August 8, 2011: Stocks Fall Hard, Dow Records Its Second Largest Loss Since 2008, In Just Two Days; Credit Swap Prices Rise By Record Amount (insurance, banks)

On Friday, August 5, 2011 the Dow Jones recorded its largest single day loss since the 2008 recessionary period, just following that the S&P downgraded its credit rating to AA+ from AAA (even though other debt-laden countries such as France were allowed to keep their AAA rating) and another record breaking day ensued on Monday, August 8 when the Dow fell twice as much, 635 points (5.55%). All three American indices fell by a significant amount (S&P 500 6.66%, Nasdaq 6.90%), that compares to drops of 3.77% in Shanghai, 2.18% in Japan, 2.17% in Hong Kong, 3.39% in the UK and 4.04% in Toronto.

Investor confidence is also at a low point evidenced by the rising popularity of Credit Default Swaps (CDS, if a government default occurs, holders of the bond are able to exchange it with the seller of the CDS for its face value less value of defaulted debt, if there's no default, the seller earns an annual rate of interest, 1bp = 1 basis point = $1000 annually on contract protecting $10 million worth of debt). Overall, the average credit swap for the 6 biggest banks by assets was 32.3% higher to 210.9 bp (highest since May 2009). Bank of America default swaps rose 42.2% (to 295 bp) at the same time AIG was suing it for $10 billion in losses claimed on mortgage bond investments, Morgan Stanley swaps up 40.1% to 280.1. Swaps on the biggest insurers was up to its highest level since July 2010. (SFGate: Bank of America Leads Surge in Credit Swaps on Downgrade Concern) There was concern also that S&P might lower its ratings of major US banks but it shot down that rumour saying that none of the banks have a higher rating than the AA+ US rating. Though risky, on the year, bonds have had the second highest rate of return second only to gold (price of gold up 43.93% or $527.70 (August 9, 2010 - August 9, 2011).

The market volatility, inflation and overall economic tightening are errily reminiscent of the 2008 recession, the big problem now though is that the US government has used up most of its arsenal (quantitative easing, stimulus) leaving it highly vulnerable. Grmike's advice: Don't take cheap energy for granted! It's the best remedy for an economy on life support. Per kWh of energy production: coal 4 cents, natural gas 9 cents, renewables 23 cents.

As big as the US news was, the potential for a financial armageddon came from Europe where the world's 8th and 12th largest economies (Italy and Spain) are also facing possible defaults down the road as high borrowing rates make it harder to borrow and borrowing is something the countries cannot do without (interest on debt is already very high). The European Central Bank (ECB) risked its own downgrade by buying up Italian and Spanish bonds in a bid to lower interest rates enough to keep those economies afloat. The fix is short term only, it doesn't change the long term outlook for either economy but does have long term negative ramifications for the European Central Bank which has now committed itself to buying €2.5 billion worth of Spanish and Italian bonds, daily; That's a significant increase from the €80 billion worth of debt in total that the ECB invested in Greece, Ireland and Portugal. The move lowered Italy 10 year bond yields (interest rate) by 0.7 to 5.3% and Spain bond yields by 0.9 to 5.14%. The European Reserve Fund has put together a $1.5 trillion rescue package for Italy and Spain, France which is in its own fiscal quagmire will be responsible for a couple hundred billion of that. Can the euro withstand the European debt crisis? Will the bond between EU countries become stronger or weaker? What is an appropriate level of debt? those are just a few of the many questions that have investors frustrated.On August 11, 2011 Italy and France joined Greece, South Korea and a growing list of other countries in banning short selling (borrowing stocks/securities/assets from a broker, selling them to another group with the intent of returning them to the broker some time later) after it was rumoured that short sellers were trying to exploit a French downgrade. A Europe-wide ban is unlikely given the Europe's lack of authority to impose it.

Some other things to take note of

Italy is home to the third largest bond market in the world (valued at about US$ 2 trillion) meaning a bond crisis would have an even more devastating effect on the country. Italy is also the world's 7th leading export nation (US$ 458 billion in 2010).

French banks hold a lot of France's debt, which credit agencies are beginning to take a closer look at. Holding French debt is getting more expensive and that is taking a toll on them, on August 10, 2011 Societe Generale lost around 14% of its market value (down to $24.11 billion), Credit Agricole 11.8% (to $14.59 billion), BNP Paribas 11% (down to $68.12 billion); In Italy, Intesa Sanpaolo lost 15.4% (to $29.45 billion); In Spain, Banco Santander 9.48% (to $70.14 billion) and Banco Bilbao 10.42% ($37.55 billion). BNP Paribas Credit Agricole and Societe Generale rank 2nd, 10th and 18th among all companies in terms of assets ($2.7 trillion, $2.2 trillion and $1.5 trillion (Forbes: March 2011 The Global 2000 List) but their combined market value has fallen to $74 billion about the same as the Royal Bank of Canada (August 10, 2011 at the close of the market) making them severely undervalued (considering Societe Generale earned about the same amount of net income as Royal Bank of Canada ($5.3 versus $5.6 billion), had more than twice as many assets but only half the market capitalization. Further complicating things for France is the 0% 2nd quarter gdp growth announced on August 12, 2011, which follows 0.9% growth in the first three months (business stocks increased which didn't happen in the second quarter, consumer spending ended with the 2010 fiscal year). Only if France's gdp grows by at least 2% in 2011, will it be able to lower deficit to 5.7% of gdp which is important since that could determine whether credit rating agencies downgrade the country's debt.

The Canadian dollar was the only major currency to lose ground against the greenback (August 8, 2011). Possible reasons for that include 0.78% drop in the price of oil (down to US$ 80.45 or about 20% off what it was a couple months ago); even more concerning for Canada is that heavier oil (crude) was down 5.15% to $103.74 a barrel, government policies designed to keep the exchange rate from being too high as to encourage exports (60% of exports go to the USA) and Canada having one of the lowest bank rate/interest rates in the world (was as much as 4X lower than Australian rates). Gains by Canada's gold companies have helped to buffer against losses in other sectors (on August 10th, gains by Canada's gold miners pared losses suffered by oil and technology companies). When oil companies begin to release their second quarter results (Crescent Point Energy, Canada's 12th biggest oil company with $11B in market cap, experienced 158% increase in 2011 2Q earnings, up to C$184.9M or 59% of revenue compared to a loss of C$102M in the previous qtr), they should begin to prop up Toronto's Stock Exchange.
Of concern in Canada is a widening trade deficit; in June it was up to $1.6 billion or $5.2 billion with countries other than the United States making it even harder for the country to lessen its reliance on trade with the USA (in the USA, the trade deficit was $53.1 billion in June, the highest since October 2008). For Canada, both imports and exports fell but exports fell by a wider margin.