Banking Crisis Anatomy

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Did bankers around the world learn their lesson in the banking crisis of 2008?

Yep, they sure did. They learnt the lesson that when they get into financial trouble they can expect the government to bail them out. That’s why they are back in exactly the same fix again today.

But wait, ‘exactly the same fix’?

Pretty much the only difference this time around is that the banks hold less mortgage-backed securities than they did in 2008 and more of other worthless assets, like Greek bonds, instead. But what this weekend’s Daily Reckoning focuses on is how banking crises develop. How close we already are to a banking crisis. And what this means to you…

The European Banking Crisis and How it Will Affect Australian Banks

If funds dry up in Europe, they will dry up elsewhere. And Australian banks rely on liquid funding markets overseas to run themselves.

If credit markets freeze overseas, so will bank lending in Australia. That means people won’t be able to take out a loan to buy property. Demand for property will dry up. And property values will disappear. By that we mean that an asset without demand doesn’t really have a price. It’s like a pebble on the beach. Until someone wants to give you money for it, it’s not worth anything.

Australians expecting a housing bubble to pop may have to adjust their narrative. The straw that breaks this camel’s back may be falling on the other side of the world – in Europe’s debt markets.

But it’s not just home lending that could disappear. Personal loans usually freeze up first.

All this means your business will not be able to get loans, your children won’t be able to get a mortgage and your credit card will stop working.

When the EFTPOS machine spits out ‘insufficient funds’, you won’t know whether it means the bank can’t afford to pay you or you don’t have any money left in your account.

A Background into The Banking Crisis of 2008

Before we look at today’s impending banking crises let’s first see how one got started in 2007.

Banks don’t really fund themselves with deposits. That’s why investment companies that don’t take deposits exist. Instead, funding comes from debt markets. Just like when the bank lends money to you it demands collateral (the house), financial institutions demand collateral from each other. They do this in all sorts of odd ways with odd names. Repos, swaps, and so on.

The point is banks need collateral to access these sources of funding. Even the so-called lenders of last resort – central banks – require banks to post collateral with them before they lend money.

The problem with widespread use of one particular type of collateral is that it goes from being accepted one minute to unacceptable the next. The whole repo or swap market can freeze up in an instant if the commonly used collateral is called into question. And so it was in 2008 banking crisis.

Companies like Bear Stearns and Lehman Brothers used their vast amounts of AAA-rated Collateralised Debt Obligations (CDOs) as collateral in funding agreements, usually repos. (A CDO is basically a bundle of mortgages.) The repos required assets posted as collateral to be rated AAA, so when those ratings were finally reduced, Bear and Lehman were suddenly unable to fund themselves. That’s why they failed. It was their inability to provide acceptable collateral to their lenders.

The Up and Coming Global Banking Crisis

Fast forward to the impending banking crisis of today and you see exactly the same story – it’s just sovereign bonds instead of CDOs and European banks instead of American ones. The banks find themselves short of acceptable collateral to post with normal lenders. The European Central Bank, Europe’s lender of last resort, has relaxed its standards to allow even Greek sovereign debt to be posted as collateral in exchange for emergency lending. Without these changes, Europe’s banks may have failed already.

But The Economist says a collateral c*ck up may be developing anyway:

With funding ever harder to come by, banks are resorting to the financial industry’s equivalent of a pawn broker: parking assets on repo markets or at the central bank to get cash. “We have no alternative to deposits and the ECB,” says a senior executive at one European bank. Yet what happens if banks run out of collateral to borrow against?

The boss of UniCredit, an Italian bank, has reportedly asked the ECB to accept a broader range of collateral. And an increasing number of banks are said to conduct what is known as “liquidity swaps”: banks borrow an asset that the ECB accepts as collateral from an insurer or a hedge fund in return for an ineligible asset – plus, of course, a hefty fee.

This should have you very, very, very worried. More worried even than Germany’s failed bond auction. Because it means things are freezing up in the same way they did in the banking crisis of 2008. And things are already desperate.

This type of collateral crisis can start rapid contagion in seemingly unrelated parts of the financial system. Once dodgy assets are no longer any good as collateral for funding, they become even less useful to hold. So banks sell them to raise cash. This puts assets, which used to be thought of as ‘safe’, under immense selling pressure.

Bankers might have learned the wrong lesson in 2008. They learned that governments will bail them out. But this time around, it’s sovereign debt that is the big issue. Governments will need the bailing out, as well as banks. The lifeboat launched in 2008 is itself sinking and another banking crisis is bubbling to the surface.

Until next week,

Nickolai Hubble.
The Daily Reckoning Weekend Edition

Nick Hubble
Nick Hubble is a feature editor of The Daily Reckoning and editor of The Money for Life Letter. Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like. He then brought his youthful enthusiasm and energy to Port Phillip Publishing, where, instead of telling everyone about The Daily Reckoning, he started writing for it. To follow Nick's financial world view more closely you can you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails.
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2 Comments on "Banking Crisis Anatomy"

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masalai
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Well said and nicely explained, Thanks…

Sadly there are too many blinded by their own position, still in total denial, or failing to read – – as in http://www.gata.org/node/10705

Joe
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My prediction of a few weeks ago was that some time late February or early March of next year the news will be released that back in late November or early December the RBA started buying up Australian bank bonds because no one else would. That is the great thing about economic reporting cycles, the shit news has already happened, its’ just you don’t get told until the last.

wpDiscuz
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