Monday, 29 August 2011 13:20

Did You Know That The Upcoming Italian Auction Can Spark Contagion That Touches A BIG US Bank? Featured

Early last year, I released The BoomBustBlog Sovereign Contagion Model, a sovereign contagion model which illustrated prospective paths of contagion throughout much of the financially developed world. This model was unique in that it didn't simply assume "x" country owed "y" country "z" among, but attempted to focus on the nuances that could cause contagion to veer off of the expected course and into unexpected areas. The update to said contagion model this year is the research note released to subscribers, The Inevitability of Another Bank Crisis. This piece garnered significant interest from the banking sector, as could have been expected. It was followed by the blog post Is Another Banking Crisis Inevitable? and the keynote speech at ING's Valuation Conference in Amsterdam.

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On August 12th of this year I released research the Bank Run Liquidity Candidate Forensic Opinion. In said piece I made it very clear that the subject bank in question has roughly 40% of its equity exposed to Italy (the economy to be affected by the debt crisis that cannot be rescued via bailout), among a plethora of other risk factors (those who don't subscribe can access the free preview French Bank Run Forensic Thoughts - pubic preview for Blog). This bank has proven to be an exceptional short candidate that has (and still is) throwing off extranormal returns for everyone who moved on the research on a timely basis. The bank's price movement was pertinent due to the acute stress that Italy was experiencing, stress that we warned of thoroughly a year in advance - please reference Italian Bank Problems Now At The Forefront. It is now apparent to the markets in general that several French banks are at risk, and in no small part due to Italy's woes.

The EU has implemented several mechanisms to stem Italy's financial fall, including having the ECB outright purchase Italian debt on the secondary market (charter prevents primary market direct purchases). Alas, this artificial manipulation of market forces tends to have an increasingly short half life as was explained in my piece a few weeks back, ECB As European Lender Of Last Resort = Institutional Purveryor Of A Pan-European Ponzi Scheme

All in all, I believe we were in the forefront of anticipating the breadth, depth and speed of the European debt contagion, which brings us to where we are right now, as per Bloomberg's article on the topic this morning: Italy Tests Appetite for Debt When ECB Is Absent

“This is where the litmus test comes, the test to see whether the ECB’s buying power can hold yields where they are,”said Shahid Ikram, head of sovereigns at London-based Aviva Investors, which has some of its $440 billion of assets invested in Italian bonds. “From a risk-return perspective, there’s a great deal of uncertainty. You are going to see more volatility in the Italian yield, some concession will be required and then it’s just a case of what real demand there is.”

The ECB began buying Spanish and Italian government bonds on Aug. 8 to stop the debt crisis from spreading to the euro-region’s third- and fourth-biggest economies. The purchases brought the nations’ 10-year bond yields down to about 5 percent from euro-era records, even as Europe’s leaders disagreed over how to contain the turmoil.

‘Huge Volatility’

Italian 10-year bonds yield 5.09 percent, after reaching a euro-era record 6.40 percent on Aug. 5 and sliding more than one percentage point to 5.02 percent in the five trading days after the ECB began buying. Both Aviva’s Ikram and Werner Fey, a fund manager at Frankfurt Trust Investment GmbH in Frankfurt, which oversees about 6.5 billion euros of fixed-income assets, said they won’t be buying at this Italian auction.

“The problem for fund managers is that there is huge volatility and big event risk,” Fey said. “The politicians are not coming up with a solution. There’s a risk the ECB may end its program and there will be a massive hit on Italian paper. You cannot exclude that the market will test the Italian bond yield highs again.”

At the most recent auction on July 28, the 10-year yield demanded by investors climbed to 5.77 percent from 4.94 percent a month earlier. That compares with 4.73 percent at a May 30 sale, while the average yield at three auctions prior to May was 4.83 percent, according to Bloomberg data.

The half-life of ECB interevention is ever so fleeting. Already the ECB buying of Italian bond seems to have reached a point of diminishing returns. Italian 10-year bond yield rose approximately 16 bp this past week and at 5.09% is at a two week high, a high that was broken only by direct ECB intervention. The key question is what happens when the artificial 3rd party that is ECB liquidity it steps away?

Financial Contagion vs. Economic Contagion: Does the Market Underestimate the Effects of the Latter? posted a full year and a half ago in March 2010 (yes, these issues were easily foreseen):

Many countries in the Eurozone will have to do some serious belt tightening, and I don't mean just the current whipping boys of the media and red bull juiced CDS traders either (from The Coming Pan-European Sovereign Debt Crisis, Pt 4: The Spread to Western European Countries):

Expected higher fiscal deficit and bond maturities due in 2010 have increased the need for bond auction financing for all major European economies. Amongst all major European economies, France and Italy have the  highest roll over debt due for 2010 of €281,585 million and €243,586 million, respectively.


For those who think Italy may be having some problems, you see who has a heavier burden to carry...

... However, the recent spate of bond auction failures across Europe is forcing governments to increase premiums on new bond auctions (higher yields), which in turn is resulting in a decline in existing bond prices.

As previously stated, Italy's problems were evident as far back as the beginning of 2010...

PIIGS - A troublesome area


So, pray tell, what happens when austerity measures hit these countries that need to reign in the debt from the (I say current, others say past) financial crisis by raising taxes, cutting services, firing state workers either outright or through attrition and reducing wages. The quick answer: lower aggregate demand for goods and services. Raise the price (through taxation), lower the demand. Lower income and wealth (through taxation, layoffs and wage decreases) and you lower demand as well.

Greece Reports: "Circular Reasoning Works Because Circular Reasoning Works" - Or - Here Comes That Default!!!

The Bull Argument For Europe Is Credible, Except For The Circular Argument: You Can't Solve Debt Problems With More Debt!!!

Italy has close to a quarter trillion euros of bonds maturing around now and another $352 bln maturing next year. The market has already soured on Italy's need to raise so much capital and has punished it through rate increases. The ECB already holds an estimated 20% of Greek, Portugal and Irish outstanding bonds yet it has jumped on the Italian bond buying bandwagon as well. It is doubtful that it has the political will to do the same for Italy and Spain, and even if it did it may not have the financial will to politically monetize the guaranteed losses it will endure. Just take a look at the losses it took on Greek bonds last year, before they really tanked...


The same hypothetical leveraged positions expressed as a percentage gain or loss…


One should doubt that the new EFSF is likely to be large enough to rescue all of insolvent Europe without the necessary debt destruction taking place.

Knowing that Italy's CDS price levels remain elevated despite ECB assistance should be telling. They are less than their peak, but still high enough to denote distrust and concern among market participants. This is not a bright start for the amount of debt that Italy needs to sell in the near future.

Back to the Bloomberg article... 

Italy had 1.6 trillion euros of debt at the end of last year, according to its debt management office, making it Europe’s biggest national bond market. The ECB may have to buy as much as 5 percent of outstanding debt over about 30 weeks to keep borrowing costs at 5 percent, according Kornelius Purps, a strategist at UniCredit SpA in Munich.

This is one of the most telling portions of the Bloomberg!

When the central bank began its bond program on May 10, 2010 -- buying 16.5 billion euros of government securities in a bid to support the Greek market -- Greece’s 10-year bond yields fell more than 4.5 percentage points to 7.77 percent. Ten weeks later, as the ECB’s spending dwindled to 176 million euros, Greek bond yields climbed to 10.43 percent. They reached as much as 18.18 percent today.

Again, this is a snapshot of the ECB losses before the Greek bonds tanked that much...


Just imagine where the losses stand now. Even more telling is that although we know the ECB can't truly go broke since it owns the inkjet brigade, the same cannot be said for the many private banks that are stuffed to the gills with this stuff.

This is the entire European "Catch 22". You see, the only way out is debt destruction yet most European banks are sitting on this stuff as risk free collateral marked at par - leveraged 30x or more! Debt destruction is tantamount to Europank bank destruction, yet the only out of this malaise is through debt destruction. See Is Another Banking Crisis Inevitable?

Impact of bank’s banking books on haircuts

EU banking book sovereign exposures are about five times larger than trading book. The table below gives sovereign exposure of major European countries for both trading and banking book. The EU trading book has €335bn of exposure while banking book has €1.7t exposure towards sovereign defaults. EU stress test estimated total write-down’s of €26bn as it only considered banks trading portfolio. This equated to implied haircut of 7.9% on trading portfolio with losses equating to 2.4% of Tier 1 capital. However, if the same haircuts (7.9% weighted average haircut) are applied to banking book then the loss would amount to €153bn equating to 13.8% of Tier 1 capital.

The aforelinked Bloomberg article even goes on to say more of the same...

ECB Support

The bond-buying program didn't provide enough support to prevent Ireland and Portugal following Greece in requesting financial aid. Ireland’s 10-year yields fell to 4.72 percent on May 10, 2010, the day the ECB began buying, from 5.86 percent the previous trading day. They had climbed to 8.9 percent by Nov. 11, the week before the nation requested aid.

Portugal requested a bailout on April 6 this year as its 10-year yields surpassed 8 percent even after the ECB had spent 77 billion euros on government debt. Its yields climbed to a record 13.44 percent on July 11 as the central bank took a five-month pause from bond buying.

“The risk is that the ECB stays out of the market, yield spreads widen significantly and then trading out of Italy is a challenge,” said David Schnautz, a fixed-income strategist at Commerzbank AG in London. “There’s a decent risk that investors will have to buckle up for a yield increase above 6 percent.”

Deficit Measures

ECB President Jean-Claude Trichet wrote to Italian Prime Minister Silvio Berlusconi demanding more deficit measures in return for buying the country’s bonds. To win ECB support, Italian politicians approved the second austerity package in a month on Aug. 12, aiming to balance the budget in 2013.

That’s a tall order, said Eric Wand, a bond strategist at Lloyds Bank Corporate Markets in London, because the global economic outlook is deteriorating. Italy’s debt stands at about 120 percent of its gross domestic product, the biggest ratio in Europe after Greece, whose fiscal woes sparked the sovereign crisis.

...The yield difference, or spread, between Italian 10-year securities and similar-maturity German bunds is about 2.9 percentage points, compared with a five-year average of about 0.9 points.

“If you believe that the ECB will be able and willing to keep up the support then this is a fantastic bond to buy,” saidLuca Jellinek, London-based head of European rate strategy at Credit Agricole Corporate & Investment Bank. “There’s no reason to believe that the ECB lacks resolve, but it’s risky. It’s a guess.”

This is not about the ECB lacking resolve, it's about the ECB not being able to outright override the dictum of global markets and solving the world's problem by buying a bunch of overpriced debt. Then again, maybe the ECB will do better with the much larger and difficult to handle markets of Italy as compared with the much smaller and theoretically much more manipulable Greek, Portuguese and Irish markets. After all, you read how successful the ECB has been in sustainably suppressing the borrowing rates of these countries.

Well, that's neither here nore there, since Italy will be going to Mother Market without the explicit aid of the ECB very soon to test its desirabiliy among global bond buyers. The question is, will they be well accepted? If they are not, then the question of contagion quickly comes back to the forefront, and more importantly BoomBustBloggers will be well prepared to act on such.

Remember, we have identified one of the large American banks most susceptible to an Italian bond failure - by way of contagion

Subscribers are urged to download and reread File Icon Actionable Note on US Bank/French Bank Run Contagion after reading:

File Icon French Bank Run Forensic Thoughts - Retail Valuation Note
File Icon Bank Run Liquidity Candidate Forensic Opinion (the extensive professional note version of the document above)
File Icon The Contagion Prone US Bank Forensic Review - Retail
File Icon The Contagion Prone US Bank Forensic Review - Professional

Informative reading for all...

  1. Eurocalypse Trading Update 8/17/2011 - US Markets, CRE and Fixed Income

    ... zone. On bunds, the German debt, there is still this joker that it is suddenly rerated as bad as PIIGS if Merkel gives in to support Italyand Spain (which she has shown she is thus far refusing to do ... Wednesday, 17 August 2011

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    ... zone. On bunds, the German debt, there is still this joker that it is suddenly rerated as bad as PIIGS if Merkel gives in to support Italyand Spain (which she has shown she is thus far refusing to do ... Wednesday, 17 August 2011

  3. The French Government Creates A Bank Run? Here I Prove A Run On A French Bank Is Justified And Likely

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  4. SocGen CEO Dismisses Rumors, Says France Is Not US - He's Right, But It May Be Worse And Bank Run Can't Be Ruled Out!!!

    ... Spain, Italy and Portugal. In its interim management statement, published in April, Barclays reported a wholesale exposure to Spain of £6.4bn, compared with £7.2bn last June, while its exposure to Italy ... Wednesday, 10 August 2011

  5. Just As Predicted Over The Past Month, The French Bank Run Seems To Have Commenced

    Attention subscribers! The French Bank run has BEGUN! Below is grab of the CDS chart of just one our subject banks as run candidate featured in the subscriber document, Italy Exposure Producing Bank Risk... ... Wednesday, 10 August 2011

  6. Game Over For The European Ponzi Scheme? Monetizing Pan-European Sophisticated Ignorance Via US Options, Part 1 For Retail and Professional Realists... delta hedge), as its 2010 lows was the target and were oversold in daily. seems to be big govt intervention now. weve seen BOJ on the ccy markets. ZH headlines about cancelling auctions in Italy, short ... Thursday, 04 August 2011

  7. Trading the BoomBustBlog Forensics: Observations From The Field... the “PIIGS” – Portugal, Ireland, Italy, Greece and Spain – fell 70 per cent to €3.7bn over the same period. ... Stefan Krause, Deutsche’s chief financial officer, linked the dramatic reduction in Italy ... Tuesday, 02 August 2011

  8. On Your Mark, Get Set, (Bank) Run! The Dominos of Serial Lehman 2.0 (x 4) In The EU Are Falling Into Place At A Quickening Pace... among banks with large exposures to the troubled European countries Greece, Ireland, Spain, Italy and Portugal. ... One source said it was “inevitable” that British banks would look to minimise their ... Monday, 01 August 2011

  9. Observations Of French Markets From A Trader's Perspective... of the bigger credit players are drawing conclusions similar to those espoused in the BoomBustBlog subscription documents regarding Italy and the path of contagion. Posts of relevance: The Mechanics ... Friday, 29 July 2011

  1. The Mechanics Behind Setting Up A Potential European Bank Run Trade

    This is the introductory post to a series of trade setups for the Bank At Risk featured in the subscription document Italy Exposure Producing Bank Risk. These trade setups are for professional and institutional ... Thursday, 28 July 2011

  2. Let's Walk The Path Of A Potential Pan-European Bank Run, Then Construct Trades To Profit From Such

    ... Popolare shares were off 5 percent. This comes a week after releasing the very informative subscritpion document Italy Exposure Producing Bank Risk and a series of blog posts leading astute followers ... Wednesday, 27 July 2011

  3. The Anatomy Of A European Bank Run: Look At The Banking Situation BEFORE The Run Occurs!

    ... Spain, Italy and Portugal. In its interim management statement, published in April, Barclays reported a wholesale exposure to Spain of £6.4bn, compared with £7.2bn last June, while its exposure to Italy ... Saturday, 23 July 2011

  4. The Fuel Behind Institutional “Runs on the Bank” Burns Through Europe, Lehman-Style!

    ... that Europe's debt crisis could engulf the much bigger economies of Spain and Italy. Greece, Portugal and Ireland have already succumbed. The draft summit statement obtained by Reuters showed the EFSF ... Thursday, 21 July 2011

  5. Now That We All Agree Greece Will Default, What Happens As A Result?

    ... bank may compromise and allow a temporary Greek default as officials scramble to fix a sovereign debt crisis that’s spreading to Italyand Spain before a leaders’ summit in two days. As Spanish financing ... Tuesday, 19 July 2011

  6. Didn't Anyone Notice The Seemingly Irreparable Damage To The Eurozone Last Week? Global Short Ban, Here We Come!

    Guest Post: An (important) point regarding the Eurocalypse... italy_10_yearWhen last week's Italian 10Y surged from 5% to 6%, it marked something irreparable, which was not indicated in the extent of ... Tuesday, 19 July 2011

  7. Eighteen Percent of the EU is Literally Junk, Carried As Risk Free Assets at Par Using 30x+ Leverage: Bank Collapse is Inevitable!!!

    ... a solution to the contagion that’s threatening to spread to Italy from the so-called peripheral euro-area states. Ireland’s debt agency said the downgrade will make it “more difficult” for Ireland ... Wednesday, 13 July 2011

  8. Italian Bank Problems Now At The Forefront

    ... our European bank and soveriegn research from last year. Italy public finances projection Italian Banking Macro-Fundamental Discussion Note Of note, please look at the charts from Mish.  ... Monday, 11 July 2011

  9. Click, Clack, Click: The Sound of Falling Dominoes Behind The Door of the Eurocalypse!

    ... cut its exposure in recent months as senior managers have become increasingly concerned about developments among banks with large exposures to the troubled European countries Greece, Ireland, Spain, Italy ... Sunday, 19 June 2011

  10. Over A Year After Being Dismissed As Sensationalist For Questioning the ECB's Continued Solvency After Sovereign Debt Buying Binge, Guess What!

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