‘Spectacular’ Losses = USA Banks

The rule, named after former Federal Reserve Chairman Paul Volcker, was included in the 2010 Dodd-Frank Act in an effort to restrict risky trading at banks that operate with federal guarantees. Five U.S. regulators released the 298-page proposal seeking comment on how it would affect market-making, liquidity, foreign institutions and private equity and hedge fund investments.

Volcker, 84, defended the rule in his own letter yesterday, challenging banks’ arguments that the rule would hurt markets.

“The recent years of financial crisis have seen spectacular trading losses in large commercial and investment banks here and abroad,” Volcker said. “Consequently, the stability of important banks was jeopardized, contributing to a financial crisis of historic dimension.”

The Volcker Rule will push risk outside the US Federal envelope and make it the risk takers problem and not the taxpayers problem....

You stress test a plane well before takeoff, BUT we stress test banks when they may be in a nose dive....

The Federal Reserve sought to bolster confidence in the U.S. banking system as concerns over the European sovereign-debt crisis roil financial markets and pose risks to the economic expansion.

The Fed yesterday told the 31 largest U.S. banks to test their loan portfolios against a deep recession to ensure they have enough capital to withstand losses. Banks with large trading operations will also test against a European market shock. The most severe scenarios outlined by the Fed include an unemployment rate of as much as 13 percent, an 8 percent drop in gross domestic product and a 52 percent plunge in stocks from the third quarter of 2011 to the fourth quarter of 2012.


“This is a daunting test,” said Karen Shaw Petrou, managing partner at Federal Financial Analytics, a Washington regulatory research firm whose clients include the largest banks. “The Fed’s credibility as a tough guy can’t be challenged based on this.”

The tests, which the Fed said don’t represent its outlook for the economy, aim at making banks’ capital adequacy more transparent by demonstrating whether they can handle a deeper downturn and financial market shock. The Fed helped clear away uncertainty surrounding banks in May 2009, when it published stress tests showing that 10 U.S. firms needed to raise a total of $75 billion, giving investors more clarity.

Fra il dire e il fare c'è di mezzo il mare...

What are the implications for the U.S given the weaknesses in Eurozone? Think about the market turbulence over Greece, Ireland and Portugal, and multiply.

All of this means the U.S. needs another round of stress tests. It would be wise for U.S. banks to raise enough capital now to withstand any trans- Atlantic storms, such as say hmmm Italy!

Italy has close to 2 trillion euros in debt outstanding. It’s inconceivable that Germany or the IMF could provide a rescue to protect its creditors. Such a package would have to involve loans and guarantees of at least 500 billion, and possibly 1 trillion, euros to impress the markets. This would be a significant fraction of Germany’s gross domestic product of about 2.5 trillion euros. With a debt-to-GDP ratio of about 80 percent, Germany’s ability to take on new debt is limited. Also let’s not forget east of Berlin issues.

The Netherlands, Finland and Austria, combined with Germany, have a GDP of about 3.5 trillion euros. France adds 2 trillion more, but its debt, already 85 percent of output, is expected to grow over the next several years.

Europe does not have enough fiscal firepower to handle an Italian crisis -- at least in such a way as to protect creditors completely. Why would Germany or other EU countries lend to Italy, particularly when its politicians show no sign of coming to grips with their reality?

Italian banks aren’t likely to fail. Regulators will offer plenty of forbearance, so the banks won’t have to value assets at true market values. But the overhang of sovereign-debt losses and a potential ratings downgrade (after a recent warning on Italy from Moody’s Investor Service) could cause banks to cut back on private-sector lending. This would lower GDP growth and further worsen Italy’s debt-to-GDP projections.

What Italy needs is industry, jobs, real value creation equaling real growth. Debt management without social transformation will only delay an inevitable default.

The little engine that couldn’t!

First the facts. Greek debt amounts to about $380bln or 2.7% of Eurozone total sovereign debt. Greece contributes about 3% to the total Eurozone GDP of $16 trillion. So talk of Greece being the cause of the Euro collapse is a little like the dollar collapsing because Mississippi gets downgraded or defaults. In fact, we have witnessed bigger economic states in the USA default without much effect at all on the greenback…e.g., California and New York to name two.
But that doesn’t mean there isn’t some great trading (ok speculating) to be had -- certainly aided by the capital flight from Greece by Eurozone member banks. More on this shortly.

Some more data. The cost of insuring Greek sovereign debt hit a new lifetime high on Monday (12 June). It now costs €1.6m to insure €10m of Greek debt, a record amount, after the five-year Greek credit default swap jumped 1,600bp. The prices of insuring Ireland and Portugal's debt also hit new all-time highs, according to data from Markit.

On top Greece getting downgraded to CCC, looming quickly is the big sovereign-debt rollover for Italy and Spain. Now, if the debt market locks up, and the global economy falters – then you have about 33% of Eurozone debt in three sovereigns that are struggling with their economies (deficit, employment, debt, negative growth) – things then get very interesting.

A collapse in the euro isn't the only potential catastrophe lying in wait, either. A more immediate concern would be the collapse of a major European financial institution. Any fear of a bank failure will result in another interbank liquidity-and-funding panic.

Figures from the Bank of International Settlements (BIS) show French, German and UK banks have embarked on a mass exodus from Greece, Portugal, Spain and Ireland, in what analysts see as an effort to bolster their balance sheets and conform to new rules designed to protect financial institutions from going bust.

The move is expected to add to tensions in Brussels over how to prevent Greece defaulting on its loans because vital business contracts will cost more to insure.

French banks cut their exposure to Greece from $92bn (£57bn) to $65bn in the last three months of 2010. They also reduced their involvement in Ireland, Portugal and Spain, slicing their total exposure to the four hardest-hit economies by $112bn.

German and French banks held over two-thirds of the Greek government bonds at the end of last year, accounting for 70% of the $54.2bn owned by banks from 24 countries that report to the BIS.

International loans to Greece stood at $161bn at the end of December, down $75bn from a year before.

BNP, which has almost $3 trillion of assets, refused to disclose how much it had reduced its exposure. A spokesman played down its involvement in Greece, Ireland or Portugal, saying that it had no retail operations in those countries.

Of the European banks that are most at risk for Greek default:

* Fortis NV (OTC: FORSY) holds $5 billion in bonds.

* Dexia SA (PINK: DXBGY) holds $4 billion.

* Société Générale (OTC: SCGLY) holds $5.2 billion.

* BNP Paribas SA (NYSE ADR: BNPQY) holds $8 billion.

* ING Groep NV (NYSE ADR: ING) holds $4.6 billion.

* Barclays PLC (NYSE ADR: BCS) holds $6 billion.

* Deutsche Bank AG (NYSE: DB) holds $2.6 billion.

Together, that's a total $35.4 billion in Greek bonds.

There's plenty of opportunity in shorting some of the big European banks and then getting long them after they've taken their hits.

The market is applying a level of pressure well beyond what the Eurozone and European Union (EU) were designed to handle. The Eurozone and the EU are both in trouble.

Change, quick deep structural change is needed now. There could be no better wake-up call than when credit-default-swap (CDS) pricing on Western European states is higher than Eastern European states!

Change = >> Fiscal union, which involves harmonizing aspects of fiscal policy across the euro area, would be a bold move and essentially result in a treasury department for the entire Eurozone.

The euro crisis is just as much underpinned by politics as it is by unbalanced economies, rigid labor and product markets, burst property bubbles and unsustainable public and private debt levels. A Federal Treasury = Fiscal Union for the EU is long overdue.

The alternative – someday – given the lack of fiscal discipline of the EU member states: A Eurozone breakup. The result: widespread series of defaults, bank runs, capital controls and periods during which countries (and their banks) would be frozen out of the markets. It would be extremely messy -- a lot like the 60s & 70s…

To quote the international man of mystery, Austin Powers: “Oops. I did it again, baby!”