Houston, We Have a Problem...

While the talking heads seek to reassure us that the Greek problem is behind us, consider this little-noticed news from Moody's.

I doubt any of my regular readers own these bonds, and thus would likely feel unaffected by the news.  But, I'm seeing more and more of these little blurbs lately.  And, the cumulative effect could be devastating to the markets.

Institutional investors (pension funds, corporations, insurance companies, money market/mutual funds, foundations etc.) are all about rules.  In almost every case, an investment committee establishes very precise rules governing what the fund may and may not invest in.  So, when an instrument formerly rated A1 is downgraded to Baa1, there's a decent chance some investors will be required to dump it.

Many bond issues lack the inherent credit-worthiness to be considered high grade on their own merits.  They purchase credit enhancement from a high grade bank, analogous to renting a co-signer on a loan.  When that co-signer's credit takes a hit, as occurred here when Bayerische Landesbank was downgraded, everything the co-signer vouched for is suddenly affected.

In a healthy, orderly market, it's not a big deal.  The issuer finds a new co-signer and life goes on.  But, when there's a systemic decline in the credit ratings of most of the co-signers out there... well, Houston we have a problem.  In the article accompanying the BL downgrade this past November, Moody's noted:

Moody’s said in July it initiated or continued credit rating reviews for 12 German banks on concern assumptions of support for the lenders may be challenged as the political will to shoulder bailout costs weakens.

Well, with CDS being triggered Friday, banks across Europe are being hit with costs they had assumed would never be realized.  And, with Ireland and Portugal scheming to snag their own bailout restructurings, the contingent liability is in store for the Euro Zone financial community is about to soar at a most inopportune time (Basel III.)

Add in the fact that many of the affected countries are facing elections in the coming months -- meaning even less support for the sweetheart deals the incumbents made with banks -- and it's pretty likely that more downgradings are in store for the co-signers.  Given the degree to which they partook of the latest LTRO, it would seem there are too many snouts in the trough as it is.

So, to bring the idea full-circle, what happens when even more banks suddenly lose support from governments no longer willing to bend over backward to keep them from failing?  We'll be seeing lots more downgrades from the rating agencies -- which, of course, means lots more downgrades for all the instruments backed by said banks.  Institutional investors will have no choice but to dump the affected instruments -- meaning even more underfunded pensions (another story getting no coverage whatsoever) and financial institutions which will lead to...yep... more downgradings.

It's a feedback loop that could get real ugly, real fast.