naked capitalism

Since this will be trumped by the market opening in the US, I’ll be brief.

So far, this is playing out like I expected. Bad but not horrific. That does not mean we can’t see a moderately bad day in the US slide into nasty end of session erosion and then cascade into Asia overnight. But as much as the markets were psychologically rattled by the wild card of the US downgrade, the bigger deal is whether the ECB will stem the tide of the liquidity crisis underway in Europe. Yes sports fans, we also have a solvency crisis in place like Greece, but the danger of a liquidity crisis that it will lead a big financial domino to fall over and do a Credit Anstalt to the European banking system. Richard Smith’s top contender is Italy’s Unicredit, which had the bad fortune to overpay to get into pretty much every bad housing market in its reach (save the UK and Spain).

A top line overview: S&P future have ranged (at least when I was paying attention) from down 18 to down as much as 32.50, now at about 31.9. European market were down 2% ish on open, some traded up to positive territory or down less than a percent, they’ve now lost faith and are back to meaningfully negatives: FTSE down 1.87%, CAC 40 down 2.48%, Dax down 2.80%.

The dollar was down a mere .3% on the DXY index in Asia, and the euro has weakened meaningfully since then, so I suspect it will be flattish or only slightly negative. Treasuries are moving back from losses overnight that still put them well above the levels of a week or so ago. The ten year yield is up only 10 basis points. Gold is up big, over 3%, and Brent is down 2.87%.

The latest on the Euro interventions, courtesy Bloomberg:

European Central Bank President Jean- Claude Trichet started buying Italian and Spanish assets today in his riskiest attempt yet to tame the sovereign debt crisis.

Italian and Spanish bonds surged as the ECB entered the market, sending 10-year yields down more than 70 basis points. The euro rose to $1.4355 at 10:30 a.m. in Frankfurt from $1.4277 at the close of European trading on Friday.

With governments failing to act swiftly enough to stop contagion from Greece’s fiscal meltdown, it has fallen to the ECB to battle a crisis that’s now threatening the survival of the euro. Buying Italian and Spanish debt may require the ECB to massively expand its balance sheet and open it to accusations of bailing out profligate nations, breaching a key principle in the euro’s founding treaty and undermining its credibility. Germany’s Bundesbank opposes the move.

The problem is we have no idea how much the ECB is prepared to commit or what its aims are (as in does it have an interest rate target it is trying to hit). It is worth remembering that the ECB has intervened aggressively and successfully in the past, when the euro fell to about 1.22 to the dollar and bond spreads were blowing out. The question remains whether they are prepared to maintain a large and persistent enough effort this time.

Update 7:30 AM: Reader Tim Coldwell point to this reading from the ever useful Golem XIV. The bottom line is Euribor, the European answer to Libor, is locking up. If the ECB can’t intervene forcefully enough to reverse that, you will start to see banks fall over pronto. From the post:

According to Bloomberg, The Euribor, the European equivalent of the Libor (remember that from 2008?) is locking up as banks decline to lend to each other. Those European banks that do have money are putting it in the ECB overnight in preference to lending it to the European banks that desperately need it – such as Santander in Spain and all the Italian Banks led by UniCredit.

Once the Euroibor starts to freeze that is the signal for non-European banks to stop lending to European banks altogether. Why should they trust European banks if fellow Europeans don’t. Banks have to have overnight funding or they die.

I think we are now closer to the edge of then cliff than we have been at any time since AIG and Lehman’s collapsed. Without short term and overnight funding Europe’s banks will die within the week, so the ECB will now certainly step up its overnight lending to any and all not as a matter of prudent banking but of political panic. That however will be merely the response to the weekend’s Euribor freeze. I say response because it is not a solution. The banks can’t stay addicted to ECB methadone. The amounts would simply run out of control.

This goes back to multiple problems: the refusal to wipe out equity and force bondholders to take losses and partially convert to equity, and the obsession of the ECB (and the influential Bundesbank) with inflation, meaning they do not want the ECB balance sheet to get too large.

Mind you, I am not saying there are pretty ways out of this mess. There are less bad ways, however and I’m not optimistic the ECB will resort to them.