Europe and its banks are a key risk

US debt markets stabilized in the 1st and 2nd quarters of the current year: the difference in spreads is far from both August-September 2011 and levels before last year's shocks, late 2010 - early 2011. In particular, the CDS spread calculated on the basis of S & P / ISDA indices for debt instruments of investment and speculative levels in the USA was in the region of 458 BP in May-June, which is close to the average for the 1st quarter of 445 BP and corresponds to the levels of 2009, but noticeably lower than in September-November 2011. Consider also an index that tracks the dynamics of the yield of US bonds with a rating of BBB to the yield of US Treasuries - here the situation is similar. The spread is subject to slight fluctuations in recent months and is far from the peak levels of 2008, however, in recent months it is higher than the levels of 2010 - early 2011.

Thus, the general condition of the US debt markets, despite a tangible correction in the stock and commodity markets, can be assessed as stable - the market took into account all relevant risks in the returns of speculative instruments, primarily from Europe and the banking sector.

Note that the situation in Europe itself is more complicated. So, the iTraxx Europe 5Y index is now at its highs from August-September 2011. And since 2008, reflecting high credit risk premiums of the region’s largest corporate borrowers. This situation as a whole looks logical, since the European debt crisis is a central event and a risk factor for markets # 1.

The Markit / iTraxx Europe Crossover Index, which monitors the dynamics of CDS spreads of the 50 largest European companies with non-investment grade ratings, is at elevated levels, but is far from the 2008 peaks. Thus, the sales affected mainly the investment grade securities segment, which is not only a result of economic deterioration the situation in the region, but also the liquidation of positions by large participants - mainly European banks.

Not surprisingly, the state of European debt markets has been more exposed to the growing crisis and widening spreads of sovereign borrowers, which puts upward pressure on corporate spreads.

The cost of CDS sovereign borrowers of the GIIPS group is steadily growing amid a loss of investor confidence in the solvency of the countries of this group. In recent years, only premiums on Portuguese securities have noticeably narrowed amid progress in lowering public debt and bringing budget parameters in line with the requirements of European state lenders. However, this country still remains cut off from the markets. In addition, the situation is complicated by the fact that a Portuguese court decision blocked one of the key initiatives of the government aimed at fulfilling fiscal requirements, reducing the salary allowance for civil servants. Thus, the situation in Portugal remains no less complicated than in other GIIPS countries, despite a temporary surge of optimism.

At the end of June, another Euro-summit took place, the results of which led to a short-term rise in the markets. However, we note that the solutions proposed at the European summit are only “blueprints” for future actions, and questions of their practical applicability and timing of implementation remain open.

Thus, there is no way to talk about easing the debt crisis in Europe - the flywheel is gradually spinning up, more and more countries are losing access to the debt market and are unable to finance the budget deficit through new borrowings, the only salvation is turning to the “troika” of supranational creditors for help, imposing very stringent conditions, which de facto means the loss of a part of sovereignty in relation to public finances. Already five countries - Greece, Portugal, Ireland, Cyprus and Spain, the latter so far have turned to the EU for recapitalization of the banking sector. Among the expected events, an appeal to the EU with complete “capitulation” first of Spain, and in the future, Italy.

Yields on bonds of 3rd Italy and 4th Spain in terms of the size of the European economy have reached critical points, and the slightest deterioration in the situation in state finances can completely cut them off from access to the debt market. It should be noted that these countries are trying to bring budgets in line with EU requirements, but not only a high debt burden at a sovereign level is a problem. The main problem in Spain is the state of the banking sector. It was significantly affected by the dynamics of the mortgage market, which is experiencing a severe recession, which affects high levels of delay in loans issued, about 9% of assets and declining prices of collaterals.

The growing negative media background led many European banks to reduce their deposit base, giving rise to cash gaps in an almost paralyzed interbank lending market. By formal parameters, the MBK market remains in an acceptable state, but the problem is that classic indicators, such as LIBOR, as it turned out, are no longer adequate benchmarks and do not fully reflect the general state of the market, Barclay's case was indicative. The reason is that the difference in cost and simply the availability of funding for large, medium and small banks is very significant, which means that the banking system, for example, Spain, represented by hundreds of medium and small credit institutions, is increasingly unstable.

Equally important is the general problem of the European financial sector, associated with a negative drop in the value of traded assets. The cessation of access to the pan-European interbank market has forced Spanish and Italian banks to seek other sources of funding. The main tool was the ECB's mid-term (MRO) and long-term liquidity (LTRO) mortgage auctions held in December 2011 and February 2012. Under these programs, Spanish banks borrowed a total of more than 250 billion euros, or 25% of total number of loans issued under LTRO (LTRO1 & 2: 1018.5 billion euros). Italian banks borrowed another € 200 billion from the “lender of last resort”, or about 20% of the total LTRO auctions.

Liquidity was also provided to banks in crisis countries through the TARGET2 interbank payment system in Europe, built on the basis of SWIFT. The key creditor of these banking systems in TARGET2 was Germany's banks, including Bundesbank: their requirements for counterparties in the system increased to 729 billion euros in early July. This is approximately 14% of the country's GDP.

Thus, the absence at this stage of the development of events under the shock scenario is almost exclusively a consequence of the efforts of the ECB and the Bundesbank.

As for the general exposure of Germany to the economies of the periphery, the volume of net investment in these countries reached 1 trillion. Euro at the beginning of 2012, approx. 20% of GDP. The funds are mainly concentrated in Italy, Spain and Ireland. We also note that this figure does not include obligations of peripheral banks to German banks under the TARGET2 system. Thus, according to the latest data, the size of Germany’s exposure to the “periphery” reached 1.7 trillion. Euro. The main danger, therefore, is that loans from German banks can turn into real losses in the event of a possible collapse of the eurozone. Thus, the state of the EU banking sector is a major alarming factor.

Most market experts tend to see Spain and Italy turn to the EU for help this or next year. While these countries retain access to markets, however, the worsening banking crisis could lead to a decrease in their credit ratings to the “junk” level, which would block their access to financing. It is possible that during the year the question of the exclusion of Greece from the eurozone will be raised again, the country is not able to fulfill its obligations, it is possible that the prospects for this will become clear after the visit of the representatives of the troika of creditors to this country in September or December. In addition, most investors share the view that Portugal and Ireland will probably need additional financial assistance programs, their debt / GDP may exceed 130% in 2013-2014.

The ECB has a moderately proactive policy. True, while trying to avoid "unconventional" measures, such as QE. At the last meeting in early July, the bank lowered its key rate by 25 bp. up to a historic low of 0.75%; deposit rate was reduced to zero. The effect of lowering the last rate had an effect already in mid-July: the volume of deposits on ECB accounts fell immediately to 324.7 billion euros as of July 12, which is the minimum since December 2011, i.e. close to the volume observed before the first LTRO. In our opinion, this trend could have a moderately positive effect on risky asset markets. However, taking into account the short effect of LTRO, the recession in Europe and the remaining high yields in key debt markets, the EU, the USA, we are confident in the short-term support for the markets of the latest ECB decisions.

Interesting in this regard is the development of the dynamics of the profitability of German sovereign bonds, as well as US treasury bonds. Over the past months, we have seen a serious avoidance of risk, which has fueled a decrease in yield on risk-free bonds in the absence of other comparable alternatives for placing funds by banks and investment funds. The only comparable quality alternative was the placement of funds on ECB deposits at a rate of 0.25% per annum. After zeroing the deposit rate in the EU, global banks can more actively search for other investments, in particular in the corporate and sovereign bond markets of Europe, as well as commodity assets and stock markets.

In our opinion, the slightest improvement in the news background in Europe and the removal of the risks of a strong slowdown in the global economy may “trigger” a many-month trend in the Bunds and Treasuries market, and securities yields without replenishment of incentives from central banks may again begin to rise. However, we do not expect strong movements in these markets in the coming quarter. The outflow from deposits of the ECB, coupled with a decrease in the key rate, may cause a further weakening of the euro against the US dollar. In our opinion, the position of the European currency in the next couple of months may remain weak - the European currency, due to the zeroing of the deposit rate of the ECB, will probably become the funding currency, for example, LIBOR rates in euros for the first time fell below the corresponding LIBOR terms in dollars. However, we do not exclude the possibility that after the completion of the main wave of the outflow of funds from banks from the ECB, the euro may partially regain lost positions.

In addition to the development of the debt crisis, Europe is also experiencing an economic crisis. Thus, European PMIs consolidated their positions on the recession territory, in June even PMIs in German industry dropped below 50 points, and business activity indices in Italy and Spain were significantly below the threshold level of 50, which indicates a deep recession of these economies. The decline in industrial production and a decrease in business activity is a consequence of the spread of the recession, primarily from the south of the European region.

The Citigroup Economic Surprise Index for Europe has dropped to lows since September 2011. In our opinion, in the coming quarters there is no way to talk about a sustainable recovery of the eurozone economies, which means that a positive economic surprise is unlikely to be realized. Italy and Spain this year has to repay about 10% of the total issued public debt. However, the peak payments of these countries falls mainly next year.

By the end of this year, Italy should repay / refinance about 221 billion euros, which corresponds to 5% of the country's GDP 2011. In general, the amount is seemingly “lifting”, but the situation is aggravated by the fact that the cost of servicing debt is growing due to the development of the debt crisis in the region. According to the Bloomberg consensus forecast, the country's GDP decline this year will be 1.95%, and next year only 0.2%. The budget deficit indicators are more than comfortable and in general even comply with the EU Covenant, less than 3%.

The situation in Spain is somewhat more complicated. Until the end of this year, Spain will have to repay a public debt of 94.7 billion euros, which is equivalent to 6.4% of GDP in 2011. The financial situation in Spain looks relatively stable, while the situation in Greece is not clearly visible. So, the current ratio of public debt / GDP is 68.2%, which is far from a critical indicator. According to the Bloomberg consensus forecast, GDP decline this year will be 1.7%, and next year - only 0.7%. The budget figures are worse: it is planned that in the current year its deficit will amount to 6.15%, and by 2013 - reduced to 4.7%. The situation with unemployment is unfavorable - it is expected that this year it will amount to 24.6%, and next year it will grow by 1 pp up to 25.6%.

The big risk of Spain, obviously, among other things, is the complex structure of state power, a large degree of autonomy of a number of problem regions can nullify all the efforts of the central government to improve the situation in the economy and the crisis of the banking system burdened with bad debts.

Banks of Spain in an unenviable position. The volume of non-working reserves in the banking system of Spain increased over 2.5 years from 4.1% to 5.3% according to official figures, and banks also experience a serious outflow of depositors. The main alternative to deposits with banks in Spain, and of all GIIPS countries for citizens, is investments in reliable banks, primarily Germany: the latter have accelerated the growth of the deposit base in recent months.

In fact, until now, the outflow of deposits and losses on the portfolio, mortgages, traded financial instruments of Spanish banks were covered by raising funds on LTRO from the ECB and financing through Target2. However, these funding sources can hardly be called sustainable, and the size of the losses can continue to grow. Almost none of the market experts doubts that 100 billion euros for the recapitalization of several large banks in Spain, which was approved at the last meeting of the Euro group, is only the beginning of a large-scale program to help the financial sector, and the nationalization of Bankia and the consolidation of small and medium-sized banks are the first steps.

In our opinion, the current phase of the crisis in Europe is to a somewhat lesser extent a public debt crisis and more so a banking system crisis, which, given the size of the banking systems of Spain and Italy, causes, for example, the assets of the two largest banks in Spain exceed its GDP, fears of a rapid wave sovereign debt burden due to rescue programs of the largest banks, many of which are “too big to fail”. And the decisions of the EU summit on involving pan-European funds in the recapitalization process, which are not very large in terms of plans, but still do not have real capital, look half measures against this background. Given the experience of Ireland and the consequences of the bailout'a banks of this country, the consequences for Spain, for example, can be sad for the global financial system.

One of the main reasons for concern for GIIPS banks is the high proportion of demand deposits in the banking system. So, in Spain, about 30% of the total deposits are on demand, in Italy such deposits are 48%, and in Portugal - 21%. According to Citi, GIIPS banks may lose about 90-340 billion euros in the event of Greece leaving the eurozone. As a result, huge cash gaps can be created, the result of which could be the sale of assets, a reduction in lending, which will increase the economic downturn and bankruptcy / salvation by the EU.

Doubts about the stability of banks not only in the periphery, but also in the EU as a whole remain: BIS data show that many banks in the EU have fewer reserves compared to 2008-2011, as well as the United States and Great Britain. In order to stop the outflow of deposits and reduce risks on banks, European states are striving to create a unified deposit insurance system, which was one of the themes of the EU summit that ended in June. There are doubts that the integration processes in the financial system that the eurozone intends to launch can be brought to an end and can reduce market risks in the coming quarters. The main reasons are as follows:

A number of key institutions are controlled by governments. Eurozone countries are unlikely to want to lose control of banks, as they are the main buyers of public debt.

EU banks need recapitalization to provide the necessary reserves, and the creation of reserves will reduce the net interest margin. In the current state of the markets, banks: a) may not be able to recapitalize in large volumes and b) the massive creation of reserves will hit investors and banks and will affect, for example, the cost of debt.

The deposit guarantee system may not save from the outflow of deposits, as it saves individual banks, but not the system as a whole; moreover, it does not guarantee large deposits and corporate funds.