Proof That Europe Is Primed For A Lehman Brothers-Style Bank Bust, But Likely On A Much Larger Scale!!!

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" to subscribers. 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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Comments

[Spitzer]

Defflation in Euro terms then ? or hyperinflation in Euro terms Reggie ?

[Zero Govt]

if i may speculate it'll be absolutely Deflationary... credit crunches, and that's what Reggie is describing in collapsing debt and seizure in the inter-bank loan market, are always deflationary 

indeed if you look at the West the inflationary items are commodities and stocks, 2 sectors very tuned into the big banking and financial system that received all the funny money (inflation of the money supply) and 2 sectors on the receiving end of much of their speculatve money flows

While shop prices and pump prices have reflected this commodity price inflation the shops are also caught between a rock and a hard place because consumer pressure is entirely for ever lower prices (see explosion of £PoundWorld type shops in the UK etc). 'Cheap' and saving money is 'the new black' amongst price conscious consumers

the rest of our economic sectors, such as property, retail, big ticket consumer goods (TV's, furniture etc), airlines and tourism and the credit/debt markets themselves are very much in deflation mode and have been since 2008 despite the printing presses going 24/7. Consumer credit and use of credit cards has dropped 20% despite the Govts protestations to get credit and spending going again

[jack stephan]

Bishop: I'm sorry, but the crash caused too much damage. An overload was inevitable at this point.

[Zero Govt]

Very Frustrated Reader (and European Bank Depositor) Here Reggie!

Love the in-depth analysis again and learnt a few very good things from your article but it comes up short because it's such a tease... we'd obviously like to know the banks you're talking about (who wouldn't!) that are teetering on the edge of abyss . . . ???

You're at your most interesting when you mention actual time-lines too, such as the Year & a Half (left) for banks rolling over debt

But it's a bit like watching an Action Movie without any bullets being fired! And when you think the first dominos in a pan-European banking collapse could start in "weeks even days" you're turning up the heat but not releasing the steam in the pressure cooker you're boiling up out here

Is there a balance that can be struck between subscribers and readers? ...can you drop some firm clues after your subscribers are informed but timely enough your (faihtful, loving, loyal) readers don't get screwed!

[Sudden Debt]

Reggie... I don't think you'll pass passport controls in Europe after this post :)

[Zero Govt]

actually all the Totalitarian State border-Nazis are on the Yanks side of the Pond

..i heard US tourism has only 'grown' a beyond pitiful 1% in 10 years entirely due to the Washington Fascist Brigade ...fuking terrible what GOP and DEM's vandalise to 'protect' the nation they're destroying far more effectively than any terrorist could imagine in his wildest dreams!!!

[Coldfire]

Totalitarian
State
Authority

[Neezer]

And I always thought that a bank buys long-term assets and sells short-term liabilities. My mistake.

:)

[bankruptcylawyer]

simply and directly explained. i've heard this many time, but your explication was still excellent thank you. they need to teach this in econ 101.

[Zero Govt]

the only thing taught in State Schools across Europe and America is 'Ideology 101' ...economics is the trivial part that simply follows the political path to The Promised Land ..and we always seem to be robbed and bankrupted just before we get there 

when will we get State, corporate and personal bankruptcy courses taught at school? ..seems these salutry lessons are a glaring omission from the State curriculum!

[I am a Man I am...]

so have you commented on Apple yet and their kick ass numbers, their blow their analyst estimates to smithereens numbers, their sell more iPhones than RM thought numbers??  what happened to all of that margin compression?

[MacGruber]

Yeah, no joke. That fictitious margin compression is really hurting Apple, so much so, they expect to INCREASE margins across the board going into next year. Of course I'm sure Reggie will continue with his complete lack of humility and we won't hear a word more - until Apple posts bad numbers sometime in the distant future at which point Reggie will continue his endless "I told you so, I'm so smart" self promotion.

[whirlybird rules]

To almost all points stated above - I agree!   However, nothing will happen to the euro until the Chinese decide something should happen.

[tom]

But some are worse than others, and some are more overvalued than others.

Santander remains popular but seems to me to be very vulnerable. It may have some Latin American cream on top, but it's still Spanish mortgage pie.

[NotApplicable]

After inflicting a little contagion pain on Germany, won't Merkel have to give the EFSF the power to "save" Europe?

It looks to me like they will kill the financial markets (other than fees for gov front-running services) with the Fed and the EFSF papering over the whole mess as the ZIRP4EVA plan is implemented. When that blows up, well, then it's time to give the IMF a magic checkbook too.

[Keith Piccirillo]

If this is a George Bailey syndrome who gets to play the role of Potter?

[SparkySC]

Both Lehman was Pushed (via shorting/naked shorting collusion) into BK and WAMU was seized Illegally by the OTS, since WAMU was SOLVENT. Oh and WAMU was CONVENIENTLY LEFT OFF THE NO SHORT LIST even though it's asset base was over 300B. What a great GOVT the USA HAS. Oh my, with friends like that, who needs enemies.

Great that we have US Govt agencies seizing SOLVENT INSTITUTIONS TO GIFT TO THE REAL BANK THAT WAS IN JEOPARDY OF FAILING.

[Monday1929]

That is JPM, everyone.