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.
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.