By Mike Whitney
Credit conditions in the eurozone continue to deteriorate while yields on French, Spanish, Belgian and Italian bonds move higher. Italy’s 10-year yield increased 19 basis points to 6.89 percent on Tuesday, just a stone’s throw from the “unsustainable” 7 percent. French debt is also under increasing pressure. The spread between France’s 10-year debt and German bund hit a new high on Tuesday, widening by 174 basis points. If yields continue to rise, European Central Bank (ECB) chief Mario Draghi will be forced to either expand his bond buying program (Securities Markets Programme) or watch while defaulting sovereigns domino through the south taking most of the EU banking system along with them.
Germany will not permit the ECB to act as lender of last resort. As the Bundesbank’s president Jens Weidmann explained in an interview last week, unsterilized bond purchases (monetization) would violate Article 123 of the EU treaty.
“I cannot see how you can ensure the stability of a monetary union by violating its legal provisions.” Weidman said. “I think the prohibition of monetary financing is very important in ensuring the credibility and independence of the central bank, which allow us to deliver on our primary objective of price stability. This is a very fundamental issue. If we now overstep that mandate, we call into question our own independence.”
So, for now, the ECB’s hands are tied, but as bond prices continue to fall and credit markets freeze, German opposition will weaken and the ECB will asked to intervene.
Samsung Securities is now warning of a run on Italian banks. Here’s an excerpt from their report:
“A more immediate issue confronting investors is whether we are likely to soon witness a significant run on Italian-based banks. If the answer is yes, then this without question will be the end of the road for the eurozone and will confront the ECB and Germany with an inescapable choice of either providing unlimited support for all eurozone commitments (including deposits) or allowing the disintegration of the euro….
In the case of most countries that are starting to suffer from deposit outflow, the banks have to increasingly rely on higher interest rates to lure depositors. Is this starting to happen in Italy? The answer is yes, particularly in the case of corporate accounts….
One of the key leading indicators of a bank run is the bank’s increasing reliance on ECB’s refinancing facilities. Over the past three-to-four months, we have seen increasing reliance by Italian banks on eurosystem refinancing. Whereas in 2008 and 2009, Italian banks were average users of ECB facilities, accounting for only 3-4% of the total vs Italy’s share of 13.7% of the eurozone’s banking assets. However, since July, the share of ECB’s refinancing attributable to Italian banks rose to a historically high level of 18.8% (end-October)
….markets remain frozen…Banking refinancing markets remain largely closed. Whether one looks at OIS spreads (90bps on the euro), ECB deposits or CDS spreads between the eurozone’s senior and subordinated debt (235bps) remain at extremely elevated levels, indicating extreme reluctance of banks to lend to each other for longer than overnight or preference for depositing funds with the ECB rather than lending.” (“Samsung Securities, Prepare for the Italian bank runs”, Pragmatic Capitalism)
Samsung’s conclusions are no different than those of other analysts who’ve followed developments in the credit markets closely. Banks are depositing record amounts of money at the ECB rather than lending it out, funding is getting more difficult as US money markets reduce their lending to EU banks, credit gauges are steadily rising, and new capital requirements are forcing banks to dump risk-weighted assets on an already-saturated market. These are all signs of a deepening crisis. Here’s a clip from the Wall Street Journal:
“Worries over the fate of European nations are gumming up the intricate gears of the financial system….The rising cost of borrowing demonstrates the lack of faith investors hold in European leaders to resolve the region’s debt crisis. It also suggests that the region’s banks remain under stress, despite officials’ efforts to restore confidence. Taken as a whole, the markets show that private money is flowing only in fits and starts to select few European financial recipients.
“The funding market is not working properly,” said Giuseppe Maraffino, a European money-market strategist at Barclays Capital…
The latest sign came on Monday, when the European Central Bank reported that money going into its low-interest-rate overnight-deposit facility has been surging, effectively pulling money out of the banking system. Last week, euro-zone banks’ overnight deposits with the ECB hit €288.43 billion ($397.8 billion), the highest level since the debt crisis first erupted last year. (“Financing Markets Tighten Spigots”, Wall Street Journal)
So, how bad will the EU credit crunch get? That’s a question the Financial Times blog tries to answer on Monday in a post titled “It’s a capital ratio of two halves”. Here’s a clip from the article:
“In another sign of how bad this is looking, Commerzbank, Germany’s leading lender to central and eastern Europe, is ceasing all loan origination outside of its home country and Poland…….But assuming any adjustments to the rules will come too little to late, we could be in for €1,500bn to €2,500bn of deleveraging according to a note published by Morgan Stanley on Sunday.” (“It’s a capital ratio of two halves”, FT. Alphaville)
Well, now, if the banks are going to unload a hefty $3 trillion in assets, (in an effort to meet the new 9% capital requirements) then they’re not going to be doing a lot of lending now are they? And, if there’s no credit expansion (new loans) then there’s no growth, right? In that case, people would be well advised to pick a cozy spot outside the unemployment office now before the lines form.
Reuters blogger Felix Salmon has an excellent post (Monday) that explains the implications of the credit storm raging across the eurozone. Here’s an excerpt:
“Europe is in the middle of a textbook liquidity crisis. Banks are not lending to each other — and the ECB isn’t stepping in to solve the problem. This is a serious structural issue with the way that the European monetary system was constructed: the ECB is tasked only with guarding inflation, and not with ensuring the health of the banking system. Individual national central banks are meant to do that. But they can’t print money — only the ECB can. So when there’s a liquidity crisis, no one’s able to step in and solve it…..
There is no reasonable amount of capital that can cure a liquidity shortage. The reason why people are refusing to lend to the banks is not primarily because they fear an underlying solvency problem (although some people do), but because they fear an obvious and immediate liquidity problem. It is rational not to lend to an institution that you believe to be illiquid.
The real problem here is simply that banks are hoarding their cash and not lending to each other. Look at the way that bank debt issuance has fallen off a cliff…
And the way the banking sector works, banks have to be constantly lending to each other: in nearly every country in Europe, the amount of bank debt coming due every day is higher than the total amount of bank capital in the system. The overnight interbank market is the bloodstream of the European financial system, and the flow of blood is coming to a halt.” (” Europe’s liquidity crisis”, Felix Salmon, Reuters)
So, soaring yields on sovereign bonds are only a small part of a bigger and more complicated story. The real problem is in the credit markets, where plunging asset values and funding woes are paving the way for another full-blown financial meltdown.