Erste Bank’s research analysts draw attention to the following chart of the iTraxx Senior Financials versus the iTraxx Main index on Friday:
There is a notable breakout in the financials index — which represents the cost of insuring the senior debt of 25 European financial companies against default — at the beginning of April. From the chart we can tell it’s the first such break since at least January 2008.
Erste’s thoughts are clear as to why it’s beginning to move higher:
The nervousness in the financial sector can mainly be explained by the high dependence on the sovereigns – as also suggested by the most recent “Global Financial Stability Report” of the IMF that was published last week.
The logic is beautifully simple. Financials were only stabilised thanks to the massive intervention of sovereign states. They took much of the ‘insolvency’ out of the financial system by transferring the bad loans of banks directly onto their own state balance sheets — sometimes directly, sometimes through guarantees.
But now that sovereigns are under pressure, due to their own deteriorating budgets, those financial guarantees might be standing on shaky ground.
This could be especially tricky for Europe, says Erste, because the continent still hasn’t finished with its bank writedowns.
As the analysts explained:
According to the IMF, the risks for the financial markets and the economy have been on the decrease since autumn 2009 due to governmental support packages and central bank interventions. Total write-downs in the banking sector were revised downwards by USD 500bn to USD 2,300bn relative to six months ago, with about two thirds of the total write-downs estimated (USD 1,500bn) already accounted for.
The regional breakdown yields a mixed picture: whereas the US banks will only have to recognise 20% of the write-downs anymore this year, the additional need for write-downs among Eurozone banks is higher.
According to the IMF, banks are facing refinancing needs of USD 5,000bn in the next three years. The IMF regards the development of the sovereign debt as the biggest challenge in the coming years, where a barrage of new issues of sovereigns can be expected alongside stepped up primary market activities of banks and companies.
And here’s the scale of the problem in graphic form.
First, the proportion of writedowns the IMF still expects to see in the US, UK and the euro area:
And second, the bank debt rollover challenge that faces the market in the coming years:
At which point, it’s probably worth reading John Hempton of Bronte Capital’s fabulous explanation of how bank solvency arithmetic works.
The key points being:
First observation: at zero interest rates almost any bank can recapitalize and become solvent if it has enough time.
—-This is an important observation – because – absent another wave of credit losses – a marginally insolvent bank with a government guarantee will certainly recapitalize over time provided its funding costs are pinned somewhere near zero. The pinning of the funding costs near zero is not a subsidy (except in-as-much-as the government guarantee is a subsidy). Both these banks have the same spread and have the same profitability. The answer depends criticially [sic] on whether you can pin the funding to a low interest rate.
Unfortunately with sovereign crises running high, it could be very difficult for certain states in Europe to guarantee those crucial zero rates from now on.
Hence Hempton concludes:
Extend-and-pretend (what Felix Salmon crudely deigned to be the Hempton plan) worked well in America. It won’t work in Spain because you can’t pin rates at zero even with a government guarantee. The scale of financial restraint needed to solve this problem is enormous. But the alternatives are worse.
Related links:
Goodbye to the risk-free rate - FT Alphaville
Cat or canary? – FT Alphaville
On the matter of sovereign spreads widening – FT Alphaville
