Fears of a banking crisis and rolling contagion are making global stock and bond markets extraordinarily volatile – and with good reason.

Another financial meltdown, on par with what we saw in 2008, is looming large on the horizon.

One of two potential triggers could ignite a new banking crisis, a rapid contagion, and a second financial meltdown:

  • One or more of the troubled European countries could default outright.
  • Or a major money center bank could be turned away from the interbank borrowing market by its peers.

The panic resulting from either catalyst could start at any time.

[ad#Google Adsense 336×280-IA]And it would spread like wildfire.

The threat of a banking crisis leading to a meltdown centers on Europe. European banks hold huge amounts of their home sovereign’s debt, as well as debt of their Eurozone neighbors.

So when default risk rises for any sovereign in the euro area, every one of the region’s banks feels the impact on their balance sheets.

Of course, it may not be immediately reflected in write-downs because many banks hold sovereign bonds in their “held-to-maturity” books, as opposed to accounting for them in their “available-to-trade” books.

Being held to maturity means bonds are accounted for at amortized cost as opposed to being marked-to-market, as they would have to be in the trading book.

This is a double-edged sword for banks. Banks don’t have to mark down bonds in the long-hold book unless they become “impaired.” But in an uncertain market, fearful investors may hammer a bank’s stock because its true exposure to bad debt is unknown.

A less obvious spillover of holding so much sovereign paper is that banks use those sovereign bonds as collateral to borrow from other banks in the short-term funding markets. As the value of sovereign collateral comes into question, it can be haircut (reduced in value as collateral) drastically, or not accepted at all.

Banks right now want solid collateral from the counterparty banks to which they are lending their funds. And since lenders already own huge amounts of sovereign debt, they are starting to turn away distressed sovereign paper as inadequate collateral.

When that happens, banks in need of funding are forced to turn to central banks. And that’s where it gets really scary.

Central banks already hold large amounts of sovereign debt on their balance sheets, and now they have to take on even more sovereign debt and government-guaranteed securities as collateral for the loans they’re making to distressed banks.

And where do central banks get the money they lend out? They get it from the same sovereign governments whose bonds are distressed in the first place.

That leaves a twofold problem for central banks.

First, if they borrow from distressed sovereigns to lend out to distressed banks holding the same debt, they are simply adding more suspect debt to their own balance sheets. That essentially makes them a leveraged extension of the sovereign country they’re supposed to backstop.

The second problem for central banks is that if they print money, they end up devaluing the debt they are holding.

Add to these scenarios the attendant stresses that would accompany any downgrade of underlying sovereigns’ creditworthiness and everything gets even more slippery. Not only are debt obligations directly affected, but the downgrades would flow through to other assets held by banks.

Worse, downgrades reduce explicit and implicit government guarantees on all outstanding obligations carrying the backing of the sovereign.

Finally, by virtue of their overly leveraged holdings of bilateral contract derivatives and their unquantifiable exposure to attendant counterparty risk, banks have significant exposure to the already suspect derivatives market.

All of the stresses on sovereigns and their debt obligations flow through to the banks that hold those debts as well as the banks indirectly exposed to rolling contagion effects.

The primary danger we face is not a sovereign default. It’s that banks will stop trusting what’s really on the balance sheets of their peers and consequently stop lending to one another in the short-term funding market.

If just one money-center bank with significant balance sheet exposure is turned away from the interbank funding market, other banks will clamor for liquidity by hoarding cash and seizing collateral. Consequently, the whole system could falter, freeze and crack.

Market volatility has many fathers, but the big daddy of them all is that worldwide contagion will follow a banking panic.

So be sure to watch volatility to determine if it is rising because of increasing contagion fears. And, if you see a breakdown in any of the interconnected sovereign and bank funding mechanisms I just identified, get out and get out quickly.

Safeguard your investments and tread lightly.

— Shah Gilani

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Source:  Money Morning