Is Brexit Moment a Lehman Moment? Fear Factor in Financial Crises

Posted on July 19, 2016 by Yves Smith

http://www.nakedcapitalism.com/2016/07/is-brexit-moment-a-lehman-moment-fear-factor-in-financial-crises.html

Yves here. Note that Öncü’s article is looking at events during the financial crisis that did (or didn’t) produce liquidity crunches. One squeeze that is not on his list is November-December 2007, and that is because it was not triggered by a particular event. Liquidity in financial markets becomes thin at year end because many investors try to minimize or halt trading after December 15 so they can settle things up for the year without undue stress.

In 2007, trading conditions in credit markets were becoming difficult in early November. At least part of the reason was concern about structured investment vehicles, which had been buyers of subprime debt and depended on short-term funding. Recall that Hank Paulson spent weeks flailing around trying to orchestrate a private sector rescue plan, which we correctly predicted would never get off the ground. The Fed announced its first emergency program, the Term Auction Facility, on December 12.

Of course, another issue is that is it not yet clear what Brexit means….but that was also true of some of the events during the crisis.

By Sabri Öncü (sabri.oncu@gmail.com), an economist based in Istanbul, Turkey. This article was written on 2 July 2016 and first published in the Indian journal EPW on 16 July 2016

The Lehman moment is the moment when Lehman Brothers—one of the largest investment banks in the United States (US) at the time—collapsed. The collapse happened on 15 September 2008. Almost nobody disagrees with that the Lehman moment has been the most important moment in the ongoing global financial crisis that started in the summer of 2007, at least, up until the Brexit moment.

What is Brexit Moment?

The Brexit moment refers to the 23 June 2016 referendum in the United Kingdom (UK) in which the Britons voted on whether to remain in or to leave the European Union (EU). Its outcome became official on 24 June 2016.

Naturally, there were two sides. The “Bremain” side, supported remaining in the EU, and the “Brexit” side, supported leaving the EU. The Brexit side beat the Bremain side 51.9% to 48.1% on 23 June, unexpectedly. The next day, the Brexit moment hit the global financial markets leading to major drops in almost every equity market around the globe. And since then, the internet has been flooded with unidentifiably many articles analysing sociological, psychological, political, geopolitical, economic, financial and other difficult-to-imagine aspects of Brexit.

This article comes from two of those articles. There was one statement from each that struck me. The statement from the first article, attributed to the Allianz Chief Economic Advisor Mohamed El-Erian, is: “Brexit: Not a Lehman moment.” The statement from the second article is: “Brexit is a Bear Stearns moment, not a Lehman moment.”

Prior to Lehman moment, there were three other important moments. The first Bear Stearns moment (20 June 2007), BNP Paribas moment (9 August 2007) and the second Bear Stearns moment (14 March 2008).

Shadow Banking

Simply put, shadow banks are non-bank financial institutions which behave like banks. They borrow in rollover debt markets, leverage themselves significantly, and lend and invest in longer-term and illiquid assets. The difference between the two is that, unlike banks, shadow banks cannot create deposits—that is, money. If we leave this aside, then the two are more or less the same.

The significance of this is that just as bank runs can occur on banks, shadow bank runs can occur on shadow banks.

A bank run is rioting of the bank’s depositors—the most important and largest section of the bank’s short-term creditors—at the bank’s door to get their money out. A shadow bank run is more or less the same. Except that, since shadow banks have no depositors, it is their short-term creditors who riot at the door. This riot takes place electronically at a virtual door. It is not visible, because it is not physical.

The reason why those who claimed Brexit was not a Lehman moment must have been that there was neither a bank nor a shadow bank run at Brexit moment.

First Bear Stearns Moment

The signals of the first Bear Stearns moment became noticeable early in 2007. Like Lehman, Bear Stearns was one of the largest investment banks in the US at the time. When the real estate bubble in the US started to burst in the first quarter of 2006, the subprime mortgage market began to deteriorate.

The first casualty was two highly levered Bear Stearns hedge funds. They were shadow banks speculating in subprime mortgages by borrowing short-term funds in the repo market and pledging their mortgages as collateral.

With the deterioration of the subprime market in early 2007, creditors began asking these funds to post more collateral by June 2007. When the funds failed to post more collateral, Merrill Lynch seized $850 million of their assets and tried to auction them on 19 June 2007. When Merrill Lynch was able sell only about $100 million of these assets, the illiquid nature and the declining value of subprime assets became evident. The next day, these funds collapsed.

This is the first Bear Stearns moment.

BNP Paribas Moment

Although the collapse of these two funds did not freeze the repo market, it increased the fears of counterparty risk and made the problem systemic.

Here, the key word is fear. When fear hits financial markets, it spreads.

In early August 2007, a run started on the assets of three special investment vehicles (SIVs) of BNP Paribas. These SIVs were bankruptcy-remote entities financing their subprime holdings through issuance of asset backed commercial paper (ABCP). On August 9, BNP Paribas suspended redemptions from these SIVs when their ABCPs lost their liquidity and became non-tradable. This caused the entire ABCP market to freeze. When fears of counterparty risk spread through markets, all short-term debt markets froze, only to open after central banks injected massive amounts of liquidity (Acharya and Öncü, 2013).

This is the BNP Paribas moment.

The BNP Paribas moment is what started the ongoing global financial crisis. The reason why most people do not know about BNP Paribas moment is that it effected the US markets mostly. Lehman moment is better known, because it globalised the crisis.

Second Bear Stearns Moment

It is all about fears and, beginning late Monday, 10 March 2008, fears spread about liquidity problems at Bear Stearns, freezing the repo markets in which Bear Stearns was funding its illiquid assets.

This happened on 13 March 2008. Then, on Friday, 14 March 2008, on the second Bears Stearns moment came.

On 14 March, the Federal Reserve Bank of New York agreed to provide a $25 billion loan to Bear Stearns to save it, sending the signal to markets that Bear Stearns was dead. Failing to save Bear Stearns on Friday, the Federal Reserve Bank of New York arranged a costly marriage between Bear Stearns and JP Morgan Chase on Sunday, 15 March 2008, about two years after which Bear Stearns name went into oblivion.

This is the second Bear Stearns moment which laid the ground for Lehman moment.

Fear Indices

There are many fear indices in the global financial markets and I will compare the above described four moments—namely, the two Bear Stearns, BNP Paribas and Lehman moments—with the Brexit moment based on two indices— VIX and the TED Spread.

Their main significance is that they are publicly available and daily data for these indices go way before the onset of the ongoing global financial crisis.

A third index I will touch upon is SKEW, but unfortunately, its daily history I was able to obtain starts only after 2010.

VIX: VIX is the ticker symbol for the Chicago Board Options Exchange Volatility Index, a measure of the 30-day volatility of S&P 500 index options. It is constructed using the implied volatilities of a wide range of S&P 500 index call and put options, and meant to be a forward looking measure of volatility. It was introduced by Whaley, a Vanderbilt University finance professor, and had gone through several modifications since its introduction in 1993. Often referred to as the fear index, it has been considered by many to be the world’s premier barometer of investor sentiment and market volatility.

TED Spread: The TED spread was born after Chicago Mercantile Exchange developed and introduced the Eurodollar futures contract in December 1981. When first defined, and traded, the TED spread was the difference between the interest rates for the 3-month Eurodollar futures and 3-month Treasury bill futures contracts. Indeed, ED is the ticker symbol of the Eurodollar futures contract. These days, the TED spread is the spread between the 3-month LIBOR and 3-month US Treasury bill rate. The TED spread is viewed as another fear index, because many view it as a measure of the perceived difference between the safety of lending to other banks and the safety of lending to the default risk free US Treasury by the banks of concern. A big jump in it indicates funding liquidity freezes, that is, “bank runs”, in money and credit markets.

SKEW: SKEW is the ticker symbol for the Chicago Board Options Exchange Skew Index, a measure of tail risk—that is, the risk of extreme events such as major crashes in equity markets. SKEW is calculated from a wide range of (out-of-the-money) S&P 500 index options and considered by many as the real fear index. Historically, it fluctuates between 100 and 130 and its historical maximum is 151. Its values beyond 130 usually indicates increased risk avoidance in financial markets.

Comparison of the Moments

Let me now compare the five moments based on VIX and the TED Spread as percent changes from a day earlier in the table below.

 

The very first conclusion from the table may be that Brexit moment is neither any of the two Bear Stearns moments nor the BNP Paribas moment nor the Lehman moment. It is a new moment. While based on VIX, the Brexit moment is the worst (given its impact on the global equity markets, this is expected), based on the TED Spread, the Lehman moment is the worst and the Brexit moment is just an ordinary event (given that the UK is neither a bank nor a shadow bank, this is expected also).

Two other observations are as follows. The first is that from 23 June to 30 June, the TED Spread jumped about 17.7%, which may indicate some funding liquidity issues. The second is that SKEW reached its all-time high of 151 on 28 June, which may indicate increased risk avoidance and market expectation of an extreme event, that is, growing fears.

Apart from all of these, most European banks are zombies. Since 23 June, the Italian bank shares crashed more than 20% and the Italian banks are dying one by one these days. Furthermore, the International Monetary Fund called Deutsche Bank (the largest German bank) the riskiest financial institution in the world as a potential source of external shocks to the financial system on 30 June. With few exceptions, the government interest rates are falling in almost every country, and even the long term Japanese, German and Swiss interest rates are in the negative territory. True, the world equity markets recovered their losses after the Brexit moment. But, this was because of the expected coordinated interventions by the world’s major central banks, which they fulfilled.

Now, what should we conclude from all of these?

La Sagrada Familia

One of my favourite albums of all times is Gaudi album by Alan Parson’s Project. One of its song is La Sagrada Familia. Here is a part of the lyrics.

Who knows where the road may lead us, only a fool would say

Who knows what’s been lost along the way

Look for the promised land in all of the dreams we share

How will we know when we are there? How will we know?

Only a fool would say

Reference

V.V. Acharya and T.S. Öncü (2013), “A Proposal for the Resolution of Systemically Important Assets and Liabilities: The Case of the Repo Market,” International Journal of Central Banking, January, pp. 291-349

Did the European Court of Justice Just Rescue Italy’s Banks?

Posted on July 19, 2016 by Yves Smith

http://www.nakedcapitalism.com/2016/07/did-the-european-court-of-justice-just-rescue-italys-banks.html

As readers may recall, Italy has been trying with no success to get the ECB and European banking authorities to allow it to rescue its banks. Unlike banks in most other European countries, Italy’s got sick the old fashioned way: by lending to businesses in its own market, and then having the loans go bad, in large measure to how lousy the post-crisis economy has been.

New Eurozone-wide banking rules took effect in January. They require bank bail-ins as the remedy for sick banks, with only narrow exceptions. “Bail-in” means wiping out shareholders, and then wiping out bondholders and converting bondholders to equity holders to the degree that you now have a bank with a decent equity cushion.

That might sound sensible, except in Italy, many banks defrauded depositors by persuading them to buy bonds that are junior enough to put them first in line in a bail-in, by telling them those bonds were just as good as deposits. So bail-ins would hurt and potentially wipe out a lot of retail savers. That would not only damage the economy in a serious way, but it would also create political havoc. Premier Matteo Renzi is already at risk of losing to Beppe Grillo’s Five Star movement in elections this fall. Bail-ins would seal his fate. Five Star has vowed a referendum on exiting the Eurozone. Given that the currency union has become an economic hairshirt for Italy, a referendum is seen as having good odds of passing

One would think the foregoing would motivate the Eurocrats to cut Italy some slack, and Renzi has made several cases as to why Italy should get a waiver. Commentators at the Financial Times are sympathetic. From an article last week:

Wriggle room was an issue much debated by investors in Europe’s banks this week: can Italy use as much as €40bn of public money to help its banks when the aim, if not the fine print, of EU rules is that it should not?

The question is pressing because Monte dei Paschi di Siena, the world’s oldest bank, may fall short when regulators this month assess its ability to withstand losses. Estimates for how much capital is needed range from €3bn to €6bn, after finding a buyer for perhaps €20bn of loans gone bad.

A cascade of problems could follow from the knock to confidence in the Italian financial system. The prospect of merging strong banks with weaker ones could fade. Retail investors, who the International Monetary Fund estimates own a third of the €600bn of bonds issued by Italy’s banks, may panic at the prospect of losses.

Yet the authorities have ignored Renzi’s pleas. But has the European Court of Justice given Italy a reprieve? From Reuters (hat tip Richard Smith):

European Union member states are not obliged to make shareholders and junior creditors pay before intervening to rescue a bank, the EU top court said on Tuesday.

EU rules imposing losses on bank creditors before a bank bailout were considered legal by the Luxembourg-based European Court of Justice in its ruling over a Slovenian banking rescue.

However, the rules are not binding on member states, the court said in its ruling that slightly limits the European Commission’s antitrust powers amid talks for an Italian banking bailout. The court said that burden-sharing by shareholders and subordinated debt holders was not a precondition for granting state aid to a troubled lender.

[…]

Diebold Accidentally Leaks Results Of Election

Will Italian Banks Tear Down Europe?

Posted on July 18, 2016 by Yves Smith

http://www.nakedcapitalism.com/2016/07/will-italian-banks-tear-down-europe.html

Yves here. The updates in this MacroBusiness report are consistent with our reading on the arm-wrestling between Matteo Renzi versus the ECB and other Eurocrats. Short version: since early this year, Renzi has been trying to get what has widely been described as a “bail out” for sick Italian banks, of which there are many. The term “bail out” makes Renzi’s plan seem more generous than it is, since he is not proposing to prop up diseased banks, but to have them spin out their bad assets into a “bad bank”. This is similar to the approach used in the US savings & loan crisis and in Sweden’s widely praised early 1990s bank rescues. A good bank/ bad bank approach leave the cleaned up banks considerably smaller. Some banks may have so many bad loans that there is no or pretty much no “good bank” left, so you can expect this approach to lead to some consolidation too. I have to confess that am not clear as to how Renzi proposes to change the operations of the “good banks” that needed state intervention to survive.

It would seem to make eminent good sense to give Renzi the waivers he needs to rescue the banks since:

If Italian banks start falling over, the dominoes will quickly reach Deutsche Bank

As the article below points out (and we’ve stressed earlier), if Renzi is forced to do bail-ins, small Italian savers will take a big hit. Many were fraudulently sold subordinated bonds and told they were the same as deposits. That’s not true, since they will be next in line after bank equity to be wiped out in a bail-in. Any meaningful losses to these small savers would both further damage Italy’s already weak economy, and boost the Five Star movement, which already has good odds of winning in elections this fall. Five Star has promised a referendum on exiting the Eurozone. The UK leaving the EU would be very damaging economically but it’s remotely possible that it might not be a total disaster. By contrast, Italy leaving the Eurozone would be cataclysmic.

So with the stakes so high, one would think the ECB and Eurocrats would relent, since they have a perfectly good face-saving excuse for retreating from their barmy bail-in scheme: with Brexit in play, banks are already looking wobbly, and the new bail-in rules allow for rescues under extraordinary circumstances. But Renzi tried that argument, as well as another escape hatch, public interest, and was told “Nein” both times.

Why are the European banking regulators being so self-destructive? Part of the answer may be prejudice against periphery countries. But as David Llewellyn-Smith indicates, again consistent with what other analysts have sad, the authorities are wedded to the newly-nstituted bank regulations, even though banking experts all deem the bail-in procedures to be guaranteed to produce runs and shake confidence. While bail-ins would be a useful tool in a regulator’s arsenal, the bail-in rules are “one size fits all,” making them unsuitable for real-world use.

This situation is disturbingly analogous to Lehman. After the Bear Stearns rescue, there was such a strong political backlash that the Bush Administration decided it was not doing that again. Moreover, it was obvious from the media that they were not going to relent. Yet Dick Fuld nevertheless convinced himself that Lehman would get government help if he could not find a moneybags to save Lehman. That led him to blow up the one deal he could have had, an investment by the Korean Development Bank in a Lehman “good bank”. Fuld regarded it as unacceptable to have to wind down the bad parts of Lehman.

Oh, and in a telling bit of history…the successor to Creditanstalt is over 96% owned by Unicredit, Italy’s biggest bank.

While the politics are different, we again have political imperatives trumping real-world consequences. And here, the downside is more obvious than it was with Lehman.

By David Llewellyn-Smith, founding publisher and former editor-in-chief of The Diplomat magazine, now the Asia Pacific’s leading geo-politics website. Originally posted at MacroBusiness

From the AFR:

Platinum, the Sydney-based global value investor, is defying the bearish mood and buying more European bank stocks after its positions in banks accounted for almost half of the fund manager’s losses so far this year.

The Platinum Unhedged Fund’s latest report shows that its value fell 10 per cent in 2015-16 compared with a 1 per cent fall for global equities. Platinum is not alone; many Australian fund managers who invest globally have seen returns hurt by the Brexit vote through falling positions in European bank stocks such as Lloyds Banking Group, including at PM Capital and Magellan among others.

…What is unusual is Platinum’s willingness to buy more

…”The banks’ share prices are factoring in fear of further political risk, namely, a full break-up of the European Union. The impact of recency bias plays a big role here. As we have just seen, a large country making a shock exit, suddenly the probability of further exits feels significantly heightened,” the fund manager told clients. “But we need to take into account that the European governments will react and concessions will be made.”

I am sure that Platinum is joking when it says that European banks are priced for a “full break-up of the European Union”. They have fallen a long way, however, and that rather amusing statement does not mean that it is wrong about Europe giving ground on Italy, from Bloomie:

It may seem like there are many different ways this critical situation can pan out, but all bar one would be fatal for the euro zone. The only option is to bail out the banks without “bailing in” investors.

Of course the banks will be rescued. This column has previously outlined how Italian banks will be saved precisely because the alternative is the collapse of the Italian economy, which would likely precipitate the breakup of the euro.

So the crunch decision is whether bond investors share some of the cost of that bailout. Since January, the EU has legislated that investors must be bailed in, and bail-ins have happened elsewhere, e.g. 54% haircut for senior creditors of Heta Asset Resolution in Austria.

Surely the EU can’t blatantly break its own new rules just for Italy? That would set a bad precedent, completely undermine its authority, create large moral hazard within the euro zone, and weaken the euro.

But it can. And it most likely will. Because the alternative is much scarier. In Italy, too much of the subordinated bank debt is owned by private individuals. If they’re made to pay for this, then Italy’s constitutional referendum in October will fail, resulting in Prime Minister Renzi resigning and the collapse of the government.

Italy will be in crisis, and anti-EU sentiment will gain a significant boost at a time when the euroskeptic Five-Star Movement has already become the most popular party. Again, the euro zone will be in serious jeopardy.

So there’s really only one path to be followed: the one that doesn’t threaten to break up the euro zone. The Italian banks will be bailed out and investors will not be bailed in.

This will be a boost to global equities and positive- yielding bonds, yet another boon for emerging markets. It will be less good for the euro, which is trading within 1% of its 18-month high versus a trade-weighted index.

That is probably too black and white and a partial bail-in is more likely with a distinction made between small and large bond holders. So, to that extent, Platinum is probably right.

Except that that is not the real problem. This is, from The Telegraph:

The bondholders’ losses risk harming the government’s reputation at a delicate moment.

Prime Minister Matteo Renzi is already facing a close-fought referendum over a planned constitutional reform. If he loses the vote, it could mean the end of his government, and polls indicate that the eurosceptic Five Star party, headed by Beppe Grillo, could perform well in a general election, spreading further political instability through the European Union.

Italian pragmatists argue the cost of a government-backed bailout would be worth paying, to avoid financial instability. Yet the equation is not that simple.

The EU insists bondholders have to bear the cost of the recapitalisation, sparing taxpayers and forcing investors to think about the risks they are taking, to help stop future crises at banks and in governments’ finances.

Officials at the Eurogroup and European Central Bank are digging in their heels – they do not want the past five years of financial reforms undermined immediately by Italy.

Such a result would sap their own authority and open the door to similar state-backed deals in Portugal, which is also suffering from bad bank loans.

Still, even a bailout would bring political risks to Mr Renzi.

Lorenzo Codogno, former director- general of the Treasury Department at the Italian economy ministry, says there is a risk that a bail-in of retail investors could be politically toxic, even if a conversion of debt into equity, could be a “gift” for many bondholders who now have illiquid subordinated debt.

“The risk is clearly that it is not taken well by the electorate, affecting political support for the PM,” says Codogno, the current chief economist of LC Macro Advisors.

Does Platinum understand Italian politics so deeply (making it pretty unique) that it knows how this is going to play with the polity amid BREXIT, French attacks, a rising Five Star Movement, as well as the likelihood that any European bailout concession will very likely come with reform conditions that will do great harm to growth before anything improves? Platinum clearly did not see BREXIT coming so why would it be any better on Italy? The blood is up in Europe, this is not just a numbers game anymore.

Perhaps holding on at this juncture makes sense given Platinum’s losses but buying more?