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The chances are good that Europe is now over the edge [ClearOnMoney]
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The chances are good that Europe is now over the edge

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Commentary

The chances are good that Europe is now over the edge

9 Nov 2011 by Jim Fickett.

Selling engenders further selling, and it will be very hard to stop the panic in the Italian bond market now. There is still a chance the politicians can rescue the situation, but things have progressed far enough that “muddling through” is the unlikely, speculative position, while bank runs and a financial crisis are the mainstream base case.

Italian 10-year bond yields rose to 7.25% today. There are many signs now of a vicious circle downwards.

1. Rising margin requirements on sovereign bonds

Falling bond prices cause clearing houses to demand greater margin, which lowers the value of the bonds for repo operations, thereby further depressing prices (Italy may already be over the edge). Today LCH Clearnet increased the margin requirements on Italian bonds. From Bloomberg:

LCH Clearnet increased the so-called deposit factor for Italian bonds due in seven-to-10 years to 11.65 percent, the French unit of the clearinghouse said on its website dated yesterday. That compares with a charge of 6.65 percent announced on Oct. 7. The additional costs will be applied from close-of-day positions today, LCH said. Italy has 1.9 trillion euros of debt, the world’s fourth biggest.

The clearing firm said it has no plans to increase margins for trading of other nations’ bonds and will monitor all markets. LCH raised margins on Italy “because we’ve seen more volatility and less liquidity,” John Burke, the firm’s head of fixed income in London, said. “Liquidity is the key issue.”

Italy may be “beyond the point of no return” in becoming the next victim of Europe’s debt crisis even if the government implements promised austerity measures to reduce debt, Barclays Capital analysts say.

“Once set in motion, these self-reinforcing negative dynamics are very difficult to break,” analysts Michael Gavin, Piero Ghezzi and Antonio Garcia Pascual wrote in an e-mailed note late yesterday. “Prompt and effective policy action from Rome may be necessary to remove Italy from the downward spiral that threatens it, but we doubt that is sufficient.”

2. Banks under pressure to get rid of sovereign bonds

Yesterday I mentioned (Vicious cycle of sovereign bond selling is hard to stop) that banks were being forced by the worries of shareholders to reduce holdings of Italian debt. Mohamed El-Erian goes further, and points out that now it is even fashionable for lenders to loudly declare that they are moving away from Italy. In any case, as more banks jump on the bandwagon, it forces prices down, causing further pressure on remaining positions.

3. US lending to European banks under pressure

Yesterday I mentioned that US banks tightened lending standards for European bank recipients. The Federal Reserve reports that commercial paper issued by foreign financial institutions and held in the US is down 35% from its peak in the summer.

4. Bank runs

Greek depositors are moving their money:

Greeks withdrew as much as 5 billion euros – nearly 3 percent of total deposits – after outgoing Prime Minister George Papandreou's shock call last week for a referendum on a euro zone bailout, said one banker, who declined to be named.

“Many people withdrew their money from banks on Thursday and Friday and money couriers had a hard time supplying banks with cash to satisfy the emergency demand,” said another banking source, who declined to be named. …

“We got to the point where customers ordered amounts of up to 600,000 to 700,000 euros in cash to take home – unbelievable,” the first banker said. “This strains the system.” …

One bank clerk was overheard saying to a co-worker at an Athens branch of National Bank, the country's biggest bank: “A lot of money was withdrawn on Friday.”

Deposits have fallen more than 21 percent since January 2010, when Greece's debt crisis shifted into a higher gear, and the banks have become increasingly reliant on the European Central Bank for their liquidity needs.

Latest figures show banking deposits fell about 3 percent in September to 183.2 billion, and the first banker said an additional 8 billion euros are likely to have been withdrawn from the system in October.

It is very likely the same is happening in Italy now.

There is no sign of a real rescue

European politicians hoped to avoid donating more money to the EFSF by leveraging it, but even talk of leveraging has made it difficult for the EFSF to raise money in the markets (Big problem: politicians don't understand markets). Unless Germany wants to contribute a lot more, which seems very unlikely, the EFSF will remain too small to rescue Italy.

There has been talk of an IMF rescue, but no sign of real interest on the part of most nations to fund such a thing.

Most informed observers say that much greater involvement by the ECB is the only hope for a rescue, but Germany has made their opposition plain (Vicious cycle of sovereign bond selling is hard to stop).

Some say there is still hope that Italy could implement reforms and convince the market of its solvency. Maybe. But fear is now widespread, so Italy would have to make widespread, decisive changes. Even if Berlusconi does leave, is it likely that the same political processes in Italy that have produced this situation are suddenly going to reverse and correct it? The chances seem small.

Now what?

If you want to speculate, it is quite likely now that stock markets are headed down.

If you want to be ultra-safe, get out of prime money funds (which still hold European commercial paper), financials, and cyclical stocks, and put the money in investment grade short-term corporate or municipal bonds.

But mainly, be ready for opportunities.