Thursday February 4, 2010 - 17:09:19 GMT
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Forex Blog - EZ Budget Crisis Threatens Global Contagion
EZ Budget Crisis Threatens Global Contagion
In the 20 years I have worked in the financial markets, I canâ€™t ever recall having seen a case of collective amnesia like the case I currently see. If subprime nearly took down the financial system, what does one think a run on sovereign credit can do? And classically Europeanâ€¦maybe this is the get back for the US bringing the subprime crisis to the rest of the world. EZ budget constraints under Maastricht lanced the boil of a highly exposed and undercapitalized banking system (again)â€¦well that is what is unfolding. Suddenly sovereign counterparties to all sorts of trades with the banking system, and largely uncollateralized (James Aitken and NFSI), are leaving the banks very exposed. How does a bank cover this? Sell assets. Write down the asset (everything from a Greek bond to a derivative contract sold to the Greek government). Or buy CDS on Greek sovereign risk. Like subprime, banks are all over the bid in sovereign CDS. EZ PIIGs debt markets are weaker too no doubt, but the move in yields is not nearly as sever as the move in CDS. But if not for collective amnesia we would have remembered that in a still highly leveraged and undercapitalized banking system, these events run the risk of initiating a feedback loop that is akin to the subprime problem.
Perhaps Europeâ€™s banking system is not as exposed to weak sovereign credits like PIIGs (surely separating national banks in PIIGs from the local government financing is impossible) as they were to subprime. But in its current form how much new pressure on asset quality and balance sheets can the system take if the current problem spins out of control and causes a broad run on sovereign risk â€“ into eastern Europe, Central Europe, Turkey, India, Asia including China, and Latam including Brazil? My guess is that the banks and investment community have a large chunk of that wall of central bank liquidity injected this market segment either directly and indirectly. Keep an eye on CDS for Brazil and China aheadâ€¦this will be the litmus test for real contagion taking hold.
We all know the unsustainable nature too of the US federal and state deficits. But, as long as the USD is the reserve currency, the flight from risk to risk-free assets will ironically help the fiscally challenged US debt market and currency. That is very clear this week and should hold ahead whoever underserved.
If G7 has a clue about the still impaired banking system (clearly bank leadership does not and this is the message that is only being heard at all levels in Washington), then they would pitch any time for discussing Chinaâ€™s yuan policy and focus on getting in front of the next wave of financial contagion and global capital market crisis. For starters the ECB should be taking the other side of the CDS sovereign trade ASAP. Unfortunately the chance of this is near zero. And the G7 should release a statement (something it already has said it wonâ€™t do) on a general set of principles for reforming the global banking system.
If anyone thinks the crisis of 2008 can not happen again (2009 banks were given a free pass on mark-to-market and near zero cost of funds) and is delusional. And Paul Volcker will be around to witness it and not his ghost as he warned Congress on Wednesday.
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