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The Walking Dead: Something is Rotten in the Banking System

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wizard bank 2

:  A Curious Collapse – Ever since the ECB has begun to implement its assorted money printing programs in recent years – lately culminating in an outright QE program involving government bonds, agency bonds, ABS and covered bonds – bank reserves and the euro area money supply have soared.

Bank reserves deposited with the central bank can be seen as equivalent to the cash assets of banks.

The greater the proportion of such reserves (plus vault cash) relative to their outstanding deposit liabilities, the more of the outstanding deposit money is in fact represented by “covered” money substitutes as opposed to fiduciary media.

1-TMS- euro areaEuro area true money supply (excl. deposits held by non-residents) – the action since 2007-2008 largely reflects the ECB’s money printing efforts, as private banks have barely expanded credit on a euro area-wide basis since then- click to enlarge.

 

Many funny tricks have been employed to keep euro area banks and governments afloat during the sovereign debt crisis. Essentially these consisted of a version of Worldcom propping up Enron, with the central bank’s printing press as a go-between.

As an example here is how Italian banks and the Italian government are helping each other in pretending that they are more solvent than they really are: the banks buy government properties (everything from office buildings to military barracks) from the government, and pay for them with government bonds. The government then leases the buildings back from the banks, and the banks turn the properties into asset backed securities. The Italian government then slaps a “guarantee” on these securities, which makes them eligible for repo with the ECB. The banks then repo these ABS with the ECB and take the proceeds to buy more Italian government bonds – and back to step one. Simply put, this is a Ponzi scheme of gargantuan proportions.

Still, in view of these concerted efforts to reliquefy the banking system, one would expect that European banks should be at least temporarily solvent, more or less. Since they have barely expanded credit to the private sector, preferring instead to invest in government bonds, the markets should in theory have little to worry about.

 

2-NFC loans, euro areaEuro area bank loans to non-financial corporations, with annual growth rate (blue line) – click to enlarge.

 

In fact, on account of new capital regulations, European banks are almost forced to amass government securities – as government bonds have been declared to represent “risk-free” assets, which reveals an astounding degree of chutzpa on the part of European authorities in the wake of the sovereign debt crisis.

This makes one wonder why the Euro Stoxx Bank Index suddenly looks like this:

 

3-Euro-Stoxx Banks-1The Euro Stoxx bank index has been in free-fall since July – click to enlarge.

 

Clearly, something is rotten here – but what?

 

Bail-Ins, Dud Loans, Insolvent Zombies and Hidden Risks

Back in September last year, with the bank index still close to its highs of the year, we referred to European banks as “Insolvent Zombies”. This may have sounded a bit uncharitable at the time, but it is beginning to look like an ever more accurate description by the day. In December, we reminded readers that European banks are still sitting on €1 trillion in non-performing dud loans (see “Still Drowning in Bad Loans” for details).

In January we finally got around to write about the new European “bail-in” regulations, noting that these were bound to bring about unintended consequences. We pointed out that while there is absolutely nothing wrong with exposing bank creditors to risk and sparing taxpayers from involuntarily shouldering same, such an approach would over time likely prove completely incompatible with a fractionally reserved banking system – especially one as highly leveraged and teetering on the brink as that in a number of European countries.

We moreover pointed out that some governments have begun to apply the new regulations in rather arbitrary fashion – for instance as a means to escape guarantees they themselves have extended to creditors. Two recent bank collapses in Portugal and the still festering Heta (formerly HAA) wind-down in Austria served as recent examples.

This seems indeed to be on the minds of investors, who have begun to sell convertible and subordinated bank bonds left and right. And in concert with the decline in bonds and stocks, risk measures like CDS spreads on senior bank debt have begun to surge. Below are several charts we have taken from a recent article by Peter Tchir, who has commented on the situation at Forbes.

 

4-ITRAXX-SNR-FIN-1200x515I-Traxx senior financials CDS index – this index tracks CDS spreads on the senior debt of 30 major financial institutions – click to enlarge.

 

5-DB-Coco-1200x515Deutsche Bank CoCos: these convertible bonds have special features that allow for “automatic” conversions and the suspension of coupon payments, making them eligible as tier 1 capital under Basel 3. Investors have liked this instruments – until they suddenly stopped liking them.

 

Mr. Tchir agrees that the arbitrary manner in which bail-ins have been pursued – especially the overnight bail-in of senior

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