Facts and Rumors

The recent bounce in stock and commodity markets didn't go as far as we had thought it would. In fact, it was interrupted rather rudely on Thursday. There was no discernible single trigger one could pin the swoon on, but rumors regarding the state of the European banking system keep bubbling to the surface and economic data continue to weaken dramatically.

More specifically, the fact that one euro-land bank recently borrowed $500 million from the ECB at a penalty rate has raised a few eyebrows, as has the reopening of currency swap lines between the Fed and the SNB to the tune of $200 million. It appears there is ever more dollar funding trouble in the European banking system, something we have pointed out was  inevitable, as US based money market funds have pulled back from lending to euro-area banks. The funding problem continues to be confirmed by the action in euro basis swaps as well. The only thing that has to our slight surprise not happened thus far is a visible strengthening of the US dollar, but this can probably be explained by the fact that money supply growth remains ample and that the market expects even more easy money from the Fed.

Speaking of the Fed,  the US central bank has begun to scrutinize the finances of euro area bank subsidiaries in the US. Note here that these subsidiaries have US banking licenses and thus fall within the Fed's regulatory ambit (they are also allowed to borrow from the Fed's lending facilities).

As the WSJ reports ('Fed eyes European banks'):

„Federal and state regulators, signaling their growing worry that Europe's debt crisis could spill into the U.S. banking system, are intensifying their scrutiny of the U.S. arms of Europe's biggest banks, according to people familiar with the matter. The Federal Reserve Bank of New York, which oversees the U.S. operations of many large European banks, recently has been holding extensive meetings with the lenders to gauge their vulnerability to escalating financial pressures. The Fed is demanding more information from the banks about whether they have reliable access to the funds needed to operate on a day-to-day basis in the U.S. and, in some cases, pushing the banks to overhaul their U.S. structures, the people familiar with the matter say.

Officials at the New York Fed "are very concerned" about European banks facing funding difficulties in the U.S., said a senior executive at a major European bank who has participated in the talks.

Regulators are seeking to avoid a repeat of the 2008 financial crisis, when the global financial system began to seize up. This time the worry is that the euro-zone debt crisis could eventually hinder the ability of European banks to fund loans and meet other financial obligations in the U.S. While signs of stress are bubbling up, the problems aren't yet approaching the severity of past crises.“


(emphasis added)

Indeed, as the trading day began in Europe on Thursday, the selling once again concentrated on the banking sector. This sector has been weak all year long and has recently gone into full blown crash mode. Indeed, the moves in the stocks of these banks continue to have a 'Lehmanesque' air.



The Euro-Stoxx bank index – still crashing as though it were indeed 2008 – click for higher resolution.



UK and French banks bore the brunt of the selling, with RBS crashing by more than 11% to a new low and the stocks of SocGen and BNP once again getting crushed badly as well.  Readers may recall that French banks were among the biggest borrowers in the US commercial paper market, so the funding problem is likely a big issue for them. In addition, French banks have enormous exposure to sovereign debt issued by the 'PIIGS' – for instance, their exposure to Greece is the largest in Europe right behind the Greek banks themselves.

UK banks on the other hand are among the biggest lenders to Ireland, which is their particular Achilles heel. Ireland's government of course continues to be de facto bankrupt, and depends fully on the EFSF to keep afloat.



France's SocGen gets crushed again – click for higher resolution.



BNP Paribas lands at a new low as well – click for higher resolution.



The UK's Royal Bank of Scotland crashes to a new low on big trading volume – click for higher resolution.



Euro basis swaps (three months, one year and five years) – hooking down again after a brief bounce. The three month swap at minus 80 basis points shows that systemic stress in terms of dollar funding is now not too far from where it was in 2008. Basis swaps involve the swapping of Euro LIBOR against USD LIBOR, and in theory these swaps should oscillate around the zero line. When they don't, it means that the perception of counterparty risk has worsened amid a scramble for dollar funding. Interested readers can download an explanatory article here (pdf) – click for higher resolution.



One thing that commentators and market participants (apart from traders in CDS) have blithely ignored in recent weeks is the precarious situation surrounding Swiss franc denominated loans. In many Eastern European countries (CEE nations), CHF denominated loans represent the great bulk of all outstanding mortgage loans and sizable CHF denominated lending has taken place in the rest of Europe as well. The biggest issuers of such loans have been  Austria's banks. Up until recently,  Austrian banks have escaped the Europe-wide selling, but that has clearly changed.



The stock of Austria's Erstebank has begun to crash as well, but still remains far above its 2009 lows, contrary to the shares of many other euro-area banks – click for higher resolution.



As reported by Daily FX:

“With all the focus on France as the next possible destination for the Euro Zone debt crisis this week as rumors of a credit downgrade to the region’s number-two economy began to circulate around the news wires, little (if any) attention has been paid to increasing sovereign stress in Austria . Indeed, compared with other countries in the currency bloc, the country has seen the largest percentage increase in 5-year CDS rates – a gauge tracking the cost of insuring against a default that rises when the risk of such an event increases – over the past month.

The danger is in Austrian banks’ exposure to Eastern and Central Europe. As we discussed in July , the region have borrowed aggressively in Swiss Francs to take advantage of Switzerland’s low interest rates. Stratfor – a global intelligence advisory – points out that, “currently, 53 percent of outstanding mortgages in Poland and about 60 percent of those in Hungary are denominated in Francs”. The majority of those loans were made by the top six Austrian lenders: Bank Austria AG (owned by Italy’s UniCredit SpA) , Erste Group Bank AG, Raiffeisen Bank International AG, Oesterreichische Volksbanken AG, BAWAG P.S.K. Bank, and Hypo Alpe-Adria International AG. Austrian borrowers themselves have also dabbled heavily in foreign-currency loans, which now make up almost a third of the country’s household debt, with most denominated in Francs.

With the Swiss currency perched just off a record high against its top counterparts, Central European borrowers (and many Austrian ones, for that matter) will find it hard to pay on their CHF-denominated obligations, causing massive losses for Austrian banks. If the government has to step in to bail out these banks – one of which ( Alpe-Adria ) was already nationalized in 2009 – the size of the package could be considerable. Multiple sources cite Austrian lenders’ Central and Eastern European exposure at about €230 billion, or 61.2 percent of 2010 GDP. As with Ireland, assuming a significant chunk of these liabilities could put the Austrian government – whose debt-to-GDP ratio is already equivalent to Italy’s (4.6%) – under tremendous funding stress, with the ultimate burden for the rescue likely falling on the already stretched-thin EFSF as well as the European Central Bank.


(emphasis added)

Austria's politicians better hope and pray that the SNB's attempts to rein in the enormous rise in the CHF will bear fruit. As it were, the SNB has not shied away from really piling on after cutting interest rates to 'as close to zero as possible'. Swiss swap rates have now turned negative as the SNB pumps francs into the system with gay abandon. Bloomberg reports:

“The rate to exchange fixed- for floating interest rate payments denominated in francs turned negative for the first time while the Swiss National Bank loses ground in its fight to halt a surge in the currency.” […]

The Swiss National Bank in a statement yesterday said that it will boost liquidity to the money market, expanding banks’ sight deposits to 200 billion francs ($253 billion) from 120 billion francs. The bank will also continue to buy SNB bills and use foreign-exchange swap transactions. The franc gained after the move as the actions fell short of speculation that the central bank would announce a target rate or temporary peg to the euro.

“What the market is doing is making the move to negative interest rates for the SNB,” said Douglas Borthwick, head of foreign-exchange trading at Stamford, Connecticut-based Faros Trading. Even with the decline in rates, “people still are buying Swiss securities out of fear and wealth preservation anxiety. Investors continue to purchase Swiss assets as well as gold.

The franc surged as much as 2.2 percent against the euro yesterday. Traders’ concern over the escalation of the euro regions debt crisis also were heightened after a meeting this week between German Chancellor Angela Merkel and French President Nicolas Sarkozy failed to bring any new concrete measures to stymie the contagion.


(emphasis added)

As is usually the case, when it rains it pours. Things aren't much better for a number of US banks either.  Bank of America remains in the line of fire, as investors ponder the size of its mortgage related liabilities. Depending on one's assumptions, the end result could differ vastly. As Branch Hill Capital notes (chart via Barry Ritholtz), the problem could mushroom quite a bit.




The trouble with BAC – not surprisingly,  option traders are once again piling in and amassing massive bets against the stock. Specifically, a huge bet on the BAC November 4 strike put has been placed. Readers may recall that we noted a similar trade in the August 10 put a while ago – we thought the traders involved represented 'smart money', a correct assessment as it turned out – click for higher resolution.



Further exacerbating the issue is that mortgage insurer MBI may be about to win its  mortgage related court case against BAC. MBI not unreasonably alleges that the loans it insured for BAC were 'improperly made'. As Bloomberg notes:

Bank of America Corp. (BAC) may face billions of dollars more in liability for faulty mortgages if a judge agrees with insurer MBIA Inc. (MBI) that the lender must buy back loans even if the errors didn’t cause a borrower’s default. If New York Supreme Court Justice Eileen Bransten and judges in similar cases across the country rule that the issue of “causation” doesn’t apply — meaning it’s enough to show that the loan was improperly made — it “could significantly impact” Bank of America’s potential costs, the bank said in a regulatory filing this month.

Such court defeats may add as much as $9 billion to what Bank of America owes bond insurers, according to hedge fund Branch Hill Capital, which is betting against its stock and has invested in MBIA. A victory for Armonk, New York-based MBIA may also strengthen claims by mortgage-securities investors that want the Charlotte, North Carolina-based bank to pay more than the $8.5 billion it’s offered them as a settlement.

“You don’t have to wait until you’re in a severe accident before you return the car with bad brakes,” said David Grais, a partner in New York at Grais & Ellsworth LLP who represents investors objecting to the bank’s proposed settlement with Countrywide Financial Corp. mortgage-bond holders.”

Not surprisingly, BAC's share price has resumed its sinking ways with verve:



Trading volume explodes as BAC resumes its decline – click for higher resolution.



Below is a chart that was recently published in the WSJ – it was compiled by Laszlo Birinyi's research company. It shows how US bank stocks fared in the 1930's compared to how they have fared in the crisis since 2007. This shows that there is still quite a bit of potential downside left. It also shows that bank stocks can be 'dead money' for a long time once a credit bubble implodes.



US bank stocks in the 1930's compared to the current crisis, via the WSJ – click for higher resolution.



Recession Confirmed?

We have been warning in these pages for many months that 'the big surprise of 2011 will be a weakening economy in the second half' – as opposed to the then prevailing consensus that there would be a 'second half recovery' once the effects of the Japanese tsunami on global supply chains had dissipated.

We based this forecast on deductive reasoning, noting that the data showed that too much capital had been drawn toward investment into the higher order goods stages of the economy's productive structure without a sufficiently large corresponding increase in voluntary savings, while investment in lower order stages was neglected – a typical sign that monetary pumping and too low interest rates have once again caused malinvestment on a large scale.

On Thursday the important Philadelphia's Fed's business survey was released and seemed to confirm that the economy has indeed fallen back into recession.

The terrible details of the survey can be found here. As Marketwatch reports:

“The Philly Fed’s business outlook survey fell to negative 30.7 in August from 3.2 in July. This is the lowest reading since March 2009.

Readings below zero indicate contraction in the region’s factories. The size of the decline in the index stunned analysts — economists had expected a reading of 0.5 in August, according to a survey conducted by MarketWatch — and added fuel to Thursday’s rout in the stock market.”


The Philly Fed survey, current and future activity indexes – such a big decline usually indicates the economy is in recession – click for higher resolution.



As the WSJ notes:

“The Philly Fed index has never been as low as it was in August without the economy being in recession. There’s not much of a history here, going back to encompass only two prior recessions, but you can see the data. The internals of the report were horrendous, too.

The “prices received” index came in at -9, down from 1.1 in July. That’s not inflationary, though “prices paid,” at 12.8, suggests pressure on profit margins. The “new orders” index was -26.8, the worst since March 2009. Employment was -5.2, the worst since October 2009.”

This news item, along with higher than expected weekly unemployment claims and yet another batch of weak housing data  no doubt contributed to the stock market rout – as it becomes ever harder to deny that the economic contraction has indeed resumed in full force. The combination of Keynesian fiscal stimulus spending and monetarist-inspired inflationary pumping by the Fed has clearly failed and the stock market is belatedly taking note of this fact. However, the stock market remains deeply oversold, so a retracement rally can still commence at any time. Note also that a slight bullish divergence between the DJ Industrial and Transportation averages has occurred on Thursday. Whether it is meaningful will depend on whether it persists. If the DJIA quickly confirms the new low in the Transports, then the divergence will obviously disappear – but this is something one should certainly keep an eye on here, especially if one is a short term oriented trader.



The S&P 500 index plunges again – note how trading volume once again explodes on the sell-off, while it weakened considerably on the preceding bounce. This is quite a bearish datum for the medium to longer term – click for higher resolution.



The Dow Jones Industrial Average – it plunges as well, but failed to make a new low – click for higher resolution.



The Dow Jones Transportation Average by contrast did fall to a new low. This constitutes a slight bullish divergence for the short term, unless the Industrial Average very quickly confirms the new low in the Transportation Average – click for higher resolution.



Not surprisingly, the 'go-to' safe haven assets gold and treasury bonds continued their blow-off moves. The ten year t-note registered a yield of less than 2% for the first time since the 1940's in intraday trading (the all time low in yield of 1.5% was made in 1942).



Gold's explosive rally continues. It is very overbought, but as we noted yesterday, that may not necessarily mean that a decline is imminent. Of course, traders must expect a lot of short term volatility. A sharp pullback could occur anytime, but that would not necessarily obviate the idea that a blow-off move is underway – click for higher resolution.




Gold in euro terms also remains very strong – click for higher resolution.



This could actually be an 'exhaustion gap' in the t-note yield. Note that the yield did not manage to stay below the psychologically important 2% barrier – click for higher resolution.



In summary, we would point out here that even if a recession has indeed begun, this does not preclude a rally in the stock market that corrects a part of the recent decline. Such a rally would however very likely represent yet another selling opportunity. Risk remains very high and the medium to long term trend has clearly turned down until proven otherwise.



Charts by: StockCharts.com. Bloomberg




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One Response to “Anatomy of a Bad Hair Day – Bank Troubles & Recession”

  • SMaturin:

    “We have been warning in these pages for many months that ‘the big surprise of 2011 will be a weakening economy in the second half’ – as opposed to the then prevailing consensus that there would be a ‘second half recovery’ once the effects of the Japanese tsunami on global supply chains had dissipated.”

    I am not concerned.

    Paul Krugman will solve this problem by calling the space aliens to invade us. Time to get long in aerospace sector and buy Star Wars Bonds like a good patriot.

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