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How European Banks Play Extend and Pretend Right Now

M. Lorden | Taxi | Getty Images

The lamps of liquidity are going out all across Europe.

Banks are no longer borrowing on the bond market, for the very good reason that bond investors aren't willing to lend to banks at any sustainable yield. Money market funds are desperately extricating themselves from European exposure. In the wake of MF Global, US financial institutions are attempting to prove their health by selling any exposure to European sovereigns and financials that remains on their balance sheet.

The short-term interbank lending market is seizing up, as banks look at their own balance sheet and figure everyone else is slightly worse.

Corporate depositors are pulling cash.

Banks have been trying to sell assets but there aren't enough buyers for anything not sold at extreme discounts. And the European banks can't afford to have a Black Friday sale without wiping themselves out.

"European banks are being forced to abandon their efforts to sell off trillions of euros worth of loans, mortgages and real estate after a series of talks with potential investors broke down, leaving many already struggling firms with piles of assets they can barely support," Gareth Gore writes at International Financing Review. (Hat tip: Business Insider.)

The "homogeneity of assets" also makes sales difficult. When everyone is trying to sell the same financially engineered products based on the same underlying collateral, it's hard to find enough buyers. Plus sensible investors see the flood of inventory and figure that eventually pricing will have to adjust. But the banks resist selling too cheaply, for fear of exposing their balance sheets as even weaker.

Some banks are close to running out of their best assets—those that can be used in repo transactions with the Federal Reserve or the European Central banks. "What can we repo?" is a common question.

Banks are pressuring central bank regulators to expand the asset classes they will accept at repo windows, just as the Federal Reserve did in 2009.

I spoke to a European banker over Thanksgiving who explained one way banks are using their balance sheet assets to obtain funding is to "repo to bankable assets." What this means, according to the banker, is that European banks short on assets acceptable to central banks go into the market with lesser quality assets. They use these "crap bonds" (the banker's words) as collateral to borrow assets that can be used in repos with central banks.

He describes this as "both desperate and hopeful." The desperate part comes from the huge haircuts the banks are taking in trading non-repo-able assets for repo-able assets. The hopeful part comes from the conviction among some bankers that repo-ing the "crap bonds" is a better deal than an outright sale because someday those bonds may recover their value.

"It's pay-and-pray," he says.

I presume you are not reassured to learn that banks are attempting to rescue themselves from Euro-meggedon with financial engineering.

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