Tuesday, June 7, 2011

Ratings History and Credit Risk for Southern EU Sovereign Debt

Contagion in 2008 was driven by credit losses, and so it follows that the main risk for a new round of contagion is also credit risk. This is to say that the EU banks potentially could lose a lot on the default/restructuring of Greek and/or Irish debt, and/or other Southern EU debt.

Credit losses depends in part on the previous ratings of, in particular, Greek and Irish debt -- anything above A would mean that the European banks could hold the government debt without much in the way of reserves. (I believe under Basel, a bank can buy with AAA rated debt with no reserves, AA with 10% or so and A with 20% or so -- need to check this)

This is what got the banking system into such a tangle with the subprime mortgages -- they were rated AAA, and so the banks bought them without almost any reserves. The losses flowed down straight into equity.

So rating history of Greece: (Moody's)
currently as of 6/11 Caa
A1 --> A2 12/09
A2 --> A1 11/02
Baa3 (oldest I can find) 1996

So Greece has never been above A2, which means the European banks likely have some reserves for this debt. (this is to say, the writedowns won't be the same as write downs on AAA debt)

Raing History of Ireland (Moody's):
Baa1 --> Baa3 4/11
Aa2 --> Baa3 12/10 (ouch!)
Aaa --> Aa2 7/10 (Ireland was rated triple A??)

Note that from 2000 to 2007 Irish debt/gdp was below 38%, reason for the AAA rating, now it's at 93.6%. However, the main problem in Ireland is the banking system not necessarily the governmental debt. If the governmental debt became an issue, this could be a problem (only slightly mitigated by the fact that overall Irish governmental debt is not overwhelmingly large at around $US165Bn approximately -- in so far that the EU banks tend to be highly levered and any losses will put capital ratios at risk).

Other countries:
Aa1 --> Aa2 3/11
Aaa -> Aa1 10/10 (Spain was also triple A!)

Note however Spain has debt to GDP of 63% so isn't a huge default risk currently.

Aa2 (current)
Aa2 (2007)
Aa2 (2004)
Aa3 --> Aa2 5/2002

Appears Italy has been rated Aa2 for a long time, before in 2002 it was Aa3 (thank goodness it hasn't been AAA).

Overall, the main risk again appears to be Italy -- due to its relatively high rating and above 100% debt, so far the market isn't worried about Italy, rather Greece, which was never rated higher than A2 -- EU banks likely have reserved (in part) for holdling Greek debt.

Still there is risk due to the fact that the European banks tend to be more levered than American banks. I´ll research to see if the major EU banks publicly disclose their EU sovereign debt holdings.

Sunday, June 5, 2011

Some Thoughts on the Current Market Volatility

I spent the weekend reviewing the economic situation and the most concerning situation to my mind is Greece and Ireland, in the EU. Northern Europe -- mainly Germany - is effectively transferring capital to Ireland (through Central Bank transfers) and Greece, direct monetary transfers to the government. Losses in the banking system in Ireland, and a lack of tax revenue in Greece to cover governmental debt interest costs are driving the need for capital transfers.

Greece is interesting because it is mainly a governmental problem, not a banking problem -- Greece has serious societal problems. Most other countries with problems in this last downturn saw banks sort of drive the economic problems, (one can think of the US, Ireland, Iceland, Britain) but Greece mainly has problems because of governmental corruption, lack of work ethic and lack of transparency with regards to taxes.

It seems these problems are fixable (if the problems are only isolated to Greece and Ireland), in so far that Ireland isn't that large -- Germany can cover Ireland's banking debts (Germany is the fourth largest economy in the world, Ireland has only 4.4M people, although Ireland's banking debts are quite large, as shown in Figure 1 below) while Greece,seems to be coming back every year for funds. Greece, it seems, eventually they have to start paying taxes and working a bit longer -- in any case Greece's sovereign debt is not that large as a total sum.

Contagion can happen if there are additional large writedowns of sovereign debt in other EU countries -- one can think of Portugal -- but especially Spain and Italy. So far Spain looks ok -- the debt to GDP is in the 60-65% of GDP range (the US is now getting up to over 90% of GDP). Greece is up at 142% of gdp --this is why there are problems. I don't think there will be problems with Spanish governmental debt too soon, due to the relatively moderate debt/GDP level.

However, Italy does not look strong with debt/GDP of 114% -- but they do not seem to be a major concern for the markets now. Italian debt is yielding around 4.5% -- not in danger territory. Actually also Belgium looks not so great, with debt/GDP at 100%. The other EU countries look ok (with the exception of Portugal but they are getting IMF assistance).

So the main problem is that problems in Greece and Ireland can trigger problems in Italy and Belgium. Here is a nice chart showing the interrelations --

Source: http://www.minyanville.com/businessmarkets/articles/italy-piigs-europe-sovereign-debt-crisis/1/7/2011/id/32053

So far it appears problems in Greece (and note, Greece is much smaller than Ireland, in terms of debt owed) are more impacting Germany and the UK. If there are problems in Italy, in particular, there will really be problems in Europe - in so far that Italy owes significant total amounts of debt to countries outside of its borders.

The other issues, slower growth in China-- so far my impression is that China is following growth at all costs so is still going to register 9% growth this year (even with the slowdown) according the the IMF. The US is shaky -- I am not sure what to make of the stimulus and the Quantitative easing coming to an end.

So overall things look shaky out there but so far not nearly as bad as the subprime problems going into late 2008, when major institutions were failing every month (but it would be this bad if Italy was having serious economic and debt problems).

In terms of holdings, I think oil should be ok -- interest rates will have to be kept low in the EU, leaving commodity inflation -- but copper may be a bit more unpredictable -- copper is being driven by China,(and mainly construction in China) -- I'll look to pare down a bit of exposure here).