Here is the contagion!

Despite the liquidity surge engineered by global central banks last week, the problems in the eurozone haven't gone away. In fact, last week the Economist article entitled "Contagion? What contagion? American banks have been strangely immune to Europe’s crisis" rhetorically asked if American banks are insulated from the crisis in Europe:

America’s banks are reasonably healthy. They have significantly bolstered capital since 2008 and now boast core capital of 9% of assets, well above regulatory requirements. While many European banks held dangerous quantities of American mortgages in 2008, American banks today have relatively little exposure to Europe’s troubled sovereigns. For the five biggest, total exposure to Greece, Ireland, Italy, Portugal and Spain (net of hedges) ranges from $16 billion at Citigroup, or 14% of core capital, to $2.5 billion at Goldman Sachs, or less than 5%, according to Peter Nerby of Moody’s, a credit-rating agency. (But if France gets into trouble, that would be a far bigger problem.)

The markets, however, are telling a different story. The relative performance of the BKX, or banking index, shows that the banks remain in a relative downtrend compared to the stock market. Despite last week's uptick, the major relative downtrend is still intact. I wrote back in May 2011 (see On the fence, watching for an Apocalypse) that a violation of relative support (the green line) has been a signal of "rising systemic risk in the financial system that ultimately culminated in market meltdowns". The two previous occasions were the Russia Crisis in 1998 and the Subprime Crisis in 2007.

In addition to the banks, market stresses are also showing up in the broker-dealer stocks and the group has been in a well-defined relative downtrend since the start of 2011.

In a way, the analysis from the Economist is correct. The BKX is highly weighted with the large Too-Big-To-Fail banks, which have greater European exposure through their investment banking arms. By contrast, the regional banks are less exposed to Europe and the relative performance of the regionals have recovered from the banking scare in the Fall.

In the end, there will be few places to hide should the eurozone implode. The article in the Economist closed with the following paragraph [emphasis added]:

On November 30th the Fed, ECB and other central banks sought to rectify this by lowering the spread to 50 basis points. Stockmarkets soared but the euphoria may not last: illiquidity is a symptom of Europe’s crisis, not the cause. As long as sovereigns are at risk of insolvency, their banks are, too. If the euro collapses, the resulting chaos will not spare America’s economy, despite the health of its banks.

Commerzbank the first domino?
Indeed, cracks are appearing again in the European banking system. Mish reported that Germany is considering the nationalization of Commerzbank. Readers may recall that last week, I identified Commerzbank as one of the "canaries in the coalmine" of European stress (see Tripwires to a market crash):

While the shares of the Commerzbank rallied last week, they remain in a downtrend that began in April 2011 and the stock price has descended below the lows of 2009 - which is another indication of imminent market stress.

The failure of a bank like Commerzbank will be as big as Dexia. The latest interim report from the bank shows their balance sheet to have €738.2 billion in size and €244.2 billion in risk-weighted assets. By comparison, the August 2011 (pre-collapse) report from Dexia showed risk-weighted assets at €127.0 billion. As I also pointed out in my post, other major banks are at risk to follow, namely Credit Agricole, Societe Generale, KBC, RBS, Intesa, Unicredit and Santander.

Merkozy better unveil an immediate solution at the Dec 9 Marseilles summit, instead of a plan to have a plan (e.g. rewriting treaties will be a long involved process, etc.) Events like a Commerzbank failure may catch up with them quicker than anyone thinks.




Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

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