During the financial crisis of 2008, money market funds who subjectively agreed to hold their NAV (net asset value) unit prices at $1 “broke the buck”. That is, the unit of share of the fund fell below $1 (the $62.5 billion Reserve Fund, to be specific, one of only two funds to “break the buck”), which was a significant problem for the investors who used (and considered) said money market funds as cash in the bank. All of a sudden, everyone’s cash account at the Reserve Fund just dipped in value. Uh Oh! This caused short term credit to literally freeze, worldwide, because others were concerned that their bank-like security and liquidity was no longer that secure nor liquid.

Regulators stepped in to make sure this didn’t happen again by demanding that all money funds who do not invest in sovereign securities (those entities who “should” be able to print their own monies, but we’ll get into that in a later post) allow their NAV to freely float with market prices.

The result? Money flew out of prime money funds into perceived safer vehicles.

US and European markets are rallying once again on news that a new bailout agreement (think this is the 3rd, 4th or 5th, I lose count) has been reached. This one is unique in that it will allow/endorse a short term selective default and create a fund whose goal is actually to manipulate the debt markets and recapitalize banks! This news is quite timely for I have just released one of the banks that I believe are susceptible to a Lehman/Bear Stearns style "run on the bank". All paying subscribers, see Exposure Producing Bank Risk (788.3 kB 2011-07-21 11:00:20). Professional and institutional subscribers should feel free to contact me on this topic. I will be releasing additional info to Pro and institutional subscribers in the upcoming week. Now, from CNBC:

Minds have been concentrated by the danger that Europe's debt crisis could engulf the much bigger economies of Spain and Italy. Greece, Portugal and Ireland have already succumbed. The draft summit statement obtained by Reuters showed the EFSF rescue fund would be allowed for the first time to help states earlier with precautionary loans, to recapitalise banks and to intervene in the secondary bond market.

"To improve the effectiveness of the EFSF and address contagion, we agree to increase the flexibility of the EFSF," it said, listing those three key steps, all of which Germany had previously blocked.

... Dutch Finance Minister Jan Kees de Jager said a short-term or selective default for Greece, long vehemently opposed by the ECB, was now a possibility.

"The demand to prevent a selective default has been removed," he told the Dutch parliament. The chairman of the 17-nation currency area's finance ministers, Jean-Claude Juncker, also told reporters: "You can never exclude such a possibility, but everything should be done to avoid it."

According to the draft, the maturities on euro zone rescue loans to all three assisted countries would be extended to 15 years from 7.5 and the interest rate cut to around 3.5 percent from between 4.5 and 5.8 percent now.

The EFSF would be able to lend to states on a precautionary basis instead of waiting until they are shut out of market funding, and to recapitalise banks via loans to governments, even if they are not under an EU/IMF assistance programme.

It would also be allowed for the first time to intervene in secondary bond markets, subject to an ECB analysis recognising "exceptional circumstances" and a unanimous decision. Germany blocked all these measures when the European Commission proposed them back in February, at a time when the crisis was less acute, EU sources said. The wider EFSF powers could help deter or minimise any market contagion in case of a temporary Greek default.

In an apparent trade-off for Merkel's new willingness to embrace such bolder steps, Sarkozy dropped a French call for a tax on banks to help fund a second Greek bailout.

... The proposed expansion of the EFSF's role would have to be ratified by national parliaments, and could fall foul of critics in Germany, the Netherlands and Finland. Thursday's summit is very unlikely to mark a complete resolution of the crisis, as Merkel herself acknowledged earlier this week.

A second bailout may simply keep Greece afloat for a number of months before a tougher decision has to be made on writing off more of its debt.

I have yet to thoroughly vet the afore-referenced plan, but at first blush I tend to strongly agree with Merkel. This is but another stop gap, and an ephemeral one at that, to the road to Perdition, or at least that's what European appear to believe a true and actual default is. My opinion is that it is a necessary evil needed to purge unpayable debt and push the profligate EU states back onto the path of growth and prosperity.

The portion about intervening in the secondary public markets brings one to mind of how the UK came to be outside of the EMU, and that is due to their hubristic mindset that they were bigger than the world's largest, deepest and most liquid markets as well in their attempt to manipulate the price of the pound upon (attempted) entry into the EMU. Speculators world wide, exemplified in the media by George Soros, apparently taught them otherwise. He became known as "the Man Who Broke the Bank of England" after he made a reported $1 billion during the 1992 Black Wednesday UK currency crises. Soros correctly speculated that the British government would have to devalue the pound sterling, as per Wikipedia:

Black Wednesday refers to the events of 16 September 1992 when the British Conservative government was forced to withdraw the pound sterling from the European Exchange Rate Mechanism (ERM) after they were unable to keep sterling above its agreed lower limit. George Soros, the most high profile of the currency market investors, made over US$1 billion profit by short selling sterling.

In 1997 the UK Treasury estimated the cost of Black Wednesday at £3.4 billion, with the actual cost being £3.3 billion which was revealed in 2005 under the Freedom of Information Act (FoI).^[1]

The trading losses in August and September were estimated at £800m, but the main loss to taxpayers arose because the devaluation could have made them a profit. The papers show that if the government had maintained $24bn foreign currency reserves and the pound had fallen by the same amount, the UK would have made a £2.4bn profit on sterling's devaluation.^[2] Newspapers also revealed that the Treasury spent £27bn of reserves in propping up the pound.

...

The UK's prime minister and cabinet members tried vehemently to prop up a sinking pound and withdrawal from the monetary system the country had joined two years prior was the last resort. Major raised interest rates to 10 percent and authorised the spending of billions of pounds to buy up the sterling being frantically sold on the currency markets but the measures failed to prevent the pound falling lower than its minimum level in the ERM.

The Treasury took the decision to defend Sterling's position, believing that to devalue would be to promote inflation.^[5] On 16 September the British government announced a rise in the base interest rate from an already high 10 to 12 percent in order to tempt speculators to buy pounds. Despite this and a promise later the same day to raise base rates again to 15 percent, dealers kept selling pounds, convinced that the government would not stick with its promise. By 19:00 that evening, Norman Lamont, then Chancellor, announced Britain would leave the ERM and rates would remain at the new level of 12 percent (however, on the next day interest rate was back on 10%). It was later revealed that the decision to withdraw had been agreed at an emergency meeting during the day between Norman Lamont, Prime Minister John Major, Foreign Secretary Douglas Hurd, President of the Board of Trade Michael Heseltine and Home Secretary Kenneth Clarke (the latter three all being strong pro-Europeans as well as senior Cabinet Ministers), and that the interest rate hike to 15 percent had only been a temporary measure to prevent a rout in the pound that afternoon.

Currency speculation

On September 16, 1992, Black Wednesday, Soros's fund sold short more than US$10 billion worth of pounds,^[27] profiting from the UK government's reluctance to either raise its interest rates to levels comparable to those of other European Exchange Rate Mechanism countries or to float its currency.

Finally, the UK withdrew from the European Exchange Rate Mechanism, devaluing the pound sterling, earning Soros an estimated US$1.1 billion. He was dubbed "the man who broke the Bank of England."^[31] In 1997, the UK Treasury estimated the cost of Black Wednesday at £3.4 billion.

On Monday, October 26, 1992, The Times quoted Soros as saying: "Our total position by Black Wednesday had to be worth almost $10 billion. We planned to sell more than that. In fact, when Norman Lamont said just before the devaluation that he would borrow nearly $15 billion to defend sterling, we were amused because that was about how much we wanted to sell."

Stanley Druckenmiller, who traded under Soros, originally saw the weakness in the pound. "Soros' contribution was pushing him to take a gigantic position."^[32][33]

Hmmm! One would think maybe a statue should be erected of Druckenmiller and Soros in Trafalgar Square considering the euro state's current predicament, which is probably about to be made worse by trying once again to "out market" the market! On that note, let's explore what happens when true market participants - savers and instititutional counterparties - get the hint before governments, regulators and bank management.

Asset/Liability Funding Mismatches: The Major Cause of Institutional “Runs on the Bank”

Modern day banking business models (fiat banking system) fund business investment that often require expenditures in the present to obtain returns in the future (for example, spending on machines and buildings now for production in future years). Therefore, when businesses (banks included) need to borrow to finance their investments, they usually do so on the understanding that the lender will not demand repayment(s) until some agreed upon time in the future. Usually, the farther into the future, the more preferable, thus entities with exposures to business cycles (businesses) often prefer loans with a longer maturity. This longer maturity leads to lower liquidity, which is in the better interests of the borrower. This very same principle applies to individuals seeking financing on the purchase of big ticket items such as real estate, housing, boats, small businesses and cars. The flip side of this equation contains the primary funding source in the fiat banking system, the individual savers (both households and firms). These savers strive for relatively high liquidity due to shorter cycles in their (sometimes sudden) and considerably less predictable needs for cash. The products that serve these needs are the demand accounts that commercial banks use as their primary funding source.

Commercial and investment banks (as well as some broker/dealers) profit by acting as intermediaries between short term savers who prefer highly liquid demand accounts and borrowers who prefer to take out long-maturity loans with considerably less liquidity. When things are working as anticipated in the fiat banking system, banks acting as intermediaries profit by channelling capital from short term savers to long term borrowers, underwriting and eating the risk of this “asset liability funding mismatch”.

Banks also carry on their capital intensive businesses (ex. trading, market making, etc.) in a similar fashion by borrowing heavily on the short end of the yield curve on a relative sliver of equity and investing in the longer end of the curve or in more volatile, risky asset classes (i.e. public equities, private equity, real assets, commodities, etc.)

The premise behind the fractional reserve (a system where only a fraction of deposits are required to be kept in house as reserves against deposit demands)/fiat banking system is that under ordinary circumstances, savers' unpredictable needs for cash are unlikely to occur at the same time. This premise has been justified by the theory that depositors' needs reflect their own and mostly unique individual circumstances. The fiat/fractional reserve banking institution, by accepting deposits from myriad and differing sources, assumes risk has been effectively diversified away, with the bank expecting only a small fraction of withdrawals in the short term at any given time. This is despite the fact that all depositors have the right to take their deposits back at any time. Adherence and acceptance of the logic behind the fractional reserve system allows fiat banks to make loans and investments over a long horizon, while keeping only relatively small amounts of cash on hand to pay any depositors (and counterparties) that wish to make withdrawals, capital calls or collateral calls.

Traditional views on this “bank run model” largely (or more aptly, only) consider individual savers in the form of depositors on the short side (liquid liabilities). It is a run such as this that caused the banking collapse during the US Great Depression. 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!

This phenomena essentially discredits the thinking at large and currently in practice that “since individual expenditure needs are largely uncorrelated, by the law of large numbers” banks should expect few withdrawals on any one day. The fact of the matter is that in times of severe distress, particularly stemming from solvency issues (read directly as the Pan-European Sovereign Debt Crisis, and Greece, et. al. in particular), the exact opposite is the case. Individual depositor and counterparty actions are actually HIGHLY correlated and tend to move in tandem, particularly when that move is out of the target fiat bank. They tend to take heed to the saying “He who panics first, panics best!"

Asset/liability mismatch can, at the margin nearly assure a Lehman-style fiasco in the case of an impetus that sparks herding mentality, whether it be among depositors/savers or institutional counterparties.

Since banks both lend out and often invest at long maturity, they cannot quickly call in their loans or sell their investments. This scenario is exacerbated when said loan and/or investments have materially dropped in value causing a capital gap in between what said loans/investments can be called in for, and what is actually owed to the short term creditors. Again, this is a perfect example of what happened in the US with AIG, Lehman Brothers and Bear Stearns. Therefore, if a significant portion of depositors or counterparties either attempt to withdraw their funds or raise collateral/capital requirements simultaneously, a bank will run out of money long before it is able to pay all of its short term the depositors. The bank will be able to pay the first depositors who demand their money back, but if all others attempt to withdraw too, the bank will be realized insolvent and the last depositors will be left with nothing. It is for this reason that short term creditors tend to “panic first” in an effort to “panic best”, leading to a chain reaction that perpetuates a bank run. Essentially, the fiat/fractional reserve banking system creates a self-fulfilling prophecy wherein  each depositor/counterparty's incentive to withdraw liquidity and funds depends on what they expect other depositors/counterparties to do. If enough depositors/counterparties expect other depositors to withdraw their funds, then they all have an incentive to rush to be the first in line to withdraw their funds. “He who panics first, panics best!"

Next up on this topic I will discuss the sovereign states that I see exacerbating this risk through contagion, and will produce additional banks that are at risk to the big bank run for paying subscribers. In addition, I will post technical trade setups for Pro and institutional subscribers as well. After that, we will explore the effect that EVERYONE seems to be overlooking, and that is what happens to European CRE when that 70% of mortgage obligations come up for rollover in the next year and a half? There are basically ony two countries at risk, but they are at risk in a big way. Then again, if the excess funding (you know, to fill that equity gap formed by the devaluing real estate) fails to materialize on top of the expected funding needed just for the anticipated rollover, then lookout below in all of those countries whose CRE wasn't necessarily roaring to begin with. That would be basically... All of them! As all who attended my keynote speech at ING in Amsterdam know, I have proposed solutions for many and will make them part of the upcoming European CRE posts.

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It is now time to start putting in some serious short positions across the board - globally - for all those who have not already done so. Anyone who has followed me on BoomBustBlog knows that I have clocked heavy four digit gains (250% to 450%), mostly unlevered, throughout the first leg of the financial crisis - see Sample Research & Performance. This was accomplished by keeping my eyes open and objective, and in doing so recognizing the enormous holes in economic value that were trading at ridiculously high risk adjusted prices. The result of which enabled me to publicly call the fall of nearly every major collapsed FIRE sector institution that did actually fall, and do so months in advance, including Bear Stearns, Merrill Lynch, WaMu, Countrywide, Lehman Brothers, General Growth Properties, etc. The near 100% equity run up at the height of the correction was easily seen by my and my staff, but I (and I put the blame squarely on myself and no one on my staff) severely underestimated the breadth and depth of this synthetically contrived, central bank centrally planned, bear market rally. This underestimation of the depths that our Federal Reserve would stoop to in mortgaging the future of this country, and this country's children of the next generation cost me 50% of the gains that I made over the previous two years. For this I was actually forced to apologize to my subscribers in a lengthy letter with tears dripping off of my virtual typewriter, reference 2009 Year End Note to BoomBustBlog Readers and Subscribers. I felt horrible about underestimating the self destructive staying power of the concerted efforts central bankers around the globe attempting to rescue a failed oligarchy, but despite this significant shortcoming, I still ran many circles around what the best Sell Side Wall Street had to offer, reference Did Reggie Middleton, a Blogger at BoomBustBlog, Best Wall Streets Best of the Best?

Yesterday, I went through a quick timeline that illustrated what was once considered sensationalist now considered by most to be fact: The ECB, several national central banks, and a good portion of the private banking system are insolvent. This is the case regardless of what name you want to cut and paste on the state of insolvency. As excerpted from Over A Year After Being Dismissed As Sensationalist For Questioning the ECB’s Continued Solvency After Sovereign Debt Buying Binge, Guess What!:

European Banks’ Capital Shortfall Means Greece Debt Default Not an Option: A failure by European regulators to make banks raise enough capital to withstand a sovereign default is complicating efforts to resolve Greece’s debt crisis. The “fragilities” of Europe’s banking industry mean a Greek default isn’t an option, European Union Economic and Monetary Affairs Commissioner Olli Rehn said in New York last week. By delaying a decision some investors consider inevitable, policy makers risk increasing the cost to European taxpayers and prolonging Greece’s economic pain. “European officials are trying to buy time for the troubled economies to get their house in order and the banks to be strengthened,” said Guy de Blonay, who helps manage about $41 billion at Jupiter Asset Management Ltd. in London. While estimates of the capital shortfall vary, the vulnerability of European banks to a sovereign shock isn’t disputed. Independent Credit View, a Swiss rating company that predicted Ireland’s banks would need another bailout last year, found in a study to be published tomorrow that 33 of Europe’s biggest banks would need $347 billion of additional capital by the end of 2012 to boost their tangible common equity to 10 percent, even before any sovereign default.

Here’s a newsflash for all of you who are still not grounded in reality. The loss to the banks have already occurred it just hasn’t been officially recognized. You see, their bond and debt holdings are already devalued. The value is gone, vamoosed, disappeared. I have made this perfectly clear, both in my keynote speech at the ING valuation conference and here on BoomBustBlog.

Do you remember my recent missive "There’s Something Fishy at the House of Morgan"? Well, in it I queried how it was that JP Morgan can continuously pull risk provisions and reserves to pad quarterly accounting earnings at time when I not only made clear that we are in a real estate depression but the facts actually played out the same. As excerpted from the aforementioned article:

I invite all to peruse the mainstream financial media and sell side Wall Street's take on JP Morgan's Q1 earnings before reading through my take. Pray thee tell me, why is there such a distinct difference? Below are excerpts from the our review of JP Morgan's Q1 results, available to paying subscribers (including valuation and scenario analysis): JPM Q1 2011 Review & Analysis.

Well, I’ve a confession to make. I really do know why there is such a distinct difference. A very similar situation was illustrated in my article on Apple's presence on the Goldman Sachs' "Convict"ion buy list, which I fear is a must read before you finish this article. Reference Goldman Sells Nearly Half $Billion Of Apple Stock Directly Into Their Client’s Conviction Buy Recommendation: Guess Who Really Agrees With Reggie Now! These shenanigans were clearly and plainly illustrated in two recent mainstream articles, believe it or not. Here they are…

On 5/24/11 I recorded a podcast interview with the Sound of Money, an interesting financial show that airs on NYC's WNYE radio. You can listen to 46 and a half minutes of my viewpoints and opinions via this link, Sound-money-interview-of-reggie-middleton-05-24-11. Be sure to peruse the blog of the show as well.

Anybody who has been following me since 2006 knows me to be a real estate bear. I was massively bullish from 2000 to 2005, after which I started selling off my investment assets. No, it wasn't perfect timing, luck or a gift from God. It's called a spreadsheet. Simply do the math and the truth will be self-evident! The Wall Street Journal and Bloomberg ran articles earlier this week on the home market tumbling further in the US: Home Market Takes a Tumble - WSJ.com.

I warned thoroughly of this occurrence throughout last year and this - see The Latest Case Shiller Index – Housing Continues Freefall In Aggressive Search For Equilibrium Monday, February 7th, 2011. The .gov bubble blowing accomplished the mission of taking observers eyes off of the fundamentals and macro environment and back into optimism central. To Bloomberg TV's credit, they gave me the opportunity to call it like it is.

I invite all to peruse the mainstream financial media and sell side Wall Street's take on JP Morgan's Q1 earnings before reading through my take. Pray thee tell me, why is there such a distinct difference? Below are excerpts from the our review of JP Morgan's Q1 results, available to paying subscribers (including valuation and scenario analysis): JPM Q1 2011 Review & Analysis.

Here we go...

There's Something Fishy at the House of Morgan

JPMorgan’s Q1 net revenue declined 9% y-o-y ad 3% q-o-q to $25.2bn as non-interest revenues declined 5% y-o-y (down 5% q-o-q) to $13.3bn while net interest income declined 13% y-o-y and (-2% q-o-q) to $12.5bn. However, despite decline in net revenues, noninterest expenses were flat at $16bn. Non-interest expenses as proportion of revenues went was 63% in Q1 2011 compared with 58% a year ago and 61% in Q4 2010. However, due to substantial decline in provision for credit losses which were slashed 83% y-o-y (63% q-o-q) to $1.2bn from $7.0bn, PBT was up 78% y-o-y (15% q-o-q).

Lower reserve for loan losses and consequent decline in Eyles test (an efficacy of ability to absorb credit losses) coupled with higher expected wave of foreclosures which is masked by lengthening foreclosure period and overhang of shadow inventory, advocate a cautionary outlook for banking and financial institutions. As a result of consecutive under-provisioning since the start of 2010, JP Morgan’s Eyles test have turned negative and is the worst since at least the last 17 quarters. The estimated loan losses after exhausting entire loan loss reserves could still eat upto 8% of tangible equity.

As nearly every proclamation and warning that I have given in 2010 has come to pass in 2011, the coming mass restructuring of the European banking system is nigh upon us. Let me make this perfectly clear. Despite what you may have heard, those banks and institutions holding and hoarding EU periphery debt are getting slaughtered.  Let's walk through the simply math. I borrow €100 million with €10 million equity and purchase €110 million in bonds from Greece at par. These bonds are now roughly half of what I paid for them. That is a €55 million loss on a €10 million equity investment. A 550% loss! This is not rocket science, yet there are many who are dismissing this concept as sensationalist. Try dismissing it as basic math, first!

Exactly one year ago tomorrow, I went through this scenario in the article "How Greece Killed Its Own Banks!", which my regular readers should be quite familiar with.