The sovereign banking situation in Europe continues to deteriorate, as Portugal continues to feel the squeezed by the bond vigilantes.  The spread of bond rates between what Portugal 5 years rates are valued by the market, and what the same equivalent 5 year German Bund bond continues to increase.

The higher the spread, the more the market is pricing in a failure of the Portugal sovereign bond structure, when compared to German Bunds.  The pressure has become self feeding, as demand for German Bunds increases with each paired trade put on by hedge funds.

The traders love to go long German Bunds, and go short a sovereign of the PIIGS.  They have levered into a trade that cant go wrong, until it does.  Allot like the famous VW Vs Porsche arb trade of 2008, trading desk around the world have backed into this trade in size.

This form of speculation, driven by hedge funds and large bank prop desks has helped to drive up the demand of the Bund beyond its normal market issuing demand (lowering its yield), and correspondingly driving down any support the ECB can give the sovereign bonds of the PIIGS in the market.  This one way trade will have interesting affects on the market when the German Bund starts to experience selling pressure.

The irony of this is that Germany is not immune to a banking crisis of its own.  While it is the healthiest of the European states, it has its own issues. It appears that the German leaders are preparing the German Banks for some forced haircuts.  The market is just noticing and starting to evaluate the implications of what is coming down the pike.

On November 2nd the German Parliament passed the Germany Bank Restructuring Act.  It gives regulators authority to take action against a bank, as necessary, to protect the system.  In it, it allows the forced applying of haircuts to unsecured debts.  This caused some consideration this fall, when originally discussed and voted on.

This act has opened up a hole in the German banking wall, and with that the start of a systematic undermining of the German banking debt issues.  CDS on German banks will start to rise verses Bund yields, as individual bank debt risk is priced into the trading models that use Moody.

Moody’s has downgraded $33 Billion in subordinated debt securities of German banks. The downgrades will continue, as pressure builds in the system.

“The new regulatory tools allow authorities to impose losses on debt holders without necessarily placing the entire bank into liquidation,” the ratings firm said in a statement today. “Moody’s considers subordinated debt to be most at risk under the new law.”

The cut in ratings affects 24 banks, and 248 securities plus their sub tranches.  The average cut was 2.5 steps according to Moody’s.

“The regulatory tools provided by the Bank Restructuring Act are broad enough to allow the imposition of losses on senior unsecured and subordinated bondholders,” Moody’s said.

The usual suspects (Deutches Bank AG, Commerzbank, Bayerische Landesbank) were slapped with the downgrade.  This is the first slippage in the invincible German bankers wall.  It wont be the last.  Germany has its own issues to deal with, the hair cuts are coming.

Links of Interest

  • Bloomberg

German Bank Debt Securities totally 33 Billion cut

Cliffard Chance

German Bank Restructuring Act Update