Are We Heading Towards Another Financial Crisis?

Definitely maybe.

It's always hard to predict the future (as the saying goes, those who live by a crystal ball shall eat crushed glass) but I will say that all there are signs that we are approaching another leg of the financial crisis.  One possible sign is that despite being in an environment where they should be making money, hand over fist, bank stocks are underperforming.  In fact, the KBW bank index is down 10.1% this year.  Stocks moving up or down 10% are usually not a reason to worry as equities are notoriously volatile, but the weird thing is that they are underperforming like this with a steep yield curve.  A steep yield curve simply means that banks can perform short term borrowing for very little and then loan out that money for quite a bit more.  When you add leverage into the equation, this is when banks are supposed to shine.  It is when a yield curve flattens or inverts that things usually get dicey as there is almost no way to make money borrowing in the near term and then lending for the long term as those rates might be the same, or might even be lower longer term.

So the question people have been asking lately is why have they been underperforming like they have been when they should be doing really well in this environment.  One answer is like a phoenix rising out of our memories of the last crisis, mortgage backed securities.  Yes, banks still have them, and while they might have been able to get rid of some of them, they seem to still own hundreds of billions of dollars worth.  And as you can see from the chart below, showing the index for 20 AAA CDO's,, they are starting to nosedive.  You can see a bunch of related charts here.

Another issue with banks seem to be their exposure to the Euro crisis.  It's been my understanding that it was European banks who were selling a lot of the insurance on Greek sovereign debt.  According to the Bank for International Settlements data, as waded through by The Street Light blog, that understanding was wrong.

US institutions have sold approximately $34.1 billion in insurance on Greek sovereign debt, about 56.3% of the total!  It's as if we learned nothing from AIG!  Of course, our exposure doesn't end there, we've sold $54 billion in default insurance on Ireland and another $41.2 billion on Portugal.  So if a Greek default, starts some sort of cascade, the numbers add up quickly, to the tune of $129.3 billion for those 3 countries alone.  Given these totals don't include any insurance sold on bank debt in those three countries, our true exposure to defaults is probably much greater.  Are we going to have to bailout our banks again???  You just have to cringe at the thought.

So when could a default happen?  It depends, it might not happen until next year, or it can happen this year if Greece is bailed out and as one of the conditions for the bailout is "private sector participation".  Any private sector participation would be considered a default by the ratings agencies and at that point, our banks will be on the hook.  And things don't look good, S&P downgraded Greece debt to CCC today, the cost of sovereign bond insurance is at record levels, and the Bundesbank President just said that the Euro will remain stable in the case of a Greek default (a little pregame damage control?). 

Cash may turn out to be king, once again.