Monday, November 7, 2011

Is the world about to end? No but some basic preparations can be taken

A few weeks ago at a dinner party I mentioned that it was a good idea to keep a few bucks (a couple of grands) in your safe.  People at the dinner seem to assume that I though the end of the world was about to occur -- this is not the case!  

The OWS movement and the inertia of the US Congress means that any shock to North America's banking system will probably not have a "political" response.  Especially if you consider that the banks have been piling on additional risk since the 2007 crisis and maintain that their balance sheets are safe.

My argument was always that if there is a shock to the system the impact ill be felt up here in Canada too.  Lets take an example:

  • It is well know that European banks are excessively leveraged, the German and French banks are leveraged 60x (US banks are leveraged about 14x and Canadian banks are in the same range).  
  • Lets assume that they crisis in Europe deepens (not exactly improbable) and that one or two European banks face a liquidity and solvency crisis (BTW on the liquidity issue we are there right now with the European bond market being closed to banks, and second we don't know the condition of European bank's balance sheet.  What is known about European banks is that they (and the authorities) have worked hard at hiding the truth --- Ernst bank is a good example, in June in said it had no CDS of any kind -- in October it announced Euro 500 MM in write off on its Euro 2.5 billion CDS book (that it had maintain didn't exist!).  
  • Contagion to America would be in the form of a short solvency crisis (remember the high European bank leverage) that would suddenly put the American banks "we are fully hedge on our $350 trillion derivative portfolio" [I wish I was exaggerating but America's 4 largest banks total derivative (gross) portfolio totals $350 trillion].  Because hedging is the elephant int he room, you are hedge as long as your counterparty doesn't go bankrupt.  People forget that the derivatives market is totally unregulated! 
  • Suddenly US banks find that the French/German counterpart can no longer post collateral, and therefore the bank become exposed because if one side of a trade goes away in the derivatives market the guy in the middle (e.g. the banks) is left holding the bag!  The risk is a cascade failure of European banks because of inter-connectedness.
  • Suddenly, US banks are facing liquidity and solvency problems of their own, and the US payment system become "at risk", depositors reduce accounts (to $100,000) or even to zero -- don't forget there is no value in having bank deposits -- you receive no interest on your deposits -- a safe will achieve the same goal!
  • Payment system grinds to a halt (that includes credit cards that are cleared via the banking system), suddenly there is a short and sharp shut down of the system (a good example is what happened to HSBC two weeks ago:  client had no access to their accounts, credit cards or debit cards).


This would not last, a few days at most, emergency measures would be put in place.  In Canada, the BoC would provide liquidity facilities, ring fence the credit card payment system (to insulate it from the rest of the world).  This is not a doomsday scenario -- in fact, its a short term temporary set back, just need some preparation (low cost at that!)

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