A few more words regarding the 'Operation Twist' aftermath: we want to once again stress a point we touched upon yesterday, namely that the merry pranksters at the Fed have failed to consider a number of points when they decided to embark on their newest experiment.
One of these is that insurance companies, pension funds and banks are now faced with lower 'risk-free' long term yields. This upsets the actuarial calculations pension funds and insurers base their contracts on and means that existing commitments will eat into their profit potential, while new commitments will have to reflect the lower yield landscape, meaning that the expected payouts to their new clients will decline. This in turn means that people will be even more inclined to increase their precautionary saving and cash balances, increasing the deflationary undertow of the private sector deleveraging cycle. This effect is ultimately salutary, as it is a countervailing force to the capital malinvestment that artificially lowered interest rates tend to produce. It is however almost certainly not what the central bankers wanted to achieve. Banks meanwhile will record large accounting profits on the increase in the market value of their treasury bond holdings, but their ability to squeeze profits from such holdings in the future has declined commensurately, as the steep yield curve has provided them with a considerable source of income.
It is important to consider again what we pointed out yesterday: experience shows that in the fiat money system, a steepening yield curve is associated with inflationary growth, rising asset prices and growing economic confidence. A flattening yield curve is associated with the opposite: growing deflationary psychology, falling asset prices and a decline in economic confidence. In other words, the reaction of the markets to 'OT' was perfectly logical, although it has presumably 'puzzled' the helicopter pilot once again.
The Banking Crisis
Standard & Poors has cut the ratings of seven large Italian banks, putting them on the same slippery slope the French banks find themselves on. This is to say, many counterparties will halt or reduce their trading in certain items with these banks, wholesale funding sources will dry up, while large depositors are likely to pull their deposits and move to places perceived to be safer at this time. In short, the 'institutional bank run' is now going to engulf Italy's banking system more fully. We expect ECB funding to Italy's banks to soar as a result. According to RTE News:
“Standard & Poor's tonight downgraded seven Italian banks after dropping Italy's sovereign rating to A/A-1 two days previously.
The long-term ratings of Mediobanca, Findomestic, Intesa Sanpaolo and their units Banca Imi, Cassa Risparmio Bologna and Biis were downgraded to A from A+. Their short-term ratings remain unchanged at A-1.The rating of BNL was reduced to A+/A-1-. Unicredit, Italy's biggest bank, escaped a ratings downgrade for the moment but was put on negative outlook.
Standard & Poor's on Monday downgraded Italy's sovereign debt rating, citing economic, fiscal and political weaknesses.”
(emphasis added)
On Wednesday, the credit ratings of Bank of America (BAC) , Citigroup and Wells Fargo were downgraded by Moody's on the grounds that these banks are no longer considered 'fail-proof' due to an alleged change in policy (really?). This of course means that they are now also subject to the risks we discussed above. Ironically, Moody's noted in its report that the 'contagion risk' between banks has declined – just as the downgrades it has dispensed once again increase contagion risk! BAC's share price promptly collapsed to a new low, more than eradicating the 'Buffett bounce', which we rightly denounced as a typical bear market 'hopium bounce' at the time.
The 'hopium bounce' in BAC after Warren Buffett's investment in the company has been given back in its entirety – click for higher resolution.
The big French banks meanwhile are forced by the tense funding situation to vastly shrink their bloated balance sheets. This means there is a wave of 'distress selling' in the offing, while these banks will concurrently turn into 'zombies' with regards to new lending. Note here that euro-area banks provide some .6 trillion in lending to Asia, so the fact that they are now shrinking their balance sheets will redound on credit availability around the world.
As Bloomberg reports:
“BNP Paribas SA and Societe Generale SA, France’s two largest banks, are trimming about 300 billion euros (5 billion) off their balance sheets as Europe’s deepening debt crisis threatens to make them too big to save.
At the end of March, French financial firms had 2 billion in public and private debt in Greece, Portugal, Ireland, Italy and Spain, according to Basel, Switzerland-based Bank for International Settlements. That’s the biggest exposure to the euro-area’s troubled countries and almost a third more than German lenders. The four largest French banks have 5.9 trillion euros in total assets, including loans and bond holdings, or about three times France’s gross domestic product.
“The banks are entering a slimming cure, which is forced by the sovereign crisis,” said Jerome Forneris, who helps manage billion, including the two French lenders, at Banque Martin Maurel in Marseille, France. Rather than tap the market for capital, BNP Paribas and Societe Generale are seeking to free up a combined 10 billion euros through asset cuts and disposals. Paris-based BNP Paribas plans to cut billion of corporate- and investment-banking assets, while Societe Generale may exit businesses such as aircraft and real-estate finance in the U.S.
The banks have been forced to act after concerns about their sovereign debt holdings made funds reluctant to lend to them, crimping liquidity options. At the end of 2010, France’s three largest banks had at least 500 billion euros of short-term and interbank funding rolling over within three months or less, according to a Barclays Capital note dated Sept. 7.
“If liquidity conditions worsen, their size and the weight of their trading books would make it more problematic for the government to replicate a rescue like in 2008,” said Christophe Nijdam, an analyst at AlphaValue in Paris. France provided about 20 billion euros to bolster capital levels at its largest banks after Lehman Brothers Holdings Inc.’s September 2008 bankruptcy. President Nicolas Sarkozy also set up a 320 billion-euro fund to guarantee bank debt. “If guarantees had to be put in place again like in 2008, it would represent close to 20 percent of GDP,” Nijdam said. With French public debt set to rise to almost 90 percent of GDP in 2012, it would “be more problematic today,” he said. [no s***, Sherlock, ed.]
Credit markets signal a squeeze at French banks, with increased risk of default. Credit-default swaps on BNP Paribas have almost tripled to 292 basis points from 110 in July, according to CMA. Contracts on Credit Agricole SA have climbed to 297 from 130, while those for Societe Generale have surged to 399 from 128.”
Not surprisingly, the market concerns about these banks continue to percolate, although the banks themselves continue to sotto voce deny that they are in any kind of trouble. In other news, they also have a certain bridge in Brooklyn that's up for sale.
These problems are a major reason to expect some sort of concerted intervention measures soon. The upcoming G-20 meeting may well be used to lay the groundwork for such a coordinated intervention.
The Eurostoxx bank index. The selling pressure in European bank stocks has been unrelenting – click for higher resolution.
Another noteworthy development in this context was a rumor – in our view a credible one – that the Fed is about to cut the interest rate on its foreign exchange swaps with the ECB and other central banks. This will relieve some of the pressures that the current 'penalty rate' exerts on banks required to access this type of funding, but it is of course the exact opposite of what was once considered prudent policy in times of financial stress. The WSJ reports:
“With global financial markets under pressure, you can bet central bankers, at least those in Washington, would like to do something about it. Their toolbox is getting a little bare, but there may be some tinkering they can do. From IFR, via Russ Certo at Gleacher & Co., comes the suggestion that they might cut the rate they charge for dollar swap lines to Europe:
The Fed currently charges 100bps over OIS on the 7-day dollar operations and this is what will also be charged once the 3-month operations get underway. For some this is too high and thus it is understandable that there are rumors now circulating that the Fed will cut the rate on FX swap lines to Europe. These swap lines act as a ceiling but clearly the ceiling is too far away to have a material impact unless the market clearly considers you as a bad credit. We have seen a rewidening of the 3mth EUR currency basis swap back to the highs of this year as well as a widening of USD Libor/OIS spread (Dec IMM) suggesting that such an action from the Fed cannot be ruled out.”
It's a good bet that this isn't going to end the budding recession, but as far as the willingness of central bankers to 'tinker' goes, we would certainly think it likely that this move is on the agenda.
