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Tuesday Review: Hidden Credit Stress Escalates

  • Written by Syndicated Publisher 35 Comments35 Comments Comments
    November 23, 2011

    Little different Market Recap today but the news flow once again has been rather impressive and keeping track of it rather difficult. If you can put it all together though beyond all the noise and nonsense being discussed the underlying investment theme becomes a lot clearer.

    Key News Events

    The expanded IMF liquidity facility has been approved by only a fraction of the member states and limits a country’s ability to borrow to rather small levels, far below the headline of $750 billion. If you were waiting for that bazooka instead you got the “trial balloon” today with little if any substance.

    The five year treasury yield fell to .94% a historic low with a 3.15 bid to cover ($3.15 submitted for every $1 in bonds sold) during today’s treasury auction as another sign of the high demand for “risk free” assets.

    Highly rated countries like Austria and Belgium are now seeing their yields rise as contagion beyond the PIIGS has truly begun. If and when Germany and France are forced to recapitalize their banks it is highly probable the ratings agencies will downgrade them leaving no one with a AAA rating in the EU to backstop anyone.

    The Spanish yield curve inverted with 2 year yields now higher than 10 year yields while Italy is close to inverting (source ZeroHedge and PIMCO). In simple economic terms recession is at hand in those countries at the same time the credit markets and EU are demanding less government spending and rising taxes via austerity. Although this step is necessary, at this critical juncture it will simply compound the problems and truly make this one of solvency and not liquidity.

    From Bloomberg

    “Spain paid more than Greece and Portugal to sell three-month bills as the newly elected People’s Party called for a European agreement to “save” the nation’s debt, saying the country can’t afford 7 percent interest rates.

    Spain’s three-month borrowing costs doubled as it sold bills at an average yield of 5.11 percent, more than twice the rate at the previous auction a month ago. The Treasury paid more than the 4.63 percent for 13-week bills sold Nov. 15 by Greece, which received a European Union-led bailout last year. Portugal paid 4.895 percent on three-month bills the following day.”

    From Reuters

    “Euro zone banks’ demand for European Central Bank funding surged to a two-year high on Tuesday, as fast spreading sovereign debt worries left lending markets virtually frozen and the ECB the only available funding option for many institutions.

    The ECB’s weekly, limit-free handout of funding underscored the widespread problems on Tuesday with 178 banks requesting a total of 247 billion euros. The amount was the highest since mid-2009 and well above both the 220 billion expected by traders polled by Reuters on Monday and the 230 billion taken last week.

    Banks are now borrowing more than 500 billion euros but data shows almost two thirds of that money is being deposited back at the ECB, compared to around one third after the collapse of Lehman Brothers back in 2008.”

    Credit Market Stress

    I suspect many don’t fully appreciate what is meant by tightness in interbank lending facilities, how collateral quality affects repurchase agreements (repo) or what collateral calls mean. Here is an overly simplified explanation.

    The failure of MF Global highlights two important events (1) the breakdown of confidence and (2) the use of short term financing for long term assets.

    Event 1 – Breakdown Of Confidence

    “The futures market is a globally connected market and it is a key mechanism for farmers, metals miners, and metals fabricators (among others) to hedge their risk. Confidence in the futures market has been shaken. No one knows if their money is safe.” – Janet Travakoli

    Option and futures traders now and in reality all traders and investors need to wonder if their broker is next? $1.2 billion in client money was illegally used by MF Global to meet capital calls. That money has somehow vanished and is not coming back. Customers may get some money back but certainly not all.

    How do any of us know if our money is safe? Most likely MF was not the only one using short term debt to finance long term assets and then taking customer money to meet capital shortfalls. Do you know if your money is safe? No one does. Confidence is the backbone of any system and in the capital markets it has truly been shaken.

    Event 2 – Reliance On Short Term Financing

    MF Global used short term financing to buy long term debt with a product called repo to maturity. They would take Italian debt maturing in 2012 for example and pledge those bonds as collateral in the repo market. In other words MF would take for example $100 million in Italian bonds and use that as collateral to receive cash to pay for the bond. The counterparty accepting the collateral may lend for example 80 cents on the dollar or in this example $80 million.

    Now what if Italian debt falls in value. The counterparty now says I will only lend 70 cents on the dollar so you need to meet your “margin and or collateral call” with $10 million in new collateral. Remember the new structure would only lend $70 million against that $100 million in collateral. MF needed to make up the shortfall and apparently did not have the capital so they used client money.

    So what is happening now is counterparties are concerned there may be more MF’s out there and thus not lending through repo markets, no longer accepting sovereign debt as collateral, etc. The financial system relies on short term financing for the purchase of long term assets. When the financing disappears your only other option is to sell those assets and that is what we are witnessing across the globe.

    Bottom Line

    Retail investors have no idea what is going on behind the scenes. Few are privy to the reality of just how much stress there is within the market. You won’t see this in the ES futures or the price of AAPL stock but rather through various credit and currency markets. It is not a credit isolated event. It is not an MF isolated event. And it is certainly not an EU isolated event.

    There is far more to the equity markets right now than oversold or overbought RSI or triangle patterns. There is real stress. There is the unloading of assets to raise capital.

    2008 was about financial institutions assuring investors of the strength of their balance sheets while governments were there to backstop. Today it is about those same financials but now the guarantors as well. We are literally witnessing history as sovereign nations fight for their very economic independence and survival.

    Images: Flickr (licence attribution)

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