brother disco stu's shocker - tuesday, page-42

Financial Panther:

It's simple.

Banks have to set aside short term liquidity for the short term funding requirements.

Banks are also having to backstop the ongoing sales of Italian, Spanish and Greek debt (which eats into their short term funding facilities).

The problem is they are not able to use the "assets" they purchase on the short term balance sheet.

It's akin to you spending 1000 dollars on a company listed on the stock exchange that is illiquid, and keeps on issuing new shares. Yet after buying this, you are not able to use the shares as part of your margin portfolio, thus giving it an LVR of 0%. As the company issues more and more shares, the chances of your shares actually going up in value from the price you pay for it gets less, as your 1000 dollars worth of shares are worth collectively less than before - but yet you are paying interest to fund it.

So why a circle of death?

Think about it.

ECB has to continue its bond buying program to create sufficient liquidity to allow the banks to lodge these bonds to qualify as "short term liquid assets". And these countries keep on issuing newer debt and rolling over old ones (at a loss).

There will come a time where the ECB runs out of bullets, since the purchase of these bonds, requires a buyer AND a seller to create liquidity (which is why some banks end up owning some bonds themselves, in addition to selling to their clients).

At the same time, the ECB and IMF will increase stringent requirements on these very same banks, to insist on greater Tier 1 liquid capital.

So these banks are caught in a very bad situation.

It's okay as long as there is a "final" pawnshop available to these banks for liquidity (ECB) which will always provide a floor price. But as we have seen, the ECB is in turmoil, with its chief resigning last Friday.

So you have to ask yourself - which will give in first?

a) The time it takes for these countries to right themselves fiscally will require the ECB to provide continuous liquidity for many years to come (like the US)

b) Or the ECB dissolves due to Germany pulling out and Greece being bankrupt, resulting in all these bonds being worthless and bank funding terms having to be renegotiated in order to maintain solvency.

To put things in context you may understand, as I fear my explanation will have some flaws or not disseminated properly - imagine the example above.

1000 dollars worth of XYZ company which is illiquid except for 1 buyer bidding at 10 cents a share. As XYZ issues new scrip, the buyer will bid at 9 cents. And then 8 cents. And then 7 cents. But he will still be bidding, soaking up all these new shares.

Meanwhile you the investor (read SG) has bought the tranche at 10 cents, and you value your shares at 10 cents, although little trades at 10. But your margin lender (ironically the ECB itself) doesn't. It values it at whatever price it can sell it out at - even if it means selling it to itself.

Add to all of that, imagine you need X dollars out of your margin portfolio to meet interest payments, run your business and pay wages. And imagine there are fewer and fewer places you can go to for margin lending.

That is the predicament of SG.

I hope this explains it a little better. If someone has a less long winded and better way, I'd love to hear it.