Goldman On Deleveraging And The Sovereign-Financial Feedback Loop

It is no surprise that there is both an implicit and explicit link between financial entity risk and that of their local sovereign overlord. The multitude of transmission channels is large and the causalities, not merely correlations, run both ways, providing for both virtuous (2009 perhaps) and vicious (2010-Present) circles. Goldman Sachs, in its 2012 investment grade credit outlook takes on the topic of the feedback loop which is engulfing financials and sovereigns currently - noting that despite the 'optical' cheapness of financial spreads to non-financials (and equities) that it is unlikely to compress significantly without a 'solution' to the sovereign crisis being well behind us. The key takeaway is that pre-crisis sovereign credit premia were, in hindsight, uneconomically tight (unrealistic) and expectations of a return to those levels is incorrect as they see the current repricing of sovereign risk as a paradigm shift as opposed to temporary repricing due to market stress. "Sovereign spreads will likely emerge from the crisis both more elevated and more dispersed", meaning floors on bank spreads will be elevated and deleveraging pressures to be maintained raising the real risk, outside of spam-and-guns Euro-zone crashes, of a potential credit crunch. This is already evident in European loan spreads, which as we have discussed many times is the primary source of funds (as opposed to public debt markets as in the US).

Goldman Sachs: The Feedback Loop Between Sovereigns And Financials


The spread differential between financials and non-financials is at all-time highs. Even so, we do not expect this relative spread premium to compress until the risk from the European sovereign crisis is safely behind us. Financials remain disproportionately exposed to the interaction of downside macro risk and the enormous pressure under which European sovereigns and banks are laboring. Exhibit 15 shows that US and European bank spreads have been highly correlated with European sovereign spreads in 2011—a trend we expect to persist in the next few months. It is therefore hard for us to see how financial spreads can outperform as the crisis worsens (which in our view is still the most likely scenario from here).




It now seems clear that European policy efforts will not try to stabilize sovereign credit spreads at pre-crisis sovereign spread levels. In hindsight, the credit premium built into sovereign spreads were unrealistic. Looking forward, the ECB (backed by the Germans) has publicly resisted the notion that it either can or should push back against the market's recent repricing of this risk. Instead, policy makers want to see peripheral sovereigns make the adjustments to domestic demand necessary to accommodate this sharp increase in sovereign borrowing costs.


There will be even greater pressure on sovereign spreads in the near term since the core countries and ECB clearly need to keep the external pressure elevated to assure the continued adaption of austerity measures. The "benefits" of austerity will not likely be visible for at least a year (on the contrary, the front-loaded portions of these austerity measures will most likely prove counter-productive). And demands for austerity are more likely to grow as it becomes evident that the repricing of sovereign risk has a large permanent component, reflecting a paradigm shift in the pricing of sovereign risk as opposed to a temporary repricing of market stress. Sovereign spreads will likely emerge from the crisis both more elevated and more dispersed.


For banks, this means credit spreads are almost surely going to embed a persistent premium for sovereign risk. This logic implies there is much less upside room for spread tightening in periphery banks than a simple naïve benchmarking to pre-crisis levels would suggest.





We also expect deleveraging pressures on banks to remain high. The magnitude of announced deleveraging plans of European banks already totals hundreds of billions. We expect the deleveraging trend to continue in 2012. This raises the risk of a potential credit crunch that would further weaken growth, which in return negatively impact banking activity, impair bank assets, and thus amplify the banking crisis.


To be clear, we think losses to senior bond holders of pillar banks in Europe are highly unlikely. Banks have significantly increased their liquidity positions, and we think the ECB can probably do enough to trim the tail risk of a Lehman-style shock. Nonetheless, the number of distressed banks that are now on the ECB “life-support” has increased as the sovereign crisis intensifies. The health of these banks is likely to deteriorate over time, making the final cost more expensive the longer the ECB has to provide this support.


This suggests the Senior-Sub decompression trade is warranted (as we have been saying for a while - pre-downgrades) and picking the carry on financials-non-financials seems like nothing but a beta play to us. Up-in-quality via Main ex-Financials may be lower carry but stands to benefit both ways and XOver looks set to suffer more if deleveraging forces a credit crunch.