Banking crisis looms

What's next?

The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought. - Rudiger Dornbusch

We will publish a primer for a banking crisis preparation in the GnS Economics Newsletter tomorrow. It will start a series of preparation publications.

The past week has been tumultuos in the financial markets. On Wednesday, 28 September, the U.K. pension funds nearly become insolvent due to a massive margin call saved, in the nick of time, by the Bank of England. On Saturday, credible rumours of major investment bank being on the ‘brink’ appeared, and on Sunday it was identified as Swiss banking giant Credit Suisse.

This week was started with speculations that the Federal Reserve would ‘pivot’ from its earlier, very ‘hawkish’ stand towards inflation and interest rates to a more milder one. Markets, quite naturally, rallied not really acknowledging what such a pivot would mean.

It was, for example, speculated on the CNBC:s Squawk Box Europe that a Fed pivot would mean that the condition of the real economy is worse than thought. This was partly correct, imho, but the Fed pivot would most likely demonstrate that our financial system is in the brink of a collapse, yet again.

And, we seem to be approaching that point.

Interbank stress is building, at places

Rates in the inter-bank markets, i.e., in the markets where banks extend both unsecured and secured loans to each other has started to signal heavy stress. For example, the the HIBOR rate, determining the interbank lending rates between banks in Hong Kong, has risen to the highest level since November 2007.

The same applies to USD Libor (London Interbank Offered Rate), measuring the lending rate in the international London banking markets.

In essence, Libor is an estimate on short term rates on uncovered loans banks use to settle transactions in their respective currencies as well as transactions denominated in other currencies, globally. It thus acts as a stress (trust) indicator in the banking sector. It tends to follow the interest rates set by central banks, which determine the rate financial institutions can get money short-term (over-night).

Within a year, 3-month Libor has risen from near zero to 3.57% at the time of writing, which is the highest figure since early 2007. With federal effective funds rate at 2.56%, banks are thus expecting much higher rates in the near future reflected in their lending operations.

The TED spread, measuring the difference between the three-month Treasury bill and the three-month LIBOR, stands at normal (under 50 basis points range). However, as the Federal Reserve currently buys also 3mo Treasury bills, it’s unclear how well it reflects the view in the markets.

So, it seems, that the current bank stress metrics are not signaling anything truly worrying, yet.

Hedging costs of bank debt increase rapidly

However, CDO:s tell a different tale. They are used to hedge debt against a default, i.e., they are is a financial (swap) agreements, where the seller of the CDS agrees to compensate the buyer in the event of a debt default.

As a historical note, the first known CDS contracts was made between Exxon and the European Bank for Reconstruction and Redevelopment (EBRD) after the Exxon Valdez oil tanker accident in Prince William Sound, Alaska, in March 1989. Exxon was threatened with a fine of $5 billion, and it asked for the credit line from J.P. Morgan and Barclays bank. Barclays declined.

Blythe Master from J.P. Morgan credit derivatives team came up with an idea of insuring the loan. She contacted the European Bank for Reconstruction and Development, to ask whether they would insure the Exxon credit line in exchange for an annual fee paid for the insurance. If Exxon would default, the EBRD would compensate the J.P. Morgan for the loss. If not, EBRD would make good (practically free) profit from the fees. Because the likelihood of an Exxon default was considered very small, the EBRD agreed, and the CDS market was born.

The CDS:s of Deutsche Bank and Credit Suisse had already risen to same hights as right before the Panic of 2008. Now, the same is happening, e.g., to CDSs of the UBS bank.

Contagion, that is, the fear of a banking crisis, is spreading.

What’s next?

The worrying aspect here is that we are only at the very beginning of this economic downturn and energy crisis. Alas, things can only go worse from here regardless of what central banks do.

The problems of banks and pension funds should thus worry us, a lot. The fact remains that a new banking crisis can truly start at any minute, even though all measures are likely to be in use to postpone it.

Like we wrote in the Deprcon September Outlook:

Now there is a threat that the combination of rising interest rates, accelerating inflation and an energy shock will cause a mass default of households leading to a nearly un-survivable losses to banks. And it will not stop there.

The situation among corporations is no better, at least among the small- and medium-sized corporations, who are struggling with rising producer prices, declining sales and rising interest rates. It’s rather obvious that such a combo, if un-addressed, will lead to cascading bankruptcies and, again, mass defaults on bank loans.

Alas, the outlook for the banking sector is extremely grim. Banking crisis would be all that would be needed, in addition to the ‘flood’ of failures of corporations and households, to cause a systemic crisis, where the modern financial infrastructure simple seizes to function.

Governments will try and are trying to master a bailout of (some) corporations, households and banks, which will likely postpone the onset of the crisis.

The only question is, will they be enough to stave of the crisis altogether?

Considering the scope of the banking issues, I am skeptical, but I’ve been wrong on this once before.

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Disclaimer:

The information contained herein is current as at the date of this entry.  The information presented here is considered reliable, but its accuracy is not guaranteed.  Changes may occur in the circumstances after the date of this entry and the information contained in this post may not hold true in the future.

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