The "Neutron Bomb Of Capital Calculations" And A Kyle Bass Refresher

Tyler Durden's picture

In a double-whammy of downbeat dystopian discussions, GMO and Kyle Bass are active on the inevitability of Europe's demise. Perhaps that is too strong but the two are focused directly, in separate pieces, on the huge need for capital and the dire dearth of it available. GMO's central focus on the direct capital needs of the European banking system in the case of a recovery (but under Basel III) and under stress scenarios. Dismissing the EBA's efforts, and recognizing that the problem is capital/solvency (if there were more, the market would not be worrying about liquidity and deposit flight), their 'neutron bomb' scenario where sovereign debt is recognized as a 'risky asset' (which seems more than plausible to us), the capital needs are almost EUR300bn with Spanish and French banks dominant but Italian and German banks are close behind. As Kyle Bass notes "There is no savior large enough with a magic potion of capital to stave off this unfortunate conclusion to the global debt super cycle.".

GMO asks - What if banks were forced to treat sovereign loans as risky assets, rather than enjoying the current risk weighting of 0%?

If the capital standard is raised to 9%, the needs are unimaginable: 289 billion euros. Spanish banks still have the largest capital demand, 69 billion euros; but French needs exceed those of Italian banks, and German capital demands at 43 billion euros barely lag those of the Italian banks.


...equity investors can survive but will not be smiling. As of December 7, 2011, the needs are 98% of the market capitalization on average for the Italian banks, 60% for the French banks, and 48% and 70% for Spanish and German banks, respectively.

The Neutron Bomb of Capital Calculations

One obvious question is whether one should move to so extreme a scenario as provisioning against all sovereign debts, or even all European sovereign debt. Ever-expanding capital requirements can be the neutron bomb of banking regulation; the branches might still be standing, but the banks themselves would be barely recognizable if they were to survive the cataclysm. Once the Germans understand that they too are exposed, they presumably will be amenable to more reasonable approaches to the sovereign debt problems, such as more generous volumes and maturities at collateral facilities or even a direct use of the ECB to support sovereigns so as to avoid crushing the banking system.


The cataclysm plays out because the banks do have an alternative to raising capital – shrink the balance sheet. Deleveraging is already going on in a number of countries, with loan-to-deposit ratios dropping in recent months in Portugal, Spain, and Italy. This reduces the capital needs of banks, but fairly quickly starts to cut into the muscle of the financial system. The banks have little alternative but to keep holding sovereign debt in the short term, since it is the collateral for their borrowing needs. In countries such as Spain, a big chunk of private sector loans cannot be reduced because they involve property that will be inactive for years, perhaps a decade. So, once banks trim their healthiest borrowers and perhaps reduce their overseas exposures, they quickly run into the need to cut loans to small and medium enterprises, providing another negative impulse to European growth.


Perhaps more serious is the direct risk that Spain’s real estate problems pose to Spanish banks, which could expand to indirect risks for other banks. Recent conversations in Spain have led me to the conclusion that there are over 200 billion euros of property loans on raw land and developments, which will have little income-producing potential this decade. While Spanish banks have done some provisioning, there is much more to do, and the losses will be high.The incoming Spanish government is rumored to be interested in accelerating this resolution through a good bank/bad bank solution.


A few of the banks could probably cover their capital needs through further asset sales, but most of the losses would probably have to be backstopped by capital infusions by the Spanish sovereign, temporarily raising its own deficit.

And as if that was not enough doom and gloom, Kyle Bass was on BNN this morning discussing not just European endgames but the US and Japan in his eloquent manner:

Prepare For a European Default

click image for video (no embed available)


A negative disposition on financial markets has made Kyle Bass a wealthy man.

He made millions betting on the collapse of the U.S. housing market. And as European policymakers scramble to solve their sovereign debt crisis and avert a breakup of the euro zone, the founder of Hayman Capital Management says investors should prepare for the worst when it comes to Europe.

"As the dominoes fall, it's clear that the peripheral countries that are in the news so much -- the PIIGS as we like to call them [Portugal, Ireland, Italy, Greece and Spain) -- will have to restructure their obligations," he tells BNN. "I think that's coming much sooner than others would think and that is something you must prepare for in 2012."

"You see the deposits leaving the periphery at an annualized rate of more than 20 percent. This is the final precursor for a sovereign default and it's happening while we speak."

Bass believes that the excessive leverage at European banks will continue to haunt the region.


"Europe's banks have three times as much leverage from equity to assets that U.S. banks have," he says. "Spain, by looking at a snapshot on a piece of paper looks like they might have a manageable scenario, but when they recap their banks they won't have a manageable scenario and they have to recap their banks and so do the rest of Europe."

Bass says Germany -- considered the economic powerhouse of Europe -- is no better: "[Germany currently has an] 82 percent on balance sovereign-to-debt GDP today…in a post-recap world Germany will be north of 100 percent and will also be in a very difficult scenario."

This leads to only a bad and worse outcome for Europe, as the cataclysm plays out because the banks do have an alternative to raising capital – shrink the balance sheet. Deleveraging is already going on in a number of countries, with loan-to-deposit ratios dropping in recent months in Portugal, Spain, and Italy. This reduces the capital needs of banks, but fairly quickly starts to cut into the muscle of the financial system. The banks have little alternative but to keep holding sovereign debt in the short term, since it is the collateral for their borrowing needs. And as we have been so vociferously explaining recently, should they be forced to delver even more, and sell reduce these sovereign assets, then the daisy-chain effect of de-hypothecation on shadow banking will not end well for anyone.

Full GMO note:


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HedgeAccordingly's picture

kyle bass loves nickels .. as much as merkel loves to grimmace 

Ahmeexnal's picture

Tension in the Falklands about to escalate:

Rockhopper Petroleum has unveiled another oil discovery near the Falkland Islands, sending its shares up almost 10pc.


But Argentina isn't the UK's only worry.  Eurozone threatens to boycott UK 2012 London Olympics.

Potemkin Village Idiot's picture

Why would anyone want to boycott the Olympics? I hear they give out physical gold & silver to the winners...

redpill's picture

It drives me nuts in these interviews that they want to force him to describe entire nations'  economies in one sentence so they can rush off to commerical break.  They should either narrow the focus of the discussion or give him time to explain what are some very complex situations. 

Bicycle Repairman's picture

I believe the typical "gold" medal is a gold-plated rubber disc.  They should change the prizes to paper, rock and scissors.  Except for the runners.  Instead of scissors they should get road apples.

Potemkin Village Idiot's picture

I believe the typical "gold" medal is a gold-plated rubber disc.

Oh... so they manufacture them from the Comex stash then?

StychoKiller's picture

Rubber is more flexible than tungsten.

slaughterer's picture

Kyle: three trivial questions about the man (since I find nothing to question in his macro view or investment thesis):

1.)  What is that pin he always wears?

2.) Why do most of his answers begin with "So..."

3.) Why do you do interviews with MSM, where they inevitably just want brief views before the commercials?

Potemkin Village Idiot's picture

"the pin" looks to me like a Texas Ranger badge to me...

Winston Smith 2009's picture

"Why do most of his answers begin with "So..."

Because so many of the questions asked so clearly display the ignorant conventional "wisdom" position being taken by the questioner.

In the above interview, I love it where he says the pending default of Japan should be obvious to a kindergärtner, shortly after the interviewer had shown his skepticism of that mathematical fact.  Kyle uses simple math and easily available figures to show what any idiot unimpeded by hopium use should be able to see:  the positions in Europe, Japan and, eventually, the US are untenable and, in fact, both Europe and Japan are in a far worse, totally hopeless position while the US is not (YET).

hedgeless_horseman's picture




Kenny says, "Ireland will do whatever is required to ratify the EU pact."

Wolfe Tone said, " Our independence must be had at all hazards."


CPL's picture





An old phrase with a renewed interest.

falak pema's picture

Ireland : Either you get shafted by the Brits and their RE banks who got you into this mess or else you now eat humble pie served by Angela M; its damned if you do and damned if you don't. So if the Euro explodes what happens to Ireland?

Ahmeexnal's picture

This explains why many euro-peon young are already leaving the sinking ship.

Ahmeexnal's picture

US, Canada, LatAm, India, Africa, SE Asia.

GeneMarchbanks's picture


Last year I met an American girl at an internet cafe. She had just come from contracts teaching english in South Korea and China. She left for the same work in Budapest because the conditions were 'so horrible'. Masters in Anthropology. For those of us who actually travel, there is no haven. Stories like this repeat ad infinitum,

Migration patterns stay stable unless there are major changes( natural disaster, war etc)

hedgeless_horseman's picture



For those of us who actually travel, there is no haven.

I respectfully disagree.  For those who actually want to work, there is a haven in the countryside.  I have been to farms on four continents, including Europe, and found young people building prosperous and rewarding lives away from the city.



topcallingtroll's picture

I always found the conditions pleasant, life joyful, and more girls wanting to date el americano than I had time for.

Go to south or central america and teach english. You dont need a fuckin work permit. A tourist visa is fine.

GeneMarchbanks's picture


You are absolutely correct. Let me clarify, there is no safe haven country. What needs to be addressed is that major metro areas are entering a world of hurt. Each major city and country is different. Some lack basic resources like water while others have massive property inflation problems.

Seeking asylum in some 'magic' free country is absurd.

Spitzer's picture

Kyle Bass is down on Japan. Timing....timing timing.

CPL's picture

Japan is cancer cancer cancerous.  We will all see that in the coming years just like Europe.


Name anyone planning on relocating for the business environment.

DormRoom's picture

The entire debt-leverage pyramid is based on collateral, ostensibly safe 'AAA', which have been shown to be anything but.  So you have a mountain of leverage, based on mathematical models, where the invariants (riskless collateral) have suddenly changed. They were never suppose to change. So the model breaks down.  Worse, the world is running out of safe collateral, as risk re-pricing cascades though the market, in a viciuos feedback loop.


you cannot unsee. 


Central Banks cannot stop the collapse of shadow banking, without hyperinflation in the real economy.  zee Germans know this.

topcallingtroll's picture

Yes central bankers can.
Stagflation is the middle way, the muddle through.
I would be ok with that if they would also get religion and solve the moral hazard and financial feudalism we are facing.

MsCreant's picture

Interesting post, but why not hyperdeflation? Asset values going down in a negative feedback loop. No one willing to put money into it. Prices have to go down more...

Potemkin Village Idiot's picture

"Asset values going down in a negative feedback loop..."

The way I see it, asset prices ARE deflating...

- 401K - down

- House value - down

- Your paper cash - down (which is why it takes more of it to buy PM's & gasoline & food & heat)

The price that it takes the same cash (asset), to buy another asset (home or equity), may not appear to change that much in the process if you consider cash an asset & since they're in the process of deflating together...

Bankers will tell you that gold & silver are 'barbarous relics' (NOT assets)... So that argument... YOU'RE TOLD... is irrelevant... (& oh by the way, that means that since that means there is no INFLATION, then they can continue to do the only thing they know how to do... PRINT MONEY [whether that means 'big bazookas' when times get rough, or just by PRINTING THE COUPON, when people say 'enuf'])...

Disclaimer: THEY created this POTEMKIN VILLAGE... I'm just the IDIOT who lives in it...

DormRoom's picture

yes, it's a binary outcome. hyperinflation or hyperdeflation.


Iliketurtles's picture

maybe I read this wrong but I consider this not just bullish but very bullish.

LookingWithAmazement's picture

European banks and governments will succeed in funding. Mark my words. Fed and ECB provide unlimited money otherwise banks will be nationalized. No crisis. Merry Christmas and a happy, recession-free 2012.

Ghordius's picture

the problem is more that the banks in Europe are resisting recapitalization and will probably have to be forced to, up to the point of full nationalization if "necessary".

but yes, for this the ECB will print as much "as necessary", I agree

Iliketurtles's picture

hey sport back to reality. What will this new funding do to Oil Prices? Every politician will be voted out of office and any whiff of banker bailouts will result in anarchy. the citizens of both US and Europe are no longer willing to accept a bailout like the ones in the past.

the extend and pretend is coming to an end and sooner than you think

Ghordius's picture

nationalization of banks is not perceived as bailout

and in Europe it's not perceived as "bad"

throw out a few top managers and the deal is done

I'm talking about the small and mid-sized commercial banks, not the TBTF megabanks, btw

Potemkin Village Idiot's picture

the citizens of both US and Europe are no longer willing to accept a bailout like the ones in the past.

the extend and pretend is coming to an end and sooner than you think


Get back to me on the day that they tie the SNAP benefits & Social Security checks to the "bailout" wagon...

agent default's picture

QE to hell will not save or change anything.  Unless TBTF are broken up, OTC derivatives are eliminated and some form of sound money is introduced, forget it.  Unlimited money will, eventualy, just cause a default with unlimited zeros at the end.

SheepDog-One's picture

Imaginary money cant solve anything, of course.

Ghordius's picture

imaginary numbers are the driver of life and growth

imaginary money is the driver of...

LongSoupLine's picture

1) abusive fleecing of the middle class.

2) increased wealth to select few.

3) increased physical PM value.

delacroix's picture

the FUNDS are unicorn farts, there aren't even any skittles left

Ratscam's picture

any trade recommendations other than precious metals?

Potemkin Village Idiot's picture

hooch, popcorn, & some cubans

CPL's picture

Ah, the grain and agriculture trade versus the usual PM commodities of Ag, Pb and Silver.

FEDbuster's picture

For the grain trade, take delivery of 35 lb. lots of oatmeal in mylar sealed bags in five gal. buckets.  Alternative metals trade, brass, lead and copper jacket.

LongSoupLine's picture

or just buy cases of MRE's and save tons of money on the back end when the collapse occurs.