European Banks Still Exposed to CDS Risk

It’s a big mistake to assume that bank balance-sheets across Europe have already seen the worst as the global economic recovery enters its sixth month.

Credit default swaps, contracting bank lending, tepid consumer spending and regional woes in Central Europe all pose ongoing threats to a sustainable recovery in Europe.

To be sure, the risk of a systemic bank collapse has receded since governments across the euro-zone announced blanket guarantees on deposits last October. Many of the weakest institutions have been de facto bailed-out by local governments, and stock prices have surged off their multi-decade lows.

Yet it’s important to point out that despite all efforts to expand the money-supply and grow inflation since last fall, euro-zone M3 (the broadest measure of bank credit growth) is still contracting.

Loan growth is also contracting.

And consumer prices across the euro-zone remain in the deflation zone, yet another challenge for central banks hoping to boost inflation, which remains in short supply since oil prices and asset bubbles collapsed starting in July 2008.

Storm clouds still loom on the horizon for European financial institutions – especially in the banking and insurance sectors. More losses are coming our way in 2010.

Back in late August, the European Central Bank (ECB) voiced concerns about financial derivatives or credit default swaps (CDS). These instruments are used for insurance-like purposes to hedge credit risk if a sovereign or corporate issuer defaults; the ECB continues to warn about CDS counter-party risk.

The top ten counter-parties of the leading European banks accounted for 60% of CDS exposure, according to the ECB.

Governments in the West are still in the process of regulating a global platform to settle or clear outstanding credit default swaps, which according to some estimates tops approximately $30-$60 trillion dollars in notional value.

Nobody really knows what the total value of these derivatives is or how to even settle most counter-party trades. The entire sector remains a massive house of cards. Both Warren Buffet and George Soros continue to warn of impending trouble if a global platform is not launched to identify counter-parties; Soros proposes banning credit default swaps altogether.

If global markets were in a freefall from October 2007 through March 2009 – reacting negatively to the deluge of bad economic news – then the opposite is true today. Risky assets have continued to appreciate since March 9 in the biggest rally since 1932 measured in percentage terms.

Good news about the global economy and its continued recovery has pushed stock prices through the roof while even the occasional dose of bad news hasn’t affected prices. These include record U.S. insider stock sales in August, a gaping hole still widespread in financial sector intermediation, contracting loan growth among banks, declining consumer and wholesale prices and rising job losses.

The markets continue to feed only on good news. Just how long this mirage will last is hard to forecast. But at some point reality will check-in. My guess is that will happen in 2010.

Comments

[hampden:]

The 60 trillion notional number that alarms equity investors is a gross notional number, ie sum of all the long and short notional amounts traded; it's not some huge potential liability. The gross notional of interest rate swaps is 6 times as big. You don’t get an idea of the net investor exposure of the Bund Futures market by summing all the gross notional traded over the life of the contract; positions get closed out or are hedged with cash bond positions etc.

Anyway, CDS have rallied massively over the last six months along with all risky assets as investors realise we’re not heading to Great Depression 2. The vast majority of them are written on investment grade companies and the volumes of central/eastern European and EM CDS is very small. In Europe we have only had a few investment grade default throughout the whole crisis. For example, the Icelandic banks traded in the CDS market but with very little volume. Positions were marked down (and margined) long before default.

The market was largely driven by the demand for CDOs backed by investment grade corporate CDS meaning that most exposure is highly diversified. The risk is more macro credit - if a whole sector of investment grade credit goes bust. Hence the concern last year when finance and insuance sectors seemed at risk. This risk seemed real in Q4 08 but much more remote now, hence spreads on CDOs have more than halved.

That doesn't mean there is nothing to worry about. It's just that CDS isn't it. Subprime ABS exposure maybe. But mainly, European banks are staring at large quantities of bad loans as the recession hits consumers. These are regular small corporate loans, consumer loans, mortgages etc. Banks are under pressure for making unsuitable loans and to reduce the size of the over-inflated balance sheets. This means less lending, risking stalling the economy...

Sep 17 05:35 AM