The Correlation of Contagion

Interesting discussion by Conor Sen on the set-up for a EU-based contagion now vs the housing/credit market contagion we experienced in 2008.

An important difference, he notes, is that in 2008 there was leverage across the board. Debt was piled high on consumer, corporate, and government balance sheets. He suggest that since then, corporate balance sheets have improved dramatically making them more capable of withstanding a credit event.

He does not discuss the changes in consumer and government balance sheets. Consumer balanced sheets have improved marginally as individuals begin to save and pay down debt. But governments have levered up as risk has shifted from private to public hands over the past few years. Systemic leverage has gone up.

The similarities between then and now include the persistent run-up in risk spreads despite interventionary efforts to put down problems. For example, sovereign yields of Greek, Spanish, and Italian sovereign bonds have been rising over the past year or so in the face of ECB interventions. Similar to 2008, Conor notes, stock markets have been basically chugging higher, basically ignoring problems in the credit markets.

The other similarity is interlinked and leveraged exposure to smoldering credit problems. Some institutions are long sovereign debt while others are short sovereign credit default swaps in a complex, levered manner that is difficult to figure out. The exposure reaches the US, including risk to cash assets. Approximately 40% of domestic prime money market funds are parked in unsecured European bank debt.

You would think domestic institutions would have sold off their Euro exposure by now in order to manage risk. Well, it so happens that in 2008-2009 we changed the accounting rules so that institutions could mark distressed securities as 'held to maturity' rather than having to market them to market in the 'assets for sale' category. Marking them to market would have meant lower values. When you're highly leveraged as banks are, lower values to balance sheet assets drive you toward insolvency. By designating securities as 'held to maturity,' institutions only need to recognize losses if cash flow issues drive them to sell.

It was this fun with numbers, extend-and-pretend approach that helped stave off a more severe decline two years ago. Consequences of that manipulation may now be coming home to roost, however.

Should an institution elect to sell 'held to maturity' securities before they mature, the accounting rules require that other assets in the 'held to maturity' category must be moved back to the 'held for sale' bucket, meaning that they must be marked to market once again.

Because marking them to market would require significant write-downs and threaten solvency, Conor suggests that institutions are 'not going to sell sovereign debt until they can't.' (nicely put) The important consequence of this is that banks seeking to reduce risk will instead sell correlated assets. This means that they might sell anything from corporate bonds to stocks in order to avoid a margin call or outright failure.

This is what a 'contagion' is about. Investors selling anything that isn't nailed down in order to stay solvent. Contagions cannot occur without leverage, or debt. The more debt that's in the system, the higher the chance that a deleveraging contagion will occur at some point.

As we noted above, while debt has been shifted around, the overall systemic leverage is high. The potential for contagion, thus, is also high.

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