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Italy may already be over the edge [ClearOnMoney]
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Italy may already be over the edge

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Commentary

Italy may already be over the edge

7 Nov 2011 by Jim Fickett.

Italy seems to be on a trajectory followed by other nations that had to be bailed out, with the yield on the 10-year bond ending the day over the critical 6.5%. Probably the only remaining hope that the crisis can be contained lies in much greater involvement by the European Central Bank. That is politically difficult, but perhaps still possible. The outcome remains ambiguous, but investors should be prepared for a possible panic.

Italy may have passed the point of no return, where falling bond values encourage more sales in a self-reinforcing cycle. This is due in part to poor fundamentals, in part to Berlusconi being completely out of touch with reality, and in part to the euro zone's “comprehensive solution” being full of holes. Here is Bloomberg:

Italy’s 10-year notes traded above 5.5 percent for 40 days before breaching the 6 percent mark on Oct. 28 and reaching as much as 6.68 percent today. The bailed-out nations followed a similar trajectory, consistently averaging above 6 percent for about a month before crossing the 6.5 percent barrier. After that, it took an average of 16 days for yields to pass the unsustainable 7 percent level.

The Financial Times goes into a bit more detail on how the vicious cycle could accelerate:

Indeed, with the eurozone crisis in a new and dangerous phase, investors are once again on the lookout for important inflexion points; moments at which rising government bond spreads or yields can rapidly change the fate of the region’s troubled sovereigns. Bond yields above 6 per cent are the point “beyond which other sovereigns have found it very difficult to return”, note Matt King and Joseph Faith of Citigroup

One such feedback loop involves margin requirements, or payments that must be made to counterparties when the price of bonds used as loan collateral falls. On Monday, there were growing fears that these margin payments could lead to a further downswing in the markets. …

The higher these so-called margin requirements, the less return a bank can make from lending the bonds. If haircuts become too high, banks may choose to sell off their bond holdings, sending yields and spreads over benchmark debt such as German Bunds even higher. That, in turn, could lead to another rise in margin requirements, and so on. It was just such a loop that helped push Ireland towards an international bail-out last year. If Italian yields stay at current levels, then it becomes vulnerable in the same way. …

However, one potential trigger for margin increases that the market has fixed on involves the premium – or spread – of government debt over a basket of triple A-rated collateral. Once the bonds’ spread to this basket exceeds 450 basis points, LCH.Clearnet has said, it may decide to raise haircuts by 15 per cent.

On Monday, Italian spreads to triple A-rated Bunds reached 491bp. They are trading at about 420bp over the triple A basket, which includes French bonds.

Where is all this going? European leaders have been counting on having months to leverage the EFSF and to recapitalize banks, while the markets may abandon Italy within days. It is still unclear whether this will end in a new financial crisis, but the number of possible outcomes is shrinking.

Most commentators are saying that there is no intersection between euro zone solutions that could work and euro zone solutions that are politically possible. That might be true, but increasing danger also increases what is politically possible, and an indirect bailout of Italy through the European Central Bank might still be possible. For example if the EFSF buys Italian bonds and then transfers them to the ECB via repo operations, in order to fund further purchases, perhaps the losses for the northern countries would be sufficiently delayed and opaque for politicians to get away with it. The Financial Times article quote above ends thus:

Some bankers say [the ECB] should suspend mark-to-market margin payments on bonds used for collateral, in an effort to encourage banks to buy Italian and other peripheral bonds. The central bank could even lend to the eurozone’s rescue fund, the European financial stability facility, so it can buy Italy’s bonds, they say.

“The ECB can do one of three things,” says one trader. “Buy a very large amount of Italian bonds, relax its rules on collateral or give the EFSF extra firepower by lending to it. But one thing is clear; the ECB is the last line of defence. It has to do one of the above or more to stop the death spiral.”

If the ECB does not greatly increase its involvement, we are probably set for serious problems. Italy may have already been pushed so far that it is headed for insolvency, but that will take time to work out, since rising yields only affect new debt issues. So probably the next stage of the crisis is likely to be bank runs in Greece and Italy, followed by panic spreading in the wider financial system, and stock market falls. Be prepared for a possible panic, and hence possible buying opportunities.