As the summer months begin to hit their stride, volatility in the market, seems to ebb and flow, and remain above historically high levels. The VIX, which is the index that follows the implied volatility of the S&P 500 index is 4 points above the 200-day moving average of the volatility index, even though volume on stocks and futures contracts are lower than average, given we are in the heart of the summer.
The VIX tracks the prices of the at the money options for the S&P 500 index, and create a gauge of fear within the market. In general, the higher the VIX, the more demand there is for protection on a portfolio of stocks.
Fear in the markets exists for a number of reasons. Recent data released by US government agencies has been rather disappointing. The US jobs picture continues to show lackluster growth. Manufacturing for the month of June was disappointing, as the ISM reported an index gauge that was worse than expected, although the numbers continued to show expansion.
Another source of anxiety stems from the stress test in which the European banks are currently undertaking. The market waits for the European Bank Supervisors to provide more details about the stress tests. If the market has a better sense of the robustness of the stress tests, it might lift some uncertainty among investors. There are several reasons why investors are anxious. . The credit default swaps for Europe’s top banks are about 50% higher than for US top banks. Europe’s top 20 banks trade at a discount to book value of a bit more than 10%. The top 20 US banks trade at a modest premium to book value. A credit default swap is a security in which investors can speculate or hedge on the change of a company defaulting on debt. In fact, the instrument is the opposite of a bond, and a long position on a credit default swap is similar to shorting corporate bonds.
The IMF projects that by the end of this year, US banks would have written down about 7% of their assets, while euro zone banks would have written down about 3%. The BIS reports that at the end of last year European banks had assets valued at 31.1 trillion Euros which is 3.5 times more than US banks. Given that the economies are roughly comparable, it points to significantly greater leverage for European banks.
In late ’08, EU leaders pressed for an accounting change to allowed banks to avoid marking down asset values to the plunged market values unless default was thought likely. Some reports suggest this accounting shift helped “save” billions of Euros. It is not immediately clear what happens to a bank that is judged to need for capital. Several countries have bank funds that might be able to be drawn upon.
The market appears to have so much to worry about that it is having difficulty choosing which to focus on. The immediate interest is on the details of the European bank stress tests. The criteria is expected to be announced by the Committee of European Bank Supervisors. The market is keen to know if the banks are strong enough not only to withstand weaker growth and higher unemployment, as was the case of the stress tests on US banks a year ago, but also if they can cope with problems rolling over current funding and a potential sovereign default. There have been numerous press reports warning that the stress test may reveal serious capital requirements. Officials from numerous countries seem to be playing down the risks and highlighting the relative health of their banks. While the focus of many observers has been on the German Landesbank sector and the Spanish Cajas, the “bad bank” created to manage the troubled real estate loans indicated that it now expects only 25% of the 81 billion euro in loans it has purchased will be income producing. This is down from its previous estimate of 40%. Finance Minister Lenihan admitted that NAMA discovered “a horrific picture within the banking system.” NAMA said it may lose as much as 800 million Euros over its life time under a stress scenario outlined yesterday. NAMA’s central projection is for a profit of 1 billion Euros, which compares with an estimate at the end of last year of a 5.5 billion Euro profit.
Some reports suggest that the stress that European banks may be tested for include a 17% loss on Greek bonds and a 3% loss on Spanish bonds German bunds and possibly French bonds will not be stressed–that is to say the stress test will not include a long on bonds from those two. While these details have yet to be confirmed, the stresses on Greek and Spanish bonds seem modest. Greece pays 750 basis points more than Germany on 10-year bonds today. Additionally, a 3-percentage point deviation of GDP for 2010 and 2011 from the EU’s economic forecasts and a deterioration of sovereign risks beyond what was experienced in early May will be used.
The anxiety created by the stress test and disappointing US data, is creating a higher than normal level of implied volatility, which is evident in the value of the VIX. Once expectations on US data, are lowered, along with a satisfactory outcome to the European bank stress test, the VIX will decline and drop to a level below 20 seen in March and April of 2010.
