Kyle Bass, head of Hayman Capital Management, sent letter to his investors yesterday. He mainly explained the risks hidden in the banking system in Europe .
The spectacle on display this past weekend in Latvia is a reminder that old-fashion bank runs are not entirely a thing of the past. The reality, however, is that modern bank runs often take the form of deposit flight from one institution to another – which begs the question: if you were a Spaniard, a Portuguese, a Frenchman, a Latvian, a Greek, or an Italian, why on earth would you leave your euros deposited in your home country’s banks (that are most likely insolvent)? If there was any risk of your deposits being redenominated into pesetas, escudos, francs, un-pegged lats, drachmas, or lira, why not open accounts in Switzerland, Canada, Norway, or at the very least in Germany? Why take the risk that you end of like the Argentines who were restricted to withdrawing a pittance per week after the authorities changed the rules regarding the mobility and the value of the peso?
The IMF released a working paper in November highlighting the significant decline in source collateral for large dealers in the Post-Lehman world. In other words, dealers’ clients (sovereign wealth funds, asset managers, etc.) are not making their excess collateral available for use and re-use by their prime brokers for securities lending or repo activities. The author, Manmohan Singh, is particularly insightful with regard to the length of the collateral chains and how they have shortened over the last few years. This shortening effectively reduces the amount of “grease” needed to keep a highly-levered financial system operating smoothly and is undoubtedly closely connected to the de-leveraging that is beginning in the European banks. Basically, participants no longer trust dealers (which is not surprising, considering the behavior cif players like MF Global?) to re-hypothecate collateral. The chart below neatly displays the new paradigm with regard to collateral movements and the increasing awareness by financial markets participants that their excess collateral is safer in the hands of a third-party custodian than in the hands cif their prime brokers. This is quite a statement given that up to an incremental 200 bps can be earned on excess collateral kept at a prime broker. Some large European funds are even beginning to shun European banks in the OTC marketplace. This pre-emptive action by asset managers is, in part, a natural response to the European Banking Association’s failure to conducted [sic] truly robust stress tests. Case in point: Dexia, a Franco-Belgian bank, passed a prior stress test with flying colors and approximately 90 days later failed miserably. In fact, 190 billion euros was needed for Daxia’s bad bank alone. The most recent stress tests proved to be meaningless even sooner than last year’s tests.
(Click here to see the full letter from Scribd)