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Contagion Concerns From a 2007-08 CDS Trader


Charts don't matter, macro data doesn't really matter, and until the contagion stops, valuation doesn't really matter either.

And Spain and Italy are dancing ever so precariously with contagion. The Spanish 10-year yield closed the other day above 5.6% for the first time during this crisis. Italy's yield is creeping back towards its old highs.

The Euro to Swiss Franc currency rate, one of the best measures of stress in the European banking system, closed today below 1.20, at 1.195, for the first time.

In addition, the German 2-year yield dropped from 1.48% to 1.37% in a single day today on contagion fears.

We've been getting these panic moves every three to four months since the beginning of 2010. Spreads for a country widen, EUR/CHF falls, stock markets fall, policymakers announce a bigger liquidity facility or do something else to regain market confidence, spreads back off a bit, and stocks go on their merry way. But the spreads and yields never fall back to their prior levels. EUR/CHF never bounces back as high. It's a problem Europe could fix by having Germany and France write a big check and then letting some of the PIIGS countries devalue their currencies or leave the eurozone, but so far they have been unwilling to do that. And we're running out of time.

We know about the interlinked exposure that European governments and banks have with each other. We have some idea about the amount of sovereign debt they hold. We have no idea about how much debt banks hold of other banks. This is where the Lehman parallels seem to fit. Greece is not an important counterparty to the European banking system, but if Greece restructures its debt or defaults then banks will take impairments, which will threaten their already meager capital levels. Immediately some of these banks will be more or less insolvent. If that happens there will be a general distrust of many banks in Europe just like there was in the US after Lehman fell. Banks will horde pristine collateral and repo markets will dry up. Leverage will have to come down which means forced asset sales into a market that will shun risk. The solvency of the European banking system will be a concern, which is a big problem for Americans since 39%, or $620 billion, of prime money market fund assets are in unsecured European bank debt, as Bank of America pointed out last week.

Why haven't banks sold all of this debt? Assuming there's a bigger sucker somewhere, of course, whether that be in Asia or elsewhere. Well, during the credit crisis and since banks moved assets from their "assets for sale" bucket where they were marked to market, to their "held to maturity" bucket where they only need to recognize losses if cash flows are threatened. And as this Citigroup (C) piece on accounting for a rescheduling/restructuring of sovereign debt notes, if banks sell securities from their "held to maturity" bucket they are impacting by "tainting rules" which state that other assets from their "held to maturity" bucket must move back to their "assets for sale" bucket, which means marking to market again.

So they're not going to sell sovereign debt until they can't. If they want to reduce risk they'll have to sell other correlated assets -- which could be anything from corporate credit in Europe and the US to equity futures to currencies.

My experience in 2007-08 taught me that in credit contagions understanding these dynamics is all that matters. Charts don't matter, macro data doesn't really matter, and until the contagion stops valuation doesn't really matter either. A $1 bill could trade for 70 cents if firms need to raise capital.

That being said, in December, 2008, the S&P 500 recovered to make a new high for the year. All of the losses from the Russian default and LTCM were made back and then some. This episode may very well be the same, with the economy and stock market valuations much more balanced than they were in 2008. But that doesn't mean that stocks can't fall 10-40% first if this gets out of hand. Be careful out there.
No positions in stocks mentioned.

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