From Capital Context
Systemic Risk Elevated
The credit risk of the 30 most systemically critical financial entities in the world just broke an important channel and is at its highest in over four months at 135bps with its largest three-week rise of over 14% since Nov2010.
Before and during the financial crisis, we were crucially involved with the creation of several indices designed to track stability in financial markets with a focus on both liquidity and counterparty risk. While the liquidity measures we designed have been largely disintermediated by government intervention since then, the measures of counterparty risk remain highly visible and appear to have been a successful guage of public perceptions regarding financial systemic risk.
The Financial Stability Board created a list of 30 large global financial entities that represented to it the most systemically worrisome firms in the world. The chart above tracks a weighted average of the 5Y CDS (or credit risk) of these 30 names. The higher the index, the great the credit risk perceived among the world's most systemically worrisome financial entities. The greater that credit risk, the more concern there should be for another round of potential insolvencies or collapse of the financial industry.
While the currrent level is certainly not in the critical zone, it is rising rapidly and is approaching key levels at which risk managers will begin to start evaluating CVA overlays in our opinion. A 14% rise in the index over the last three weeks is extremely fast and we note that at current levels we are almost twice as risky currently as were prior to the financial crisis and also at the trough post the financial crisis in Jan2010.
The geographic split is evidently more concentrated in European entities than in the US and Asia, as seen in the chart above, and we also note that while a cursory glance shows considerable dispersion (the table is sorted worst to best in each geographical region), it is clear that migration (or discrimination) among these banks is drifting upwards. North American components average 120bps, European components average 138bps, and Asian components average 126bps.
With China raising rates (and a housing bubble seemingly bursting), Japanese stress from the vicious circle of the tsunami and macroeconomy spiralling with a weak demographic, European banks clearly burdened by mismarked sovereign debt on their books, and a US financial system that continues to practice extend-and-pretend all the time hosuing weighs heavy and TLGP debt must be refinanced, it would make sense that risk is elevated. It should be clear from the chart above that not only is systemic financial risk rising but globally it is becoming more correlated - a factor that should be of great concern for both central bankers and risk managers attempting to mitigate any insolvencies. The apparent realization, of an increasingly inter-linked and even bigger financial system since the financial crisis, among credit market participants is a signal not to be ignored.
We have not seen this reflected in the typical measures such as Libor, OIS etc which became so prevalent among the media during the crisis and the simple reason is the amount of government overlay of simple impliciit guarantees that seem so evident in those markets. This index is transaparent and offers a very clear market interpretation of the stress the global financial system is under. All too often, we have found our old agage that credit anticipates and equity confirms to be true. Keeping a close eye on this financial stability index over the course of the summer as European stress continues will be important.
As actionable trades , we still like Financials vs Ex-Financials decompression (especially given where SovX is trading). The triangle trade between SovX-Main-SENFIN remains in a regime where we think there is upside also. Senior-Sub financials spread remains lower than expected. In the US, interestingly, our contextual framework shows that XLF (the financials ETF) is actually modestly cheap at current levels given current and empirical relationships between credit, equity, and vol - but this would be a long XLF for a trade with maybe 5% upside and a tight stop.