The specter of Hurricane Katrina haunted government officials along the eastern seaboard. Wide-ranging precautionary measures were put in place but in the end Hurricane Irene simply didn’t pack that large of a punch, although I’ll be bailing out my basement for weeks to come. Just as state governors now prepare for each category 1 storm as the next big one, investors seem to be battening down the hatches with each bit of negative news, extrapolating market decline as the beginning of the next great financial crisis. Can the 100-year perfect storm come twice in five years?
The ghosts of 2008 are back to spook investors not in the hard economic data but instead in signs of disruption in the European bank funding markets. Remember, the crisis of 2008 began with delinquencies in a seemingly small part of the mortgage market. But with banks writing down assets on their own balance sheets and knowing full well that the bank down the street was doing the same, interbank lending froze, margin calls ensued, and forced selling caused correlations to rise and markets to plunge.
This time, playing the role of subprime mortgages are the bonds of the highly indebted, generally uncompetitive countries of Europe’s periphery. The health of the European banking system is only as sound as the sovereign debt which it holds. It was difficult to watch European bank lending rates double in August and to not hearken back to October 2008. Sure, the Euribor-OIS spread is roughly one-third of where it stood when Lehman Brothers collapsed, but the recent upward move in European interbank lending rates may be ill-omened. With countries like Greece and Portugal already insolvent and market appetite being tested for debt issued by countries like Italy and Spain, the European banking system is vulnerable to further asset write-downs. Newly minted International Monetary Fund chief Christine Lagarde opined at last week’s Jackson Hole meeting that European Banks, “need urgent recapitalization. They must be strong enough to withstand the risks of sovereigns and weak growth…If it is not addressed, we could easily see…even a debilitating liquidity crisis.”
Lest we get too apocalyptic, the Eurozone banks have built up large cash buffers, the size of the sovereign debt market pales in comparison to the U.S. mortgage market, and policymakers have a number of tools at their disposal to protect the banking system. The European Central Bank (ECB) is already serving as the lender of last resort to commercial banks needing short-term funding and according to (ECB) Chairman Jean-Claude Trichet, European banks hold €14 trillion ($20.3 trillion) in eligible collateral for additional funding. Additionally, the expanded capacity of the European Financial Stability Facility (EFSF), the €440 billion ($633 billion) rescue with the power to recapitalize banks, will become functional in the fall. The EFSF is large enough to cover the next debt outstanding of Greece and Portugal, but not Italy and Spain. The ECB stands ready for further purchases of Spanish and Italian debt in the secondary market to keep borrowing costs at sustainable levels.
The biggest question now is political will. Should appetite to support the periphery wane, governments can act unilaterally to protect their banking systems. The French and German versions of the U.S.’s Troubled Asset Relief Program may be in the offing.