Monday, June 20, 2011

The dam breaks

When it rains, it pours. On Friday Macro Man detailed the big macro concerns the market faces (TMM=Team Macro Man), namely the US, Europe and China:
TMM reckon that the current state of the World can be described as follows:

The US: The slowdown is dramatic (more on this below) but positive actual GDP prints, a Pavlovian dog-like response in the form of dip-buying on weakness (learned over the past two years), and a belief in the Fed coming to the rescue have prevented both the PhD and punting community from embracing a negative view.

Europe: Smoke is coming out of the tail pipe, kangaroo-ing down the the road. Going to break down soon.

China: "DON'T TALK ABOUT ANYTHING NEGATIVE!" as China is the only hope the West has. It seems to TMM as though punters are looking through to the peak in inflation and holding onto the soft-landing view - something they sense from the fact that most commentaries on China they receive seem to talk about how too many people are fearful of a hard landing/inflation etc... where is the *real* consensus?
Of the three, I am least concerned about the US macro outlook. It appears that market is pricing in growth of about 2% but it is about to decelerate to 1%. Add in the end of a dose of QE2 market steroids, the adjustment process for the equity market will likely be painful, but such a move is best classified as a plain vanilla correction of 10-20%.

Europe's Bear Stearns moment?
The problems in Europe and China, however, have Russia Crisis or Lehman Crisis written all over them. Matthew Lynn, writing in Marketwatch, expresses the consensus opinion that a deal will be done to save Greece:
Forget all you’ve read about it being a catastrophe for the markets when it happens, however. Only things that nobody really forecast make prices move in any dramatic fashion. A Greek default is about as unexpected as Rafael Nadal making the finals at Wimbledon this year.

In reality, it is already priced in. And the Germans and the French aren’t going to let it happen until they know their banking systems are safe — so there isn’t going to be a Lehman-syle collapse.
Felix Salmon, on the other hand, believes that a Greek default has not been priced in by the market:
[N]o one has any idea what would actually happen in the event of a Greek default. In order for markets to be pricing in a default, traders would have to be buying debt now on the expectation that if Greece defaults the price of its debt would not fall further. I don’t think anybody’s doing that yet — as Stopford says, they might be taking risk off, but they’re not expecting catastrophe. If Greece were actually to default, I’m pretty sure that markets would fall further.

In 2008, Bear Stearns' hedge fund imploded in July - a precursor to the Lehman collapse a few months later. The Greek situation is starting to look a lot like Europe's Bear Stearns moment. Looking more closely, Joseph Cotterill at FT Alphaville writes that the ECB is caught between a rock and a hard place. Greek banks are experiencing a run on their assets, but where do they go for funding?
But whatever has caused the depositor flight, it’s odd that not many are making the connections to Greek bank funding at the European Central Bank. Having fewer deposits to draw on, the only other place Greek banks can go for replacement funding is from the ECB. That means pledging more, not less, Greek government-backed collateral.

So, what are we to make of the ECB’s repeated threats to cut off the collateral’s eligibility if the Bank is prevented from dictating terms on a bond rollover?
I have been closely watching the relative strength of the Banking Index (BKX) as a barometer of the market perception of systemic risk in the financial system. Previous technical breakdowns have been signals of serious problem, i.e. Russia Crisis (1998) and Subprime Crisis (2007). Looking at the chart, the relative strength of the BKX just broke down:
The relative performance of the BKX is important is because exposure to European credit doesn't stop at the shores of the Atlantic. No one quite knows how much indirect exposure American financials have to European credit in through the credit default swap (CDS) market. Kash at The Street Light has made a stab at estimating the exposure:
As last week's new BIS data showed, it appears that US banks indirectly have substantial exposure to the peripheral Euro-zone countries that are teetering on the edge of bankruptcy. Exactly what form that exposure takes is a bit uncertain, though it seems likely that much of it is in the form of credit default swaps (CDS) written by the US banks to provide insurance against default to the holders of bonds from Greece, Ireland, and Portugal.

But it's a bit frustrating not to have a clearer understanding of exactly what form this exposure takes. So I've been trying to see if there is any public information that can give us a hint about exactly how the big US banks have incurred such exposure.
The problem is, no one really know. Here are his tentative conclusions:
1. Bank of America, Morgan Stanley, and Goldman Sachs are the most aggressive in terms of taking open positions on default outcomes. But we have absolutely no idea how much of those positions (if any) were with peripheral Euro assets. Also, while the last two firms don't break out income attributable to CDS activities (at least not that I could find), B of A made a huge portion of their profits in 2010 from them. (Note that Citi did not indicate how much of the CDS protection that they sold was covered by purchases of CDS insurance, so they may or may not be in that list as well.)

2. The aggregate CDS exposures of the big US banks are certainly large enough to be plausibly consistent with the BIS estimate of about $100 bn in indirect exposures to peripheral Europe. If you add up the highlighted numbers (and make a guess at Citi's position), it seems reasonable to guess that the total net open positions on CDS protection sold to third parties by the big US banks is between $1,500 and $2,000billion. Attributing $35 bn of that (about 2%) to Greece, which has certainly had one of the most active markets (proportionally) for CDS contracts over the past year, doesn't seem to be a stretch.

3. Banks do not have to provide much detail about the indirect credit exposures that they take on when they sell default insurance through the CDS market. We have incredibly scant information about the positions that US banks take through default insurance, and therefore no idea about how any individual bank will be affected by a Greek default.

4. It's hard to find any other potential exposures to Greece, Ireland, and Portugal in the banks' public filings, other than through CDS contracts. Combined with points 2 and 3 above, the process of elimination suggests to me that CDS contracts are indeed likely to be the source of the bulk of US banks' indirect exposures to a Euro-zone default.
As for the current Greek crisis, I am sure that the troika will find the few measly euros to tide the Greeks over to the next deadline (though Mish has reported that Der Spiegel claims the agreement negotiated between  Merkel and  president Sarkozy has collapsed and Bloomberg reports Europe will pressure Greece by withholding half of the next tranche of money). In the next round of negotations that begin in July, the rescue numbers start to get much bigger. If the Greeks default or restructure, the Apocalypse looms. Here is what I think happens next:
  • The Irish, the Portuguese and the other peripheral countries will cry, "What about us?" The troika may the resources to rescue the Greeks, but they will be faced with a wall of protests to "reschedule" other peripheral debt. As an example, consider this interview with Kevin O'Rourke on the Irish attitude that the EU "owes" Ireland for bailing out the Irish banks and therefore deserving of relief.
  • A flight to safety will ensue. Risky assets get sold - the result is a cascading "margin clerk" market where everything gets sold.
Does this sound like a Lehman moment about to happen?

China: The elephant in the room
In addition to the looming crisis in Europe, the risk of a hard landing in China is real and it could spark a substantial selloff in risky assets as the markets price in a synchronized global recession. Such a prospect is too scary to contemplate in a fragile global economy.

The indications of a China slowdown are already there and real estate prices are cooling. Last week Standard and Poor downgraded Chinese developers' outlook from "stable" to "negative". Moreover, the Hang Seng Index has decisively broken support, which is a sign of trouble.

The technical picture of the Shanghai Composite is more complicated. It has broken an initial level, but arguably it is now trading in a support zone.

Will the Chinese authorities be able to engineer a soft landing? It's starting to look a little dicey, given the economic headwinds of China's trading partners in North America and Europe.

Given that the markets are oversold and poised for a tactical rally, I would be using market strength as a opportunity to lighten positions.

Addendum: David Merkel pointed out to me that Bear Stearns blew up in 2007, not 2008. I stand corrected.


Ivo said...

Bear Stears' hedge fund blew up in February and later May (or July?) 2007. But the bank itself blew up in sping of 2008

Ivo said...

The BS HFs blew up in Feb and May (or July?) 2007, but the bank itself blew up in spring of 2008. So you were about right (at least with the year)