonds in limited amounts is barely holding the line, with the former's borrowing costs above the 7 percent level widely seen as unsustainable and the latter's homing in on that level.

"It keeps contagion intact not just for the peripherals but also for the core countries and increases the pressure on the ECB to do something," Nick Stamenkovic, bond strategist at RIA Capital Markets said of the Spanish and French auctions.

"Clearly at the moment the ECB is reluctant to do anything."

BANKS UNDER THE COSH

With turmoil reaching a crescendo, euro zone banks are finding it harder to obtain funding. While the stresses are not yet at the levels of the 2008 financial crisis, they have continued to mount despite ECB moves to provide unlimited liquidity to banks.

Fitch Ratings warned it might lower its "stable" rating outlook for U.S. banks because of contagion from problems in troubled European markets.

And fellow ratings agency Moody's cut ratings of 12 German public-sector banks, believing they are likely to receive less federal government support if needed.

German Finance Minister Wolfgang Schaeuble said on Thursday that the euro zone's debt crisis was beginning to hit the real economy and urged vigilance to prevent contagion from infecting banks and insurance firms.

The International Monetary Fund replaced its European Director in a sign the global lender is setting a more forceful course of action in dealing with the European crisis.

The Fund named Reza Moghadam, currently director of the fund's strategy, policy and review department, as its new director for Europe, replacing Antonio Borges who last month suggested the IMF could buy Spanish or Italian bonds alongside the euro zone's bailout fund but was forced to backtrack.

Monti starts his first full day as Italian prime minister comforted by an opinion poll that said an overwhelming majority of Italians supported him.

Greece's new technocrat Prime Minister Lucas Papademos faces mass street protests on Thursday, the day after winning a confidence vote for a national crisis coalition that is already split on the need for further austerity measures.

The size and mood of the rally, an annual march marking the end of military rule in 1973, will signal just how bitterly a restive public will fight further tax rises and spending cuts that international lenders demand in return for a massive bailout.

Greece's main conservative leader Antonis Samaras has refused to bow to EU demands for a written commitment to the bailout program and called for elections in three months to restore social peace.

Andreas Koutras sent me his comment on Greece's new dawn, which is well worth reading. Right now, this crisis has quickly metastasized into something much bigger and uglier than most analysts thought possible. As I wrote yesterday, the latest EU debt plan will not be enough to calm markets down. Much more is needed in terms of a credible fiscal response but so far, Ms. Merkel is balking at any solution, including a eurobond market or expanded powers for the ECB, pitting her against France.

I think when speculators forcefully go after German sovereign debt, she will cave, but we won't have to wait till that happens. The shift in IMF's European Director is a clear signal that US plans on getting involved in a much more forceful way. At the end of the day, when US banks are threatened, European politicians will succumb to US interests.

In the meantime, investors will have to endure a bad case of euro fatigue, but stay alert and use overblown fears of a ''contagion crisis'' to build positions in US financials, tech stocks, energy stocks, materials, mining, and alternative energy. Berlusconi is out and it looks like the world is ending again, but my hunch is smart money is positioning itself for La Dolce Beta.

Below, Willem Buiter, chief economist at Citigroup Inc., discusses Europe's sovereign-debt crisis and the role of the European Central Bank in resolution of the crisis with Tom Keene on Bloomberg Television's "Surveillance Midday." As he says: ''Time is running out fast!''

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