We have mentioned the risks Italy poses to the euro area in the past, but the markets proceeded to ignore both Italy and Spain for quite some time, by compartmentalizing them into the "not as risky as the GIP trio" drawer (GIP=Greece, Ireland and Portugal). There was thus little reason to dwell on it too much, but it was always clear to us that the topic would eventually make a comeback. As we have frequently mentioned, it has always been our belief that contagion would rear its ugly head again at some point.
In early July 2010 we posted Faith In The Impossible, where we inter alia discussed the situation of Italy in a paragraph with the title "Italy is quietly lying in wait." It appears it is no longer so quiet.
In late May this year we posted Et Tu, Italy?, following an announcement by the rating agencies that Italy's credit outlook was to be moved from stable to negative. The main worry with regards to a possible downgrade of Italy's government debt relates of course – as always – to the banking system. Italy sports the second highest public debt-to-GDP ratio in the euro area at 120% and the exposure of the euro area banking system (chart) – and especially the Italian banks themselves – to the €1.2 trillion large Italian government debt mountain is commensurately staggering.
The markets have hitherto treated Italy's public debt situation as slightly dubious, but not outright alarming. As we have noted before, there has been a perception that due to Italy's high personal savings rate and the large proportion of Italian government debt held domestically, Italy could be seen as a kind of European version of Japan, able to amass a large amount of government debt without having to fear ill effects. It seems now that the markets are in the process of reassessing this particular notion. Both CDS prices and the yields on Italian government bonds have recently sprinted higher, with the latter only a smidgen away from breaking out to new highs for the move.
[Click all to enlarge]
Italy's 10-year government bond yield ends the week at 4.977%, perilously close to breaking out from the sideways consolidation that has pertained for most of this year. Spain's government bond yields have just broken out from a similar consolidation formation.
What is undeniable is that Italy's stock market has been mired in a bear trend for quite some time. The Milan stock exchange index (FTSE-MIB) has made its post 2008 crash rebound peak in October of 2009 and has gently drifted sideways/lower ever since.
The Milan Stock Exchange Index has been a "bear market leader" since 2007. It peaked in May of 2007 – well ahead of the S&P 500 Index. It made its post-crash rebound high back in October of 2009.
The MIB has been in a relentless downtrend relative to the S&P 500.
The MIB has also just plummeted to a new low vs. gold.
Last Friday, the Italian stock exchange sported a solid gain of just over 307 points two hours into the trading day. European markets took their lead from a strong day in Asian stock markets following remarks by China's premier Wen Jiabao that "China is winning the war on inflation," which market participants evidently took as a hint that the recent tightening of monetary policy in China may be close to ending. An unexpected small gain in the German business confidence index (IFO index) reported early on Friday also boosted sentiment at the beginning of the trading session somewhat.
It looked as though a risk-on day was in the works, which means sell the dollar, and buy the euro, stocks and commodities. However, it was not to be. At about 11:00 a.m. Central European time, a rumor surfaced that Italian banks would have to raise more equity in the wake of the most recent European stress test exercise and that a major credit rating agency was preparing to downgrade Italy's sovereign debt.
Late on Thursday, Moody's had warned that 16 Italian banks faced a possible credit rating downgrade in the event of a downgrade of Italy's sovereign debt, coupled with a reassessment of the willingness of governments to support the debt of financial companies. This was initially ignored, but when the above mentioned rumors started on Friday morning, the remarks by Moody's no doubt lent additional credence to them. Italian bank stocks literally crashed within minutes – with many falling by the 10% daily threshold after which trading halts are imposed by the Milan exchange.
The weakness in Italian bank stocks then quickly spread across Europe, with UK banks especially hard hit, not least because BoE chairman Marvyn King muttered darkly about the risks the euro area debt crisis poses to financial stability in the UK – echoing Jean-Claude Trichet's "red alert" remarks made on Wednesday in connection with the euro area's banking system.
As Bloomberg reported:
A gauge of banks was the worst performing industry in the Stoxx 600 this week, sliding 4.3 percent to the lowest level since July 2009.
Popolare Milano, the oldest Italian cooperative bank, plunged 15 percent to the lowest since at least 1989. Monte Paschi slid 11 percent, the biggest drop in more than a year.
Moody’s Investors Service said on June 23 that it may downgrade 13 Italian banks because they would be vulnerable were the government’s credit rating to be cut. The ratings company last week warned that Italy’s credit ratings may be trimmed because of slowing economic growth and the potential for the sovereign crisis to drive the country’s borrowing costs higher.
European Central Bank President Jean-Claude Trichet on June 22 said danger signals for financial stability in the euro area are flashing red as the debt crisis threatens to infect banks.
Lloyds Banking Group Plc, Britain’s biggest mortgage lender, fell 10 percent and Royal Bank of Scotland Group Plc decreased 12 percent.
The euro-area debt crisis poses the biggest risk to the stability of the U.K. financial system and banks should build up capital buffers when earnings are strong, Bank of England Governor Mervyn King said in London yesterday.
The MIB on Friday – after initially gaining 307 points to an intraday high of 19,775.67 points, the market suffers a steep decline, plunging to an intraday low of 19,067.84 points as Italian banks stocks crash. Following a trading halt in the worst hit bank stocks, the market attempts a recovery, but then drifts back to near the lows of the day.
While the credit markets have heretofore given Italy a pass – at least relatively speaking, compared to the relentless plunge in the bonds of the 'GIP' trio and the huge rise in CDS spreads on their debt – the Italian crisis has always been evident in the action of the stocks of the country's major banks. Friday's plunge was merely the exclamation point on what has been a relentless and utterly brutal bear market that has been in train for several years. Readers may recall the charts of Greek bank stocks we have occasionally posted in the past (a comprehensive overview can e.g. be found in Looking Into The Abyss from late April – since then, these stocks have declined even further) -- somewhat surprisingly perhaps, many Italian bank stocks don't look any better.
The share price of Unicredito, Italy's largest bank. Note that the mini-crash last Friday follows on the heels of a relentless downtrend. Just how relentless is revealed by the next chart.
A one decade chart of Unicredito shows what an enormous amount of damage stockholders have had to endure. Note that there was a huge bubble in Italian bank stocks from about 1997 to 1998, as Italy's bond yields were falling sharply in anticipation of the country's entry into the euro. The same factor that worked in the banks' favor then now works to their detriment as, Italian bond yields diverge ever more from Germany's.
The share price of Intesa Sanpaolo, Italy's second-largest bank.
Intesa Sanpaolo's share price over the past decade – only at the 2002 and 2009 bear market lows was the stock trading at a lower level than currently.
The stock price of Monte Dei Paschi di Siena bank, which was founded in 1472 – 22 years prior to the bankruptcy of the Medici Bank in 1494. In short, Monte Dei Paschi has survived many a credit crisis, including the severe busts of the late medieval period when no lender of last resort existed that could bail overextended and insolvent banks out. Judging from its stock price, the presence of a lender of last resort isn't doing much for shareholders.
The share price of Monte Dei Paschi di Siena over the past decade. Is the bank finally going to be done in after surviving for almost 540 years? Once a stock declines well over 90% from its former highs, one begins to wonder about the company's ability to survive. Note that the stock has now plummeted well below even its 2008-09 crash low.
The share price of Italy's Banco Popolare over the past year. This is a noteworthy crash – on a par with the action in the stocks of Greek banks.
Banco Popolare's share price over the past decade. This represents a decline of 94% from the 2007 high. Again, one wonders whether this one isn't close to death's door as well.
The shares of Italy's leading investment bank, Mediobanca di Credito Finanziario, which was founded by Enrico Cuccia in 1946 to help finance the post-war reconstruction of Italy's industry, have fared only slightly better than those of its commercial banking brethren.
The share price of Mediobanca di Credito Finanziario, Italy's leading investment bank, over the past year. After showing some strength until April, the shares have sold off sharply and have also suffered quite a bit in Friday's sector-wide decline.
Mediobanca's share price over the past decade – at least it still remains above both the 2002 and 2009 bear market lows, but not by much. It seems doubtful that its shareholders are very happy.
Regional Italian banks are similarly stricken as the next chart reveals.
Banca Popolare dell'Ertruria e del Lazio over the past year – another bank stock closing in on strong support at zero
A ten year chart of Banca Popolare dell'Ertruria e del Lazio's stock – click for higher resolution.
Not to put too fine a point on it, Italian bank stocks are a horror show. While bank stocks haven't done particularly well all over the Western world following the 2008 mortgage credit-related crisis, these stocks are in a class of their own, with a 1929-1932 type collapse under their belt – nota bene in nominal terms. In real money, i.e., gold terms, it's a complete wipe-out. It is understandable that bank stocks in Greece have suffered a collapse of roughly comparable size (although ironically, they have lately slightly bounced off their multi-year lows). The market is simply extrapolating the effect that a marking to market of the Greek government debt held by Greece's banks would have on their equity. In the worst case of the Bank of Piraeus, a 50% haircut – and the haircut implied by market prices is oscillating around that figure – would wipe out its equity completely. National Bank of Greece (NYSE symbol NBG) would be left with less than 3% of tangible equity. With CDS on Greek government debt implying a close to 90% default probability, the sell-off in Greek bank stocks can be easily explained. It is not quite clear why the market has adopted an almost similarly negative view of Italy's banks. It could of course mean that the panic has gone too far and a tradable rebound is soon in the cards. However it may also mean that the market has a well-founded and growing concern about the fate awaiting Italian government debt that these banks hold such ample amounts of. Across the euro area, banks hold about €1 trillion of Italy's sovereign debt, with Italian banks the biggest holders by far. The rise in yields to date has already produced a sizable 'paper loss' on these bond holdings, but it is for now still in the realm of the tolerable.
Obviously, it would not do if contagion were to continue spreading in the direction of Italy and Spain.
Italy's current account deficit.
Italy's public debt as a percentage of GDP.
Italy's external debt in US dollar terms.
A Lack of Containment
Numerous observers have in recent weeks raised the specter of the Lehman failure as a model for what to expect in the event of an official Greek default. It may well make even bigger waves. In the course of this coming week the Greek parliament will vote on the new austerity package, the enactment of which is a precondition for the next disbursement of bailout funds. However, as anyone engaging in a spot of mental arithmetic can probably tell right away, all these antics will likely prove to be for naught in the end. As we have pointed out before, when a fractionally reserved banking system expands credit and money under what is essentially a fixed exchange rate regime, a bust will have severe consequences.
In the case of currency pegs, the peg usually goes. This is not possible for members of the euro area – in fact, there is not even an agreed upon procedure for leaving the euro, as the possibility was never considered. Moreover, the nations that have experienced the sharpest interest rate declines following their adoption of the common currency – back when rate convergence was still the order of the day – are precisely the nations that have either gone through the biggest property bubbles and/or have seen a sharp rise in government spending, as the cost of government debt declined and the artificial credit-induced boom filled government coffers with fictitious revenues from taxes on fictitious profits.
Prior to becoming part of the euro area, these nations would have reacted to an economic bust by devaluing their currencies through printing money. This would tend to lower the value of their existing debt. Moreover, since their interest rates always reflected this probability by sporting a commensurately large price premium, debt expansions tended to be held somewhat in check by high rates.
For the past several months, the eurocracy's bailout agenda seemed to at least succeed in exerting a containment effect. Interest rates and CDS spreads on the GIP trio kept rising, but the "S" and "I" in the famous PIIGS acronym appeared to be decoupling. However, we always suspected that this would not work for long. This is due to several reasons, the most important ones of which in brief are:
1. While in terms of their total public debt relative to economic output and tax revenues the GIP trio is is among the worst offenders, at least Italy and Belgium are in a roughly similar league.
2. Even a relatively low public debt to GDP ratio is not a guarantee that the country concerned will be spared if it goes through the severe economic problems that follow a property bubble and uses taxpayer funds to bail out the banks. This is what did Ireland in, where the decision to bail out the senior bondholders of insolvent banks led the government into an insoluble debt trap. It also holds true for Spain, where the still fairly low total public debt is growing fast as the country remains mired in economic contraction. Both Ireland and Spain have had large inflows of capital from abroad to finance their current account deficits, i.e., they both have large exposure to foreign creditors.
3. The supranational ECB can not simply help individual nations to print their way out of fiscal trouble. It's just not doable, at least not yet.
4. The interconnectedness of banking systems in and around the euro area means that no-one is spared in case the peripheral sovereigns officially default on their debt. Note that we are saying "in and around," as the contagion effects are felt in nations neighboring the euro area as well.
A good recent example of how the failure to contain the crisis is making itself felt in at first seemingly unlikely places is provided by the action in the stocks of UK banks last week. The two worst offenders were Royal Bank of Scotland (RBS) and Lloyds TSB, both banks that required vast government bailouts to survive. Last week the media prominently reported on the fact that the UK would not be required to chip in any funds in support of the latest bailout round for Greece, along with the information that the direct exposure of UK banks to Greek debt was fairly negligible at only $ 13 billion, of which about $ 4 billion are in the form of exposure to sovereign debt. However, BoE governor Mervyn King warned on Friday that these numbers understate the risk, which largely stems from the above mentioned interconnectedness of the financial system.
The Telegraph reported on this:
King made clear last week that Britain’s banking sector has a “remarkably small” exposure to Greek sovereign debt. Yet the Governor also warned that contagion can spread through financial markets, especially when there is uncertainty about the precise location of exposures.
A UK bank could have lent to a bank that itself lent to a bank that is turn was exposed to Greek sovereign risk,” King said. UK banks may only be holding a limited about of Greek debt but they are mightily exposed to French and German banks which, in turn, are among the very biggest lenders to Greece.
King’s words, and the Bank’s Financial Stability Report published last week, pay testament to the ghastly inter-connectedness, right across Europe, of sovereign insolvency and bank fragility.
Looking at the charts of UK banks, the very same idea seems to have occurred to stock market traders. After all, even if the UK banks' involvement in Greece is negligible, their involvement in Ireland is considerable – and Irish government bond yields and CDS prices have exploded in concert with the worsening Greek crisis.
The share price of RBS was in free-fall last week – it ended at the lowest level since March of 2010. Traders were evidently thinking ahead on the contagion issue.
Shares in Lloyds TSB have been falling sharply for many weeks, with the decline accelerating markedly last week.
Below you can see why Ireland remains a big worry – these charts also illustrate nicely that a low public debt to GDP ratio at the outset of the crisis proved largely irrelevant, as discussed above.
Ireland's current account deficit in millions of euro.
Ireland's annual budget deficit as a percentage of GDP.
Ireland's unemployment rate.
Ireland's total public debt as a percentage of GDP – note that the latest 2011 estimate is actually somewhat higher by now at 102%.
Ireland's external debt in US dollar terms.
Similarly, Spain's economy is beset by problems that are putting the most recent estimate of its total public debt to GDP ratio of about 67.5% into perspective. It remains uncertain how much it will in the end cost to repair the banking system – it is only clear that if Spain remains committed to recapitalizing its banks with government funds it may ultimately face a bill that significantly dents its public finances, just as has happened in Ireland's case.
Spain's current account deficit in billions of euro – it has been shrinking considerably since the beginning of the bust, but lately it has widened again due to rising commodity import costs.
Spain's annual budget deficit as a percentage of GDP – the 2011 estimate may well turn out to be too low.
Spain's unemployment rate – this documents in what sorry shape Spain's economy remains.
Spain's public debt-to-GDP ratio – it has already reached 67.5%, so the 2011 estimate is certain to increase.
Spain's total external debt in US dollar terms.
Last week was very notable in the sense that the meme that Greece can no longer be rescued no matter how much money is thrown at it seemed to gain considerable ground. In reaction to this, the financial markets were refocusing on the contagion question – with a vengeance. Both Jean-Claude Trichet and Mervyn King gave voice to their growing unease, with the latter contributing his own 2 cents, or pennies as it were, to the Greek bailout question when he noted:
"Right through this episode, from the very start,” said King, “an awful lot of people wanted to believe it was a crisis of liquidity. It wasn’t and it isn’t. It was a crisis based on solvency, not liquidity. And until we accept that, we will never solve it .... Providing liquidity, can only be used to buy time,” as King correctly observed last week. “Simply the belief, 'oh we can just lend a bit more’, will never be an answer to a problem which is essentially about solvency."
This is what everyone has probably realized by now, but the eurocracy still insists that it will be better to kick the can further down the road – even if there will at least be a certain degree of voluntary private creditor contribution this time around. A huge and apparently still underestimated problem is that the markets are not working according to the bureaucratic time table, especially when said time table is beset with uncertainties (such as, "Will the Greek parliament vote for more spending cuts and tax increases next week, or will it balk?"). The markets, as one trader put it last week, "are smelling blood."
Try putting yourself in the shoes of a large holder of Spain's or Italy's government debt. What would you do as this crisis continues to evolve? A good rule of thumb is that he who panics first gets to keep most of his money in such situations. After all there is by now a considerable body of historical evidence available with regards to the euro area's sovereign debt crisis and the damage it inflicts on the bonds of suspect governments – and none of it is particularly comforting.
As a result of all this, the eurocracy finds itself once again extremely close to a point where things could spiral out of control for good. Even if it turns out that last week's market convulsions were another short term peak in the evolving panic (so far, the crisis has moved like an upwardly slanted sine wave), it would merely postpone the moment of truth. The fundamental problem will certainly not be solved in a few week's time, but will continue to fester.
More Charts
Below is our usual collection of CDS prices (in basis points, color coded) plus euro basis swaps and government bond yields across the euro area (in a similar arrangement of color-coded four-in-one charts this time). Obviously, many markets are well beyond the complacency stage by now, although risk asset prices – with the exception of certain bank stocks (see above) – have not really broken down decisively yet. This may be based on false hopes, but it is always possible that these markets are correct in assuming that another pause in the crisis is imminent and that some sort of retracement of the recent losses is likely to occur. Nevertheless it is clear that the situation is fraught with danger at the moment.
1. CDS
Five-year CDS spreads on Portugal, Italy, Greece and Spain – new highs for Portugal and Greece at 839 and 2405 basis points respectively, with both CDS on Italy's and Spain's sovereign debt still racing higher in a spirited catch-up move that is coming ever closer to negating the previous divergence.
Five-year CDS on Ireland (a retest of the recent high), France, Belgium and Japan. There was quite a big move in CDS on France's debt. At just above 90 basis points these are closing in on what can per experience be considered the upper boundary for a EU core economy.
Five-year CDS on Austria, Hungary, Croatia and Bulgaria. We're not quite sure at this point why Croatia seems to merit such a big move. The credit claims of Greek banks in Croatia amount only to $180 million, so that is probably not the reason (though this could become a problem for several other countries - see this chart).
Five-year CDS on Slovakia, Slovenia (both in a remarkable rocket-ride higher last week), Latvia and Lithuania. The Baltic nations are evidently profiting from the fact that their public debt is very low.
Five-year CDS on Romania, Poland, Estonia, and Slovakia.
Five-year CDS on Saudi Arabia, Bahrain, Morocco and Turkey. The sharp move higher in CDS on Turkey's debt was especially noteworthy last week.
2. Euro Basis Swaps and Bond Yields
One-year euro basis swap – still trending in the wrong direction.
Five-year euro basis swap.
10-year government bond yields of Spain, Ireland, Portugal and Greece – note the sustained breakout in Spain's 10-year yield and new highs for both Portugal and Ireland – ironically, Greece's yields were the only ones to pull back slightly late last week.
10-year government bond yields of Austria, Italy and UK (gilts), plus the Greek two-year note. Austrian yields have been trending lower along with Germany's, UK gilts seem to reflect mostly the weakening of the UK economy, but Italy's bond yields have clearly become a contagion victim.
Lastly, here is the SPX, the SPX-gold ratio, T.R.'s proprietary VIX based volatility indicator (adjusted by gold-silver ratio) and the gold-silver ratio. All of these have lately moved in directions that are not friendly to risk assets. The gold-silver ratio appears poised to move higher.
