Wednesday, July 7, 2010

The Debts of the Spenders: European Stress Tests A Joke But Fiscal Austerity Measures Are Working

Apparently, EU ministers believe that CDS traders and European bond desks are stupid. Their stress tests do not account for any sort of default scenario. This is ironic considering how a potential Greek default has led to a freeze on interbank lending among the PIIGS. Besides the more obvious triggers of outright bankruptcy and delays, please also note that the legal language of most CDS contracts states that a debt restructuring CAN lead to a default. Such catalysts are referred to dryly by lawyers as "credit events" and WILL drive the CDS spreads wider.

Of course, when the market tries to act efficiently traders will somehow be blamed for lower prices and higher yields.

FRANKFURT (MNI) – Planned stress tests for European banks will cover their resistance to a crisis in the market for European sovereign debt, but not the scenario of a default of a Eurozone state since the EU would not allow such an occurrence, a German newspaper reported Wednesday.

But not everything is bad in Europe - for one thing, the British, Greeks, and Germans seem able to pass an austerity budget - a fact that forex markets have noted with optimism by driving up the value of the GBP and Euro in recent days. If only the US could learn that lesson. Unfortunately, our politicians' bad behavior is being subsidized by the Chinese, who continue to buy treasuries blindly.

While default risk remains virtually non-existent at the federal level, the same cannot be said of state and local finances. The US muni market which consists of state and municipal finance is facing severe funding problems.

"Commercial lenders added more than $84 billion to their holdings since 2003, according to the Federal Reserve, pushing total investments to $216.2 billion at the end of the first quarter. Bank regulators and ratings companies are ramping up scrutiny of banks most at risk of being forced to raise more capital should debt prices slide.

“There is a huge untold problem here,” said Walter J. Mix III, a former commissioner of the California Department of Financial Institutions who closed 30 banks during the last banking crisis in the 1990s. “The economics lead to the conclusion that there will be downward pressure on these bonds.”

Default speculation and a move by investors to the safest securities drove municipal bond yields to a 13-month high relative to U.S. Treasuries in the first half of the year. Now, the Federal Deposit Insurance Corp. has asked analysts to look into the issue, according to spokeswoman Michele Heller.

U.S. states are likely to face $140 billion in cumulative budget gaps in the coming year, according to the Center on Budget and Policy Priorities. Last year, 187 tax-exempt issuers defaulted on $6.4 billion of securities, the most since 1992, according to data from Distressed Debt Securities in Miami Lakes, Florida.

“It’s a market where it’s clear that the underlying fundamentals are lousy,” said Michael Aronstein, chief investment strategist at Oscar Gruss & Son Inc., a New York- based brokerage. “People can say fundamentals don’t matter but I’ve been doing this for 32 years. They do.”

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