Debt Crisis Could Develop into Credit Crunch

March 17, 2010

The LIBOR-OIS spread continues to inch its way higher which signals lack of banks willingness to lend to each other. The yield differential between 3-month LIBOR and the Overnight Rate, is now wider by 2 to a spread of 24 basis points.

LIBOR-OIS Spread Historical Chart

BNP Paribas had this to say regarding the duress that banks are facing:

“There are three big themes impacting FX markets. First, EMU contagion with the OIS and cross currency swap rates rising as markets fear EMU’s sovereign debt crisis developing into a full blown credit crunch. The rise of interbank funding costs may work as the catalyst for this development. Bank and other financial institutions are packed with peripheral bond exposure and although this bond exposure has been state guaranteed for the next three years by the EU750bln package, investors see increasing risk of sovereign defaults undermining banks balance sheet outlook. For instance, the FT reports today that 53% of the French population view a French government default within the next ten years as likely. This compares to 28% in Germany, 40% in Italy and 46% in the US.”

Furthermore, BNP Paribus added going forward:

“After the break of the March 2008 1.2360 low markets have started to discuss the likelihood of EUR supportive intervention. Our verdict is clear: Should there be EUR supportive intervention being conducted at this stage we expect this operation to fail for two reasons. First, the liquidity reducing effect of this intervention would drive OIS and currency swap spreads even wider which in consequence would undermine especially undercapitalised banks further. Secondly, sterilising the intervention amount might keep spreads calm, but would be understood by the market as creating a EUR selling opportunity increasing the pace of the EUR decline.”

  • These are some good points you brought forward. One thing I don't think is clear is what it means for a country to access the package. Is it a credit event? Is it not? Because this is clearly not market-based financing. It's almost like DIP financing for sovereigns, if you ask me. I called it a home for wayward debt before, but you get my point.

    Watching LIBOR-OIS, the TED spread, etc. I keep getting the feeling all this liquidity is just making volatility in the market worse - not better. I say that because we're essentially in a global ZIRP environment. With rates being where they are, the volatility of a basis point move (i.e. DV01) is amplified. Most of us know it as convexity, but if folks don't know about it, it can be very damaging.

    The EUR is still in a death spiral at this stage. The ECB can sterilize its bond purchases but that's just creating the opportunity to sell the EUR, just as BNP suggests.

    All in all, there are no good choices at this stage.

  • Rom_Badilla

    Hi Professor,

    I think it really depends on how you define a "credit event". From a bond investors point of view, it doesn't matter how a country, troubled or not, repays its debt. All that matters is if you will recover your principal or not. However, accessing the package arguably is a credit event from the standpoint that a country like Greece is using debt to solve its debt problems which is symptomatic of a troubled country. This "event" is expressed in the form of a falling currency.

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Posted by Rom on May 17, 2010 under Bond Chatter | Tags: , , , , , , , , , , , , , — | View Comments