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“Smart Money” and Interest Rates

11/14/2011

U.S. banks are required to have a certain amount of capital for each investment.  European banks are not required to have capital in order to hold certain investments, such as sovereign bonds of European governments.  That means a European bank can take in funds from depositors and buy bonds of some European government.  They pay the depositor next to nothing for the funds to buy the bonds and receive the higher interest paid on the government bonds.  Since there is no capital requirement there is no limit on the amount of government bonds they can purchase, as long as depositors continue to deposit money.  This policy was designed to hold down borrowing costs of European government but  actually increases the amount of leverage in the banking system, which is a big part of the current problem.

To protect themselves, banks and other holders of the bonds can buy protection or “insurance” called credit default swaps (CDS).  As the market perceives a particular government to be more risky, the cost of buying a CDS goes up.  Take a look at http://www.cnbc.com/id/38451750

The cost of insuring Greek debt is astronomical.  Judging from the news, one would expect Italy to be the second highest.  However, the “smart money” thinks Portugal, Ireland, and Hungary are worse credit risks than Italy.  While a bankruptcy for any of those nations would hurt investors around the world, Italy is different because it is so big.

Italy has the third largest economy in Europe and could destroy those banks across Europe who have loaded up on higher-yielding Italian debt without needing any capital to buy that debt.  More capital will cure many ills!

The good news is that Italy was able to sell $4 billion in new debt this morning.  While they had to pay a relatively high interest cost, albeit below the systemically important 7% level, it is significant that somebody was there to buy it.  I’ll bet the banks were not buyers today, which increased the cost of borrowing. 

Italy will live to spend another day . . . maybe two.

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