Investors Should Buy Protection As Italy Downgrade Underscores Intractable Nature Of Debt Crisis

 |  Includes: SPY, VXX
by: Colin Lokey

After returning from a two week trip to Italy, CNBC's Bob Pisani gave a first hand account of how bitter a pill austerity can be. On an anecdotal level, Pisani noted that everyone he encountered complained about higher taxes under Prime Minister Mario Monti, although Pisani also noted that the public seemed to want to support their leader, even in the face of adversity. On a more concrete level, Pisani says that the country's statistic agency (ISTAT) is now threatening to cease operations due to lack of funding.

Make no mistake, Summit or no Summit, the situation in Italy is deteriorating quickly, a point underscored Friday by Moody's, which downgraded Italy two notches to Baa2 with a negative outlook. Moody's decision was based on the likelihood that Italy's borrowing costs will continue to rise due to deteriorating market confidence in the country's debt and an "eroding non-domestic investor base." In simple terms: no one besides Italian banks and Italians wants to buy Italian government bonds--the vicious sovereign-bank circle is rearing its ugly head once more.

Furthermore, Moody's said that the near-term outlook for the Italian economy has deteriorated markedly (the ratings agency expects GDP to contract by 2% this year), jeopardizing the country's ability to meet fiscal targets. If the country does indeed begin to back peddle on its reform commitments, market confidence could deteriorate to the point that the Italians are shut out of the bond market altogether.

Perhaps most importantly, two of the three major ratings agencies now have Italy at sub-A ratings. Readers may recall what I said on June 17, about Spain when it found itself in the same situation:

...a downgrade by ratings agency Moody's...could prove fatal for the country's struggling banks. Once all three ratings agencies have Spain at BBB+ or below (which, after the Moody's cut, is now the reality), the country moves into the 'Step 3' collateral bucket with the ECB, requiring a 5% haircut on all maturities of Spanish government bonds, which, in turn, triggers margin calls for the banks which pledged the debt as collateral.

Italy's banks now face the same predicament. If Fitch downgrades Italy, all three ratings agencies will have Italy sub-A, which technically means the country moves into the Step 3 collateral bucket with the ECB, triggering the 5% haircuts on the Italian government bonds pledged as collateral by the Italian banks for LTRO loans, and ultimately resulting in margin calls for the Italian banks. The lesson here is that it takes a lot more than a semi-successful summit to break the vicious circle that has become the defining feature of the eurozone debt crisis.

The Moody's downgrade reinforces the view that the crisis overseas hasn't abated at all in the wake of the EU Summit. Expect yields on Italian debt to continue to trend upwards as anxiety peaks. Investors should protect themselves from the ill-effects of Europe's seemingly intractable problems by protecting any long positions with long puts on the S&P 500 (NYSEARCA:SPY) or, alternatively, by going long volatility.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.