Washington and the Fed have tried to strengthen the financial and banking system ever since it almost broke down five years ago. With the current turmoil in the emerging nations bonds and currency markets, the vulnerability of these efforts are currently being tested. With oil prices declining and with oil priced in dollars, there is a full-blown currency crisis in such countries as Russia, Brazil, Mexico and Venezuela.1) Will Big banks and National Banks,be sturdy enough to bear the shocks? (Russia’s Trust Bank is the first to fail) and 2) How dangerous are derivatives that banks now hold in record levels? Also, the Fed has bought some $3 trillion of miscellaneous bonds during its. QE buying spree. 3)If bonds start to default, will the banks price their portfolio “to the market?”

With lower oil prices, a disruption in oil producing countries economies could cause global instability and undermine the efforts of Europe and Japan to stimulate their economies. Petrobras in Brazil, Pemex in Mexico and Gazptom in Russia, sold billions of dollars of bonds to investors looking to receive high interest rates. Trouble with these State run companies, could cause worldwide investment growth to slow, leading to other corporate bond defaults. The bonds of non oil producing countries like Turkey, India and South Africa, have already suffered, as anxieties have caused selling in other emerging markets.
The problem is further multiplied by the holding of emerging market mutual bond funds and exchange traded funds, that cannot liquefy their bond portfolios as quickly as the shareholders can sell. The investors who hold these high-yielding funds have immediate liquidity. However, the managers that hold these funds in high-yielding bonds, have far less liquidity. PIMCO owns close to 50% of many foreign bonds and controls over 40% of the debt issued by the bank of China, 40% of the state bank of India and close to 30% of some Spanish banks. In some exchange traded funds like widely held BlackRock, they have 9% of its funds in government owned oil companies. These bonds cannot be sold quickly. Already this month Petrobras, 10 year bond has gone from 6% to 8% and Pemex bonds  have gone from 3.8% to 4.8%. The sell off in these bonds could quickly turn into a panic and a domino effect could occur, as managers sell more liquid bonds to meet redemption demands. This could spread to other markets including the stock market or visa versa..Anxieties are rising as Jefferies Company has reported a 73% decline in fourth-quarter revenue from its bond trading unit.

BlackRock, PIMCO and Franklin Temelton funds, among others, hold large amounts of high-yielding bonds. Since 2009, $1.7 trillion of emerging market bonds have been sold. Petrobras has $170 billion in debt, making it the most indebted company in the world. Russian companies sold some $244 billion of bonds since 2009. PIMCO’s Emerging Market Corporate Bond Fund assets soared to $1.5 billion in 2013, but now reportedly stands at only $496 million. The Russian stock market is down 50% this year and the rubble has crumbled. To some extent the panic has already started. However, its international economic implications have yet to be recognized. ‘Junk Bonds’ can very quickly become the new name for for these high-yielding bonds. Remember, markets hate the lack of liquidity!

The thing that worries me about all this, is the effect on Russian bonds, that have been plummeting in price. Russia’s central bank said on Friday that its bailout of the Trust Bank was the first major lender to fail as a result of the sharp decline of the ruble and oil prices and that this would cost the Russian government approximately $2.5 billion This is far more than previously anticipated.  Other Russian banks are also expected to need bailouts as a result of the recent currency crisis. Other oil-producing nations like Venezuela, Brazil, Iran and Mexico may find that their banks may also need a bailout. Lower oil prices are also having their affect here at home, where Texas, Louisiana, Alaska and North Dakota will have State budget problems and economic slowdowns.This could cause mutual fund selling in their high-yield bond funds, which could start an avalanche of panic selling in Greek,Spanish, etc, bonds. As these markets are not liquid either, the selling might transfer to better grade bonds, that are more liquid! Remember that the Fed holds $3 trillion dollars of bonds that it purchase during its QE buying spree and our banks are loaded with bonds and derivatives. If the stock markets worldwide starts to decline and short-term money suddenly dries up, there could be unforeseen difficulties dealing with a bond/currency crisis that has the potential to cause panic selling and a worldwide economic crisis. Who me Worry?

Updated 12/17/14

Carl M. Birkelbach 12 /17/14

Mr Birkelbach does not offer investment advice, but merely his own personal opinion. This report has been prepared from original sources and data we believe reliable but make no representations as to the accuracy or completeness. Mr.Birkelbach , his affiliates and subsidiaries and/or their officers and employees may from time to time acquire, hold or sell a position in securities. Past performance is no guarantee of future success. Upon request, we will supply additional information.


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