A Waiting Game

This is written from a European perspective but applies just as well to US banks. Banks are hoarding cash because their survival depends on it. They are all technically insolvent.

A Waiting Game

by Golem XIV

Governments, so they tell us, want the banks to lend into the real economy to get people working, earning, buying and paying both their taxes and their debts. Problem is, I do not think the financial industry shares this desire. They say they do. They say they are doing their bit. But they are not. The abject failure of the UK’s 2011 ‘Project Merlin’ is a good example. Project Merlin was the voluntary agreement between UK banks and government to set and meet targets for lending to small and medium businesses.  The big five UK banks all agreed to lend. The data showed, however, that they all lent less in every quarter. I talked to the CEO of a UK bank which specializes in raising capital for medium sized businesses and he told me there was less and less funding around. He said the big banks and the big funds simply didn’t want to know. They had other plans.

Of course if the banks had no money to lend then the mystery would evaporate. The story would be they’re not lending because they can’t, because they have no money. But the banks do have money. Lots of it. We are so mesmerized by those banks which are close to the edge – like the Spain’s moribund Bankia and the rest of Spain’s Cajas that we forget others have lots of cash. I’m not saying the headlines aren’t correct.  They are. Spain’s banks are now totally dependant on massive loans from the ECB. The amount they have to borrow from the ECB has gone up every month for the last ten. Last month they borrowed €402.19 Billion. Nearly half a trillion. The rest of Europe’s fine banking system borrows another €600 billion or so.

BUT at the same time as Europe’s banks are sitting on and dependant for their survival on over a trillion euros borrowed from the ECB they also deposited about €860 billion of that money back at the ECB. Until recently the ECB (read tax payers) actually paid the banks interest on this money. Which means we, Europe’s tax payers,  have been forced to give the banks money. The banks have then refused to lend any of it back. Instead they put it in the ECB where they claim interest which we have to pay. We pay twice and get nothing.

Recently the ECB tried to ‘encourage’ the banks to move this money out and lend it by lowering the interest it pays to zero. So the banks could leave the cash in the ECB and get nothing. Or they could lend it out and earn something.  The banks, all of them, chose the former. They simply shifted the money from where it was no longer welcome and put it instead in another part of the ECB which was still accommodating.

Remember not a single one of those euros was earned by any of Europe’s banks. The entire amount is tax payers money. It is bail out money. It is the money the banks were ‘given’ in order to ‘save’ them, restore their finances and allow them to once again lend in to the real economy so that ther rest of us could also get a little help. That has been the only policy allowed anywhere in America, Japan and Europe for the last 4 years and it has failed. The banks are not healed, they  are not lending and the rest of us are now told we must accept a decade of austerity to off-set the levels of debt, that the bank bail outs have massively inflated.

But angry as that makes me it’s not the point. The point is to ask why all the banks are hoarding cash? Why are they willing to accept zero return rather than put it to work?

The standard answer is that the banks know they have many more bad loans and rotten ‘assets’ whose value could suddenly plunge if they are ever forced into the open and valued. So it is prudent to have cash around to cover any sudden forcible recognition of losses. Hidden losses are fine. A bit like illegal libor rates or money laundering. All in a bankers day and fine as long as it never comes to light. It is only getting caught which is frowned upon.  Mea culpas are so irritating after all and some of the fines are actually large enough to nip a little out of the bonus pot!

All of the above has certainly been the case over the last 4 years and to some extent still is. The German banks in particular are still sitting on a mountain of assets they have still not marked to anything like market value. Those ‘assets’ and loans are presently sitting in off-balance sheet vehicles registered in Ireland.

How can I say this? A long conversation with a former Landesbank CEO that’s how. All banks are guilty of hiding losses by refusing to mark their ‘assets’ to market. But the person I talked to said the German Landesbanks in particular are still hiding rather large unrecognized losses in their Irish registered, off-balance sheet vehicles. Safely hidden away from the prying eyes of regulators and citizens.  The joys of regulatory arbitrage!  But should any of these dirty secrets be exposed to the harsh light of market pricing then the banks in question must have either cash hoarded away or feel they can cry to friends in government and the ECB will bail them out.

That is the traditional answer for why banks might hoard cash and it seems it is still partly correct. I should also say it’s not just in Europe that the big banks are hoarding cash. Recent figures from the FED estimate that US banks are hoarding about $1.6 Trillion in cash. Most of it earning interest.

But I have felt over the last few weeks that something about this on-going debacle and attack on our democracy and sovereignty has changed. I do not believe the banks and other financial entities are hoarding cash just as a safety measure.

Let’s look at where we are. According to ECB board member Benoit Coeure, speaking officially in July,

Europe may be sliding back into its second recession since 2009 and growth is also slowing in the United States and China.

“I don’t think we are moving toward a global recession; we are moving toward very low growth or no growth at all,” he said.

A masterful, mouthful of understatement. Rates have been held at close to zero for a couple of years now. The so called extra-ordinary measures have become fixtures, without which the chances of  the big, debt-riddled banks surviving, is zero. The problem is, while essential for their survival, such low to zero rates are also killing them. Long periods of very low rates mean the banks can’t find a return on their money through any sort of regular lending.  Thus the very measures which keep the banks alive, so they can ‘start lending again’, guarantee they won’t.

On top of which this lack of lending and general crippling of the real economy has meant real growth – as opposed to accounting ‘growth’ by means of moving numbers from one column to another column, has not only not recovered but has decreased.  Having opened the public vein for on-going transfusions into the banks, the self same banks have insisted the poor slobs who are being bled for them, must also go on an austerity diet.  And thus nations already crippled by private debt made public liability, are now also being starved.  The Greek and Spanish people have no chance of ‘recovering’. All that awaits them is a boot stamped into their faces over and over and over.

Not that the financial class cares. What they do care about is the lack of ‘yield’ available to them on their money. No ‘yield’ means no profits.  And many banks and funds are not profiting the way they would like. For example this Zerohedge article reports how 68% of Growth Funds which invest $278 billion are underperforming. For ‘underperform’ read not making a profit for their investors who will therefore soon chose to leave.

So what do you do if you can’t get no yield satisfaction? Yes, you reach for the bottle marked ‘Yield’ and ignore  the warning which reads, “Caution: Use sparingly. Contains high levels of risk.”

Here is how an article in International Financing Review put it earlier this month,

The downward pressure on yields has continued, intensified by the ECB’s slashing of interest rates…. Real-money managers are returning to exotic derivatives strategies not seen since the start of the 2008 financial crisis in an effort to boost yields in an increasingly low-returning environment.

What could go wrong? The article continues,

Real-money managers in the eurozone core have all but exhausted conservative means of boosting returns and – faced with negative yields in sovereign markets – they are now ploughing money into riskier assets, often using exotic derivatives to increase value.

“Low yields have really become a big problem over the past eight months and it’s gone from bad to worse,” said Adrian Bracher, head of rates structuring for Europe at Credit Suisse. “These big investors are now opening up for more risk tolerance.”

“Over the past six months we’ve seen the return of relatively exotic structures, and we’re not talking small-fry bets. We’ve seen a number of Northern European managers taking significant views on inter-currency spreads – things we saw a lot three to four years ago but haven’t seen a lot since,” he added.

Exotic derivatives. Big bets. Sounds great.

Then let’s add in this headline from The New York Times (15.August.12),

Risk Builds as Junk Bonds Boom

The market for junk bonds, risky corporate debt that pays high interest rates, is red hot….Fueling this frenzy are investors of all stripes — including individuals, mutual funds and state pensions — who are desperate for returns in their bond portfolios and willing to take more risk to get them. Demand is insatiable, even as analysts warn that the market has become overheated and is ripe for a fall.

Exotic derivatives, big bets and junk bonds. Booyah!

Now it might seem that hoarding cash is the opposite of all this and that the renewed growth in risky investments, argues against the idea that banks are hoarding. Surely searching for return somewhere, even if not by not lending in to the real economy, is still the opposite of hoarding. Actually I don’t think it is.

I think banks and other financial institutions are, as the above quoted articles say, desperate for return. They all need cash flow to stay alive and profit to keep clients. Bank bail outs have largely taken care of cash flow for the last few years. That, and not what we were told, is what the bail outs were for.  And with the cash pile they have hoarded they could continue to use this public money-mountain to pay off their debts for years to come. But that will not bring growth.

So there is a search for yield and a growing belief that risk is back on the menu. The hoarding is, I believe, part of this strategy. The hoarding is not just for safety. As this article from Bloomberg reports,

Hedge funds and private-equity firms have amassed an unprecedented 60 billion euros ($74 billion) to invest in distressed debt in anticipation that Europe’s sovereign-debt crisis will push banks into the biggest fire sale in history. The problem is few are selling.

I don’t think it is just Hedge funds and Private Equity firms that are looking forward to profiting from vast fire sales from bankruptcies and sovereign defaults. I think the big banks are waiting too.

The banks aren’t using their bail out money to help the real economy because they think there is a real chance the real economy isn’t going to recover the way our idiot politicians tell us it is going to. At least not before a wave of corporate bankruptcies and one or two huge sovereign defaults.

Look at it this way. Strategy A) the bank plays nice like the government says and lends at a pathetically low rate to a viable but cash starved business. The business gasps with relief, wins orders for more widgets and pays back the loan. This strategy provides employment and therefore a success story for the politician. The banks gets a pitiful return over the life of the loan. Strategy B) the bank quietly refuses to loan to the widget maker or any other business in the real economy. It might agree to short term funding via high yield bonds. With bonds the bank gets a higher return, can agree to a short duration bond only and can sell the  bond on if necessary. All round better than ‘lending’ the money to the business. But generally strategy B) says, ‘Don’t loan. Wait.’

Wait for the struggling business to collapse and then lend the money to a buy-out fund who will buy up the bankrupt business for a fraction of what it was worth as a going concern, be able to shrug off many of the old debts in bankruptcy protection, renegotiate terms and conditions with the workforce who will be desperate and worried and sell on the ‘restructured’ company for a quick and large profit.

Which strategy would a banker chose – help the economy or help themselves? The same Bloomberg article reports,

Apollo Global Management LLC (APO), Oaktree Capital Group LLC (OAK), Avenue Capital Group LLC and Davidson Kempner Capital Management LLC are among U.S. firms that have flocked to Europe, setting up offices and raising funds to benefit from the most severe period of distress in the region. The money raised for distressed-debt funds gives the firms about 100 billion euros to spend on deals including leverage, according to PricewaterhouseCoopers LLP.

But as the article says, while the vultures are gathering the problem is that no one has yet died. The European banks and their sovereigns who hold so many of the potentially juicy bad loans and ‘assets’ that could end up in a fire-sale, have so far been propped up with endless ECB money. The article quotes Elliot Management which is significant since Elliot Management are part of Elliot Associates who are one of the world’s largest and most aggressive vulture funds.

“The troubles in Europe have not yet created the volume and types of bankruptcy and restructuring opportunities that might be expected from difficulties of such monumental proportions, most likely because the governments and banks are essentially holding each other up and keeping the private sector afloat — for now — with lots of freshly minted paper money,” Elliott Management wrote in a letter to investors in April.

And so we have a strange situation where the big banks are sitting on piles of bad assets. Should they have to sell, or should a whole sovereign be forced to sell at knock down prices in a disorderly collapse – or even in an orderly looting organized by former bankers who are now running in to the ground every austerity-wracked nation they have been given – then there will be epic fire-sales. Those with cash on hand could make the killing of a generation. Possibly by killing a generation, but why lower the tone by mentioning those who don’t really matter?

So I think the big banks are hoarding and waiting. Each hopes not to fall first. Those who do fall will be pciked clean by those still standing. This is what the bail out money is being used for.

I don’t think the banks will lend in to the real economy because they calculate that such a socially useful strategy gives low returns to them. Should they ‘defect’ from this generous strategy and chose instead the selfish strategy of ‘hoard and wait’ then they could make not just a large return but an epic one. They could emerge as owners of everything people will need in order to rebuild their lives. Water, power, rail, hospitals, you name it.

This is what the banks are waiting for. And our politicians are giving them our money so they can.

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