Thursday, 03 June 2010 10:43

The Equity Markets Are Ignoring Screams of FUD (Fear, Uncertainty and Doubt) in the European Money and Credit Markets: Enter Lehman Fiasco v2.0!!!

For those who have been following me in the Asset Securitization and Pan-European Sovereign Debt Crisis series this may be old news, but let's go through the exercise anyway. It looks as if we are back to those non-sense games being played by those that manipulate the market. Taking a look at Bloomberg.com's front page, you'll see "Stocks, U.S. Futures Rally on Economic Outlook; Yen Weakens, Bonds Decline" (hey, good times are here again) followed directly by "Banks Deposit Record $394 Billion With ECB, Avoiding Loans to One Another"(hey, isn't this the exact same environment wherein Bear Stearns, then Lehman Brothers collapsed leading the Treasury Secretary Hank Paulson to proclaim the end of the financial world was coming?). Then there's "Covered Bond Sales Surge; Transocean Tumbles: Credit Markets": Sales of covered bonds are accelerating as investors seek debt backed by collateral amid concern about the creditworthiness of governments and banks.

Okay, let's take this by the numbers....

Banks Deposit Record $394 Billion With ECB, Avoiding Loans to One Another

June 3 (Bloomberg) -- Overnight deposits with the European Central Bank rose to a record yesterday as the sovereign debt crisis made banks wary of lending to each other.

Banks lodged 320.4 billion euros ($394 billion) in the ECB’s overnight deposit facility at 0.25 percent, compared with 316.4 billion euros the previous day, the Frankfurt-based central bank said in a market notice today. That’s the most since the start of the euro currency in 1999. Deposits have exceeded 300 billion euros for the past five days.

Banks are parking cash with the ECB amid investor concern that a 750 billion-euro European rescue package may not be enough to stop the crisis from spreading and spilling into the banking industry. The ECB said on May 31 that banks will have to write off more loans this year than in 2009 and their ability to sell bonds may be hampered as governments seek to finance fiscal deficits.

“The banking crisis is back,” said Norbert Aul, an interest-rate strategist at Commerzbank AG in London. “The news flow over the past few weeks has spooked banks and since nobody knows how exposed individual financial institutions are, it’s deemed safer to park cash with the ECB rather than lend it on.”

This is not just FUD (fear, uncertainty and doubt), the banks KNOW that their peers are walking, talking time bombs. Let's reference the situation in the US with The Next Step in the Bank Implosion Cycle???

So, How are Banks Entangled in the Mother of All Carry Trades?

Trading revenues for U.S Commercial banks have witnessed robust growth since 4Q08 on back of higher (although of late declining) bid-ask spreads and fewer write-downs on investment portfolios. According to the Office of the Comptroller of the Currency, commercial banks' reported trading revenues rose to a record $5.2 bn in 2Q09, which is extreme (to say the least) compared to $1.6 bn in 2Q08 and average of $802 mn in past 8 quarters.

bank_trading_revenue.png

High dependency on Forex and interest rate contracts

Continued growth in trading revenues on back of growth in overall derivative contracts, (especially for interest rate and foreign exchange contracts) has raised doubt on the sustainability of revenues over hear at the BoomBustBlog analyst lab. According to the Office of the Comptroller of the Currency, notional amount of derivatives contracts of U.S Commercial banks grew at a CAGR of 20.5% to $203 trillion by 2Q-09 from $87.9 trillion in 2004 with interest rate contracts and foreign exchange contracts comprising a substantial 84.5% and 7.5% of total notional value of derivatives, respectively. Interest rate contracts have grown at a CAGR of 20.1% to $171.9 trillion between 4Q-04 to 2Q-09 while Forex contracts have grown at a CAGR of 13.4% to $15.2 trillion between 4Q-04 to 2Q-09.

In terms of absolute dollar exposure, JP Morgan has the largest exposure towards both Interest rate and Forex contracts with notional value of interest rate contracts at $64.6 trillion and Forex contracts at $6.2 trillion exposing itself to volatile changes in both interest rates and currency movements (non-subscribers should reference An Independent Look into JP Morgan, while subscribers should referenceFile IconJPM Report (Subscription-only) Final - Professional, and File Icon JPM Forensic Report (Subscription-only) Final- Retail). However, Goldman Sachs with interest rate contracts to total assets at 318.x and Forex contracts to total assets at 11.2x has the largest relative exposure (see Goldman Sachs Q2 2009 Pre-announcement opinion Goldman Sachs Q2 2009 Pre-announcement opinion 2009-07-13 00:08:57 920.92 KbGoldman Sachs Stress Test Professional Goldman Sachs Stress Test Professional 2009-04-20 10:06:45 4.04 Mb, Goldman Sachs Stress Test Retail Goldman Sachs Stress Test Retail 2009-04-20 10:08:06 720.25 Kb,). As subscribers can see from the afore-linked analysis, Goldman is trading at an extreme premium from a risk adjusted book value perspective.

bank_forex_exposure.png

As a result of a surge in interest rate and Forex contracts, dependency on revenues from these products has increased substantially and has in turn been a source of considerable volatility to total revenues. As of 2Q-09 combined trading revenues (cash and off balance sheet exposure) from Interest rate and Forex for JP Morgan stood at $2.4 trillion, or 9.5% of the total revenues while the same for GS and BAC (subscribers, see BAC Swap exposure_011009 BAC Swap exposure_011009 2009-10-15 01:02:21 279.76 Kb) stood at $(196) million and $433 million, respectively. As can be seen, Goldman's trading teams are not nearly as infallible as urban myth makes them out to be.

bank_ficc_trading_revenue.png

Although JP Morgan's exposure to interest rate contracts has declined to $64.5 trillion as of 2Q09 from $75.2 trillion as of 3Q07, trading revenues from Interest rate contracts (cash and off balance sheet position) have witnessed a significant volatility spike and have increased marginally to $1,512 in 2Q09 compared with $1,496 in 3Q07. Although JPM's Forex exposure has decreased from its peak of $8.2 trillion in 3Q08, at $3.2 trillion in 2Q09 the exposure is still is higher than 3Q07 levels. Even for Bank of America and Citi , the revenues from Interest rate and forex products have been volatile despite a moderate reduction in overall exposure. With top 5 banks having about 97% market share of the total banking industry notional amounts as of June 30, 2009, the revenues from trading activities for these banks are practically guaranteed to be highly volatile in the event of significant market disruption - a disruption aptly described by the esteemed Professor Roubini as a rush to the exit in the "Mother of All Carry Trades" as the largest macro experiment in the history of this country starts to unwind, or even if the participants in this carry trade think it is about to start to unwind.

We are talking a fair amount of exposure here. Do you remember my favorite JPM grapic from  An Independent Look into JP Morgan.

Click graph to enlarge

image001.png

Cute graphic above, eh? There is plenty of this in the public preview. When considering the staggering level of derivatives employed by JPM, it is frightening to even consider the fact that the quality of JPM's derivative exposure is even worse than Bear Stearns and Lehman‘s derivative portfolio just prior to their fall.Total net derivative exposure rated below BBB and below for JP Morgan currently stands at 35.4% while the same stood at 17.0% for Bear Stearns (February 2008) and 9.2% for Lehman (May 2008). We all know what happened to Bear Stearns and Lehman Brothers, don't we??? I warned all about Bear Stearns (Is this the Breaking of the Bear?: On Sunday, 27 January 2008) and Lehman ("Is Lehman really a lemming in disguise?": On February 20th, 2008) months before their collapse by taking a close, unbiased look at their balance sheet. Both of these companies were rated investment grade at the time, just like "you know  who". Now, I am not saying JPM is about to collapse, since it is one of the anointed ones chosen by the government and guaranteed not to fail – unlike Bear Stearns and Lehman Brothers, and it is (after all) investment grade rated. Who would you put your faith in, the big ratings agencies or your favorite blogger? Then again, if it acts like a duck, walks like a duck, and quacks like a duck, is it a chicken??? I'll leave the rest up for my readers to decide.

If you had to take a guess, who do you think those European banks have hedged their exposure with??? Once it comes to the safety and "record profits" of the big banks, ie. JP Morgan, et. al., all I can say is Don't Believe the Hype!The potential blow up has the capability both reaching the Bourgeuois and rocking the boulevard, as my man Chuck D so eloquently put it. Now, back to the Bloomberg article...

Tensions

Money market tensions are resurfacing even after the ECB started buying government bonds and said it would offer banks as much cash as they want for up to six months. The measures accompanied the European Union rescue package, agreed on May 10, to counter the worsening debt crisis and promises by Greece, Spain and Portugal to rein in their budget gaps.

Hmmm, why would these Euro banks be so skitttish, untrusting (unstrustworthy) and shy even with an explicit, unlimited, and direct indemnification and subsidy from the ECB? Let me count the ways....

  1. Smoking Swap Guns Are Beginning to Litter EuroLand, Sovereign Debt Buyer Beware!
  2. Financial Contagion vs. Economic Contagion: Does the Market Underestimate the Effects of the Latter?
  3. Lies, Damn Lies, and Sovereign Truths: Why the Euro is Destined to Collapse!
  4. As I Explicitly Forwarned, Greece Is Well On Its Way To Default, and Previously Published Numbers Were Waaaayyy Too Optimistic!
  5. How Greece Killed Its Own Banks!
  6. Introducing The BoomBustBlog Sovereign Contagion Model: Thus far, it has been right on the money for 5 months straight!
  7. With Europe’s First Real Test of Contagion Quarrantine Failing, BoomBustBloggers Should Doubt the Existence of a Vaccination
  8. What We Know About the Pan European Bailout Thus Far
  9. As I Warned Yesterday, It Appears the Market Is Calling the Europeans Bluff – It’s Now Put Up Or Get Put Down
  10. How the US Has Perfected the Use of Economic Imperialism Through the European Union!
  11. PIIGSlets in a Bank: Another European Banks-at-Risk Actionable Research Note
  12. Sovereign debt exposure of Insurers and Reinsurers
  13. With the Euro Disintegrating, You Can Calculate Your Haircuts Here”
  14. What is the Most Likely Scenario in the Greek Debt Fiasco? Restructuring Via Extension of Maturity Dates

Money market rates are rising, with the euro interbank offered rate, or Euribor, for three-month loans yesterday increasing to 0.704 percent, the highest this year. Banks borrowed 9 million euros from the ECB at the marginal rate of 1.75 percent, the central bank said today.

The efforts by the EU and the ECB failed to allay investor concerns. Fitch Ratings lowered the credit grade of Spain, the euro area’s fourth largest economy, to AA+ from AAA on May 28. Standard & Poor’s in April cut Greece’s debt to junk and lowered the ratings on Portugal and Spain.

Portuguese 10-year government bonds fell today, increasing the premiuminvestors demand to hold the debt instead of benchmark German bunds.

The yield on the Portuguese security rose five basis points to 5.08 percent as of 8:56 a.m. in London. The spread over bunds widened six basis points to 231 basis points, according to Bloomberg generic data. Spain’s yield over Germany was unchanged at 177 basis points.

Speaking of Portugal, did you see those nasty McNasty haircuts???!!!

You think those are ugly? You ain’t seen nothing yet! See Introducing the Not So Stylish Portuguese Haircut Analysis. I will try to release the update Greece haircuts for subscribers today, and they are even uglier. In the process, there's a chance I'll release the overly optimistic edition (wherein the debt/GDP ratio was still over 140%, even with the haircuts) published earlier to the public. Check BoomBustBlog later on today and tomorrow for details.

Last modified on Saturday, 05 June 2010 06:10

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