Black Swan Insights

Showing posts with label debt crisis. Show all posts

Irish 5 Yr CDS On The Rise

Is there something brewing in Euro CDS land? While equity markets remained quite during another summer day, there were some interesting movements in European sovereign CDS with notable widening in Italian and Irish 5 Yr CDS. There has been no news that would account for the unusual movements so they are worth keeping an eye on. Of course if you are country like Italy with a debt to GDP ratio of 115%, it is just a matter of time before it all comes crashing down. Ireland too is in trouble and is one failed bond auction away from ending up like Greece.

Entity Name       5 Yr      Mid Change (%)       Change (bps)       CPD (%)

Italy                 197.67         +9.66                          +17.41               15.75

Ireland             303.23         +6.80                          +19.30               22.80

Germany           47.34         +5.36                             +2.41                 4.04

Greece           847.95          +3.51                          +28.79                51.00

Source: CMA Datavision

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A glimpse into Europe's Bank Stress Test Scenarios

Bloomberg has an article which outlines the the 3 scenarios involved in the European bank stress tests, which are looking more and more like a complete sham. The scenarios will simulate banks 2011 tier 1 capital assuming a yet undisclosed benchmark scenario, an adverse(recession), and a "sovereign shock," but not a sovereign default which kind of defeats the purpose. After all the threat to the European banks is not losses on corporate and real estate debt (just lie about that), but a default by Greece, Ireland, Spain, Portugal, and most of eastern Europe. But of course these stress tests are meant to be easy as possible for the banks to pass so that Europe can claim they have a "strong and healthy" banking system. The article goes on to state how the banks will have to account for sovereign debt losses:

Under accounting rules, banks have to adjust the value of sovereign bonds held in the trading book according to changes in market prices, said Konrad Becker, a financial analyst at Merck Finck & Co. in Munich. For government debt held in the banking book, lenders must write down their value only if there is serious doubt about a state’s ability to repay its debt in full or make interest payments, he said.

No problem here for the major European banks--just transfer all of your sovereign debt into your banking book and repeat the EU's proclamation that no European country will ever default. So in the case of Greece you simply take a 1-2% haircut even though those 4% 10 year bonds you bought in 2008 are now yielding 10%. Under the EU's worst case sovereign shock scenario banks would have to:

assume that rising government-bond yields will push up borrowing costs, spurring defaults in the private sector that would lead to losses in lenders’ banking books, said the person.

The real question is whether this charade will be enough to fool the market as it did in the US. Remember how American banks magically went from bankrupt institutions (in Fed-March 2009) to superior companies which were able to raise 100's of billions in new capital (by June-July 2009). We shall see.

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Euro plunges on Portugal Downgrade

Well it was only a matter of time and today it occurred. Fitch downgraded the debt of Portugal from AA to AA-. Fitch cited the usual generic boilerplate reasons such as weak fiscal position blah blah blah (they could say this about every G-8 country). Apparently this took the markets by shock which sent the Euro below 1.35 against the dollar. The reason for this movement in EUR/USD is the anticipation that Moody's and S&P will also issue downgrades. Fitch is usually the first one, which then puts peer pressure on the other two. I am still surprised the ratings agencies have such power after their previous failures in the US housing market.

Right now the EURO looks like an easy short because these fiscal problems in Europe will continue for the next few years. But take a look at the most recent COT report.

You will see that the big speculators are heavily short. It has been at extreme levels for the last few weeks. This is obviously a crowded trade which could precipitate a large short squeeze on any good news out of Europe. Believe or not the idea that Greece could get assistance from the IMF (as has been reported) would actually be good for the Euro. They would be able to successfully externalize the costs to an outside party. The commericals are now long the euro. This sets up a potentially dangerous position where one side is going to be wrong and get taken to the cleaners. This will result in high volatility in the pair. While I do not know which way it is going, I am thinking about going into the FX options market and buying a straddle position to bet on the volatility.

One last thought to consider. The EU leaders love a weak currency and have a strong incentive to make sure the EURO stays low against the dollar. This will benefit their exports (mainly Germany) in world markets. Trichet will help this process along by not raising rates at least through 2010.

Be careful trading.

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