Saturday, December 17, 2011

It didn't work for MF global, it may work for European banks

Some will have followed the Congressional hearing on John Corzin, the ex-head of MF Global, a middle size American investment bank, and broker that seems to have lost or misplaced around USD 1.2 billion of segregated client money. The picture that is emerging is that MF was using clients' money to improve its return by borrowing -- and pledging these funds to acquire government owned security .  Never mind tthe conflict that emerges from borrowing clients money without compensation, the reality is that MF was basically borrowing this cash so that MF could "gamble" in the sovereign bond market .  Usually because the risk of losses in sovereign bonds is very limited the lender (MF Global) can re-lend this moeney several times -- creating leverage.  It seems (and not all the information is in yet) that MF re-lent these funds many many times over -- but when the European bond market moved (by two or three percentage point) the collateral (Provided by MF's clients) was essentially wiped out.

Now, it is hard to see how this kind of strategy could be considered winning, it has proven dangerous when bond markets become vollatile, so imagine my suprise when the ECB annouced that this was their new strategy to save Europe and its banks.  The ECB will provide massive amoount of liquitity so that the banks can then turn around and buy the Spanish and Italian bonds that no one wanted last week.

Granted, this will reduce yields -- so investors who were buying Italian bonds at 7.25% stand to make a killing.  However, this by no means resolve the European problems;  first European banks (except maybe the Germans) have more than enough European sovereign debt on their book, secondly this will reduce the pressure on European government to reform, and third if this strategy led to the demise of MF global, why does it think that this is a good idea for European banks?

The attractive feature of this "solution" is that it removes the risk that Europe will implode during the Christmas holiday, but the growth of bank holdings in sovereign debt will soon worry holders of bank bonds -- as the size of these holdings continues to grow.  Over the next few days expect to see the price of European bank bonds to slide dramatically as this new operations gets underway.  Already the Greek government has been putting incredible pressure on the Greek banks to buy more sovereign debt.  

As a commentator recently said, the actions of the ECB and the EU are certain to promote the sale of mattresses -- as an excellent place to store your wealth.  The Greek public is withdrawing an average of Euro 5 billion per week from the banks -- believing that they are better served by keeping liquid cash hat hand.  

I don't know if this is going to work (taking the cash out), but there is no doubt that Europe is unraveling at increasing speed, every action or comment from the EU or ECB is a new way of avoiding the painful reality that some (large) write-offs will have to occur as the borrowers just don't have the capacity to repay the amounts they borrowed.

Get ready for a strong open on Monday, bank stocks will be on fire.
P.S.  For those interested something strange occurred on Thursday at the Feds.  It appears that (see here) a bank borrowed USD 80 billion...rumors are that it was a European bank (could it be one of the Germans or a French?)

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