Sovereign Risk

And here we go again. Ironically, this is nothing. Wait until S&P, which just telegraphed very loudly the next steps earlier, puts France on downgrade review...

The unerring belief that powers greater than mere mortals will vanquish the enemy of lack-of-bank-capital this weekend was enough to spur a significant turnaround in European stocks and spreads as they headed towards the close. While optically, the strength in senior financials spreads appears wondrous, we note that subordinated spreads are underperforming seniors significantly (when one would expect them to be outperforming if all was really well) and broad equity indices (and credit indices) only managed to get back to marginally unchanged. Sovereign risk remains notably wider still - which has the smell of a bailout/nationalization risk-transfer to it in our ever so humble opinion.

While equity markets in the US have been hurt hard the last 24 hours, credit has been signaling notably more weakness than equities for a while. Today's action follows a similar path to Europe with equities underperforming credit and catching up to credit's view. Last night saw the credit indices close considerably cheap to their fair-value as investors grabbed index overlays as the most liquid hedges - today we some unwind of that as HY bonds are net sold and single-name CDS are decompressing considerably.

As early as July, we pointed out the increasingly likely endgame in Europe with regard to the EFSF and centralizing/concentrating credit risk. Well sure enough, sovereign risk has risen dramatically for Germany (among many others obviously) as traders realized standing on the shoulders of giants does nothing but push them further into the dirt. What is becoming more worrisome, and dramatically escalating, is the rise in sovereign CDS relative to government bond yields - or the so-called 'basis' - as it becomes ever more clear that government-bond-yield-by-mandate may not be as 'real' a measure of the risk-free rate as CDS.

...as expected from the previous post. Now, BNP downgrade a matter of seconds.

Ladies and gents, it starts. Credit Agricole and BNP downgrades imminent.

Our hats off to JP Morgan for a creative depiction of the current European debt crisis, although we typically take a dim view of any investment vehicle that's associated with the word "leveraged" as recommended by JPM.

Despite some better-than-expected macro data overnight (admittedly marginal), investors continue to retreat from any European exposure as sovereign stress leads to financial stress and drags non-financials into an austerity-driven slowdown. The snaps wider in credit markets are very reminiscent of crises past when being hedged at any cost was more important than any short-term trade opportunity.

Over the weekend, we presented the suddenly very pessimistic outlook by Morgan Stanley's equity strategist team which stated in no uncertain terms that it "assigns a higher probability to our bear case than bull case, preventing us from becoming increasingly optimistic" adding that it "continues to assign a higher probability to the bear case than the bull case, and believe the recent price action increases the probability of the bear case." Yesterday, the firm's Credit Strategy team joined the call for a bearish outcome, when in a conference call it stated its case for why its "bearish strategic view is based on long-term structural and valuation issues." Two key metrics watched by MS: i) The unsustainable DM credit super-cycle may be approaching a difficult dénouement, and ii) based on long-term P/E valuation measures, US and UK equities are still expensive. MS warns that "a larger correction in risk assets is likely if a recession occurs, more so for equities" a topic discussed by the equity strategy team over the weekend which believes that the probability of a recession has surged (and continues to be confirmed by leading indicators such as yesterday's Empire State Fed survey). Morgan Stanley's concluding advice to clients: "look to reduce risk in Developed Markets  in Counter-Trend rallies." Luckily, any time volume trickles to a halt, the counter-trend rally should present itself providing ample opportunities for selling into it.

Citigroup makes the circular argument credible! Well.. Sort of.

One of the key catalysts for Wednesday's market rout which originated in Europe came following news that Chinese banks had cut down on their credit lines to Europe, which highlighted the key threat to the European banking system: access to liquidity. The Chinese reaction is merely a symptom of a much deeper underlying ailment: the increasing lack of counterparty confidence across various funding markets, both traditional and shadow, which has continued to accelerate over the past week, a development summarized effectively by the latest report in the International Financing Review which uses some powerful words (of the type that European bureaucrats hate) to explain where Europe stands right now: "credit taps run dry for European lenders, setting scene for liquidity crisis." For those strapped for time the take home message is that: "with bond markets shut and investors unwilling to buy asset-backed securities, the repo market – for some banks the sole remaining source of private funding – has become the most recent tap to run dry, with some investment banks pulling credit lines worth tens of billions of euros in recent weeks." This is very disturbing as with liquidity windows shut, Europe's bank have no recourse on how to roll the €4.8 trillion in wholesale and interbank funding which expires in the next two years. End result: the only recourse is the ECB, which unlike the Fed, is not suited to be a lender of last resort and has been morphing into that role over the past year kicking and screaming. And when that fails, there are the Fed's liquidity swap lines. Too bad that the liabilities in the European banking system are orders of magnitude bigger than in the US, and should this liquidity crisis transform into its next and more virulent phase, even the Fed will find it does not have enough capital to prevent a worldwide short squeeze on the world's carry trade funding currency (once known as the reserve currency).

Risk update: today everyone is more blowy upy, both core and periphery

• MAIN -1    
• XO -10     
• SOVX 283/287 +8  
• SOVX CEEMEA 245/249  
• IT +16                                   
• SP  +12
• PORT +9
• IRE +5
• BELG +6
• FR +5
• UK +1
• DEUTSCHE  +.5

And a special bonus: Intesa Sanpaolo -4.6%, Societe Generale - 4%, Unicredit -3.8%.

As both Italian and Spanish bond spreads continue slowly creeping wider toward the half a century territory, we are reminded once again that once both countries pass 450 bps, LCH will automatically hike collateral triggers for both countries, in essence initiating another waterfall effect whereby less cash is released upon repo, requiring more bonds to be pledged, which in turn means other assets have to be sold off to make up for the shortfall, which in turn leads to a sell off of the underlying financial institution (recall that banks in Europe buy their nation's sovereign debt and immediately pledge it back via various repo mechanisms) and so on. What this practically means is that the bond vigilantes now have a far more achievable task in terms of endgoals when it comes to punishing the offending debt, in this case Italy and Spain. Expect a prompt move to this appropriate level as debt holders start panicking what an extra margin demand will mean for them, and in turn try to lock up cash at current repo levels.

NPAs and devalued sovereign debt infect bank balance sheets, which are bailed out by sovereigns who assume too much debt for the bailouts, thus dropping the value of their bonds, further stressing bank balance sheets, thereby increasing the need for bailouts. Wash-Rinse-Repeat. Hey, he who panics first, panics best!

For those confused by the cornucopia of assorted debt ceiling "plans" out in circulation, Citi's Amitabh Arora has released the definitive guide for what plan does what in terms of proposed deficit reduction, probability of passage of the Congress, Senate and the President, and likely outcome to the US rating. As table 1 below shows, UBS' prescient call from last Thursday that a US downgrade is inevitable, was spot on. It also explains why the entire sellside industry, and media, have been in damage control over what now appears to be an inevitable AA rating of the world's reserve currency. Alas, just like with Lehman, nobody really has any idea what will happen to capital markets once the Poor Standards or Moody's headline of a AA cut hits the tape: one thing is certain - there are trillions in US invested money market funds, structured finance debt and munis that have rating mandates and demand a super secure (AAA) threshold, and especially an A-1+ short-term rating. Should there be a massive flow out of these securities and into other asset classes, the outcome is absolutely unpredictable. More importantly, Citi touches on a topic that has not seen prominent mention anywhere else: namely the acceleration of the GSEs status from conservatorship to receivership should there be no prompt resolution on the debt ceiling. For agency paper holders this may be a topic that merits much more diligence.