Earlier we pointed out the surge in CDS on a variety of PIIGS banks, mostly in Portugal and Spain. Now we know why: Goldman's Charles Himmelberg has just reiterrated his call for Long CDS on local banks in Portugal, Spain and Italy, hedged by selling Main (iTraxx) protection. It is our view that as accounts plough into this trade and as bank spreads blow out, it will only accelerate the funding complexities, the bank runs and the inevitable collapse of the financial systems in all of the other imparied peripheral countries, ultimately leading to the collapse of the EMU. Will Goldman be accused next of destroying Europe? Stay tuned.
This morning the Greek Prime Minister called for a financial lifeline of as much as €45bn, provided by the EU and the IMF. Our European economists discussed the mechanics of the package in their April 21, 2010 European Views: “Greece initiates formal negotiations with the IMF/EU – Q&As on the most important issues for the weeks to come”).
With total debt around €265bn, they believe Greece is not out of the woods yet. The Greek government faces a financing gap of about €51bn during the next 12 months, and will need to enact strong fiscal tightening (up to 10% of GDP) and new reforms to re-establish growth.
We continue to think pressures on southern European sovereigns are not a threat to corporate credit markets. The re-financing issues and tight fiscal policy of Greece will not translate into a broader contagion, we think, because Greek firms account for less than 1% of the Euro-zone market (Germany, the UK and France are 60%) (for more details see “Sovereign risk and the contagion to credit”, Credit Line, February 5, 2010) That said, southern European banks will likely struggle. Pressures on sovereigns will likely hit small businesses and the local banks they borrow from. Instead of popular trades like shorting sovereign CDS or the Euro, we recommended buying default protection on the local banks in southern Europe, which at the time traded tighter than the CDS of their respective countries. Following increased sovereign risk, as well as increased competition for deposits, the banks in southern Europe have sold off, underperforming both the broad market, their sovereign CDS and the Euro (Exhibits 9, 10, 11 and 12). As a result, our trade performed well over the past month and is up 142bp today.
High unemployment, decreasing house prices and poor to capital markets are likely to continue to challenge firms in southern Europe, where corporate bonds are only around 7% of GDP (compared to 14% in the rest of Europe and 28% in the US). Local banks, which used to rely on a stable deposit base, will face increased competition from larger players, who are willing to diversify away from bond funding. They will also face new regulatory charges over the coming months. While we remain positive on financials as a whole, we think the local southern European banks will continue to underperform.
For these reasons, we re-iterate our recommendation to buy protection on local banks in Portugal, Spain and Italy against iTraxx Main (Exhibit 13).