The subject of our most recent expose on the European banking system has a plethora of problems, including but not limited to excessive PIIGS exposure, NPA growth up the yin-yang, Texas ratios and Eyles test numbers that’ll make you shiver and razor thin provisions. Focusing on the most pertinent and contagious of the issues at hand leads us back to the initial premise of a European bank run. I laid the foundation for said topic discussion last Thursday in "The Fuel Behind Institutional “Runs on the Bank" Burns Through Europe, Lehman-Style" and the fear du jour is a European version of the Lehman Brothers or Bear Stearns style bank run. The aforelinked at explanatory piece is a must read precursor to this illustration of what can only be described as the anatomy of a European bank run - before the fact. Remember how the pieces of the puzzle were perfectly laid together for a Bear Stearns collapse in January of 2008, two months before the bank's actual collapse? Reference "Is this the Breaking of the Bear?" in which Bear Stearns collapse was illustrated in explicit, graphic detail. Lehman Brothers wasn't impossible to see either (Is Lehman really a lemming in disguise? Thursday, February 21st, 2008 | Web chatter on Lehman Brothers Sunday, March 16th, 2008).
I would also like to make it clear that it is my opinion that the EU leaders who insist on issuing "alleged" bank stress tests that assume its constituency are moronic simply add fuel to the bank run fire. The refusal to test for the concern that the entire bond market has simply feeds uncertainty in lieu of alleviating it, reference Multiple Botched and Mismanaged Stress Test Have Created The Makings Of A Pan-European Bank Run.
The "alleged" stress tests did not test for sovereign default and its effect on HTM inventory, which is already priced into the system and which is the primary worry of the markets. Thus, the stress test results are largely irrelevant.
It's as if I have AIDS and I go to the doctor and pass a test for measles... Does that make my multiple partners (counterparties , lenders and customers) more or less comfortable with my condition?
We have run our own numbers and produced alternative, more realistic scenarios including exposure, haircut assumptions and writedowns for individual countries. Specifically, we have applied writedowns on both banking and trading books with the results available in the subscription document The Inevitability of Another Bank Crisis? and well as European Bank's Greece exposure. In essence, after Lehman Brothers collapse, sovereign states appear to deem themselves obligated to bail out their respective insolvent banking systems, thus real stress tests should test both the banks' distressed portfolio carried at unrealistic marks and leverage and the sovereign's ability to aid said banks. Of course, this will be very unpopular from a political perspective because you will get a lot of nasty answers to the questions asked.
Below is a chart excerpted from our most recent work showing the asset/liability funding mismatch of a bank detailed within the report. The actual name of the bank is not at issue here. What is at issue is what situation this bank has found itself in and why it is in said situation after both Lehman and Bear Stearns collapsed from the EXACT SAME PROBLEM!
Note: These charts are derived from the subscriber download posted yesterday, Exposure Producing Bank Risk (788.3 kB 2011-07-21 11:00:20).
Overnight and on demand funding is at a 72% deficit to liquid assets that can be used to fund said liabilities. This means anything or anyone who can spook these funding sources can literally collapse this bank overnight. In the case of Bear Stearns, it was over the weekend.
In reviewing my post on this topic in January predicting the fall of Bear - "Is this the Breaking of the Bear?", it is actually scary how prescient it actually was...
Book Value, Schmook Value – How Marking to Market Will Break the Bear’s Back
Okay, I’ll admit it. I watch CNBC. Now that I am out of the confessional, I can say that when I do watch it I hear a lot of perma-bulls stating that this and that stock is cheap because it is trading at or below its book value. They then go on to quote the historical significance of this event, yada, yada, yada. This is then picked up by a bunch of other individual investors, media pundits and other “professionals,” and it appears that rampant buying ensues. I don’t know how much of it is momentum trading versus actual investors really believing they are buying on the fundamentals, but the buying pressure is certainly there. They then lose their money as the stock they thought was cheap, actually gets a lot cheaper, bringing their investment down the crapper with it. What happened in this scenario? These investors bought accounting numbers instead of true economic book value. Anything outside of simple widget manufacturers are bound to have some twists and turns to ascertain actual book value, actual marketable book value that is. This is what the investor is interested in, the ECONOMIC market value of book, not what the accounting ledger says. After all, you are paying economic dollars to buy this book value in the market, so you want to be able to ascertain marketable book value, I hope it sounds simplistic, because the premise behind it is quite simple – How much is this stuff really worth?. The implementation may be a different matter, though. I set out to ascertain the true book value of Bear Stearns, and the following is the path that I took...
I urge all to review that post of January 2008 and realize that negative equity is negative equity, and no matter how you want to label it, account for it, or delay and pray, broke is broke! This lesson should not be lost on the Europeans, but unfortunately, it is!
The problem then is the same as the European problem now, leveraging up to buy assets that have dropped precipitously in value and then lying about it until you cannot lie anymore. You see, the lies work on everybody but your counterparties - who actually want to see cash!
Using this European bank as a proxy for Bear Stearns in January of 2008, the tall stalk represents the liabilities behind Bear's illiquid level 2 and level 3 assets (including the ill fated mortgage products). Equity is destroyed as the assets leveraged through the use of these liabilities are nearly halved in value, leaving mostly liabilities. The maroon stalk represents the extreme risk displayed in the first chart in this missive, and that is the excessive reliance on very short term liabilities to fund very long term and illiquid assets that have depreciated in price. Wait, there's more!
The green represents the unseen canary in the coal mine, and the reason why Bear Stearns and Lehman ultimately collapsed. As excerpted from "The Fuel Behind Institutional “Runs on the Bank" Burns Through Europe, Lehman-Style":
The modern central banking system has proven resilient enough to fortify banks against depositor runs, as was recently exemplified in the recent depositor runs on UK, Irish, Portuguese and Greek banks – most of which received relatively little fanfare. Where the risk truly lies in today’s fiat/fractional reserve banking system is the run on counterparties. Today’s global fractional reserve bank get’s more financing from institutional counterparties than any other source save its short term depositors. In cases of the perception of extreme risk, these counterparties are prone to pull funding are request overcollateralization for said funding. This is what precipitated the collapse of Bear Stearns and Lehman Brothers, the pulling of liquidity by skittish counterparties, and the excessive capital/collateralization calls by other counterparties. Keep in mind that as some counterparties and/or depositors pull liquidity, covenants are tripped that often demand additional capital/collateral/ liquidity be put up by the remaining counterparties, thus daisy-chaining into a modern day run on the bank!
I'm sure many of you may be asking yourselves, "Well, how likely is this counterparty run to happen today? You know, with the full, unbridled printing press power of the ECB, and all..." Well, don't bet the farm on overconfidence. The risk of a capital haircut for European banks with exposure to sovereign debt of fiscally challenged nations is inevitable. A more important concern appears to be the threat of short-term liquidity and funding difficulties for European banks stemming from said haircuts. This is the one thing that holds the entire European banking sector hostage, yet it is also the one thing that the Europeans refuse to stress test for (twice), thus removing any remaining shred of credibility from European bank stress tests. As I have stated many time before, Multiple Botched and Mismanaged Stress Test Have Created The Makings Of A Pan-European Bank Run!
The biggest European banks receive an average of US$64bn funding through the U.S. money market, money market that is quite gun shy of bank collapse, and for good reason. Signs of excess stress perceived in the US combined with the conservative nature of US money market funds (post-Lehman debacle) may very well lead to a US led run on these banks. If the panic doesn’t stem from the US, it could come (or arguably is coming), from the other side of the pond. The Telegraph reports: UK banks abandon eurozone over Greek default fears
UK banks have pulled billions of pounds of funding from the euro zone as fears grow about the impact of a “Lehman-style” event connected to a Greek default.
Senior sources have revealed that leading banks, including Barclays and Standard Chartered, have radically reduced the amount of unsecured lending they are prepared to make available to euro zone banks, raising the prospect of a new credit crunch for the European banking system.
Standard Chartered is understood to have withdrawn tens of billions of pounds from the euro zone inter-bank lending market in recent months and cut its overall exposure by two-thirds in the past few weeks as it has become increasingly worried about the finances of other European banks.
Barclays has also cut its exposure in recent months as senior managers have become increasingly concerned about developments among banks with large exposures to the troubled European countries Greece, Ireland, Spain, Italy and Portugal.
In its interim management statement, published in April, Barclays reported a wholesale exposure to Spain of £6.4bn, compared with £7.2bn last June, while its exposure to Italy has fallen by more than £100m.
One source said it was “inevitable” that British banks would look to minimise their potential losses in the event the euro zone crisis were to get worse. “Everyone wants to ensure that they are not badly affected by the crisis,” said one bank executive.
Moves by stronger banks to cut back their lending to weaker banks is reminiscent of the build-up to the financial crisis in 2008, when the refusal of banks to lend to one another led to a seizing-up of the markets that eventually led to the collapse of several major banks and taxpayer bail-outs of many more.
Make no mistake - modern day bank runs are now caused by institutions!
Below is an excerpt of an email exchange that I had with Eurocalypse, the European CDS trader that contributes trade setups to BoomBustBlog (click here for his background), who happens to have ran an ALM department in a sizeable French bank.
FYI, im hearing from my well connected friends that the Chairman of the BoomBustBlog bank run candidate in question has been seeing Sarkozy everyday recently...
Im very surprised about the extent of the ALM gap from the BRC ("Bank Run Candidate"), but my guess is that balance sheet is including the trading books.
Typically the biggest chunk of the balance sheet are govt bonds, and they are refinanced with the repo market. That should explain a lot of the gap.
I dont think the ALM managers manage that gap, and I dont think they should either. Info on the ALM gap ex-trading book should be monitored.
The trading activity is monitored by a market risk group with another set of limits, and of course they would monitor liquidity, closely hopefully.
Of note, there are new official liquidity ratios put in place in Basel III (the LCR Liquidity Coverage Ratio which is a 1 month ratio, and the DFSR which is a 1 year ratio). Basically, Govt bonds are considered as the ultra liquid assets, and actually the LCR forces the banks to hold liquid assets against their 1 month gap calculated with some liquidity assumptions both on the asset and liability side) of course these liquid assets, will mostly be govt bonds in practice, because there is not anything more liquid, and not anything else in sufficient size...
The question is, exactly how liquid are the bonds of sovereign Greece, Ireland and Portugal. Much of this stuff should rightfully be classified as level 3 assets. The 50% depreciation in the Greek long bond should really, really cause many to rethink both the logic and the strategem behind so called "risk free asset" classes!!!
I'm not saying there is no liquidity risk on the trading books. Effectively if there are signs of stress in the repo market, all players will try (at the same time...) to reduce the size of their trading books ... leaving the market bidless... but its not the intent of banks to try to make profit on the liquidity gap in that case.
Finally the big picture, I think one cannot again ignore that the banking sector and govt debt are totally intertwined as I wrote before. Ultimately, the collapse of the banking sector means the collapse of govt finances and vice versa. Its a FEATURE of a fractional reserve lending system where the eligible asset of choice is those govt bonds, and of a system where govts can freely float more and more debt (as long as there is demand), as money is created by the CB in the process, which end up in the liability side of private banks which then need to buy something etc...
On the liquidity side, many French regional banks were overextended with loan to deposit ratios over 120% (despite being deposit-rich institutions). The main reason is they boosted a lot retail mortgage activity.
Anyway, in France, were converging with Japan.
- Tough competition within banks, shrinking margins (consumer laws against predatory lending in France, French banks earn a lot of money from the poorer clients who have temporary deficits on their checking accounts).
- The housing and CRE market bubble has not exploded yet (Paris home prices are at the highest ever).
- Then there is the Euro crisis on top of that
- ...and the govts wanting to levy more banking taxes...
The sector should be a HUGE UNDERPERFORM! The only way they can make money in the future, is buying those govt bonds and sitting on them, like the Japanese banks...and pray for the bond market not to explode like in Greece!
Or Portugal, or Ireland, or...
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