“…What’s going on is really simple. We’re having a run on the Shadow Banking System”
Europe is Heading for a Mini-Depression
By MIKE WHITNEY
Despite a nearly-$1 trillion rescue operation, financial conditions in the eurozone continue to deteriorate. All the gauges of market stress are edging upwards and credit default swaps (CDS) spreads have widened to levels not seen since the weekend of the emergency euro-summit. Libor (the London Interbank Offered Rate) is on the rise and liquidity is draining from the commercial paper and money markets. According to the Federal Reserve, the total amount of (foreign banks’) commercial paper has shrunk 15 percent or $32 billion since late April. Central bank officials insist that there’s no chance of another Lehman-type meltdown, but their actions don’t match their words. Apart from the massive $920 billion EU Stabilization Fund, the European Central Bank has beefed-up its liquidity facilities and is aggressively purchasing state bonds from struggling countries in the south. Without the ECB’s assistance, the slow-motion slide into recession could turn into a full-blown market crash. Brussels has every reason to be worried.
From the Wall Street Journal:
“In the latest indication that European banks are in ill health, the European Central Bank warned late Monday that euro-zone banks face €195 billion ($239.26 billion) in write-downs this year and the next due to an economic outlook that remained “clouded by uncertainty….Europe’s intertwined banking system remains stressed. Investors have hammered the sector, banks are stashing near-record amounts of deposits at the ECB—€305 billion as of Friday—instead of lending the funds to other institutions, risk-wary U.S. financial institutions are reducing their exposure to euro-zone banks.” (“ECB Warns Write-Downs Could Reach $239 Billion” David Enrich and Stephen Fidler, Wall Street Journal)
German and French banks have vast exposure to public and private debt in Club Med countries; Spain, Greece, Portugal and Italy. When those countries finances begin to teeter, it’s harder for the banks to exchange assets in the repo market where they get the bulk of their funding. They are forced to take a “haircut” on the value of their collateral which erodes their capital cushion and pushes them closer to default. This is what happened in the US when the French Bank Paribas started listing in late 2007. PIMCO’s Paul McCulley explains the origins of the financial crisis in a speech he gave at the Fed’s annual symposium in Jackson Hole. Here’s an excerpt:
“If you have to pick a day for the Minsky Moment [the economist Hyman Minsky wrote extensively about the modalities of economic crisis], it was August 9. And, actually, it didn’t happen here in the United States. It happened in France, when Paribas Bank (BNP) said that it could not value the toxic mortgage assets in three of its off-balance sheet vehicles, and that, therefore, the liability holders, who thought they could get out at any time, were frozen. I remember the day like my son’s birthday. And that happens every year. Because the unraveling started on that day. In fact, it was later that month that I actually coined the term “Shadow Banking System”….
“…What’s going on is really simple. We’re having a run on the Shadow Banking System and the only question is how intensely it will self-feed as its assets and liabilities are put back onto the balance sheet of the conventional banking system…..It was pretty much an orderly run up until September 15, 2008. (Lehman Bros default) And it was orderly primarily because the Fed…evoked Section 13-3 of the Federal Reserve Act in March of 2008 in order to facilitate the merger of under-a-run Bear Stearns into JPMorgan. Concurrently, the Fed opened its balance sheet to the biggest shadow banks of all, the investment banks that were primary dealers, including most important, the big five. It was called the Primary Dealer Credit Facility.” (“McCulley: After the Crisis, Planning a New Financial Structure”, Credit Writedowns)
So when Paribas made its announcement on August 9, the collateral (mainly mortgage-backed securities) that the banks had been using in exchange for funding in the repo market, was called into question. No one really knew what these mortgage-backed securities were worth, because many were comprised of subprime loans that would never be repaid. Thus, repo transactions slowed to a crawl, interbank lending collapsed, libor spiked to record highs, and the banking system suffered a major heart attack.