How European Failures Affect U.S. Investors
By Paul Lamont
January 9, 2012
Behind the Scenes
As we stated last month, “the European financial system is locked up again.” On January 3rd, European banks parked an all-time record at the European Central Bank (453 Billion in euros, as you can see in the chart below). This equates to roughly $591B dollars and is 65% of all ECB lending to banks. As Fox Business reports, “After the collapse of Lehman Brothers in late 2008 banks parked around one third of funds.”
European banks don’t want to deal with each other because as our clients are aware European banks are highly leveraged. Instead, they are putting their cash under the mattress.
What Happens After A Failed Bailout
Last month, the ECB provided banks with “unlimited three year funds.” But as you can see from the chart above, that has not stemmed the panic. Recall that on Friday morning March 14th, 2008 the Federal Reserve agreed to loan Bear Stearns money ‘as necessary’ via J.P. Morgan. After more than a week of panic the reaction at Bear Stearns was relief: “I got high fives. Oh, man we were doing a victory lap…we got access to all the cheapest money in the world. All we need.” (House of Cards. William D. Cohan. 2009.)
But a strange thing happened, other banks would still not lend to Bear Stearns. So NY Fed President Tim Geithner made some phone calls: “Geithner called the bank and reminded it that Bear Stearns had the backing of the Fed, but State Street still was not willing to lend the securities overnight. “So we went ‘Oh, shit’” a Bear Stearns executive said of Schwartz’s reaction. “He knew we had a big problem then.” Indeed they did. Later that night, the Fed pulled its backing (the bailout had failed) and forced Bear Stearns into the arms of J.P. Morgan for $2.
As Meredith Whitney penned at the time: “A company is only as solvent as the perception of its solvency.”
But how could an institution fail even with the unlimited backing of the central bank?
Essentially, the financial system is one big pawn shop.
Financial institutions use firm assets, customer’s assets in margin accounts and cash balances to finance their daily operations. This daily hocking is estimated by Gary Gorton (Yale) to amount to roughly $12 Trillion (as a size comparison, the banking system is only $10T). It is also unregulated and unmonitored by the Fed. Globally, “The FSB put the size of shadow-banking activities at roughly $60 trillion as of 2010—a sum that represents 25% to 30% of the total global financial system.” This is what we mean by ‘leverage in the financial system’ and it why we take such extreme measures to protect funds.
“One of the ways Wall Street funds itself is on a daily basis in the so-called repurchase agreement market…Our guys would borrow maybe $75 Billion a day, something in that neighborhood, most of it daily…It’s of course insane. In the normal world it would be insane, and in this world it’s really insane. But that was the only choice.” - House of Cards. William D. Cohan. 2009.
This is why we were so interested in collateral quality, last month. To explain the problem at the pawn shop in layman’s terms, the nightly pawn shop only wants jewelry and guns - and you don’t have any guns. Or if you compare it to a traditional banking system, it is as if half of all bank deposits disappeared across the Eurozone.
In the weaker countries in Europe, the bank deposits have indeed been disappearing all year as Kyle Bass’ December letter: The Hidden Bank Run Across Europe shows (chart below).
The record level of cash parked at the European Central Bank after the bailout, shows that it has failed. Weak European banks will be failing. Either that or they will be bailed out and trigger what Bass expects. He concludes: “sovereign defaults are imminent.”
Downgrades Deliver the Coup de grace
So when does this hit? In the case of Bear Stearns, it was the rating agencies that delivered the coup de grace.
“I think the downgrade really killed us. Really made it almost impossible to operate. The downgrade triggered so many bad things…There were money funds and other institutions that are lending you money through the repo lines that can’t do business with you if you’re not at least single A.“ - House of Cards. William D. Cohan. 2009.
The rating agencies threatened to downgrade Lehman but instead Lehman ran out of good collateral first. And with MF Global, the rating agencies again delivered the mortal blow. And while there is at least a 50% chance that 15 different Eurozone nations will be downgraded in the next two months, it is the weak and leveraged banks of Europe that we expect to spark the contagion.
The Transatlantic Financial Lines – Money Market Funds
So let’s say we have a failure (more likely a series of failures) in Europe. Money market funds, which hold European bank debt, would very likely “break the buck” or be forced to be bailed out by their sponsors as 36 of the top 100 money market funds were after the Lehman failure. Many U.S. investors would likely be locked out of their cash. But more importantly to the system, (and why the U.S. government stepped in to guarantee money market funds in 2008) money market funds would likely pull back from lending money out in those overnight markets. It would be 2008 all over again. Forced selling would ensue and traditional investments would (eventually) become deliciously cheap.
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