Banking - Systemic Collapse on the horizon

The big issue that doesn't seem to be getting nearly enough play in the mainstream media is the regulatory capital position of banks. Most western hemisphere banks have been running along with their Tier 1 ratios around 4.5 to 5.5% (they cannot legally function below 4%) and Tier 2 at around 8.5% to 9% (legal limit 8%) - these ratios are based on their internal valuation models which have a habit of over valuing their earnings (mark to market) and ignoring the true nature of their "off-balance sheet" positions. Most regulators are either unwilling or incapable of challenging these models and the rating agencies have been complicit in their development so are not useful as independent arbiters.

The market has paid enormous attention to the "sub-prime" mortgage situation but this is both misleading (not many of these mortgages are actually in default relative to the market fallout) and disingenuous (the real issue is that the multi-layered off-balance sheet "repackaging" business has been a massive and fraudulent racket for banks to balloon their balance sheets with the huge liquidity that the Fed and other central banks pumped into the system over the last 10 years while keeping it all "off-balance sheet" - a tidy way to profit without proper capital allocation).

In a nutshell, the central banks have been pushing large amounts of "money" (created out of thin air) into the banks. The banks have been creating new financial instruments and new ways to "invest" this money but in ways where the earning from what is essentially a casino have been trumpeted as financial boom ,while failing to have the necessary capital to support the risks being taken. Fractional reserve banking is already a racket - the banks, the regulators and the rating agencies all decided that it wasn't a big enough racket and stepped it up a few gears. It is a system based entirely on the ability to keep the illusion running. Musical chairs but with no chairs at all - as long as the music keeps going nobody notices but as soon as there is even the slightest break in the music the problem becomes obvious.

The music faltered at the end of last summer but the "system" (governments, central banks, banks, rating agencies) did some speedy karaoke so no one would notice and got a new CD on and the musical chairs continued. But those in the know could see that there were no chairs. Hence the need for massive injections of liquidity (money) into the system as the players (the banks) stopped lending to each other as they know damn well that they are all bankrupt.

From March 2006 the US Fed is no longer publishing M3 money supply statistics. One of the key components of M3 is Fed Repos with banks. Given that so many US banks are holding vast amounts of hard to value (and valueless) paper the Fed has been Repoing this rubbish at par and doesn't need to disclose it. This allows the banks to "mark to market" large chunks of their portfolios by pointing at the Fed Repos and calling them "market".

The illusion has therefore been created that the banks are not bankrupt. Despite this enormous amount of new capital has had to be injected. This new capital is being pumped into the key players but the western banks are basically screwed unless they can persuade Asia to pump in more cash. It seems that Asia will pump in cash while it can be persuaded of the benefits of keeping the system alive. After all if the system collapses there will only be a handful of winners while the rest of the world looses big time.

The Fed, Bank of England and European Central Banks are all desperately propping the system up but the strains are palpable. Add the recent change in tone in Bernanke and others public pronouncements and my take is that we are "in the late summer of 1929" but with bells on this time. I am not sure whether the central banks will be able to weather this particular storm - I rather think they will not.

That will mean a complete systemic collapse - Economic Armageddon.