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Sunday, 18 September 2011 23:59

I Will Fly In The Face Of Common Wisdom & Walk Through A Run On BNP On International Television Featured

I'm going to appear on the Max Kesier Show Tuesday. I noticed that there were some questions being asked on his site concerning the topic du jour, which is the condition of the French banking system, and BNP Paribas in particular. I will take this space and to answer the questions in detail, and will address some on the air as well, time permitting.

Reggie talks a lot about the system crashing, yet advocates taking profits from trades in the very paper that will die with the system. How does Reggie see the endgame? What does he use as a store of value?

The endgame is difficult to see, but if I had to hazard a guess, there is a strong chance the US may end up on top again. This is a topic that requires an entire show, if not a series of shows, in and of itself. The question of a store of value is a tricky one in an environment where nearly everything is at risk of an explosive devaluation. For instance, gold is a popular trade now, but even if gold maintains its relative value to fiat currencies or appreciates - and is not in an bubble, if the states are truly serious about cramming fiat down your throat, you will have your gold forcibly repriced, taxed to hell, or confiscated in some form or fashion anyway. If the government truly doesn't want the reserve trading instrument to be gold, there's a strong chance it will not be gold - at least as long as said government is still in power. Thus, if the gains to be made in a fiat currency that may collapse outrun the pace of said collapse, you are still ahead of the game - assuming that fiat currency is still liquid and accepted as legal tender.

My last comments on Max’s show were in answer to what I thought the Fed’s endgame was. At the time, it was difficult to see for I saw this country on an unsustainable path. I did theorize that the triumvirate, the global economic powers three, the US/China/EU were simply kicking the can down the road until one of the others simply blew up or imploded. Such an event would force capital flight from that economic machine into the other two, enabling the kick the can down the road game to go on much farther. Well, it appears that I may have been on to something, for Greece is nearly universally accepted as a default waiting to happen with yields reaching 150%, and now all of the periphery is on life support from the ECB, not one state, some states, but all of them! This has served to drive US treasury yields straight down, flirting with negative rates again… Yields have plummeted towards negative territory despite an explicit downgrade from one of the major ratings agencies. As I said, the capital flight of fright trade that basically throws the middle finger up at the ratings agencies and their opinions. The US is in bad shape. The EU is in a worse predicament for the near to medium term, and China is an inflationary fireball teetering on a deflationary collapse (once the massive NPAs garnered from bank lending and fraud run amok get recognized). The US may end up on top simply by being the best of a triumvirate of very bad situations! Go to the 20:55 marker in this previous Max Keiser interview for more on this view at the beginning of the year, and let me know if it makes sense given 20/20 hindsight...

If BNP Paribas does see a bank run what impact will this have on the European and global banking markets? Will it spark contagion and which entities are most at risk? If so, are there measures that can contain it.

BNP Paribas is large enough to spark a chain reaction throughout the European banking system, thus causing a domino effect that can definitely reach the financial shores of the US banking system. The entities that are most at risk are the very same entities that are:

  1. Still overleveraged
  2. Sitting on misvalued, highly depreciated, and hard to move toxic assets
  3. Materially exposed to BNP Paribas through counterparty relationships and lenders for:
    1. Depositors are likely to pull short term deposits from the bank leaving it vulnerable to an exaggerated short term liquidity crisis;
    2. Counterparties will then rush to be the first out of the door and those who don’t may very well increase collateral requirements and margin calls
  4. 1 & 2 above can combine to exacerbate the capital hole created realized by coming clean on the sovereign debt values held on the banks’ books. This can be caused by the default of Greece alone, although we all know Greece will not be alone if or when it does default.
  5. A default by Greece will devalue at best, and likely cause serial defaults in the periphery. Just imagine if Greece is perceived to gain a benefit by defaulting (which it will benefit over extreme austerity vs debt destruction), why would the voting populace of the other periphery states, ex. Ireland and Portugal, not force a default? The banking system will literally collapse from the recognition of the gaping hole that is already there.

Here's how it will play out if contagion does spark, as excerpted from the Saturday, 23 July 2011 post, The Anatomy Of A European Bank Run: Look At The Banking Situation BEFORE The Run Occurs!:

Note: These charts are derived from the subscriber download Exposure Producing Bank Risk (788.3 kB 2011-07-21 11:00:20).

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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.

Let's assume a small, but significant portion of depositors remove their money, putting some funding stress on the bank. Counterparties take notice and either pull funding or raise collateral requirements, which compound the problem. 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 borne by institutional 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!

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This house of cards sits atop an even more precarious peak. You see, the spark for this potential combustion is already alight, the action is simply awaiting for someone to turn and face the fire. That fire just so happens to be the carrying of massively devalued bonds on bank's books as risk free assets at par (or close to it). There is absolutely no way banks can even recognize the losses on the books now without massive collapse. Just imagine the situation when Greece actually does default!

For those not familiar with the banking book vs trading book markdown game, I urge you to review this keynote presentation given in Amsterdam which predicted this very scenario, and reference the blog post and research of the same:

Last week, I made available for free download models with which my followers could actually calcualate BNP's dilemma, see The BoomBustBlog BNP Paribas "Run On The Bank" Model Available for Download. The aforementioned article should be opened only after reading Research: BoomBust BNP Paribas? in order to gain the proper background thought that went into developing the models. Below is output from the free public model that I released with some realistic numbers put in for an "adverse" case scenario.

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I'm sure many of you are saying, "So exactly how realistic are those haircuts?" Well, let's take a look at countries who were in similar situations in the past to see how their bonds and bond investors fared, as excerpted from A Comparison of Our Greek Bond Restructuring Analysis to that of Argentina:

Price of the bond that went under restructuring and was exchanged for the Par bond in 2005

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Price of the bond that went under restructuring and was exchanged for the Discount bond

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To put this into perspective in terms of profit and loss...

One should keep these figures in mind, for in the blog post "How Greece Killed Its Own Banks!"I ran through a much, much more optimistic scenario that wiped out ALL of the equity of the big Greek banks. Remember, the Greek government stuffed these banks to the gills with Greek bonds in order to created the perception of a market for them. As excerpted...

Well, the answer is…. Insolvency! The gorging on quickly to be devalued debt was the absolutely last thing the Greek banks needed as they were suffering from a classic run on the bank due to deposits being pulled out at a record pace. So assuming the aforementioned drain on liquidity from a bank run (mitigated in part or in full by support from the ECB), imagine what happens when a very significant portion of your bond portfolio performs as follows (please note that these numbers were drawn before the bond market route of the 27th)…

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The same hypothetical leveraged positions expressed as a percentage gain or loss…

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Now, let's add all of this up:

  1. the depositors who can break the bank overnight,
  2. the counterparites that can also break the bank overnight, and
  3. the toxic bonds bought with leverage and currently priced to perfection which should serve as the impetus for implosion...

What do these ingredients combined to make? A pretty nasty recipe!

image012

I like Reggie. Can you ask him which is the best protest against the bankers:
1. Organise a meet up on Wall Street, with tents and guitars in tow.
2. Every “Joe Donut” (as Stacy puts it) to withdraw every cent they can from their

Guitars will only work if you enjoy the music enough to forget the rest of the problems.  Deposit withdrawal will significantly quicken the pace of banks being forced to recognize the true value of the stuff on their books though, for it will take away the mom and pop funding that they have grown used to employing to kick the can down the road ever so farther.

For those who haven't read the piece, Research: BoomBust BNP Paribas?, please do. It excerpts several pages of our BNP research which lays out the bank run scenario quite clearly. On top of that, BNP has other problems besides that plain old Bear/Lehman liquidity thing. I outline some of those for you in my next post. In the mean time, stay tuned, stay alert, and stay susbscribed to BoomBustBlog.

Last modified on Monday, 19 September 2011 10:45

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