December 14, 2011

The Hidden Bank Run Across Europe

The spectacle on display this past weekend in Latvia1 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 move them immediately to a more stable banking

environment? With the current mobility of capital, why not open accounts in Switzerland, Canada, Norway, or

at the very least in Germany? Why take the risk that you end up 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?

Just as Latvians ran to the ATMs this weekend, so will depositors all over peripheral Europe in the months

ahead. Below is a chart of the most recently published data regarding bank withdrawals in the PIIGS. As you can

see, deposits are now declining at an accelerated pace. What’s surprising is that it hasn't happened much

sooner.

1 "Latvian Banks Fight Off Deposit Run," The Boston Globe, 12/12/2011.

http://www.boston.com/business/articles/2011/12/12/latvian_bank_fights_off_deposit_run/

2 © Hayman Capital Management, L.P. 2011

PIIGS M1 Deposits (Annualized 6-Month Change)

Source: European Central Bank.

Capital mobility is an essential precondition to default as capital rushes out of a problem jurisdiction in the final

phases of a sovereign spiral. Professors Reinhart and Rogoff, whose work we have referenced many times in the

past, assessed the correlation between the liberalization of capital mobility and the incidence of banking crises

across the globe. They concluded that "periods of high international capital mobility have repeatedly produced

international banking crises, not only famously as they did in the 1990's, but historically."2 We note that their

data set, which begins in 1800, only covers through 2007 (this paper was published in April 2008). At that time,

capital mobility was at its highest point ever and we all know how that turned out.

2 Carmen M. Reinhart and Kenneth S. Rogoff, "This Time is Different: A Panoramic View of Eight Centuries of Financial

Crises", pg. 7. http://www.nber.org/~wbuiter/cr1.pdf

-20%

-15%

-10%

-5%

0%

5%

Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Aug-11 Sep-11 Oct-11

GreeceIrelandItalyPortugalSpain

3 © Hayman Capital Management, L.P. 2011

Capital Mobility and the Incidence of Banking Crisis: 1800-2007

Source: Reinhart and Rogoff (2008); Obstfeld and Taylor (2004).

Collateral Chains Shortening – Prima Facie Evidence of Distrust

The IMF released a working paper in November highlighting the significant decline in source collateral for large

dealers in the Post-Lehman world.3 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 of 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 of 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

3 Manmohan Singh, IMF Working Paper: “Velocity of Pledged Collateral: Analysis and Implications,” November 2011.

http://www.imf.org/external/pubs/ft/wp/2011/wp11256.pdf

4 © Hayman Capital Management, L.P. 2011

asset managers is, in part, a natural response to the European Banking Association’s failure to conducted 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 Dexia's bad bank alone.

The most recent stress tests proved to be meaningless even sooner than last year’s tests.

Below is an illustration provided in the IMF paper which shows the traditional flow of collateral (on the left)

versus the structure currently employed by many large market participants. The reference to “churn” in the

chart refers to a dealers’ ability to re-use (i.e. risk) excess collateral to generate positive yield for themselves.

Large Banks’ Use of Investors’ Collateral

The recent announcement of a coordinated G7 central bank action to increase the availability of currency swap

lines at cheaper rates was an attempt to put into place facilities that will act as airbags for a marketplace that

will likely disintegrate into a formless void of investor action once multiple sovereign defaults begin. We believe

the timing of the swap facilities announcement was specifically designed to forestall the impending failure of a

large Eurozone bank facing a funding crisis. The announcement provided temporary relief to the funding

markets, and the mini-crisis was seemingly averted. However, this sort of relief simply allows Europe’s banks to

continue to pick the flowers while allowing the weeds to grow, by preventing any failure and restructuring but

forcing ongoing deleveraging across the system. The majority of "good" collateral is already posted at the ECB

for repo funding, so facing a dearth of available collateral, what would you expect the ECB to do? Naturally,

they announced an expansion of eligible or “Tiffany” collateral and provided some relief on the cost of the repo

transactions. The constant lowering of collateral requirements has encouraged European banks to pledge lower

and lower quality collateral to the ECB which, over time, has seen its balance sheet expand to provide more than

half a trillion euros of loans; placing the ECB's tiny capital sliver of 5 billion euros at ever greater risk.

As European leaders press forward with failed attempt after failed attempt to suppress borrowing costs, control

spending, reduce deficits and prop up what the markets have already told us is a broken monetary system, the

5 © Hayman Capital Management, L.P. 2011

data tells us that the citizens of the most troubled and profligate nations are losing confidence in the Euro

dream. Trust has been lost, confidence in the system is being lost, and the ultimate consequence of this break

down - sovereign defaults – are imminent.

We continue to move ever closer to a great restructuring of sovereign debt.

Sincerely,

J. Kyle Bass

Managing Partner

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