The dominoes are beginning to fall a little faster now.
Portugal, Greece, Ireland, and now Spain's banks have received large bailout packages. With each new bailout, the positive effect on equity prices, sovereign yields, and the credit markets has become increasingly weaker.
The reason for this anemic market action seems to result from the fact that market participants are beginning to realize these high-risk transfers of billions in cash are doing nothing to stop the contagion to larger European economies. Furthermore, the Spanish bank bailout in particular did nothing to solve the government's funding problems, and the country still needs to roll over billions of euros in debt by the end of the year.
That magic 7% yield that everyone is so focused on is just a nice, round, pyschologically important number to indicate that the marketplace is totally reluctant to invest in nation's debt. It doesn't take a 7% yield to cause significant issues, of course.
As Spain's yields crept over 6%, its banks got almost completely shut out of the interbank market, and weak share prices have added to capital-raise concerns.
Italian banks are going to be the catalyst for increased market pressures. UniCredit SpA, Italy's largest bank, is trading at 2.45 euros, and the remaining majority of Italy's bank are also trading in the single digits. While Italian banks have been sold due to liquidity concerns, the reality is that when you have banks who rely heavily on equity funding, and the equity has shockingly low value, the banks are now insolvent, not just illiquid.
Worse still, the LTRO carry-trade that was so well-received when banks were taking in cash at 1% and "investing" it in Italian debt yielding 6%, resulted in Italian banks taking on 33% more Italian sovereign debt (300 billion euros in total). As debt prices have continued their descent, these banks are beginning to feel the pressure on their balance sheets. As the value of their assets decline, the race to total insolvency progresses ever faster.
Italy is eventually going to be forced to nationalize some of its major banks, and thus transfer their liabilities to its own sovereign balance sheet. Just as in Spain, this would have a negative effect on Italian debt, resulting in an even worse decline in the value of the banks' assets, further exacerbating the crisis.
How Can We Get Back To "Muddle-Through?"
The market doesn't really care about the long-term sustainability of this situation. Greed wipes out fears of the impending insolvency of essentially the entire European periphery, and even France. No, what investors really want is to return to the trudge-on mentality, whereby everyone knows the issues out there, but trillions in liquidity help pump equity and bond prices higher. At this point, this dynamic allegedly helps banks raise some much-needed capital and restore faith in the financial system.
Like clockwork, after a few months of the carry-trade, banks and governments end up in a worse situation than before. Banks get saddled with more toxic debt, and the LTRO cash runs out (which at least so far actually has to be paid back, something no one really discusses).
In order to produce this short-term euphoria, the ECB needs to blink and completely change the rules of the game. The ECB is going to have to either change the legislation and obtain the ability to lend directly to governments, and/or accept a deteriorated quality of asset as collateral for another round of LTRO. The ECB, however, seems far less inclined than the Federal Reserve to take such a direct role, and appears to be set on simply keeping rates low and leaving it up to Eurozone leaders to restructure debts.
Returning back to muddle-through is possible only if the Federal Reserve executes another large-scale-asset-purchase program. However, Bernanke hasn't hinted much at a full-blown LSAP program (whereby the Fed's balance sheet expands, and the "flow" dynamic of the marketplace is fulfilled), and it remains to be seen if he would even have enough voting members to get QE3.
Conclusions
Regarding the Spanish bailout, the market isn't even sure whether its the ESM or the EFSF mechanism that is being used for the source of funding. Most recently, we are hearing that the EFSF will be used until the ESM is ratified. What the heck is going on? Spain's borrowing costs are reaching fatal levels and its banks are expecting 125 billion euros, and the source of the funding is entirely unknown?
Unless the ECB ends up lending directly to Italy, it's funding gap after impending bank nationalizations will be far too large to be filled by a bailout from the ESM, EFSF, or any other combination of letters. Italian yields are going to keep rising over the next few weeks, and pressure on the market is going to become very palpable, very soon. Spain caused about 1,000 points of Dow losses, and I expect Italian worries to send the market the Dow (DIA) to 11,500, and the S&P (SPY) to about 1,225.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: I am short S&P Futures
