It is no sur­prise that there is both an implicit and explicit link between finan­cial entity risk and that of their local sov­er­eign over­lord. The mul­ti­tude of trans­mis­sion chan­nels is large and the causal­i­ties, not merely cor­re­la­tions, run both ways, pro­vid­ing for both vir­tu­ous (2009 per­haps) and vicious (2010-Present) cir­cles. Gold­man Sachs, in its 2012 invest­ment grade credit out­look takes on the topic of the feed­back loop which is engulf­ing finan­cials and sov­er­eigns cur­rently — not­ing that despite the 'opti­cal' cheap­ness of finan­cial spreads to non-financials (and equi­ties) that it is unlikely to com­press sig­nif­i­cantly with­out a 'solu­tion' to the sov­er­eign cri­sis being well behind us. The key take­away is that pre-crisis sov­er­eign credit pre­mia were, in hind­sight, uneco­nom­i­cally tight (unre­al­is­tic) and expec­ta­tions of a return to those lev­els is incor­rect as they see the cur­rent repric­ing of sov­er­eign risk as a par­a­digm shift as opposed to tem­po­rary repric­ing due to mar­ket stress. "Sov­er­eign spreads will likely emerge from the cri­sis both more ele­vated and more dis­persed", mean­ing floors on bank spreads will be ele­vated and delever­ag­ing pres­sures to be main­tained rais­ing the real risk, out­side of spam-and-guns Euro-zone crashes, of a poten­tial credit crunch. This is already evi­dent in Euro­pean loan spreads, which as we have dis­cussed many times is the pri­mary source of funds (as opposed to pub­lic debt mar­kets as in the US).

Gold­man Sachs: The Feed­back Loop Between Sov­er­eigns And Financials

The spread dif­fer­en­tial between finan­cials and non-financials is at all-time highs. Even so, we do not expect this rel­a­tive spread pre­mium to com­press until the risk from the Euro­pean sov­er­eign cri­sis is safely behind us. Finan­cials remain dis­pro­por­tion­ately exposed to the inter­ac­tion of down­side macro risk and the enor­mous pres­sure under which Euro­pean sov­er­eigns and banks are labor­ing. Exhibit 15 shows that US and Euro­pean bank spreads have been highly cor­re­lated with Euro­pean sov­er­eign spreads in 2011—a trend we expect to per­sist in the next few months. It is there­fore hard for us to see how finan­cial spreads can out­per­form as the cri­sis wors­ens (which in our view is still the most likely sce­nario from here).

It now seems clear that Euro­pean pol­icy efforts will not try to sta­bi­lize sov­er­eign credit spreads at pre-crisis sov­er­eign spread lev­els. In hind­sight, the credit pre­mium built into sov­er­eign spreads were unre­al­is­tic. Look­ing for­ward, the ECB (backed by the Ger­mans) has pub­licly resisted the notion that it either can or should push back against the market's recent repric­ing of this risk. Instead, pol­icy mak­ers want to see periph­eral sov­er­eigns make the adjust­ments to domes­tic demand nec­es­sary to accom­mo­date this sharp increase in sov­er­eign bor­row­ing costs.

There will be even greater pres­sure on sov­er­eign spreads in the near term since the core coun­tries and ECB clearly need to keep the exter­nal pres­sure ele­vated to assure the con­tin­ued adap­tion of aus­ter­ity mea­sures. The "ben­e­fits" of aus­ter­ity will not likely be vis­i­ble for at least a year (on the con­trary, the front-loaded por­tions of these aus­ter­ity mea­sures will most likely prove counter-productive). And demands for aus­ter­ity are more likely to grow as it becomes evi­dent that the repric­ing of sov­er­eign risk has a large per­ma­nent com­po­nent, reflect­ing a par­a­digm shift in the pric­ing of sov­er­eign risk as opposed to a tem­po­rary repric­ing of mar­ket stress. Sov­er­eign spreads will likely emerge from the cri­sis both more ele­vated and more dispersed.

For banks, this means credit spreads are almost surely going to embed a per­sis­tent pre­mium for sov­er­eign risk. This logic implies there is much less upside room for spread tight­en­ing in periph­ery banks than a sim­ple naïve bench­mark­ing to pre-crisis lev­els would suggest.

We also expect delever­ag­ing pres­sures on banks to remain high. The mag­ni­tude of announced delever­ag­ing plans of Euro­pean banks already totals hun­dreds of bil­lions. We expect the delever­ag­ing trend to con­tinue in 2012. This raises the risk of a poten­tial credit crunch that would fur­ther weaken growth, which in return neg­a­tively impact bank­ing activ­ity, impair bank assets, and thus amplify the bank­ing crisis.

To be clear, we think losses to senior bond hold­ers of pil­lar banks in Europe are highly unlikely. Banks have sig­nif­i­cantly increased their liq­uid­ity posi­tions, and we think the ECB can prob­a­bly do enough to trim the tail risk of a Lehman-style shock. Nonethe­less, the num­ber of dis­tressed banks that are now on the ECB “life-support” has increased as the sov­er­eign cri­sis inten­si­fies. The health of these banks is likely to dete­ri­o­rate over time, mak­ing the final cost more expen­sive the longer the ECB has to pro­vide this support.

This sug­gests the Senior-Sub decom­pres­sion trade is war­ranted (as we have been say­ing for a while — pre-downgrades) and pick­ing the carry on financials-non-financials seems like noth­ing but a beta play to us. Up-in-quality via Main ex-Financials may be lower carry but stands to ben­e­fit both ways and XOver looks set to suf­fer more if delever­ag­ing forces a credit crunch.

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