Merkel and Sarkozy have agreed to do something, details to follow, to keep the Euro banks from collapsing. Their new-found urgency arose from the imminent collapse of the Belgian financial services company Dexia, whose retail banking arm is holding bad debt. It will be carved up into a “good bank” and a “bad bank,” with the “bad bank” holding assets of nominal value ca. $130B.
Let me harp a little on the mechanism for the crisis. The banks are holding a combination of cash, mortgage derivatives, municipal bonds, corporate bonds, and national bonds, not to mention the odd dog or cat. These constitute their assets. They are required to hold a certain level of assets relative to liabilities to be considered solvent. Their profitability is based on the interest rate at which they can lend relative to the interest rate at which they can borrow.
If people are unemployed, as in the US, they can’t pay their mortgages, so those default at a higher rate. But the same risks apply to the other assets, even cash. If the dollar falls, and your obligations are denominated in Euros, you get squeezed. There’s been a big problem because many Eastern European mortgages are denominated in Swiss Francs. As the Swissy rises, those mortgages become more and more expensive to service.
The uncertainty in the value of assets means that it is much harder for banks to borrow cheaply. So, their profitability falls, which can threaten their solvency. In the US, we solved this problem by letting the banks borrow at essentially zero rates, so that any loans they made would be profitable–as long as the borrowers did not default. So, of course, the banks bought things like Treasuries and Agencies. Agencies are mostly Fannie and Freddie bonds, bundled US mortgages, which the US government offered to guarantee.
So, this brings us to the next shoe to drop. Asian and Middle Eastern investors are, according to the FT, “spooked” by the financial terrorism being practiced by Republicans in Congress. Which only goes to show that they are paying attention. Korea and Kuwait have pulled the ripcord on Agencies, and Japan is not going to buy any more. Brazil, Russia, India and China didn’t say anything: they just stopped buying. Yen-denominated debt issued by foreigners, so-called “samurai bonds” are also drying up.
Update: And another shoe has been identified: exposure of US banks to second mortgages, which John McDermott of FT Alphaville estimates at more than $70B over existing write-downs for just Citi, JPM, Wells Fargo, and Bank of America. If these are brought into default because of renewed recession/job loss, banks could be forced to re-capitalize.
The net upshot is that creditors want higher interest rates to compensate for increased risk on everything from Greek debt to Agencies to samurai bonds. If this happens, the value of assets held by banks declines, making them less well-capitalized, and therefore less able to lend. Interest rates go up. The economy slows down. Banks are in trouble.
But you see, there’s one more angle to all this. While conventional banks get burned by uncertainty, investment banks thrive on it. Like most retail investors, I have had a terrible investment year because productive assets like stocks have fallen. But in one area, I’ve done remarkably well. On a medium term volatility trade, called VIXM, I made an annualized profit of 64% (exclusive of taxes and commissions) by buying when the $VIX index was around 20 and selling when it hit 40. But on the short-term volatility trade, I made a 193% annualized profit by buying around 17 and selling around 48 (**). At the height of the 2008 crisis, VIX hit 80. Such supercharged profits are possible only when there is high volatility. Instead of owning a stock, take out insurance on it, and burn it to the ground.
The people who thrive on volatility need a crisis. If Merkel and Sarkozy are getting serious about solving Europe’s problems, a new crisis has to be ginned up. Republicans in Congress, whether knowingly or not, are contributing to volatility by making it seem as if they are willing to default on US debt. And in so doing, they are making a new crisis inevitable.
**Please note: I do not recommend VIXY and VIXM. ProShares takes a huge bite, and you have to watch these things minute-by-minute. During September, VIXY swung by 37%, while VIXM was more or less as volatile as the S&P. Also, please note that an annualized profit is very high because this all took place over a few months. The actual profit was much smaller. One has to repeat the win again and again to actually book such profits.