European Contagion Spreads; Is This Rational?
Here are two stories that I have picked up on in the last hour that demonstrate how contagion spreads during a panic. Both stories involved the strongest of actors within the Eurozone.
The first story is from Spain. The Wall Street Journal is reporting that the Spanish bank Banco Bilbao Vizcaya Argentaria (BBVA) is having a difficult time funding itself in the US commercial paper market. Moreover, according to the Journal this has been going on for some time – since the beginning of the month. The amount is small ($1 billion) given BBVA’s large balance sheet which is almost $700 billion, the same as when the crisis started in 2007. And BBVA is widely seen, along with Banco Santander, as the healthiest institution in Spanish banking. Their having problems rolling over paper speaks to the panic of CP buyers, in my view. But the commercial paper market has also been a major source of bank runs since the credit crisis began and this has to be seen by authorities in the US and Europe as a signal of liquidity problems.
The second story involves the German state. Bloomberg has reported that the auction of German five-year notes only received a bid-to-cover ratio of 1.1, as close as you can get to a failed auction (hat tip Scott). Moreover, this was the worst showing since March 2008 when Bear Stearns was having funding problems in the CP market. You have to see this as connected to the commercial paper funding problems of BBVA since Germany is considered the standard setter for sovereign debt in the Eurozone.
In any event, German bund yields are exceedingly low as there has been a flight to safety in global markets. So while the Bund story is remarkable, Germany could have received a higher bid cover had it offered a lightly higher yield on its bonds.
What do I make of this? For starters, I don’t think it is entirely rational because the two entities I identified are the strongest in their respective markets. These stories have all the hallmark of panic. Yet, it speaks to a certain Eurozone debt revulsion that is now widespread.
Moreover, Germany does have the hidden exposure of the Landesbanks who have been speculating recklessly in Spanish and US property, Greek sovereign debt and US subprime. That’s what my GMAC/HRE post last summer was about. I don’t think the Germans really understand the interconnectedness. Their banks have exposure everywhere. This is where the contagion comes from much as it did in 1931 – via the interlocking global financial arrangements.
Sources
Europe-Bank Lenders? Coalition of Unwilling – WSJ.com
German 5-Year Auction Draws Least Demand Since 2008 – Bloomberg (no link yet)
hi ed — i think liquidity is in ample supply, even dollar liquidity thru fed forex swaps. the holdup is the punitive rate — once LIBOR gets up to ECB window rate banks will access, but right now its cheaper interbank. there’s no forced selling thanks to liquidity unwinding.
at best i think what’s gone on is a carry trade unwind sparked by sovereign downgrades. banks fund cheaply thru central banks and invest in euro sovereigns. when ratings downgrades hit and/or solvency is questioned, those trades can unwind messily — ie, sovereign volatility can compel large carry trade unwinds.
but — unlike september 2008, particularly in the shadow system — the banks themselves (including BBVA) are in no danger of going unfunded. incrementally higher rates for funding up to ECB discount window rate? sure. but that’s all.
IMO if ECB cuts its policy rate 50bps the whole unwind could rewind pretty quickly.
and then we’d simply await spanish sovereign debt downgrades for the next carry trade panic.
that’s also why, IMO, bunds had a spot of trouble — yield too low vis-a-vis funding rate to make carry a great idea.
Claus has a post out about people using the Euro as a cary trade vehicle. Still thinking through the implications.
Calling Banco Bilbao Vizcaya Argentaria one of the strongest Spanish banking institutions is like calling the queen ant a symbol of royalty. While it may be true, it is still an ant.
Take the loan loss reserve as a percentage of total loans (all at year end)
2005 – 2.24%
2006 – 2.30%
2007 – 2.12%
2008 – 2.03%
2009 – 2.54%
Looks good until you look at non performing assets
2005 – .94%
2006 – .89%
2007 – 1.00%
2008 – 2.31%
2009 – 4.42%
Notice the ratio difference!! To get back to 2005 levels BBVA would need to write down 27.6 billion euros. (total equity is 30.7 billion euros and tangible equity is less than 20 billion) That would errase 2009 operating income 2x over!! Okay so we don’t need to get back to the same ratio as 2005. Lets just get back to where the ratio is even. That would take a 7 billion euro writedown!!
The bank also has 200 billion euros of loans in Spain and Portugal. Lets imagine what those are really worth.
The likilhood of BBVA and even Banco Santander which has the privilege of having huge exposure to Great Britain (everyone talks about the banks Brazil exposure but Great Britain exposure is almost 4x larger) needing massive capital injections or nationalization seems high.
marketseer I am with you on the fact that there is something wrong with BBVA and Santander’s reserving. And I have been waiting for two years now to be proven right. (See “Santander: US, Spanish and UK mortgage exposure”):
https://pro.creditwritedowns.com/2008/04/santander-us-spanish-and-uk-mortgage.html
John Hempton has pointed the under-reserving out with detailed accounting in the past (see “Are the Spanish banks hiding their losses?”)
https://brontecapital.blogspot.com/2009/10/are-spanish-banks-hiding-their-losses.html
But, I do think they can get through this just like JPMorgan Chase or HSBC. Not every bank will crumble to the ground.
Fair enough – but even JP Morgan and HSBC may have not made it on their own without the United States and British government backstoping the financial system. To much coupling within the system which when you get down to it, is one of the very core problems of the system. Whether you agree or disagree with the decision (a seperate discussion) the United States had the soverign balance sheet flexibility to make that an option. Spain does not have near the flexibility. Until they get this backstop or miracles happen and their balance sheet is magically repaired, it is not surprising they would have trouble raising $1 billion in commercial paper. Personally, I think a better comparison would be like a Morgan Stanley or even General Electric who made it but would not have made it without government support. (General Electric I think is a good comparison because of how much intervention the government did in the commercial paper market)