Goldman Looks At European Systemic Risk, CDS Concerns

By Mark Melin 

Systemic risk that was recently dormant is stirring, noted an economics research piece from Goldman Sachs. As credit spreads spike and pressure on bank equities has been building for weeks, it all just might be signaling a “reactivation of systemic risk concerns in markets.” That said analysis from Charles P. Himmelberg notes “fewer systemic concerns than credit markets are pricing.”

Yellen: Too Big To Fail still Too Big To Fail

The “systemic concerns” of credit markets are perhaps most emblematic based on the soaring Deutsche Bank credit defaults swaps, which increasingly appear to be pricing in disaster as Fed Chair Janet Yellen says in Senate testimony Thursday the problem of Too Big To Fail has not been solved.

Himmelberg notes that once a market smells fear, the emotion can create a momentum all its own. “We are acutely mindful that systemic fears, once in place, can be self-fulfilling and difficult to reverse,” he wrote. “These systemic concerns, if sustained, would be a new headwind for credit, and risky assets more generally.”

Himmelberg is surprised by the pressure on banks stocks which “mirrors our surprise at the weakness of economic growth more generally” as he looks for higher interest rates.

Deja vu all over again: credit default swaps (CDS) at issue in systemic risk

It is the European credit default swap (CDS) market once again at the center of concern? “We understand why markets might worry. Following the global financial crisis, European banks did not de-lever by nearly as much as US banks.”

Yes, it is the generally unregulated derivatives that were at the center of the 2008 financial crisis once again at the center of big bank concern. “Credit markets are clearly taking note of the systemic risk, and it is certainly unwise to minimize such risks since systemic fears, once in place, can be self-fulfilling and difficult to reverse.”

This is where bailout concerns once again raise their ugly head. “If systemic fears were to escalate further to a point where they might possibly require sovereign capital assistance, many of the largest and capital-neediest banks reside in the core economies,” he wrote.

But how low can bank stocks go? With many trading as low as one-third of book value, at what point does a value investor step in? The report noted several tactical trading views.

Goldman recommends closing out many trades, holding a long / short play on non-commodity exporters vs emerging market bank stocks

On interest rates, the report likes a relative value trade in Swedish swaps between the one and three year time horizon. They also recommend five additional trades, including closing out long US dollar trade for a loss of 5%; Closing long 10-year US break-even inflation (USGGBE10 Index) with a potential loss of 21 basis points; Close a long an equally-weighted basket of MXN and RUB versus short an equally weighted basket of ZAR and CLP with a potential loss of 6.6% including carry; Close a long 5-year 5-year forward Italian sovereign yields vs short 5-year 5-year forward German yields on 9 February 2016 for a potential loss of 49 basis points; Close long large cap US banks through the BKX Index relative to the S&P 500 with a potential loss of 5.4%.

With all those closing trades, the report did recommend remaining long a basket of 48 non-commodity exporters (GSEMEXTD Index) and short a basket of 50 emerging market bank stocks (GSEMBNKS Index), which is currently operating in the black.