Passing the time outside a crossroads store in Irwinville Farms, Georgia
Ilargi: In the beginning, there was the Glass-Steagall repeal, rejection of securities regulations, ultra-low interest rates, the president talking up homeownership. Then there was light, and with it came $14 trillion in taxpayer funded alphabet soup support (equity, loans, guarantees). First through the Treasury, and when that became tough, through the back door steps of the Federal Reserve and FDIC. Along the way, Fannie Mae and Freddie Mac were used to buy up mortgages and AIG to gobble up derivatives’ risk. All three are now part of the taxpayer alphabet soup. The $23 billion loss Fannie announced today is on you, America. And there is nothing in sight that says the annual loss for 2009 will be below $100 billion. For Fannie alone. But don't get all excited just yet, the combined Fannie and Freddie mortgage portfolio's contain some $6 trillion in goodies, and they're by law required to add $40 billion more each month, almost half a trillion per year, to keep the bankers' profits flowing. And all of it is yours. Even though both are still publicly traded and Obama didn't include them in his budget, claiming they're private companies and "their securities are not backed by the full faith and credit of the Federal Government"(that would be your faith, and your credit). That way he can try and fund the losses, with your money, outside of Congress, I guess. After all, only $400 billion of your cash has been promised to the F&F black hole cabal that keeps home sales going, and prices elevated, in the US. And, yeah, I know what you're saying, I’m not so sure I want to know the whole picture on their securities portfolio either. That could be real ugly. Regulator, anyone? Obama wants the Federal reserve to be the one and only overseer on the financial industry. The whole set-up has had only one thing in mind since the get-go: don't let the banks lose any money, if only because if they shed any more of it, some goat herd in a dress will pick them up for chump change on a drizzly Monday afternoon just to have something to do. Plenty's been said about the stress tests, and it all boils down to two points. First, there's no mention of valuing bad assets, and why should there be with accounting standards out the window and PPiP waiting in the wings? And second, under the tests, the required Tier 1 common stock amounts to 4% of the risk-weighted assets. Which means that all the biggest US banks, including those that hold most of your deposits, are allowed a 25 to 1 leverage ratio. Which sounds more like a hedge fund or a casino to me. Only 5 years ago, investment banks needed 8% in Tier 1. And then, of course, the golden calf was born. Now that the poor beast been slaughtered, the only prudent way to go forward, prudent as in looking out for the man in the street, would be to a 10 to 1 ratio, if that, at least until the system has been cleared of its problems. But that won't happen. Because it would show all US banks to be insolvent. I've said it before: there's no need to game the plan. The plan is the game. The heads of government were once the heads of the banks, and the other way around. The banks have virtually unlimited losses, and the government has virtually unlimited access to capital, that of its citizens. You have to admit, it works like a charm. But not for you.
Ilargi: Best versions of the song: Judy Garland, Chet Baker, Billie Holliday. The greatest are always the most tragic, it's the no.1 prerequisite. This is Garland 1943.
Old man sunshine listen you!
Never tell me dreams come true.
Just try it -- And I'll start a riot.
I'm certain It's the final curtain.
I never want to hear from any cheerful Pollyannas,
Who tell you fate, Supplies a mate --
It's all bananas!
They're writing songs of love, but not for me.
A lucky star's above, but not for me.
With love to lead the way
I've found more skies of grey
than any Russian play could guarantee.
I was a fool to fall and get that way;
Heigh-ho! Alas! And also, lack-a-day!
Although I can't dismiss the mem'ry of his kiss,
I guess he's not for me.
He's knocking on a door, but not for me.
He'll plan a two by four, but not for me.
I know that love's a game;
I'm puzzled, just the same,
was I the moth or flame?
I'm all at sea.
It all began so well, but what an end!
This is the time a feller needs a friend,
when ev'ry happy plot ends with the marriage knot,
and there's no knot for me.
George and Ira Gershwin
U.S. jobless rate at 25-year high
U.S. employers cut a smaller-than-expected 539,000 jobs in April, the smallest amount since October, according to government data on Friday that hinted at some improvement in the labor market and the recession-hit economy. However, the Labor Department said the unemployment rate soared to 8.9 percent, the highest since September 1983. March's payrolls figure was revised to show a decline of 699,000, compared with a previously reported drop of 663,000. Job losses in February were bumped up to 681,000 from the previously estimated 651,000.
Analysts polled by Reuters had forecast non-farm payrolls dropping 590,000 in April. The unemployment rate had been forecast to rise to 8.9 percent from 8.5 percent in March. The report showed job losses across almost all sectors, although at a less steep pace than in the previous months. The government and education and health services sectors added jobs. The manufacturing sector lost 149,000 jobs in April, after shedding 167,000 the prior month. Construction industries cut 110,000 jobs after losing 135,000 in March. The service-providing industry slashed 269,000 positions after eliminating 381,000 in March. Since the start of the recession in December 2007, the economy has lost 5.7 million jobs, the department said.
Ilargi: A bit double, I know, the above and below pieces, but I wanted to keep the correction rates mentioned above.
Job losses ease, but unemployment rate up
The unemployment rate hit a 25-year high in April, but there were signs of hope as the monthly job loss total fell to the lowest level in six months. The Labor Department reported Friday that employers cut 539,000 jobs from payrolls in the month. That's an improvement from the revised reading of 699,000 that were lost in March, and the best reading since October, when the economy shed 380,000 jobs. Still, that brings job losses since the start of 2008 to 5.7 million. And even some economists who believe that economic growth and an end to the recession are close at hand project that job losses could continue through the end of the year or into 2010.
Economists had forecast a loss of 600,000 in April, but there had been signs in recent days that the job losses might not be as bad as expected. A reading on private sector employment by payroll services firm ADP showed a big drop in job losses in April, and there has been a steady decline in recent weeks in people filing for first-time unemployment benefits. There was a 72,000 increase in government jobs, many of them workers hired to conduct the 2010 census. The health services and education sector added 15,000 jobs. But 72% of private industry sectors reported job losses in the month, although that was an improvement from the nearly 80% that shed jobs in March. Construction lost another 110,000 jobs while manufacturing shed 149,000 workers and retailers cut staff by 47,000. Business and professional services, a catch-all sector that includes accountants and lawyers that is seen as a sign of overall business hiring, shed 122,000 jobs.
The unemployment rate, based on a separate survey, rose to 8.9% from 8.5% in March, the worst reading since September 1983. Economists surveyed by Briefing.com had forecast the rate would rise to 8.9%.
But the unemployment rate, as bad as it was, doesn't indicate the extent of the pain being felt by job seekers. The report showed 27% of the 13.7 million unemployed Americans have been out of work for more than six months, the highest percentage of long-term unemployed among the overall pool of jobless in the 61 years that reading has been tracked. Almost one out of six members of the labor force are either unemployed, working part-time when they would prefer to work full-time, or are out of work and have become so discouraged that they did not look for work and thus not counted in the unemployed total. That's the highest reading in that measure that goes back to 1994.
Looking More Closely at "Good" Unemployment Data
It seems that Traders love today’s NFP data. Let’s take a closer look at the actual numbers to see what we can tease out:
- Nonfarm payroll employment decline in April (-539,000);
- Total recession job losses (December 2007 forward) now total 5.7 million;
- That is 6.5 million job losses per year on an annualized basis;
- Private-sector employment fell by 611,000; the differential between NFP and private sector employment is primarily new hires for the 2010 Census;
- U3 Unemployment rose from 8.5 to 8.9%; unemployment is now at a 25-year high;
- U6 Unemployment, the broadest measure of "labor underutilization" rose to 15.8%; This is up 77.5% (6.6 percentage points) from a year ago;
- All sectors saw job losses except Education, health services and government;
- Downward revisions made to February and April were for a net loss of 66,000 positions;
Two additional things to note:
Its hard wrapping my head around a more than half million monthly job loss as signs of stabilization; Second, I hasten to point out that the "adverse" scenario the Treasury/Federal Reserve used in their stress test was a 9.5% Unemployment Rate. We should be there by sometime this summer, and above 10% by the end of the year . . .
The Big Lie: Stress Test Optimism Just Wall Street Propaganda: William Black
Results of the stress test brought a collective sigh of relief from Washington D.C. to Wall Street Friday, and stocks were rallying again on a growing sense the financial crisis has past. Don't you believe it, says William Black, an Associate Professor of Economics and Law at the University of Missouri - Kansas City. "It's in the interest of the financial community to send this propaganda out," Black says. "It's remarkable not that they do it but that it still works." In other words, this isn't the first time we've been told "the crisis is over" and that "banks are well capitalized" - and probably won't be the last.
The professor and former financial regulator foresees another wave of foreclosures and future bank losses of more than $2.5 trillion vs. the government's $599 billion estimate. Simply put, the stress tests weren't strong enough to be considered "wimpy," Black says. Furthermore, Fannie Mae, Freddie Mac, AIG and IndyMac were deemed to have "passed" much more stringent government stress tests before their respective failures, he notes, recalling the grim history:
- Fannie and Freddie: In July 2008, Treasury Secretary Paulson testified that Fannie and Freddie were "adequately capitalized" under the test. In August 2008: "even in [Freddie's] most severe stress tests, [show] losses ... less than $5 billion." Actual losses: 20 to 40 times greater.
- AIG: "It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those [CDS] transactions." AIG claimed in 2008 "Using a severe stress test ... losses could go as high as $900 million." Actual losses: 200 times greater.
- IndyMac: Sold over $200 billion of "liar's loans." Actual losses: 160 times greater than its tests.
- Rating Agencies: Their stress tests gave AAA ratings to toxic waste. Actual losses: more than an order of magnitude greater.
"The examinations and stress tests are shams -- always precise, always farblondget," Black claims. So while others are celebrating the end of the crisis, ask yourself this: If the government sees up to $599 billion in additional bank losses, why are they requiring banks "only" raise $75 billion? That suggests the government thinks the banking sector is overcapitalized by $525 billion. "Once people learn they're being lied to, they react very badly," Black says. "And of course this is not the first lie." Maybe you really can fool some of the people all of the time.
Obama wants Fed to be finance supercop
The White House told industry officials on Friday that it is leaning toward recommending that the Federal Reserve become the supercop for "too big to fail" companies capable of causing another financial meltdown. According to officials who attended a private one-hour meeting between President Barack Obama's economic advisers and representatives from about a dozen banks, hedge funds and other financial groups, the administration made it clear it was not inclined to divide the job among various regulators as has been suggested by industry and some federal regulators. "The idea of having a council of regulators was pretty much vetoed," said one participant.
Treasury Secretary Timothy Geithner, who briefly attended the meeting but did not identify the Fed specifically as his top choice, told the group that one organization needs to be held responsible for monitoring systemwide risk. He said such a regulator should be given better visibility into all institutions that pose a risk to the financial system, regardless of what business they are in. "Committees don't make decisions," Geithner told the group, according to another participant. Officials from the Treasury Department and National Economic Council, which hosted the meeting, told participants that the Fed was considered the most likely candidate for the job, according to several officials who attended or were briefed on the discussions. The administration officials said a legislative proposal would likely be sent to Capitol Hill in June with the expectation that the House Financial Services Committee, led by Rep. Barney Frank, D-Mass., would consider the measure before the July 4th recess.
The officials requested anonymity because the meeting had not been publicly announced and they were not authorized to discuss it. A Treasury Department statement provided to The Associated Press on Friday confirmed Geithner's position that he wants a "single independent regulator with responsibility for systemically important firms and critical payment and settlement systems." A spokesman said Geithner also is open to creating a council to "coordinate among the various regulators, including the systemic risk regulator." Industry officials say such a council would likely serve as advisers and would not be given the authority that a "systemic risk regulator" would.
The Fed itself hasn't taken a position on whether it should have the job, although Chairman Ben Bernanke has said the Fed would have to be involved in any effort to identify and resolve systemwide risk. In a speech Thursday, Bernanke said that huge, globally interconnected financial firms whose failure could endanger the U.S. economy should be subject to "a robust framework for consolidated supervision." Naming the Fed as a kind of super regulator is likely to run into at least some resistance by other federal regulators and in Congress. Mary Schapiro, the head of the Securities and Exchange Commission, said Friday that she was inclined to support the idea floated this week by the head of the Federal Deposit Insurance Corp. for a new "systemic risk council" to monitor large institutions against financial threats. The council would include the Treasury Department, Federal Reserve, FDIC and SEC, according to the proposal by FDIC Chairman Sheila Bair.
Speaking to the Investment Company Institute, the mutual fund industry's biggest trade group, Schapiro said she is concerned about an "excessive concentration of power" over financial risk in a single agency. Lawmakers are divided on whether the Fed alone should assume the role of systemic regulator. Some say the Fed failed to prevent the current economic crisis and shouldn't be trusted with such a big responsibility. Others say the Fed should stay focused on its primary duty of setting monetary policy. Sen. Christopher Dodd, D-Conn., chairman of the Senate Banking Committee, said this week he is "more attracted to the council idea" than having a single regulator play that role. Unlike other regulatory agencies, the Fed does not rely on appropriations from Congress for its operating funds. It finances itself through its investments.
Fed Gov. Daniel Tarullo told Congress in March that the extent to which the new responsibility for systemic risk should fall to the central bank "depends a great deal on precisely how the Congress defines the role and responsibilities of the authority." "Any systemic risk authority would need a sophisticated, comprehensive and multidisciplinary approach to systemic risk," he testified. "Such an authority likely would require knowledge and experience across a wide range of financial institutions and markets."
U.S. Banks' Not-So-Stressful Test
The government's bank stress tests deserve a B-minus. To give a sustained boost to investor confidence, the tests needed demonstrable rigor. They achieved that up to a point. While worst-case loss rates look tough, certain loan portfolios -- in particular commercial real estate -- at some banks seem to have gotten off lightly. Meanwhile, the tests' numbers for underlying earnings -- which are needed to offset soaring credit losses -- could turn out to be optimistic in some cases. It is hard to quibble with most of the government's worst-case loss rates, which are calculated for this year and next. For example, an 8.8% loss rate for first-lien mortgages seems suitably tough, even when taking into account the aggressive underwriting during the housing bubble. The government's 13.8% worst-case loss-rate for second-lien mortgages seems fair. But it is a stretch to think Wells Fargo, with its large home-equity book focused on stressed housing markets, will have a lower-than-sector loss rate of 13.2%.
The government may have been too optimistic in positing an 8.5% commercial-real-estate loss rate. This sector is just starting to fall apart, and defaults may move sharply higher as borrowers struggle to refinance loans. BB&T's commercial-real-estate worst case is higher at 12.6%, but its portfolio may arguably show higher losses. The government's earnings projections also need to be taken with a pinch of salt. It is optimistic to assume banks can repeat their first-quarter revenue generation, for instance. Given the Fed has unleashed a tidal wave of liquidity into the system, interest rates are going to be extremely volatile for several quarters, making bank revenue very hard to predict. Another reason to be skeptical is few banks have to substantially increase overall levels of Tier 1 capital, which includes common and preferred shares, by raising new money. The government is effectively saying most large banks were solidly capitalized even when investors fled earlier this year.
Instead of immediately raising overall capital levels, some banks are just shifting the mix toward common equity -- the highest-quality capital. Lenders that need to raise fresh money include GMAC, General Motors' lending arm. Also, Wells Fargo's offering of common stock, announced Thursday, suggests its overall capital will increase. Finally, the government has effectively said it wants banks to have Tier 1 common stock equivalent to 4% of risk-weighted assets. First, investors have to decide whether they have confidence in the risk weightings. Second, Tier-1 measures of capital leave out certain unrealized losses on securities that could become real later -- something captured by tangible-common-equity ratios. Then they must decide whether 4% -- which still translates into 25-to-1 leverage -- is safe for the unpredictable environment we are in.
Major Banks Negotiate, Spin, Chafe at Stress-Test Results
Some major banks managed to wrest concessions from the government in closed-door negotiations over their "stress tests" that helped them put the best face on their results, financial analysts, industry officials and sources said. The banks were intent on sending a message that they were strong enough to weather the economic storm and didn't need additional capital infusions from the government that could all but nationalize their franchises. Citigroup successfully pushed to lower the amount of common equity it needs to raise to $5.5 billion by applying $52.5 billion from capital it has not yet reworked. It also was able to get a credit for the sale of a unit that has not been completed.
The stress tests showed that despite a deepening recession, the government will require only two of the nation's 19 major banks to raise new capital totaling $9.5 billion, far less than what many analysts had projected. The government also is requiring 10 of the largest banks to increase their capital reserves by raising $74.6 billion in common equity, which can be generated by the sale of common stock. Investors initially were relieved by the generally benign results. But executives were still chafing in conference calls yesterday that their banks didn't end up looking better. Some acknowledged intense negotiations that began after they had learned of their preliminary results about two weeks ago. Several banks were displeased with the amount of capital the government concluded they must raise and lodged their complaints with Fed leaders.
When asked in a call with reporters about its seeming success in the negotiations, Citigroup Chief Financial Officer Edward Kelly said the firm still had issues with the tests. He said the principal difference of opinion centered on revenue the bank would generate if the economy worsened. He declined to discuss the specifics, saying talks with regulators were confidential. "I can't really tell you how they came up with [their] number. I couldn't tell you even if I knew, which I don't," Kelly said to laughter. Several banks used the spotlight on the stress tests yesterday to announce plans to sell stock to raise money from private investors. Among them were Wells Fargo, the largest bank in the Washington region by market share, which said it would offer $6 billion in new stock, and Morgan Stanley, which intends to sell $2 billion.
Banks can also increase their common equity levels by converting the government's preferred shares to common shares, but that would dilute existing shareholders and make the Treasury the largest owner in their firms. The department, using bailout funds, has already injected $209 billion into the capital reserves of the stress-tested banks, excluding MetLife. Officials at Wells Fargo said the company's conclusions were at odds with those of the Fed. They called the government's findings that the firm needs to raise $13.7 billion "excessively conservative." Wells Fargo chief executive John Stumpf said the company does "not want to be in a position" of seeking to convert the government's preferred shares to common shares, which would give the government a hefty ownership stake. "There's plenty of capital in this company," Stumpf said. As for the $25 billion from the Troubled Assets Relief Program that Wells Fargo received last year, he said, "We will pay back TARP as soon as it's practical for us to do so."
Richard Bove, an analyst with Rochdale Securities, said Wells Fargo got an especially rough deal, considering that it stepped in to take a struggling Wachovia off the government's hands last year. Wells Fargo raised more than $11 billion so that it could buy Wachovia. "They did the government a massive favor," Bove said. "And the government returned it by saying: 'Screw you. Go out and raise more capital.' " The firm identified as having the biggest capital needs, Bank of America, said it would seek to avoid government aid at all costs. In a conference call with analysts last night, Bank of America officials said they would sell businesses to help raise about $10 billion and swap preferred shares held by private investors for common shares to raise an additional $17 billion. The firm's performance in the next few months will provide an additional $7 billion, said Joe Price, Bank of America's finance chief.
Capital One, which has the most bank branches in the Washington area, said it won't need to raise more capital. The firm said it is working toward repaying the $3.6 billion in taxpayer money it received last fall. Chief executive Richard D. Fairbank said in a statement that he was content with the stress-test results. They "confirm the strength and resilience of our capital," he said. The firm would not make company officials available to comment. Officials at Regions Bank did not return calls for comment. It and GMAC were the only two firms that do not have enough funds to meet the capital needs cited by the Fed. Regions Bank said in a statement that it remains "strong and stable," and that while it "disagrees with the assessment" of the Fed on the need for an additional $2.5 billion in common equity, it is committed to meeting the requirement.
Stress Tests Results Split Financial Landscape
At one bank in Alabama, the problem is a construction bust. At two in Ohio, the trouble is real estate. And in San Francisco, at Wells Fargo, the worry is credit cards — a staggering 26 percent of that bank’s card loans, federal regulators have concluded, might go bad if the economy takes a turn for the worse. The stress tests released by the Obama administration Thursday painted a broad montage of the troubles in the nation’s banking industry and, for the first time, drew a stark dividing line through the new landscape of American finance. On one side are institutions like JPMorgan Chase and Goldman Sachs, which regulators deemed stronger than their peers — perhaps strong enough to repay billions of bailout dollars and wriggle free of government control. On the other side are weaker institutions like Bank of America, which now confront the daunting challenge of raising capital on their own or accepting increased government ownership, along with whatever strings might be attached. Time is short: the banks have only until June 8 to draw up their plans for regulators. As the results of the tests streamed in from the Federal Reserve, banks began racing to raise money.
Broadly speaking, the test results suggested that the banking industry was in better shape than many had feared. Of the nation’s 19 largest banks, which sit atop two-thirds of all deposits, regulators gave nine a clean bill of health. The remaining 10 were ordered to raise a combined $75 billion in equity capital as a buffer against potential losses should the economy deteriorate. That amount is far less than many had forecast. But the potential losses that federal regulators projected, even at the soundest banks, are eye-popping. Under regulators’ worst-case assumptions, the 19 banks might suffer $600 billion in losses through 2010, on top of the hundreds of billions that have already vaporized in this financial crisis. About 9 percent of all loans might sour — a figure that is even higher than it was during the Great Depression. One in five credit card loans could go unpaid, more than double the typical loss rate. Approximately one in 10 mortgages could sour.
The tests also left some crucial questions unanswered, including the big one: What happens if this recession turns out to be even worse than that worst-case situation, and the banks’ losses start growing? The results suggest the big bailouts for the banks are over. But many wonder if banks will be in a position to make the loans needed to revive growth, even under rosier economic assumptions. "Everybody should breathe a sigh of relief," said Peter J. Solomon, who runs a boutique investment bank and early in his career worked at Lehman Brothers. "Now the question is, So what? Will they lend?" The results shined an uncomfortable spotlight on the most troubled financial institutions: GMAC, the finance arm of General Motors; Bank of America; Wells Fargo; and Citigroup. Several large regional banks — like Regions Financial in Alabama and SunTrust Banks in Georgia, and Keycorp and Fifth Third in Ohio — were also deemed to need large sums of capital.
But many banking executives, free to discuss the results publicly for the first time, sought to put a positive spin on the tests. In a rush of conference calls with analysts, they generally characterized the results as a sign that their institutions could weather another downturn in the economy. Many said federal regulators were overly pessimistic in their assessments and insisted that they would move quickly to repay bailout money. "Our game plan is to get the government out of our bank as quickly as possible," said Kenneth D. Lewis, the chief executive of Bank of America. But even Mr. Lewis acknowledged that his bank faced some serious challenges. Regulators determined that Bank of America needed to raise about $34 billion in equity capital. The bank hopes to raise half of that by selling common stock and converting preferred shares to common stock. It hopes to raise the rest by selling assets like First Republic Bank and Columbia Management, its Boston-based investment unit, and using its future earnings.
If that fails, the bank will have to convert some of the $45 billion of preferred stock that the government owns into common shares, increasing the government’s stake. Even before federal regulators announced the results of its stress tests, Wells Fargo announced that it would offer $6 billion in common stock. The government is requiring the bank to raise an additional $13.7 billion. Wells executives — who balked at accepting bailout money last autumn — said they expected to raise the remainder largely through revenue growth that they say they believe will far exceed the expectations of government regulators. But Wells Fargo officials also disputed the government’s conclusions, arguing that the government’s revenue forecasts were "excessively conservative." "In our analysis, we thought we didn’t need any capital," said John Stumpf, the bank’s president and chief executive.
Citigroup, which for many has come to symbolize the problems plaguing the financial industry, has already been moving quickly to address its problems. Regulators determined that the bank must raise $5.5 billion, on top of recent efforts to raise capital by selling businesses and converting just over half of the $45 billion in bailout funds to common stock. Vikram S. Pandit, the bank’s chief executive, said he would expand the company’s offer to exchange preferred shares of stock for common stock to a broader assortment of private investors. The moves will severely dilute the bank’s shareholders and will leave the government with a 34 percent ownership stake, slightly less than investors expected. "We have had to make some very tough decisions," Mr. Pandit said. "We are kind of happy we did them along the way." But a handful of stronger banks are pulling away from their weaker peers and emerging as institutions that could dominate the industry.
Goldman Sachs, for instance, has said that it hopes to return the $10 billion it received from the government as soon as possible. On Thursday, regulators said Goldman did not need more capital. JPMorgan Chase, which was also deemed to have enough capital, is pushing to return bailout money as well. Yet it, too, took issue with the results, arguing it was in an even stronger position than the results suggested. "We think we can handle an even more significantly negative environment and still make a profit," Michael J. Cavanagh, chief financial officer, said. For Washington and Wall Street, the main question is whether investors and depositors will take solace from these results. Banks and administration officials are eager to persuade private investors that the banks are stable enough to invest in. "The golden ring here, if you can catch it, is confidence," said Tanya Azarchs, the bank rating analyst at Standard & Poor’s.
Goldman's Test Stresses Morgan Stanley
Why did the stress tests treat Goldman Sachs better than Morgan Stanley? In the worst-case scenario used to determine bank capital needs, the government posits that Goldman might be two and a half times as profitable as its main rival this year and next. In the period, the Treasury and bank regulators are saying Goldman will have $18.5 billion in "resources other than capital to absorb losses." This number primarily reflects how much in earnings, excluding provisions and securities marks, a bank can generate. For Morgan Stanley, the government has a much lower $7.1 billion. As a result of Thursday's stress test, Morgan Stanley raised $4 billion in common stock. That shareholder dilution might not have been needed if the authorities had come up with stronger earnings generation for Morgan Stanley.
Were the tests' assumptions "stacked in Goldman Sachs' favor?" asks Michael Hecht at JMP Securities. He notes that the $7.1 billion for Morgan is 62% below Goldman's figure, whereas Morgan's actually-reported net revenue has, on average, only been 22% below Goldman's over the last five years. The government documents don't give enough detail to explain the large gap. One has to hope that the stress-testers weren't placing too much emphasis on Goldman's strong outperformance in the first quarter, when Morgan's revenue was 68% lower -- partly because it reined in risk. Few would argue that Goldman isn't the stronger of the two, and the government may have its Goldman projections right. But the numbers appear to bake in the idea that Goldman is savvier at making money from taking risk. The government had better be right.
Doubts on banks’ ability to sell assets
Some banks that require more capital after the stress tests will turn to asset sales to raise money, but their ability to find willing buyers is likely to be limited. The US Treasury said this week that to solidify their businesses, it expected banks to consider “sales of business lines, legal entities, assets or minority interests”, as well as joint ventures and spin-offs. “This will encourage asset sales,” said a banking industry adviser. “But it will target assets that would have buyers beyond the banks, which have to worry about their own capital ratios – and ideally those that don’t sell at much of a premium.”
Branches and deposits, which are typically in great demand, will be harder to sell because of accounting implications, bankers say. Such assets usually are sold at a premium. But that would force bank buyers to take charges against earnings for the premium, which is difficult for banks already facing shortages of capital. Some experts were concerned that a broad attempt at government-supported asset sales could result in another AIG-type situation, in which a sweeping effort to sell assets largely fizzled out. Many banks have put their asset management divisions up for sale, for example, and attracted little interest. “The government made that mistake already lending money into M&A that didn’t happen,” said one adviser. “There’s no M&A,” said one adviser. “People have got enough trouble working out their own stuff.”
Findings, but No Final Word
Now that the stress tests are in, what do we really know about the health of the banking system? We know that there could be further losses on mortgage-backed securities — despite claims by many banks that the securities have already been marked down to absurdly low levels. We know which of the major banks made the most dubious loans in areas that are now only starting to go wrong, such as credit cards, corporate loans and commercial mortgages. We know something about the relative health of the country’s major financial institutions, including all the ones that are deemed to be too big to fail. We know that, using a not-wildly-pessimistic economic assumption, some major banks need to raise a lot more capital. The specific numbers that came from the stress test should not be taken as anything approaching the final word. Nor is it worth the effort to argue about the economic assumptions that were used.
Timothy Geithner, the Treasury secretary, said they were very tough, allowing for the possibility that more bank loans would default than happened even in the Great Depression. Others argued that the administration underestimated how large the losses from defaulted loans would be. That argument misses an essential point: The most important goal of government policy now is to keep things from getting much worse, not to assure that the banks could survive a calamity without additional help. Most, if not all, of these 19 institutions would be in great trouble if the current recession were to become a second great depression. But that was obvious long ago. The numbers that are most impressive — perhaps shocking should be the word — are the estimates of possible losses from differing categories of assets.
For corporate loans, we are told that State Street could suffer losses of 23 percent of its portfolio through 2010. Fifth Third and Capital One could also face losses of a tenth or more of their corporate loans. For commercial real estate loans, the worst numbers are 45 percent losses for Morgan Stanley and losses of a third or more for both State Street and GMAC, a company that concluded, disastrously, that a good way to offset possible losses on auto loans was to get into mortgage lending. GMAC is also estimated to be facing substantial further losses in home mortgages. In credit card loans, the numbers are amazing across the board. The best of these institutions with a credit card portfolio, Sun Trust, could lose 17 percent on those loans. The worst, KeyCorp, could lose 38 percent. GMAC, blessedly, is one of the banks without such a portfolio.
Those are not forecasts of the most likely outcome. The government certainly hopes that its negative prospect will not come to pass. But the figures do provide a commentary on just how out of control easy credit became. That is clearly an indictment of the managements that made the loans, and of the regulators that stood by as lending standards reached historic lows. The government did not provide percentages for additional losses on securities owned by the banks, but it did give dollar estimates that added to $135 billion, most of that coming from the banks that have large investment banking operations — Bank of America, Citigroup, JPMorgan, Morgan Stanley and Goldman Sachs.
If those are worst case numbers, most of the losses from that area have already been taken by the banks. But it is worth noting that some banks have been loudly complaining that accounting rules calling on them to use market values forced them to report losses that greatly exceed the amount they could conceivably lose. Regulators disagree. The government does not want us to think the need for more capital indicates that these banks are undercapitalized now, or were even more undercapitalized before the current crisis erupted. "These examinations were not tests of solvency," said Ben S. Bernanke, the Federal Reserve chairman. "We knew already that all these institutions meet regulatory capital standards." Of course, if those standards had been good ones, we would not have gotten into this mess. There are international efforts underway to improve bank capital standards, but they will not be nearly as tough as the stress tests were.
Nor are there plans to do more stress tests in the future, on these institutions or on smaller ones. With luck, the public may conclude that, this time, the government really is on top of the situation, so that when it says a bank is O.K., it is really O.K. That confidence was critical in 1933, when President Roosevelt closed the nation’s banks for a "holiday" and then allowed well-capitalized banks to reopen quickly. Did the government really know? No. But it worked. Money that had fled banks and gone into mattresses returned to the banking system. "It’s not really clear how much they looked through the books," Mr. Bernanke told a Congressional hearing in February, when the stress tests were announced. "But when they opened them up again, people felt much more comfortable, more confident in the banks."
It is not so simple this time around, and not just because people are less willing to assume the government is right. The faith of small depositors in the Federal Deposit Insurance Corporation, which insures deposits up to $250,000, remained strong in this financial crisis, so there is not a lot of money in mattresses awaiting re-deposit. But confidence wavered among some who are not assured of F.D.I.C. protection, whether they were depositors in foreign branches or investors in bonds issued by the banks. Most important, confidence vanished among banks themselves after the government let Lehman Brothers fail in September. Banks were no longer sure which other banks they could trust, so they trusted no one. A modern financial system cannot function under those circumstances, and an American recession rapidly spread around the world.
Those fears have eased, and these banks will now have something approaching a government seal of approval, or at least they will have one as soon as they have raised the required capital, even if it comes from the government. But there will be no stress tests — and thus no seals of approval — for smaller banks. There could be a risk that some analyst or bank will look at the losses that one of the major banks might face on some category of loans, and conclude that similar losses could be in store for certain smaller institutions that employed similar strategies but are not too big to fail. If those banks run into financing problems, a new round of fears could begin. For now, the stress tests seem to have had their intended effect, of easing worries about the banking system. That will help, but in the end it will be the economy, and the actual losses, that determine how quickly the financial system recovers.
Geithner Bets U.S. Can Avoid Japan Trap Through Bank Earnings
Treasury Secretary Timothy Geithner is betting that U.S. banks can do something their Japanese counterparts were unable to accomplish in that country’s "lost decade" of the 1990s: earn their way out of trouble. The stress-test results released yesterday by regulators found that the 19 largest banks face a $74.6 billion capital hole that may be filled mostly by private money. That compares with the hundreds of billions of dollars seen by outside analysts, including the International Monetary Fund, and takes into account banks’ projected earnings over the next two years. The "stress-test results are an important step forward," Geithner said in a statement announcing the results. "Americans should know that the government stands behind the banking system and that their deposits are safe."
Still, the strategy carries risks for Geithner, 47, who served as a Treasury attaché to Japan from 1989 to 1991. If he’s wrong about the banks’ ability to weather the worst recession in at least half a century, the U.S. may just be postponing the day of reckoning when institutions will have to be shut down and taken over by the government. "This looks like Japan in 1998, when they didn’t spend enough money on the banks," said Adam Posen, deputy director of the Washington-based Peterson Institute for International Economics. "They then ended up back in crisis in 2001." So far, Geithner’s gamble is paying off. Bank stocks have surged in recent weeks as investors bet the stress tests would give the lenders a clean bill of health. The Standard & Poor’s 500 Financials Index reached its highest level in four months on May 6 as the test results leaked out, before slipping 5.8 points yesterday to 162.3.
Geithner said the strategy was designed to ease the uncertainty that drove bank shares down earlier this year. By exposing the lenders to uniform tests and then publicizing the results, he hoped to reassure investors that their worst fears about the future of the banking system were unfounded. Regulators led by the Federal Reserve found that nine of the 19 biggest banks, including Goldman Sachs Group Inc. and JPMorgan Chase & Co., don’t need more capital. Bank of America Corp. has the biggest hole -- $33.9 billion -- followed by Wells Fargo & Co., with $13.7 billion. Banks that need to bolster capital have until June 8 to develop a plan and until Nov. 9 to implement it. Geithner told reporters that regulators took a conservative approach to toting up potential credit losses and calculating the industry’s ability to absorb them through increased earnings. The forecast of future profits was at the "quite low end of analysts’ expectations," he said.
The results showed that losses at the banks under "more adverse" economic conditions than most economists anticipate could total $599.2 billion over two years. Mortgage losses present the biggest part of the risk, at $185.5 billion. Jan Hatzius, chief U.S. economist at Goldman Sachs in New York, said banks may be able to rack up enough earnings over the next two years to cover virtually all the remaining credit losses. The contraction of the financial industry over the last year, including the demise of Bear Stearns Cos. and Lehman Brothers Holdings Inc., has put those that have survived in a better position to post profits, he said. With the economy showing signs of being close to a bottom, some of the banks may even end up being overcapitalized, added Sung Won Sohn, an economics professor at California State University in Camarillo, California.
Critics remain unconvinced and charge that the regulators went too easy on the banks in conducting the tests, which were designed to ensure the firms could keep lending even if the economy deteriorated more than most economists expect. Examiners used an "adverse scenario" of a 3.3 percent contraction in the economy this year, and an average unemployment rate of 8.9 percent in 2009 and 10.3 percent in 2010. Economists see a 2.5 percent drop in output this year, and unemployment rates of 8.9 percent in 2009 and 9.4 percent in 2010, according to a Bloomberg News survey. "The stress was not much of a stress," said Joseph Stiglitz, a Nobel Prize winner in economics and professor at Columbia University in New York. Skeptics of the plan such as Posen said Geithner was trying to make a virtue out of a necessity. With public opposition to bank bailouts high, the Treasury secretary felt constrained from asking Congress for more money to help the industry. Treasury has about $110 billion left in the $700 billion bank-rescue package approved by lawmakers last year.
Geithner said the Treasury had enough money remaining in the Troubled Asset Relief Program to cover the banking industry’s needs. Still, he made clear that President Barack Obama wouldn’t hesitate to ask Congress for more should that prove necessary. It was public opposition to bank bailouts that prevented Japanese policy makers from taking more forceful action to aid the country’s financial industry in the 1990s. Like the U.S., Japan at first responded by putting capital into the banks, in 1998 and 1999. The crisis wasn’t fully resolved until 2002, after the government forced the banks to write down or sell off bad loans and effectively nationalized one institution, according to Takeo Hoshi, dean of the School of International Relations and Pacific Studies at the University of California at San Diego. "I find more and more similarities to Japan as the situation develops here," he said.
Geithner is counting on yet-to-be launched public-private partnerships to buy up the impaired assets that remain on bank balance sheets. The partnerships will be financed by low-cost credit via the Fed and the Federal Deposit Insurance Corp. R. Glenn Hubbard, a former chief White House economist under President George W. Bush, voiced doubts the partnerships would work and argued that more dramatic action -- and taxpayer money -- will be needed to fix the financial system. "Some more radical solution is going to be in order," such as dividing troubled institutions into so-called good banks and bad banks, said Hubbard, who is now dean of the Columbia University Graduate School of Business in New York. Kenneth Rogoff, a former IMF chief economist who’s now at Harvard University in Cambridge, Massachusetts, also said he fears the administration isn’t being forceful enough. Like Japan in the 1990s, Obama has put forward a big fiscal stimulus program to try to get the economy moving again, yet may have been too cautious in acting to repair the financial system. "If the banking plan still falls short, the fiscal stimulus will have been wasted to some extent," Rogoff said. "We could end up like Japan, sliding in and out of recession."
Guidelines Could Make Repaying TARP Difficult Even for 'Healthy' Banks
Some big banks could have a harder time repaying their government bailout money under a draft of new Treasury guidelines, an industry official said, even if they have plenty of cash and were judged "healthy" under the government’s stress tests. The Treasury released the six-page set of guidelines on its Web site Friday afternoon, after having given a four-page draft to banks after regulators released the stress test results on Thursday. The draft had earlier in the day been obtained exclusively by FOX Business. The guidelines include specific requirements for banks that want to repay funds they received through the Capital Purchase Program, which was the Bush Administration’s bank investment plan under the Troubled Asset Relief Program.
The document says regulators "will carefully weigh an institution’s desire to redeem outstanding CPP preferred stock against the contribution of Treasury capital to the institution’s overall soundness, capital adequacy and ability to lend, including confirming that the institution has a comprehensive internal capital assessment process." Treasury officials have previously discussed such requirements. Also, Treasury doesn’t want TARP repayments to constrict the results of the stress test, also known as the Supervisory Capital Assessment Program, or SCAP. Nine banks did not require extra capital under the test, but regulators are concerned that if any of them repay TARP money, the repayments could cut a bank’s capital levels to below new minimum thresholds.
The test forced the nation’s 19 biggest bank holding companies to estimate loan and asset losses assuming a much deeper recession for two years. As a result of the test, regulators ordered 10 banks to create capital "buffers" -- $75 billion in total. The other nine companies escaped the order because supervisors ruled their capital already exceeded new minimum levels they set as part of the test. The draft guidelines indicate the Treasury wants to keep it that way for perhaps most of the nine. "The 19 (bank holding companies) that were subject to the SCAP process must have a post-repayment capital base at least consistent with the SCAP buffer," Treasury said in the document.
Finally, referring to a temporary program at the Federal Deposit Insurance Corporation that insures bank debt against default, the guidelines said a bank that wants to repay its TARP money "must be able to demonstrate its financial strength by issuing senior unsecured debt for a term greater than five years not backed by FDIC guarantees, in amounts sufficient to demonstrate a capacity to meet funding needs independent of government guarantees." This condition was announced by officials earlier this week. An American Bankers Association executive said bankers are worried the guidelines will give regulators plenty of leeway to deny TARP repayment applications.
"Our worry all along is that TARP is a lobster trap -- easy to get into but hard to get out of," said Wayne Abernathy, an ABA executive vice president. "And each time there is a new discussion by the Treasury of what this involves, there seems to be some new little piece that’s not well-defined and could make it hard for banks to get out. The new piece we’re seeing now is, ‘we want you basically to be able to demonstrate that you can perform after you give back the money just as well as you did before,’ and they list things like lending and other sorts of activities, but they leave it kind of vague."
Goldman Sachs, JPMorgan Chase and several other banks among the top 19 firms have announced they plan to repay TARP funds as soon as possible. Treasury Secretary Timothy Geithner has said he expects banks to repay $25 billion of TARP funds -- or more -- soon. The guidelines also update Treasury rules for banks that may apply for government funding in the future through the Obama Administration’s Capital Assistance Program. A Treasury representative said, "We continually seek to be responsive to the needs of participants of the program while ensuring taxpayers are fairly compensated for these investments."
Fannie Mae Posts $23.2 Billion Quarterly Loss, Seeks $19 Billion in Treasury Capital
Fannie Mae, operating under a federal conservatorship since September, asked the U.S. Treasury for a $19 billion capital investment as a seventh straight quarterly loss drove the mortgage-finance company’s net worth below zero. A wider first-quarter net loss of $23.2 billion, or $4.09 a share, pushed the company to request its second draw from a $200 billion funding commitment from the government, Washington- based Fannie Mae said in a filing today with the Securities and Exchange Commission. The company took $15.2 billion March 31. The credit quality of loans and mortgage bonds that Fannie Mae owns or guarantees continued to deteriorate as a yearlong economic recession pushed more homeowners into foreclosure. A record 803,489 U.S. properties received a default or auction notice or were seized in the first quarter, 24 percent more than a year earlier, as employers cut jobs and temporary programs to assist homeowners came to an end, RealtyTrac Inc. said April 16.
Fannie Mae and smaller competitor Freddie Mac, which own or guarantee almost half of the U.S. residential mortgage debt, are integral components of President Barack Obama’s plan to modify or refinance loans for as many as nine million homeowners amid a rise in delinquencies. In February, the government doubled its emergency capital commitment for each company from $100 billion, which the Treasury makes through preferred stock purchases. McLean, Virginia-based Freddie Mac tapped $13.8 billion in aid in November and $30.8 billion last month as the value of its assets dropped below the amount it owed on obligations. Fannie Mae said its net worth, or the difference between assets and liabilities, fell to negative $18.9 billion as of March 31, from $15.2 billion on Dec. 31, and $9.4 billion on Sept. 30, according to company statements.
Fannie Mae and Freddie Mac are the largest U.S. mortgage- finance companies, owning or guaranteeing about $5.3 trillion of the $12 trillion home-loan market. The Federal Housing Finance Agency put the companies under its control Sept. 6 and forced out management after examiners said the two may be at risk of failing amid the worst housing slump since the Great Depression. The company increased reserves for future credit losses to $41.7 billion last quarter from $24.8 billion in the fourth quarter. Fannie has posted net losses totaling almost $87 billion since the third quarter of 2007. The amount of nonperforming loans that Fannie Mae guarantees for other investors rose to $121.5 billion after doubling to $98.5 billion at the end of the fourth quarter from the third quarter, according to the filing. The nonperforming loans that Fannie Mae owns jumped to $23.5 billion from $20.7 billion in the fourth quarter.
The fair value of Fannie Mae’s assets fell to negative $110.3 billion last quarter, compared with $105.2 billion in the fourth quarter. Fannie Mae and Freddie Mac shares, which were above $30 in March, have been trading at less than $1 since December. Fannie Mae closed at 88 cents yesterday in New York Stock Exchange composite trading, while Freddie finished the day at 91 cents. Fannie Mae was created in the 1930s under President Franklin D. Roosevelt’s "New Deal" plan to revive the economy. Freddie Mac was started in 1970. The companies were designed primarily to lower the cost of home ownership by buying mortgages from lenders, freeing up cash at banks to make more loans. They make money by financing mortgage-asset purchases with low-cost debt and on guarantees of home-loan securities they create out of loans from lenders.
Obama budget keeps Fannie/Freddie at arm's length
President Barack Obama's budget proposal for 2010 tallies up the federal aid granted to Fannie Mae and Freddie Mac but does not bring those mortgage-finance companies' obligations fully onto federal books. "They are not included in the Federal Budget because they are private companies, and their securities are not backed by the full faith and credit of the Federal Government," according to budget documents released on Thursday. In September, Fannie Mae and Freddie Mac were effectively nationalized when the government promised to by up to $100 billion preferred shares in each company and created warrants to severely dilute existing shareholders.
Freddie Mac Pressured Over Accounting Disclosure
When Freddie Mac privately suggested to regulators last month how it planned to account for its mounting losses, the mortgage giant set off a firestorm. Freddie Mac's regulator pressed the company to withhold information related to the proposal from a federal filing, concerned that this seemingly arcane discussion of accounting practices could add billions of dollars to the government's cost of bailing out financial firms, two people familiar with the matter said. But the company's executives refused, the sources said. They worried that removing the information from the report to the Securities and Exchange Commission could expose them to accusations they'd hid required details from regulators.
The dispute between the mortgage giant and the Federal Housing Finance Agency was the latest since the federal government took over McLean-based Freddie Mac and its larger sister, District-based Fannie Mae, in September, enlisting the companies in the campaign to revive the housing market and pledging to cover their losses. The transition has proven awkward for companies that are still, in part, privately owned by investors. In the middle of this debate was David B. Kellermann, Freddie Mac's acting chief financial officer who died in an apparent suicide on April 22. Kellermann, who had spent years reworking Freddie Mac's accounting after a scandal earlier this decade, "felt pressured" to withhold information that he felt he had a duty to provide, said a person knowledgeable of his tenure at the company. While several people familiar with Kellermann's final days said he took the clash with regulators personally, investigators have offered no indication that this contributed to his death. He left no note, law enforcement sources said, and no motivation has been disclosed.
Freddie Mac and Fannie Mae were seized last year after the Treasury Department determined that increasing losses at the firms posed a risk to the wider financial system. Together, the two companies have received nearly $60 billion from the government to shore up their health. In March, Freddie Mac executives, including Kellermann, had tussled with FHFA over whether to disclose to investors that government management was undermining profitability and may cost the company about $30 billion, sources familiar with the dispute said. The regulator had urged Freddie not to do so, three sources said. The company threatened to appeal to the SEC and ultimately disclosed the possible cost. An FHFA official has said that it did not try to prevent the disclosure.
This potential expense was related to the Obama administration's housing recovery program, for which Freddie Mac playing a part in modifying the mortgages of homeowners facing foreclosure. Many of these loans had been bundled into securities. So to modify the mortgages, Freddie Mac has to pluck them out of the securities, which entails reassessing the value of the loans and marking them down to their current market price. The company might then have to record a charge to reflect these decreased values. Based on Dec. 31 figures, Freddie Mac said it might have to incur "an initial pre-tax charge" of $30 billion. That loss would be covered by taxpayer dollars.
But whether to disclose this potential cost wasn't the company's only recent battle with its regulator. Freddie Mac later concluded that it would not have to take the loss after all, two sources said. But the company wanted confirmation from the SEC that this accounting approach was correct. The sources for this article spoke on condition of anonymity to protect their jobs. Spokesmen for the two mortgage finance companies and FHFA declined to comment. Kellermann prepared a memo to the SEC known as a "pre-filing," sources recounted. In this document, Freddie Mac would discuss its interpretation of accounting regulations, explain why the firm wouldn't need to take the charge and review other possible accounting interpretations. FHFA, which reviews the firm's contacts with the SEC, became concerned, [a] source said. That's because one of the alternate accounting methods that Freddie Mac planned to review was the one currently used at Fannie Mae. Freddie Mac was preparing to argue it could not use this accounting method. According to sources, officials at FHFA and Fannie Mae worried that such a claim could lead the SEC to question whether Fannie Mae was doing its accounting properly.
Fannie Mae was also involved in carrying out the administration's housing efforts and, using separate reasoning, had also concluded it would not have to take a charge. If Fannie Mae after all did have to report the loss, the tab to the taxpayers would run into the billions of dollars. FHFA asked Freddie Mac to submit a "pre-filing" to the SEC that did not discuss other alternate accounting methods, but only its own, sources said. Kellermann and Freddie Mac's accounting team refused, afraid that sending such a memo could open up the company and its employees to allegations of impropriety. Asked to comment on whether companies are required to review alternative methods in such filings, the SEC referred a reporter to the agency Web site. It says: "Staff is able to provide the clearest guidance when companies provide a written submission outlining the factual details, accounting considerations, financial statement impact, as well as the disclosures expected to accompany the accounting." Among those details is an "outline of the possible alternative answers considered and rejected."
Lynn Turner, a former SEC chief accountant, said withholding that information "certainly exposes them to the SEC coming back and saying, 'Hey, you didn't give us all the facts. Therefore, if we had known all the facts, we might have come to another conclusion.' " He added, "If they withheld that information from the SEC, I would say it would be very misleading." Freddie Mac, Fannie Mae and FHFA negotiated for several weeks about the contents of the filing before reaching an agreement, according to sources. Freddie Mac would say that its own approach was the right one. But Freddie Mac would also say that its interpretation should not invalidate Fannie Mae's continuing use of its own approach. The SEC got back in touch on April 21. It agreed. Freddie Mac wouldn't have to take the charge, nor would Fannie Mae. Most of the accounting team at Freddie Mac was gratified with the result, sources recalled. But Kellermann didn't seem allayed, a person who saw him said.
Beware of the sucker’s rally
The market is a cruel mistress indeed. Compounding the pain of big swoons, it kicks investors when they are down by luring them into sucker’s rallies – typically sharp but fleeting bounces in the middle of a bear market. The current recovery has propelled the S&P 500 a third above its March low in just 60 days, convincing many sceptics that a new bull market has begun. Noted bear Doug Kass of Seabreeze Partners said the recent nadir may be a "generational low" and strategist Tobias Levkovich of Citigroup claimed many large investors who had feared another bear market rally may soon capitulate, pushing markets higher.
The Bull Market Express may really be pulling out of the station, but Wall Street’s trains have a nasty tendency to derail just as passengers jostle for seats. Most recently, the S&P 500 soared 24 per cent over seven weeks ending in early January, only to plunge to a new low. It was a fairly typical sucker’s rally and bear markets often need more than one to create sufficient disillusionment for a definitive bottom. The 2000–2002 bear market had three, with average gains of 21 per cent in the Dow Jones Industrials over 45 days. The granddaddy of all bear markets, 1929 –1932, had six false alarms with an average gain of 47 per cent. And Japan’s ongoing bear saw the Nikkei rise by at least a third four times in its first four years with 10 more false dawns since then.
Bear markets typically end with a whimper rather than a bang, casting doubt on the latest recovery according to Hussman Econometrics, which analysed numerous US market bottoms and bear market rallies. With the exception of the 1987 crash, the month before the lowest point of a downturn saw a gradual descent. By contrast, bear market rallies were preceded by steeper declines and had sharper rebounds. Another characteristic of bear market rallies has been modest volume on the rebound compared to the decline. The current recovery fits the pattern of bear market rallies in terms of volume and the "V" shape of the trough. Analysts at Bespoke Investment Group noted that there have been only seven other periods in the past 110 years with rallies of similar magnitude for the Dow. Three preceded the Great Depression, three came during the Depression and one in 1982.
That last example is a hopeful one as it kicked off the greatest bull market of all time. Expectations of a sustainable rebound have been helped by the fact that US stocks touched a 13-year low in March. But this was also the case in 1974, the start of a long rally – technically a bull market – that lost steam after a 73 per cent gain in two years. It would take four more years to reach the 1973 high and two more, the start of the 1982 bull market, to break decisively higher. An authority on bear market bottoms, Russell Napier of CLSA sees a 1974-1976 scenario unfolding followed by an even worse slump. In Anatomy of the Bear, he scanned media coverage around the bottoms of 1921, 1932, 1949 and 1982 and does not see the apathy that characterised those turning points. "For the great bear market bottoms, you need a society-wide revulsion with equities," he said. "It just doesn’t smell like the big one yet."
Stocks also become incredibly cheap before major bull markets begin. Yale University Professor Robert Shiller notes that all four big bubbles of the 20th century saw stocks exceed 25 times cyclically-adjusted earnings and trough between 5 and 8 times. On this measure, the 2000 bubble never fully deflated and even the recent low did not breach 11 times. For what it is worth, the US market’s best-informed participants do not find valuations compelling. April saw the lowest level of insider buying (by people associated with the company) ever recorded by research firm TrimTabs with insider selling 14 times as high. Likewise, companies sold 64 per cent more shares than they bought in April. This last point though may be a contrarian indicator of a true bull market. Corporate America hardly displayed prescience prior to the bust, after all.
Sorry, We're Still Screwed
Yesterday, we explained why Jeremy Grantham, a former bear, is now a short-term bull. Basically, he thinks the fire-hose of stimulus will drive stocks (if not the economy) up another 10%-20% by the end of the year. But please note the emphasis on "short-term."
After our current rocket rally plays itself out, Grantham thinks, the market will once again crash and then stay in the dumps for at least seven years.
Because of the massive declines in our net worth, our debt problem, and compression of price-earnings ratios. Specifically, we've lost our shirts and we feel poor--which isn't conducive to profligate spending. We still need to get rid of $10-$12 trillion of debt. This debt-reduction process will pressure profit margins (lower leverage) and pressure spending--because we'll have to save more instead of spending it. We'll also need inflation to reduce the real burden of the debt.
Stocks, meanwhile, have actually climbed back to fair value (900 on the S&P). And after long periods of over-valuation (the last 15 years), we're due for a long period of under-valuation.
Here's Grantham (full quarterly letter embedded here):
For the biblical record, Joseph, consigliere to the Pharaoh, advised him that seven lean years were sure to follow the string of bountiful years that Egypt was then having. This shows an admirable belief in mean reversion, but unfortunately the weather does not work that way. It, unlike markets, really is random, so Joseph’s forecast was like predicting that after hitting seven reds on a roulette wheel, you are likely to get a run of blacks. This is absolutely how not to make predictions unless, like Joseph, you have divine assistance, which, frankly, in the prediction business is considered cheating. Now, however, and deﬁ nitely without divine help but with masses of help from incompetent leadership, we probably do face a period that will look and feel painfully like seven lean years, and they will indeed be following about seven overstimulated very fat ones.
Probably the single biggest drag on the economy over the next several years will be the massive write-down in perceived wealth that I described brieﬂy last quarter. In the U.S., the total market value of housing, commercial real estate, and stocks was about $50 trillion at the peak and fell below $30 trillion at the low. This loss of $20-$23 trillion of perceived wealth in the U.S. alone (although it is not a drop in real wealth, which is comprised of a stock of educated workers and modern plants, etc.) is still enough to deliver a life-changing shock for hundreds of millions of people.
No longer as rich as we thought – under-saved, under-pensioned, and realizing it – we will enter a less indulgent world, if a more realistic one, in which life is to be lived more frugally. Collectively, we will save more, spend less, and waste less. It may not even be a less pleasant world when we get used to it, but for several years it will cause a lot of readjustment problems. Not the least of these will be downward pressure on proﬁt margins that for 20 years had beneﬁted from rising asset prices sneaking through into margins.
Closely related to the direct wealth effect is the stranded debt effect. The original $50 trillion of perceived wealth supported $25 trillion of debt. Now, with the reduced and more realistic perception of wealth at $30 trillion combined with more prudent banking, this debt should be cut in half.
This unwinding of $10-$12 trillion of debt is not, in my opinion, as important as the loss of the direct wealth effect on consumer behavior, but it is certainly more important to the ﬁnancial community. Critically, we will almost certainly need several years of economic growth, which will be used to pay down debt. In addition, we will need several years of moderately increased inﬂation to erode the value of debt, plus $4-$6 trillion of eventual debt write-offs in order to limp back to even a normal 50% ratio of debt to collateral. Seven years just might do it.
Another factor contending for worst long-term impact is the severe imbalance between overconsuming countries, largely the U.S. and the U.K., and the overproducing countries, notably China, Germany, and Japan. The magnitudes of the imbalances and the degree to which they have become embedded over many years in their economies do not suggest an early or rapid cure. It will be hard enough to get Americans to save again; it will be harder still to convince the Chinese, and indeed the Germans and the Japanese too, that they really don’t have to save as much. In China in particular they must ﬁrst be convinced that there are some social safety nets.
A lesser factor will be digesting the much shrunken ﬁnancial and housing sectors. Their growth had artiﬁcially and temporarily fattened proﬁt margins as had the general growth in total debt of all kinds, which rose from 1.25x GDP to 3.1x in 25 years. The world we are now entering will therefore tend to have lower (more realistic) proﬁt margins and lower GDP growth. I expect that, at least for the seven lean years and perhaps longer, the developed world will have to settle for about 2% real GDP growth (perhaps 2.25%) down from the 3.5% to which we used to aspire in the last 30 years. Together with all the readjustment problems and quite possibly with some accompanying higher inﬂation, this is likely to lead to an extended period of below average P/Es.
WHAT THIS MEANS FOR THE MARKET
As I have often written, extended periods of above average P/Es, particularly those ending in bubbles, are usually followed by extended periods of below average P/Es. This is likely to be just such a period and as such historically quite normal. But normal or not, it makes it very unlikely with P/Es, proﬁt margins, and GDP growth all lower than average that we will get back to the old highs in the stock market in real terms anytime soon – at least not for the seven lean years – and perhaps considerably longer.
To be honest, I believe that most of you readers are likely to be grandparents before you see a new inﬂ ation-adjusted high on the S&P.
If we are looking for any further drawn-out negatives, I suspect we could add the more touchy-feely factor of conﬁdence. We have all lost some conﬁ dence in the quality of our economic and ﬁ nancial leadership, the efﬁciency of our institutions, and perhaps even in the effectiveness of capitalism itself, and with plenty of reason. This lack of conﬁdence will not make it easier for animal spirits to recover. This does not mean necessarily that we haven’t already seen the low, for, in my opinion, it is almost 50/50 that we have. It is more likely to mean a long, boring period where making fortunes is harder and investors value safety and steady gains more than razzle dazzle. (The ﬂaky, speculative nature of the current rally thus bears none of the characteristics that I would expect from a longer-term market recovery.)
The VL Recovery
So we’re used to the idea of a preferred V recovery and the dreaded L-shaped recovery that we associate with Japan. We’re also familiar with a U-shaped recovery, and even a double-dip like 1980 and 1982, the W recovery. Well, what I’m proposing could be known as a VL recovery (or very long), in which the stimulus causes a fairly quick but superﬁcial recovery, followed by a second decline, followed in turn by a long, drawn-out period of sub-normal growth as the basic underlying economic and ﬁnancial problems are corrected.
Toyota Posts Huge Annual Loss, Worst Ever
Toyota Motor booked its worst annual net loss ever Friday and warned that it would plunge even deeper into the red this year, a stunning reversal for an automaker whose breakneck expansion and record profits seemed unstoppable just 12 months ago. The Japanese automaker said it lost ¥765.8 billion, or $7.7 billion, in the first three months of the year — even more than the $5.9 billion lost by its near-bankrupt American rival, General Motors, in the same period.Toyota blamed its woes on the slump in global demand and a strong yen, which makes exports from Japan more expensive. The devastating numbers from the fourth fiscal quarter contributed to a worse-than-expected ¥436.9 billion net loss for the year that ended in March.
The automaker warned it would lose ¥550 billion this fiscal year. It reduced its annual dividend by nearly 30 percent, its first cut to the dividend in at least 15 years. "It will take more time before the financial markets in the U.S. and Europe normalize and the global economy recovers," Toyota’s president, Katsuki Watanabe, said Friday. "We were lacking in scope and speed in dealing with various problems and for that I am sorry." The deep losses mark a stark turnabout from the record profit of ¥1.72 trillion Toyota booked the previous year. Annual sales slumped 22 percent to ¥20.529 trillion. The loss also caps a roller-coaster year for Toyota, which in 2008 dethroned G.M. in terms of vehicles sold worldwide, a post the Detroit-based automaker had held for 77 years.
Analysts say Toyota has strong cash reserves, and is far from the bankruptcy that has claimed the American carmaker Chrysler and that threatens General Motors. Despite a $15.4 billion infusion in U.S. government loans, General Motors burned through about $10 billion in the first quarter, driving its cash reserves down to a bare minimum and putting it on the brink of collapse. Still, Standard & Poor’s, the ratings agency, on Friday lowered its long-term credit rating on Toyota a notch to AA, the third-highest rating, and gave a "negative" outlook for the company. "Toyota maintains a minimal financial risk profile, characterized by a strong capital structure with massive liquidity," Standard & Poor’s said in a statement. But with auto demand forecast to remain sluggish into 2010, Toyota will likely struggle before it can stage a recovery, Standard & Poor’s said.
Toyota’s latest forecast paints a grim picture for the year ahead. Toyota has been hit hard in its biggest market, the United States, where sales have plunged and show few signs of recovering. In April, Toyota sold 126,540 cars in the United States — a 42 percent drop from a year earlier — slipping behind Ford Motor, which sold almost 130,000 cars. Toyota has also suffered double-digit percentage drops in Japan as well as in China, where it is losing out to rivals with a wider lineup of smaller cars that have surged in popularity. Toyota sold 7.56 million vehicles in fiscal 2008, down from 8.91 million units in its blockbuster 2007. Toyota said it expected its global unit sales to fall about 14 percent, to 6.5 million vehicles, in the year ending in March 2010. To cope with the slump, Toyota has made sharp production cuts across its 74 global assembly lines, laid off about 6,000 temporary workers in Japan and sharply cut pay for its managers.
Rapid expansion earlier this decade, fueled by record profits, has meant Toyota faces higher fixed costs compared with many of its rivals. Some critics say Mr. Watanabe misjudged the seriousness of the economic downturn, pushing ahead with projects like a new factory in Mississippi to build more Priuses. A surge in the value of the yen last year has also eroded Toyota’s overseas earnings, and bloated costs at home. The company says it will cut fixed costs by 10 percent, or roughly $5 billion, this fiscal year, through salary cuts, reduced hours for its workers and other measures. Toyota plans to reduce capital spending by delaying new projects until demand recovers. The company has so far held off from laying off permanent workers, who enjoy lifetime employment guarantees. Toyota says that guarantee is a key part of its "kaizen" management principle, in which workers are required to constantly suggest ways to be more productive. But some analysts question how long Toyota can hold off from deeper cuts.
Toyota is counting on its third-generation Prius hybrid, which will be unveiled later this month in Japan, to buoy sales. But the automaker faces stiff competition from its Japanese rival, Honda Motor, whose low-cost Insight hybrid is expected to eat into Toyota’s market share. In a filing with the Japanese Finance Ministry, it indicated it may sell as many as ¥700 billion in bonds in the next two years, Bloomberg news reported. The automaker is also rallying around its iconic founding family, tapping Akio Toyoda, the company founder’s grandson, to replace Mr. Watanabe next month. Mr. Toyoda has said he will focus on "green" technology like hybrids and plug-in electric vehicles to bring about a long-term recovery. The automaker could also benefit from Japanese government stimulus efforts. Last month, officials unveiled a so-called cash-for clunkers program under which car owners who upgrade to "green" vehicles from cars that are at least 13 years old will receive government subsidies. Toyota’s numbers stand in contrast to its smaller rival, Honda, which lost $1.9 billion in the first three months of 2009 but eked out a net profit for the year that ended in March. Toyota shares closed down 1.5 percent at ¥3,980 on the Tokyo Stock Exchange before earnings were announced.
Painful lessons for lenders in Chrysler debacle
George Schultze will think twice before lending to another troubled company such as Chrysler. Schultze is one of a group of dissident Chrysler creditors who was rebuked by the US president and other lawmakers for tipping the company into bankruptcy. He rejected an offer aimed at slashing Chrysler’s debt in order to allow the carmaker to be sold. Schultze and other investors - some of whom claim to have received death threats - say the deal is unfair because it does not honour their rights as senior lenders to get paid before other claims, such as a union benefit plan, are met. They also argue that the deal was orchestrated by the US government, which held sway over the majority of the other lenders, namely a group of banks, following widespread bail-outs.
The question of whether the Chrysler creditors got a raw deal will be decided in a New York bankruptcy court over the next few weeks. Already, the verdict on Wall Street and in the conference rooms of investment firms round the country is that, at the very least, the situation raises questions about the solidity of time-honoured lending principles and parts of the bankruptcy code. These rules dictate the pecking order for claims to be repaid when a company files for Chapter 11. "It will increase the cost of credit in the capital markets for lots of companies by tinkering with the well-settled priority system," Schultze said. "Our firm and many other lenders will think twice about lending to companies who have junior creditors that might get an unfair sweetheart deal."
The Chrysler saga comes on the back of concerns by mortgage investors that they, too, are having to take losses they had thought would be absorbed by other creditors. The government has made it easier for people to modify mortgages in an effort to mitigate foreclosures, but investors say the details of new laws in effect push them down the pecking order. Mortgage investors, ranging from hedge funds to pension funds, owning the higher-ranking - or first lien - debts have already blitzed lawmakers, and some are considering taking legal action against the government. Worries about the sanctity of contracts and claims in the US could become a more widespread issue that makes less credit available and raises borrowing costs for companies in general. "Given that so much of total borrowing across all asset classes is first lien in nature, the damage that would occur to the economy as a result of higher first lien borrowing costs resulting from lenders requiring a higher return to compensate them for an unknown interpretation of claim priorities could be substantial," says Curtis Arledge, co-head of US fixed income at BlackRock, Inc.
"Many lenders make loans by being investors in US financial markets where contract law has been sacrosanct, and deviation from that could have far-reaching implications to the US economy." The situation exacerbates the unease that has held some investors back from participating in government schemes such as the term asset-backed securities loan facility and the public-private investment programme, which are aimed at boosting the availability of credit and removing toxic assets from banks’ books. "It is particularly important at this stage of the distressed cycle for lenders to have confidence in pre-existing contracts and rules. We are entering a period of record corporate defaults and the need for bankruptcy financing and financing for distressed companies will only continue to grow," says Greg Peters, global head of credit research at Morgan Stanley. In the Chrysler case, the senior debtholders say they are taking losses while other unsecured creditors, such as the United Autoworkers Union, are getting paid even though the senior debt has a first lien on the company’s assets.
A harmful hedge-fund fixation
by Gillian Tett
Almost exactly two years ago, at the craziest peak of the credit bubble, Western leaders gathered in a conference room at the World Bank in Washington to discuss what they should do about the financial world. These days it is clear what those grandees ought to have discussed – notably the wild excesses afoot in subprime lending, structured credit, monoline insurance, credit ratings and bank leverage. In practice, though, those issues were barely discussed. Instead, the hot topic for debate in that April 2007 meeting (as I describe in a book published this month) was how to clamp down on hedge funds – a topic dear to German leaders, who were chairing the G7 at that point. "It was really hard to get anything apart from hedge funds on the agenda back then," laments one international bank regulator, who tried – and failed – to divert the debate onto more pressing matters.
These days, there is an unnerving sense of déjà vu bubbling in some political quarters of Europe. Over in America the financial community is currently consumed with the matter of banking stress tests.
In London, however, there is another hot topic worrying financiers – what Brussels plans to do about hedge funds. Last week the European Commission shocked the City of London by unveiling plans to impose potentially tough new controls on the hedge fund and private equity industry. The European parliament bayed for more. Then, this week the French government warned that they might strengthen these measures, apparently because they, like many other Continental leaders, think that lax hedge fund controls have sparked the recent crisis. In fairness, some of these calls for a clampdown are not ridiculous. Regulators need to get better information about what the hedge fund world is doing, and to prevent the abuse of off-balance sheet entities. There is also a strong case to reduce the scale of tax avoidance associated with the hedge fund sector.
But the real danger with the current debate – as two years ago – is that it risks missing the wider point. For sure, some unregulated hedge funds have taken crazy risks in recent years. And unregulated shadow banks have also messed up. But what has made the current crisis so disastrous is the behaviour of large, regulated banks, which have spent the last decade operating with ridiculously high levels of leverage, and purchasing vast quantities of toxic assets. And the only thing more remarkable than the scale of those bank follies is that they went unnoticed for so long, partly because many regulators spent the last decade so obsessed with hedge funds. Pace that Washington G7 meeting in the spring of 2007. Given that, it seems self-evident that the real priority now in Europe is to ask hard questions about banks – and bank regulation. If I was a German voter, for example, I would want to know why nobody in Frankfurt tried to stop German banks from dashing into structured finance on such a spectacular scale – and why the only people who ever warned of those dangers before the summer of 2007 were investors who went short (ie, the hedge funds.)
I would also want to know why rumours remain widespread that German banks are still holding vast quantities of toxic assets which have been barely marked to market value. And why not ask what the German government will do if it turns out that the entire German system is insolvent (as the German press has recently suggested after leaked documents suggested German regulators privately fear that their banks hold over €800bn of toxic and illiquid assets.) Such questions, let me stress, do not entirely remove the need for some debate about hedge funds. But the issue is priority and scale. The global hedge funds sector is estimated to command about $1,500bn of assets on a global basis. The balance sheet of some individual European banks, by contrast, is not wildly different in scale – even today.
Of course, it is possible that European politicians have cannily spotted that logic and are simply focusing on hedge funds as a convenient, distracting scapegoat. It is also possible all the heat about hedge funds will disappear once the European parliamentary elections are over. That is what some senior UK government figures and bankers hope. But even if that argument is right – and it remains a big "if" – the lesson from the spring of 2007 about the danger of policy distraction remains clear. If European politicians were squealing about the need to clean up big banks – say, by demanding that Europe hurry up and impose its own version of bank stress test – then they might have the right to worry about reforming hedge funds too. Unfortunately, though, they are not. As a result, the likelihood is that Europe will remain plagued with doubts about the health of its financial system for the forseeable future. And that is a scenario which should worry everybody, hedge fund lovers and haters alike.
JPMorgan Faces SEC Charges Over Jefferson County Derivatives Sales
JPMorgan Chase & Co., the biggest U.S. bank by market value, says it may be charged with violating federal securities laws for selling fixed-income financing that helped push Alabama’s most populous county to the brink of bankruptcy. The potential sanctions by the U.S. Securities and Exchange Commission, disclosed yesterday in two sentences of a 162-page quarterly regulatory filing, relate to a series of bond and interest-rate swap sales in 2002 and 2003 for sewers in Jefferson County, which covers about 1,125 square miles including Birmingham, the state’s largest city with more than 240,000 residents.
Since credit markets seized up in 2007, Jefferson County’s annual sewer debt payment more than doubled. At least seven former JPMorgan bankers are under scrutiny in a Justice Department criminal antitrust investigation of the sale of unregulated derivatives to local governments across the U.S., federal regulatory records show. The SEC investigation of New York-based JPMorgan is the first by the commission to directly challenge the ways in which securities firms sell derivatives to state and local governments. Derivatives are contracts whose values are tied to assets, including stocks, bonds, commodities and currencies, or events such as changes in interest rates or the weather.
"The bigger the amount of money, the more temptation there is for corruption," said Christopher "Kit" Taylor, who was executive director of the Alexandria, Virginia-based Municipal Securities Rulemaking Board, the national regulator of the municipal bond market, from 1978 to 2007. JPMorgan disbanded the unit selling debt derivatives to municipalities in September because it said in an internal memo obtained by Bloomberg News that "the returns no longer justify the level of resources we have allocated to it." Brian Marchiony, a JPMorgan spokesman, declined to comment. The company said in yesterday’s filing that it is "engaged in discussions" with the SEC to reach a resolution before the agency files a civil complaint. SEC spokesman John Heine declined to comment and Jefferson County Commissioner Jim Carns said he was unaware of any SEC moves against JPMorgan.
Between 2002 and 2003, Jefferson County, led by current Birmingham Mayor Larry Langford, paid JPMorgan and a group of banks $120.2 million in fees for derivatives that were supposed to protect it from the risk of rising interest rates, according to a series of stories published by Bloomberg News in 2005. When interest rates unexpectedly fell, the county was unable to make sudden payments on its debt. The public financings have pushed the county toward insolvency and more than tripled Jefferson County residents’ sewer bills. The financing fees Jefferson County paid were about $100 million more than they should have been based on prevailing rates, according to estimates last year by James White, an adviser the county hired in 2007 after the SEC said it was investigating the deals.
Langford, the 61-year-old mayor of Birmingham who was president of the commission that approved the sewer financings, was charged in December with bribery, fraud, money laundering and filing false tax returns. His trial may begin as early as this summer, according to court documents. JPMorgan’s role in selling interest-rate derivatives to cities and towns has led to a nationwide federal investigation. Prosecutors are trying to determine whether it conspired with financial advisers to overcharge customers. The probe is focusing on municipal financings gone awry from Alabama to Pennsylvania.
Between 2002 and 2003, Jefferson County, relying on JPMorgan’s advice, refinanced $3 billion of sewer bonds with floating-rate debt and interest-rate swaps, public records show. The bank told county commissioners the deals would cut the locality’s borrowing costs. In a swap, parties agree to exchange interest payments based on an underlying bond. The two sides pay each other amounts based on different rates, which may vary based on a financial index. Insurers guaranteeing Jefferson County’s bonds lost their top credit ratings last year after suffering subprime mortgage related losses. As a result, the yields on the bonds surged more than three-fold in one month to 10 percent. The swaps compounded the increased borrowing costs because, under the agreements, the variable rates paid by the banks to the county declined.
Since then, Jefferson County’s annual sewer debt payment rose to $460 million, more than twice the $190 million it collects in revenue. The county couldn’t refinance the bonds without paying hundreds of millions of dollars in fees to get out of the swaps, and it didn’t have the money to do that. JPMorgan is now in negotiations to prevent Jefferson County from filing the biggest municipal bankruptcy since Orange County, California, defaulted in 1994. In Butler, Pennsylvania, JPMorgan convinced a cash-strapped school district in 2003 to sell it an option on an interest-rate swap, a so-called swaption, for $730,000. The district later said it had been duped by the bank. Last year it repaid JPMorgan seven times what it had received to get out of the deal. Erie, Pennsylvania’s school district sold a similar contract to the bank in 2003. Three years after JPMorgan paid the Erie schools $750,000, interest rates went the wrong way and the district paid the bank $2.9 million to cancel the contract.
Jefferson County now owes JPMorgan more than $600 million for swaps and the bank has so far not forced the county to pay up. The federal indictment of Langford alleged that JPMorgan paid an Alabama banker and former chairman of Alabama’s Democratic Party to get involved in the sewer financing deals. JPMorgan gave William Blount, a long-time friend of Langford, almost $3 million to arrange the swaps associated with the county’s sewer refinancing, the indictment said. Bear Stearns Cos., acquired by JPMorgan in March 2008, paid Blount $2.4 million and Goldman Sachs Group Inc. paid him $300,000 after Langford told JPMorgan to include Goldman Sachs as a condition of a $1.1 billion swap agreement in 2003, the indictment said. The banks weren’t charged.
Blount helped Langford get a $50,000 loan and paid for jewelry, a Rolex watch and expensive clothing from Ermenegildo Zegna SpA and Salvatore Ferragamo SpA, the indictment said. Langford, Blount and Blount’s associate Albert LaPierre, who was allegedly paid $219,500 by Blount for his help, have all pleaded not guilty. In response to a parallel civil complaint filed by the SEC, the men have argued that the agency doesn’t have jurisdiction over swaps. Given the scope of the case so far, it’s not surprising that the SEC would consider charges against JPMorgan, said White, the financial adviser. "If you know all that, and you’ve read the indictment, then you wouldn’t be surprised," White said yesterday.
Big US Banks May Be Headed For Extinction, And Soon
In the world of banking, too-big-to-fail may be in the process of morphing into too-big-to-exist. After hundreds of billions in federal aid and even more in lost investment capital, both the government and investors may be ready for a big sea change. The only question, for some, is how quickly it will happen. "In the next few months, we'll see the tacitly nationalized banks—Bank of America, Citigroup—sold off rapidly into pieces, turned into much smaller banks," Sanders Morris Harris Group Chairman George Ball predicted on CNBC Thursday, adding the government wants to send a strong message, to "punish too-big-to-fail banks that have blotted their copy and not exonerate their management." "Five years from now, these banks will be broken up," is how FBR Capital Markets bank analyst Paul J Miller sees it.
From Washington to Wall Street to Main Street, a dramatic change in conventional thinking appears to underway. "Some institutions are too big to exist, because they are too interconnected," Sen. Richard Shelby (R-Ala.) told CNBC earlier this week. "The regulators can’t regulate them." That conclusion became painfully obvious in the two faces of the financial crisis. On one side, the federal government had to provide billions in aid —and on more than one occasion—to the likes of to Bank of America, Citigroup and the giant insurer AIG, which has its own lending unit, to prop them up. On the other side, the failure of Lehman Brothers—which might have been averted with federal intervention—reverberated throughout the global economy.
Months later, the Obama administration and Congress now appear keenly focused on the dilemma and are expected to create legislation that will empower regulators to intervene in the affairs of big financial institutions and essentially wind down their operations in an orderly fashion with limited collateral damage to the economy. Such authority would also apply to investment banks tirned bank holding companies, such as Goldman Sachs. "They need it and they’ll get it," said Robert Glauber, who was a top Treasury official during the government rescue of the savings and loan industry two decades ago. Regulatory reform is also likely to include new antitrust authority to block mega-mergers creating financial firms whose problems could adversely affect the overall system. Analysts say, if that’s the case, the government won’t want the too-big-to-fail companies of the past essentially hanging around.
Exactly how the government does that is unclear, but experts say there are ways without resorting to a heavy-handed approach such as nationalization. "If once there is some kind of coherent policy toward systemic risk, whomever is managing that policy can start to make life difficult for an entity that is too big to fail," says former S&L regulator and White House economist Lawrence White, at NYU’s Stern School of Business. "It wouldn't upset if they were providing subtle nudges. "The Fed doesn’t want them that big and might make them hold more capital," suggests Miller. Some speculate that any further government aid to certain firms might come with such strings attached.
Others say a fresh look at regulation will help the process and unveil the complex, diverse and, at times, incompatible operations of the bank holding companies and their commercial bank subsidiaries. "They can't assess the risks of the big banks," says Frank Sorrentino, Chairman and CEO of North Jersey Community Bank, which recently acquired a failing bank in a transaction assisted by federal regulators at the FDIC. Risk, or a disregard of risk, may also have factored into the decision-making of big bank executives, who assumed the too-big-to-fail doctrine would catch them if they fell, which the bailouts obviously did. Small banks clearly have a financial interest in seeing the end of the big bank era, but that alone doesn’t undercut their arguments. In some cases it may be good for business, consumers and the overall marketplace.
"It’s an appealing idea to our clients because it will make them more competitive," says Robert C. Schwartz, a partner at Smith, Gambrell & Russell, which represents big and small banks in the Southeast. "Changes may leave gaps for the regional banks and the community banks." "If the government does the right thing, it will be the private sector that forces these companies to do what they need to do for the benefit of their shareholders," says Sorrentino, whose bank has $400 million in assets. (By contrasts, the 19 firms involved in the government’s recently completed stress tests have assets of $100-billion or more.)
Investors have clearly been focused on shrinking earnings and stock prices and what some consider diminished prospects for the future, even with a positive resolution to the financial crisis. "I also think investors are going to realize that they’ll be low-single digit growth rates," says Miller Some analysts say recent events highlight a fundamental problem that has been somewhat ignored for years; the financial supermarket structure of the big institutions makes them difficult, if not, impossible to operate with great success. "Investors will say,That business unit hidden in there; let's spin that off," says Sorrentino. "Either the regulators are going to force it or the shareholders are going force it."
Warren Report: Credit crunch alive and well
Despite recent encouraging signs in the economy, Americans are having a hard time getting credit and the effectiveness of government programs to spur lending is unclear, a congressional bailout watchdog said Thursday. "A snapshot of small business credit at the beginning of 2009 shows credit terms tightening and loan volume dropping," the Congressional Oversight Panel wrote. "Families are facing an even more difficult situation." The report looked at the availability of credit for small businesses and consumer loans, such as credit cards, auto loans and student loans. It also looked closely at the government's TALF program meant to stimulate markets for those kinds of loans.
"Small business lending has not principally advanced through TALF," said the panel's chief Elizabeth Warren on Thursday. "It's much more through SBA loans, direct loans through community beaks and credit cards." TALF -- for Term Asset-Backed Lending Facility -- aims to make consumer and small business loans more widely available by spurring what's known as the securitization of those loans. In securitization, banks that make loans in turn sell them to investors -- thus reducing the lenders' cost and risk. The securitization market in the first quarter of 2009 was 80% below the level in 2007, according to the report.
The five-member panel, established by the law enacted last fall at the height of the financial crisis that set aside $700 billion to bail out banks and other companies, is headed by Harvard law professor Elizabeth Warren. Warren has been an outspoken critic of the government's handling of the bailouts, arguing forcefully that the government rescue efforts need more transparency and tougher standards on banks. But her latest report also acknowledges that many forces could contribute to restricted lending.
Rising unemployment might mean that households will take on less credit card debt, for example. And as the economy slows, small businesses might have less need for credit. Even so, the report expressed concern about the effectiveness of TALF to help. "Despite favorable loan terms, the TALF is only beginning to generate significant demand. Some of the slow growth of demand is attributable to lack of demand for securitization, some to claimed flaws in the program's design, and some to fear of political risk. Under those conditions, it is difficult to predict at what rate the demand for TALF loans will increase."
Friedman's Resignation Shows Difficulty of Overlapping Roles
Stephen Friedman has spent a 43-year career in the financial world wearing many hats, including investment banker, chief of Goldman Sachs Group Inc., private-equity executive and economic adviser to the president. But his resignation Thursday as chairman of the powerful New York Federal Reserve Bank amid concerns about his lingering ties to Goldman shows the difficulty of playing overlapping roles in today's economic crisis. The 71-year-old Mr. Friedman stepped aside following disclosures in The Wall Street Journal that he was allowed to lead the board at the New York Fed and remain a Goldman director and shareholder, in violation of Fed rules. The New York Fed sought a one-year waiver of that rule, which was granted by the Federal Reserve board in Washington in January.
Mr. Friedman didn't return a call to his office seeking comment.
During President George W. Bush's first term, he was forced to sell nearly all his investments, including Goldman stock, a process he described in a recent interview as "very costly and a difficult thing to manage." He spent two years as a White House adviser on economic policy, gaining a reputation for his intelligence and low-profile style. That style was honed in a 28-year career at Goldman, where he made his name, and fortune. There, he was co-head of a number of key departments, including investment banking. During the takeover boom of the 1980s, he played a central role, often counseling companies that were the target of hostile takeovers. Mr. Friedman was "particularly effective in takeover negotiations," Charles Ellis wrote in his book "The Partnership, The Making of Goldman Sachs."
He became co-chairman of the then privately held brokerage firm in 1990, and ran it alongside Robert Rubin, who later became Treasury secretary under President Bill Clinton. He and Mr. Rubin created a stir in 1992, when the Journal disclosed that they both received more than $15 million in 1991 pay -- then an outsize sum on Wall Street. Mr. Friedman became sole chairman in 1992. Mr. Friedman abruptly stepped down in 1994, citing the enormous pressures of running a modern global investment bank. The surprise announcement came as Goldman was struggling through a difficult year and shocked those on Wall Street, who remarked that his departure was badly handled by a firm that long prided itself on a tradition of carefully orchestrating its succession process.
Following his departure from Goldman, two dozen partners bolted from the firm in quick succession. The upheaval was the meteor that threw the Goldman private partnership into disarray and paved the way for its decision in 1999 to become a publicly traded company. Mr. Friedman "was warned that he risked being tarred forever as the guy who quit and ran when the going got really tough, but he had made the decision and was known for persistence," Mr. Ellis wrote. He was a wrestler at Cornell University, where he received a bachelor of arts degree. There is now a wrestling center at the university named the Friedman Wrestling Center. After graduating from Cornell he went to Columbia Law School. He has served on Fannie Mae's board, and for a time after he left Goldman he was a senior principal of Marsh & McLennan Cos., the big insurance broker.
In 2002, Mr. Friedman was tapped by the Bush administration just days after the surprise departure of the prior economic team. He succeeded Lawrence Lindsey as director of the National Economic Council. He took a job his former Goldman co-chairman, Mr. Rubin, had held the prior decade, and his naming was championed by Josh Bolten, a former Goldman employee who was then deputy chief of staff at the White House. In 2005, Mr. Friedman became a senior adviser to Stone Point Capital, a private-equity firm in Greenwich, Conn. Stone Point was formed by principals of MMC, a Marsh & McLennan unit, after Marsh decided to sever ties with the unit in the wake of probes into conflicts of interest among its various businesses. Stone Point, where Mr. Friedman remains chairman, focuses on investments in the financial and insurance sectors.
The firm was recently part of a group that invested in IndyMac Bank, the failed California lender. Mr. Friedman also joined the Goldman board in 2005, collecting his annual director pay in restricted stock units. By the fall of 2008, he had amassed about 46,000 Goldman shares, according to regulatory filings. In October, he was named head of the board's audit committee, succeeding Edward Liddy. Late in 2007, Mr. Friedman was named to a three-year term as a "Class C," or public, director on the board of the New York Fed. That term, which began Jan. 1, 2008, was accompanied by a parallel term as the regional Fed bank's chairman. His chairmanship was renewed for a second one-year term late in 2008.
by Eliot Spitzer
The New York Fed is the most powerful financial institution you've never heard of. Look who's running it.
The kerfuffle about current New York Federal Reserve Bank Chairman Stephen Friedman's purchase of some Goldman stock while the Fed was involved in reviewing major decisions about Goldman's future—well-covered by the Wall Street Journal here and here—raises a fundamental question about Wall Street's corruption. Just as the millions in AIG bonuses obscured the much more significant issue of the $70 billion-plus in conduit payments authorized by the N.Y. Fed to AIG's counterparties, the small issue of Friedman's stock purchase raises very serious issues about the competence and composition of the Federal Reserve of New York, which is the most powerful financial institution most Americans know nothing about.
A quasi-independent, public-private body, the New York Fed is the first among equals of the 12 regional Fed branches. Unlike the Washington Federal Reserve Board of Governors, or the other regional fed branches, the N.Y. Fed is active in the markets virtually every day, changing the critical interest rates that determine the liquidity of the markets and the profitability of banks. And, like the other regional branches, it has boundless power to examine, at will, the books of virtually any banking institution and require that wide-ranging actions be taken—from raising capital to stopping lending—to ensure the stability and soundness of the bank. Over the past year, the New York Fed has been responsible for committing trillions of dollars of taxpayer money to resuscitate the coffers of the banks it oversees.
Given the power of the N.Y. Fed, it is time to ask some very hard questions about its recent performance. The first question to ask is: Who is the New York Fed? Who exactly has been running the show? Yes, we all know that Tim Geithner was the president and CEO of the N.Y. Fed from 2003 until his ascension as treasury secretary. But who chose him for that position, and to whom did he report? The N.Y. Fed president reports to, and is chosen by, the Fed board of directors.
So who selected Geithner back in 2003? Well, the Fed board created a select committee to pick the CEO. This committee included none other than Hank Greenberg, then the chairman of AIG; John Whitehead, a former chairman of Goldman Sachs; Walter Shipley, a former chairman of Chase Manhattan Bank, now JPMorgan Chase; and Pete Peterson, a former chairman of Lehman Bros. It was not a group of typical depositors worried about the security of their savings accounts but rather one whose interest was in preserving a capital structure and way of doing business that cried out for—but did not receive—harsh examination from the N.Y. Fed.
The composition of the New York Fed's board, which supervises the organization and current Chairman Friedman, is equally troubling. The board consists of nine individuals, three chosen by the N.Y. Fed member banks as their own representatives, three chosen by the member banks to represent the public, and three chosen by the national Fed Board of Governors to represent the public. In theory this sounds great: Six board members are "public" representatives. So whom have the banks chosen to be the public representatives on the board during the past decade, as the crisis developed and unfolded?
Dick Fuld, the former chairman of Lehman; Jeff Immelt, the chairman of GE; Gene McGrath, the chairman of Con Edison; Ronay Menschel, the chairwoman of Phipps Houses and also, not insignificantly, the wife of Richard Menschel, a former senior partner at Goldman. Whom did the Board of Governors choose as its public representatives? Steve Friedman, the former chairman of Goldman; Pete Peterson; Jerry Speyer, CEO of real estate giant Tishman Speyer; and Jerry Levin, the former chairman of Time Warner. These were the people who were supposedly representing our interests! Of course, there have been the occasional nonfinance representatives from academia and labor. But they have been so outnumbered that their presence has done little to alter the direction of the board.
So is it any wonder that the N.Y. Fed has been complicit in the single greatest bailout of poorly managed banks in history? Any wonder that it has given—with virtually no strings attached—practically the entire contents of the Treasury to the very banks whose inability to manage risk has brought our economy to its knees? Any wonder that not a single CEO or senior executive of a major bank has been removed as a condition of hundreds of billions of direct cash and guarantees? Any wonder that, despite its fundamental responsibility to preserve the integrity of the banking system, it sat quietly on the sidelines as the leverage beneath the banks exploded and the capital underlying their investments shrank?
I do not mean to suggest that any of these board members intentionally discharged their duties with the specific goal of benefitting themselves. Rather, what we have seen is disastrous groupthink, a way of looking at the world from the perspective of Wall Street and Wall Street alone. That failure has brought the world economy to the edge of unraveling. And some of Geithner's early missteps betrayed an inability to get beyond this tunnel vision, such as the idea that the banks need to be first in line to be paid and to be paid in full. We can only hope that Geithner, who, to his credit, did try to raise some of the regulatory issues that mattered while he was at the Fed, is no longer in the mental prison of Lower Manhattan and will have more success now that he has a board of one—President Obama.
Perhaps it is time to calculate what these board members have been paid by their banks in salary and bonuses over the years and seek to have them return it to the public as small compensation for their failed oversight of the N.Y. Fed. And more fundamentally, perhaps it is time to take a hard look at the governing structure and supposed independence of this institution that actually controls the use of our tax dollars and, heaven help us, the fate of our economy.
More States Start Pension Inquiries
The sprawling investigation into New York’s pension investments hints at a much bigger problem than the handful of indictments so far would suggest. What started as an investigation by the New York attorney general, Andrew M. Cuomo, into the state comptroller’s office — where Mr. Cuomo says favors were being exchanged for contracts to invest pension money — has mushroomed into a broad look at more than 100 firms by attorneys general in at least 30 other states. A survey of practices across the country portrays a far-reaching web of friends and favored associates: political contributors, campaign strategists, lobbyists, relatives, brokers and others, capitalizing on relationships and paying favors.
These influential figures can determine how pension funds are invested, as well as state university endowments, municipal bond proceeds, tobacco settlement funds, hurricane insurance pools, prepaid tuition programs and other giant blocks of public money. "What has developed is a corrupt system, where Wall Street, various fiduciaries, politicians and corporate managers are draining America’s savings," said Frederick S. Rowe, a hedge fund manager who serves on the Texas Pension Review Board, an oversight body. In Texas, lawmakers have been working on a bill to strengthen the state pension board and outlaw outside payments to public pension officials. But the bill has been drastically weakened by local pension officials who argued the law would strip them of their independence.
That may leave it up to the Securities and Exchange Commission to strengthen controls at the federal level. The commission has jurisdiction over investment firms, but not local politicians. Investing public money on the basis of political considerations, rather than merit, heightens the risk of waste and loss, an urgent issue given the market losses of the last year. In 2007 the Government Accountability Office studied a group of pension funds known to be advised by consultants with conflicts of interest, and found their average yearly investment returns were 1.3 percent lower than those of other pension funds. That may sound small, but it can severely erode a fund over time because the losses multiply. "If compound interest is the eighth wonder of the world, then it’s the plague of all time when it’s working against you," Mr. Rowe said.
Mr. Cuomo has said it is too early to estimate the size of any losses caused by the improprieties in New York. Even if the losses cannot be measured, though, he considers it essential to stop the uncontrolled peddling of access. "You can’t put a price tag on public integrity," Mr. Cuomo said in a recent news conference. "We have to be sure the system works and people have trust in the system." In recent weeks, the New York comptroller and officials in other states have issued rules barring the use of intermediaries — often called placement agents — who are paid by money managers to open doors and help them win allocations from state and local governments. But even those restraints, long resisted, may not work well. Across the country, an examination of practices suggests that time and again pension officials are making poor investment choices and incurring losses because personal connections skew their decision-making.
Consider DV Urban Realty Partners, which won $68 million from five public pension funds in Chicago. The firm was founded by a nephew of Mayor Richard M. Daley and proposed using the money to improve neglected neighborhoods that were central to the city’s 2016 Olympics bid. So far, the investments have lost money. Now the city inspector general is investigating whether the mayor’s nephew exerted improper influence, but is having trouble because some of the pension funds have declined to respond to subpoenas. Robert G. Vanecko, the mayor’s nephew, has said he did not trade on his family connections. In Texas, the city of Fort Worth’s pension fund decided to diversify into hedge funds. To help choose which ones, it hired Consulting Services Group of Memphis, which recommended that the city create a custom basket of hedge funds that paid management fees to Consulting Services Group.
Fort Worth embraced its recommendations and invested in the Bayou Fund, a fraud scheme that was exposed in 2005, and then in the Ponzi scheme operated by Bernard L. Madoff. Ruth Ryerson, who has since joined the Fort Worth pension fund as chief investment officer, says that Consulting Services was conflicted because it was collecting fees from both parties in the deal. In New Mexico, the former chief investment officer of the state teachers’ pension fund has filed a lawsuit saying he was forced out after he opposed a $40 million investment in mortgage-related securities. The investment was made anyway, and the securities are now worthless. The lawsuit describes an informal network of state officials, political insiders and campaign contributors stretching to Illinois. The disgruntled officer, Frank Foy, says these people worked in concert to talk him into making the investment, then worked together to remove him from office when he did not cooperate. His lawyer, Victor R. Marshall, said the campaign was orchestrated by David Contarino, a chief strategist to Gov. Bill Richardson. Mr. Contarino denies the accusations.
As Mr. Foy describes it, Mr. Contarino also exerted his influence to persuade another state funding pool to put $50 million in similar mortgage securities. That was the State Investment Council, headed by Governor Richardson. Gary B. Bland, the state investment officer, denied the accusations in a court response in February, calling Mr. Foy’s lawsuit "a political witch hunt." Since then, the New Mexico state council has begun reviewing whether investment firms paid fees to anyone in connection with obtaining the state’s business. That review was prompted by the New York investigation of placement fees. The New Mexico council recently disclosed that a top fund-raiser and political ally of the governor, Marc Correra, was paid a placement fee by the investment firm that sold the toxic mortgage securities criticized by Mr. Foy. The records also show that Mr. Correra has been paid roughly $11 million as the placement agent for more than 20 other investments — all private equities, hedge funds and complex structured debt — that have come through the investment council’s door since Governor Richardson took office in 2003.
Investments like those promoted by Mr. Correra, called alternative investments, are controversial for public investment funds to invest in because there is not a ready market for them should the government suddenly need money. They are hard to value, too, and they carry higher risks in the pursuit of higher returns. The investment firms that offer them tend to earn much higher fees, which means a bigger cut for the placement agents. Mr. Correra’s lawyer, Ronald L. Rubin, said his client earned his fees through hard work and believed he had complied with all the rules. "He wants to follow the law," said Mr. Rubin, with the firm of Tannenbaum, Helpern, Syracuse & Hirschtritt in New York.
Governor Richardson has suspended new investments in private equity firms, hedge funds and other alternatives. The current investigations into influence peddling across the country are virtually all connected with investments that expose taxpayers to the greatest risks, and that pay money managers the highest fees, cutting into future returns. "Money that’s gone can’t compound," said Mr. Rowe, the hedge fund manager on the Texas Pension Review Board. "The savings pool can’t grow to the extent that it should." Mr. Rowe, who has been outspoken about the need for tighter controls on public pension money, was chairman of the Texas Pension Review Board until last year, when he was removed by the governor of Texas, Rick Perry.
401(k)s Hit by Withdrawal Freezes
Some investors in 401(k) retirement funds who are moving to grab their money are finding they can't. Even with recent gains in stocks such as Monday's, the months of market turmoil have delivered a blow to some 401(k) participants: freezing their investments in certain plans. In some cases, individual investors can't withdraw money from certain retirement-plan options. In other cases, employers are having trouble getting rid of risky investments in 401(k) plans. When Ed Dursky was laid off from his job at a manufacturing company in March, he couldn't withdraw $40,000 from his 401(k) retirement account invested in the Principal U.S. Property Separate Account.
That fund, which invests directly in office buildings and other properties, had stopped allowing most investors to make withdrawals last fall as many of its holdings became hard to sell. Now Mr. Dursky, of Ottumwa, Iowa, is looking for work and losing patience. All he wants, he said, is his money. "I hate to be whiny, but it is my money," Mr. Dursky said. The withdrawal restrictions are limiting investment options for plan participants and employers at a key time in the markets. The timing is inconvenient for the number of workers like Mr. Dursky who are laid off and find their savings inaccessible. Though 401(k) plans revolutionized the retirement-savings landscape by putting investment decisions in the hands of individuals, the restrictions show that plan participants aren't always in the driver's seat.
Individual investors mightn't even be aware of some behind-the-scenes maneuvers causing liquidity problems in their retirement plans. Many funds offered in 401(k) plans lend their portfolio holdings to other investors, receiving in exchange collateral that they invest in normally safe, liquid holdings. The aim is often to generate a small but relatively reliable return that can help offset fund expenses. But in recent months, many of the collateral investments have gone haywire, prompting money managers to restrict retirement plans' withdrawals from the lending funds. Some stable-value funds also are blocking the exits. These funds, available only in tax-deferred savings plans such as 401(k)s, typically invest in bonds and use bank or insurance-company contracts to help smooth returns. But in cases of employer bankruptcy and other events that can cause withdrawals, these funds can lock up investor money for months at a time.
Investors in the Principal U.S. Property Separate Account said they understood the risk of losses, but didn't think their money could be locked up for months or years. Most participants in the 15,000 plans holding the fund haven't been able to make any withdrawals or transfers since late September. "To sell property at inappropriately low prices in order to generate cash for a few would hurt the majority of investors and violate our fiduciary obligations," said Terri Hale, spokeswoman for Principal Financial Group Inc., the parent of the fund's manager. The fund, which had $4.3 billion in net assets at the end of April, still is making distributions for death, disability, hardship and retirement at normal retirement age. As of April 28, redemption requests that had yet to be honored totaled nearly $1.1 billion, or roughly 26% of the fund's net assets. Principal doesn't anticipate that it will make any distributions to investors who have requested redemptions until late 2009 or beyond, Ms. Hale said. Meanwhile, the fund continues to fall, declining 25% in the 12 months ending April 30.
Some investors have lost hope of recovering their money. Judith Sterner, a 69-year-old part-time nurse, had more than $12,000 in the fund when she tried to transfer that balance to a money market last fall. But her transfer was denied, and her stake has since declined to less than $10,000. "This $12,000 represents a year of my retirement money that I don't have," said Ms. Sterner, of Morton Grove, Ill. Principal still allows new investors into the fund. It categorizes the U.S. Property account as a fixed-income investment, alongside much stodgier funds holding high-quality bonds. New investors are warned of potential withdrawal delays, Ms. Hale said. As for the fixed-income categorization, she said, "a substantial portion of the account return is based on income streams from rents, and its returns have been comparable to fixed-income funds." While the problems selling real-estate investments are relatively straightforward, withdrawal restrictions related to securities lending stem from far more obscure practices.
Funds often lend out portfolio holdings, through a lending agent, to other investors. These borrowers give the lender collateral, often amounting to about 102% of the value of the securities borrowed. Some of the collateral pools in which funds invest this collateral held Lehman Brothers Holdings Inc. debt and other investments that plummeted in value or became hard to trade in the credit crunch. Though agents who coordinate funds' lending programs share in profits from securities lending, the risk of such collateral-pool losses falls entirely on the funds that have lent the securities and, ultimately, retirement plans and other investors holding those funds.
The problems have limited retirement plans' ability to get out of securities-lending programs, though participants' withdrawals generally haven't been affected. Retirement plans offered to employees of energy company BP PLC last fall tried to withdraw entirely from four Northern Trust Corp. index funds engaged in securities lending. Certain holdings in Northern's collateral pools had defaulted, been marked down, or become so illiquid that they could only be sold at low values, according to a BP complaint filed in a lawsuit against Northern Trust. The BP plans halted new participant investments in the funds and asked to withdraw their cash so it could be reinvested in funds that don't lend out securities.
But under restrictions imposed by Northern Trust in September, investors wishing to withdraw entirely from securities-lending activities would have to take their share of both liquid assets and illiquid collateral-pool holdings, according to a Northern Trust court filing. BP rejected that option, and the companies still are trying to resolve the matter in court. Northern Trust's collateral pools are "conservatively managed" and focus on liquidity over yield, the company said. State Street Corp. in March notified investors of new withdrawal restrictions in its securities-lending funds. Until at least the end of the year, plans can make monthly withdrawals of only 2% to 4% of their account balance, the notice said. Plans wishing to withdraw entirely from lending funds will have to take a slice of beaten-down collateral-pool holdings. "Given the current state of the fixed-income market, we felt it was prudent to put some well-defined withdrawal parameters in place," said State Street spokeswoman Arlene Roberts.
The Big Business of Big Labor
Imagine if President George W. Bush used strong-arm tactics to bend the law to favor a politically connected company with $1.2 billion in assets, including a private golf course. What if that company’s political action committee had spent $13 million in the previous election, including more than $4 million to elect him? Barack Obama has done just that. The company is called the United Automobile, Aerospace & Agricultural Implement Workers of America International Union - or the UAW for short.
Obama and the Democrats will employ euphemisms when discussing the President’s plan to circumvent bankruptcy law and hand majority ownership of Chrysler over to the UAW. They will speak about "the workers" taking ownership of the company, with some arguing that the workers, by right, are the senior creditors in Chrysler’s bankruptcy. This paints the union-versus-creditors battle for control of Chrysler as a fight between blue-collar workingmen and greedy hedge fund speculators in suits. But that abstraction -equating the UAW with "the workers"’is grossly misleading. John Doe on the assembly line will not be running Chrysler or directing the use of billions in bailout dollar. No, the union management will become Chrysler’s management.
So this is a gift to the union management, which, when you look at it closely, is a big, politically connected company whose executives pamper themselves and practice patronage on the backs of the workers. Compare the UAW’s political activity to that of the most notorious companies that were cozy with the Bush administration. The autoworker union’s political action committee spent $13.1 million on the 2008 election. If you take the PACs of Exxon, Halliburton, Peabody Coal, and Lockheed Martin, combine their 2008-cycle political spending, and multiply it by four, you get just over $13.1 million. The UAW’s expenditures on the 2008 presidential contest alone exceed the total House, Senate, and White House expenditures of those four companies.
And even Exxon Mobil gave 11 percent of its donations to Democrats. The UAW gave less than 1 percent of its money to Republicans. The auto workers’ union is far more wedded to the Democratic Party than any company is to the Republican Party. The union’s $1.98 million to Democratic candidates last cycle (not counting the $4.87 million in independent expenditures to elect Obama president) is more than any PAC spent on Republicans. If you combine the political spending of the top three oil company PACs and the UAW’s PAC, Republicans and Democrats come out about even.
Peer deeper into the UAW’s finances, and it starts to look even more like a big business. The organization sits on nearly $1.2 billion in investments. This is money the UAW took from the paychecks of workers, money that now functions as an endowment out of which the union pays its staff and subsidizes its golf resort. Black Lake Golf Club, which the UAW brags is "one of the finest anywhere in the nation," is owned by the union. Situated at the very top of Michigan, a drive of more than four hours from Detroit, it’s not exactly accessible to the union rank and file.
The resort is subsidized by workers’ paychecks, too—the union currently has $29.6 million in loans outstanding to the resort. That’s not their only posh real estate. The UAW’s Washington headquarters, home base for the union’s $1.6 million-a-year lobbying operation, is a beautiful $2.98 million townhouse in the DuPont circle neighborhood. While UAW membership has fallen by 32.5 percent since 2002, the national headquarters has kept its spending nearly the same—a reduction of only 1.9 percent. Add these facts together, and it starts to look like the union management exists largely to preserve union management.
These are the people who would, practically speaking, own Chrysler under Obama’s plan. These are the benefactors of Obama’s upturning bankruptcy law and threatening investors. But Obama’s team will maintain that it’s "the workers" who are taking ownership of Chrysler under their plan. When Obama and Democrats extend future bailouts and subsidies to Chrysler, they will have even more reason to claim that they are simply helping the workingmen. In truth, subsidies and special favors for the UAW are corporate welfare, and considering the UAW’s political activities, the right word might be crony capitalism.
How emotions may yet save the economy
An influential Democrat who was also one of the world’s top-ten, highest-paid hedge fund managers last year thinks he knows which book is at the top of the White House reading list this spring: Animal Spirits, the powerful new blast of behavioural economics from Nobel prize-winner George Akerlof and Yale economist Robert Shiller. Judging by the upbeat economic message we have been hearing from the White House, the Treasury and even the Federal Reserve over the past six weeks, that is a shrewd guess. The authors argue that "we will never really understand important economic events unless we confront the fact that their causes are largely mental in nature". Our "ideas and feelings" about the economy are not purely a rational reaction to data and experience; they themselves are an important driver of economic growth – and decline.
Since mid-March President Barack Obama and his team have mounted a sophisticated effort to brighten those "ideas and feelings", reassuring the nation with "glimmers of hope across the economy" and the assertion that "we’re starting to see progress". The much bally-hooed stress tests – whose comprehensively leaked results were fully unveiled after the markets closed on Thursday – are both an important example of this confidence-building campaign and its toughest challenge. The sunnier rhetoric of recent weeks marked a sharp shift both from the bleak mood of the fin de regime administration of George W. Bush and from the first weeks of the Obama White House. The outgoing president’s political capital was so low in his final months in office that the mere fact of his public appearances seemed to have a depressing effect on the markets. His secretary of the Treasury, Hank Paulson, enjoyed greater confidence, but he needed to convince lawmakers the situation was dire enough to merit his $700bn Tarp programme.
Likewise, Mr Obama needed the nation to be worried enough about the economy to pass his nearly $800bn stimulus plan. And too much good cheer in the first days of his administration could have wasted one of his most powerful trump cards – the country’s belief that this recession is owned by president number 43, not number 44. But once the stimulus bill was passed, the White House calculated that, as Mr Obama told the Financial Times, lawmakers and US voters had reached their limits. No new money to rev up the economy or revive the banks would be forthcoming until the president and his team could demonstrate concrete results from the first instalment. Since then Americans have been hearing a decidedly more optimistic vibe from Washington. It has seemed to work.
A Google search for the term "economic recovery" turned up 6,991 references to the term in January and 7,831 in February. In the first week of May the phrase occurred 24,443 times. More traditional yardsticks show the same result. According to a recent ABC/Washington Post poll, Americans’ belief that their country is heading in the right direction has soared from 19 per cent, just before Mr Obama’s inauguration, to 50 per cent, the highest in six years. In what could be a textbook example of behavioural economics, the stock market has followed the same curve, recovering from what rightwing commentators were calling "the Obama bear market" at the beginning of the year to a healthy rally. Thursday night’s verdict on banks’ balance sheets will also be a stress test of the administration’s experiment in behavioural economics.
Washington has clearly learned the lesson of one of its rare, early failures. In contrast with the disastrous media management of Treasury secretary Tim Geithner’s maiden economic speech, the results of the stress tests have been so thoroughly previewed that by Thursday financial pundits and punters seemed almost bored with the exercise. Ennui is not the same thing as conviction – one of America’s biggest money managers on Thursday described the exercise to me as "the feather tests" and it is hard to find anyone who doesn’t work for the government, or one of the banks, who believes the tests have been rigorous. But, like Washington, Wall Street really does want the scheme to work and the markets to recover. Over the next few weeks the administration will be hoping those feelings are powerful enough to drive the economic data.
Baltic Economies Shrank Most on Record Last Quarter
The economies of Latvia and Estonia probably contracted the most on record in the first three months of this year since regaining independence from the Soviet Union, according to surveys of economists. Latvia’s economy contracted an annual 16.4 percent, according to the median estimate of 10 economists in a Bloomberg survey, compared with a 10.3 percent decline in the fourth quarter. Estonia’s economy shrank 12.8 percent in the first quarter, the median estimate of a survey of four economists showed, compared with a 9.7 percent slump in the fourth quarter.
The economies of Estonia, Latvia and Lithuania are suffering the severest recessions in the 27-member European Union. The Baltic region’s property boom turned to bust after global credit markets froze and domestic demand collapsed. Lithuania’s economy shrank a preliminary 12.6 percent in the first quarter, the EU’s deepest contraction, the country’s statistics office said on April 28. "First-quarter GDP will be disastrous - the Lithuanian figures released last week were a sign of just how bad things have got," said Neil Shearing, an emerging-market economist at Capital Economics Ltd. in London, in an e-mail. "The pace of decline will probably ease from here on - the outlook is bad, but successive quarterly contractions of the order of 7.5 percent quarter-on-quarter seem unlikely." Estonia’s economy probably contracted between 14 percent and 16 percent in the first quarter from a year earlier, Finance Ministry Head of Economic Analysis Andrus Saalik said in an e- mailed statement today.
"The developments are more or less in line with our" worst-case scenario," Saalik said. "Still, there has been more positive information recently that shows stabilization. It seems we are about to hit the bottom and hopefully the second quarter will bring a change to the worsening trend." The Latvian statistics office will release preliminary GDP figures on May 11, and Estonia’s statistics office will publish first quarter figures on May 13. Estonia’s quarterly GDP data dates back to the first quarter of 1994, and Latvia’s to 1995. Latvia, which had the fastest expanding economy in the EU in 2006, turned to a group led by the European Commission and the International Monetary Fund in December for a 7.5 billion- euro ($10.1 billion) bailout after it took over its second- biggest lender last year.
The country is planning to cut spending and state wages, as are Estonia and Lithuania, and implement structural measures that may include closing some hospitals and schools to satisfy the terms of its international bailout and continue receiving installments. The IMF delayed a 200 million euro disbursement in March after the Latvian government failed to rein in spending. Swedbank AB, the biggest bank in the Baltic states, in an April 29 report forecast Latvia’s economy will contract 15 percent this year. Estonia’s GDP will decline 10.5 percent and Lithuania’s shrink 13 percent, the bank said. "The bottom line is still that the region must restore competitiveness through a fall in the real exchange rate - and in the context of fixed nominal exchange rates, this means allowing wages and prices to fall," Shearing said.
Canada April Housing Starts Fall to Lowest Since 1996
Canadian housing starts fell more than expected in April to the slowest pace since April 1996 on lower construction of multiple-unit buildings. The total of 117,400 units on an annualized basis compared with a revised 146,500 in March, Canada Mortgage and Housing Corp. said today from Ottawa. Economists anticipated the pace of starts would slow to 140,000 units, according the median of 21 responses in a Bloomberg survey. The Bank of Canada estimated last month that housing will cut 1.1 percentage points from growth this year as increasing job losses and falling incomes lower demand for homes. The report "will put downward pressure on April gross domestic product numbers," Derek Holt, an economist with Scotia Capital in Toronto, said in a note to clients. The pace of work on projects such as apartments and condominiums in cities fell 33 percent to 54,700 units, CMHC said today. Single-family houses in urban areas dropped 8.7 percent to a pace of 42,100 units. The drop in single-unit starts will have a "larger effect on business activity," Holt said.
China fears disastrous steel oversupply
Reuters reported that China's steelmakers are facing low demand and potentially disastrous oversupply, supporting their insistence on a 40 percent cut in benchmark iron ore prices. China's steel industry, the world's biggest, traditionally sets a global benchmark each year after lengthy talks with three miners that dominate the iron ore trade: Vale, Rio Tinto and BHP Billiton. Mr Shan Shanghua, secretary general of the China Iron and Steel Association said the buyers had more power this year because of too much supply and too little demand. He said that "I have not seen any fundamentals to support a sustainable steel price recovery. Major steel mills have cut their production of steel coil remarkably in China and steel mills have already seen their exports falling sharply."
Mr Shan said output levels were being driven by a blind rush back to production by small mills and would not continue for the rest of the year as the weak market would force more cutbacks. He said that "We are still aiming at a yearly production of 460 million tonnes. Whether we can make it or not depends on exports and domestic demand. But I am sure that if we remain at that high production rate and do not cut output, it will be a disaster." Mr Shan said the Chinese, led in the negotiations by Baosteel, should be able to get a price below the spot market, which would mean a cut of more than 30%. He said that "There is a common sense that wholesale prices should always be lower than those for retail."
Mr Shan said some Chinese regions have cut taxes and the fees they charge miners in order to lighten the burden and support sales of domestic ore. He said that but China is unlikely to reduce a 17% value-added tax on domestic iron ore in an attempt to undercut imports. He added that "I've never heard of such plans and I think it sounds unlikely to me as changing VAT policy is a big move that the government is always extremely cautious about." Mr Shan said CISA was still opposed to the idea of switching to an index system for iron ore prices, as only long-term agreements could foster development in both the steel and mining sectors.
Mortgage Duration Risk: The Banks Are No Longer the Problem
"You think that's air you're breathing?"
Morpheus to Neo, The Matrix
We are gratified to see that Treasury Secretary Geithner and Fed Chairman Ben Bernanke take our suggestion of several weeks ago on CNBC not to allow the TARP banks to repay the government debt until they prove the ability to function in the debt markets without reliance upon a government guarantee. Washington has indeed fixed the solvency problems of the large zombie banks -- not with additional capital or stress tests, as many of us seem to think. Rather, the banks have been stabilized by turning them into GSEs via FDIC guarantees on their debt. Those banks which can end their dependence on federal guarantees will be the visible winners in the post stress test market, and valuations and spreads will reflect this divergence between zombies and viable private banks.
Seen from this perspective, Chrysler, General Motors and the large banks are GSEs rather than private companies, parestatales as they know them in Mexico. To talk about a rally in the equity of large US financials seems truly ridiculous, at least to us, especially true when you look at how the public sector subsidies being applied to the banks have distorted their financial statements. Maybe by the end of next year, when we know which banks can or cannot shed the need for government subsidies, then we can talk about investible equity in these GSEs. To that point, turning Bank of America, Wells Fargo and Citigroup into GSEs was just the first battle, Vol. II of the Lord of the Rings, to use another cinematic metaphor. Next comes dealing with the dysfunction in the non-bank market for securitization and financing, the real battle to save the US economy from a truly dreadful year-end 2009 and beyond.
By the way, is it not remarkable that the FDIC has run dozens of resolutions and bank sales processes over the past 18 months without a single leak or breach of confidentiality of these sensitive transactions, including both the WaMu and Wachovia transactions? Yet the Fed and Treasury run a confidential stress test process via overt leaks the press! One thing we learned years ago working at the Fed of New York, the senior man never talks to the media and never goes to the meeting. Maybe our friend Nouriel Roubini could whisper this into Secretary Geithner's ear next time they spend quality time. We hear from the Big Media, BTW, that Tim Geithner's growing corps of handlers directs media inquiries to Roubini for "an objective view" of the Secretary's handling of the financial crisis. One Democrat asks: Could it be Larry Summers to the Fed, Roubini to the White House?
And speaking of the fall of the elites, FRBNY Chairman Steve Friedman finally resigned yesterday, ending a scandalous period when the greater community of present and past employees of Goldman Sachs, JPMorgan Chase and other dealers was arguably in control of the most important arm of the US central bank. The fact that the Board of Governors appointed former GS ibanker Freidman as a "C" class director, who are meant to represent the public interest and not be past officers of regulated banks, was scandal enough. But then, when GS formally became a bank holding company last year, the Board failed to remove Friedman when his conflict became acute. The Board also failed too to appoint another "C" class director, making it almost seem that the Board wanted to assist in the GS operation to influence the operations of a Federal Reserve Bank.
Remember that the board of directors of the FRBNY selected Tim Geithner as President, who then bailed out AIG to the benefit of GS and the other OTC derivatives dealers that were facing AIG. That is why a congressional inquiry is needed to understand just why the Fed Board and, in particular, Fed Vice Chairman Don Kohn, tolerated the Freidman conflict and arguably neglected their statutory duty to ensure the proper governance and operation of a Federal Reserve Bank. But hold that thought.
While the idea of public stress testing is a new concept in Washington, we've been conducting a census of all US banks for years, first via our public Basel II benchmarks and Economic Capital model, and more recently with the bank ratings from our Bank Stress Index. Each quarter, we ask two basic questions about all US banks:
- Stressed View: First, how did you do this past quarter? Looking at factors such as capital, lending, realized losses, income and efficiency, we grade all US banks on a six notch scale, which forms the basis for our "A+" through "F" ratings.
- Risk Adjusted View: Second, we calculate Economic Capital or "EC" factors for all US banks, and compare the "stressed," maximum probable loss from trading, investing and lending to their current capital, from tangible common equity up through the various regulatory measures. By looking at EC, we provide users of the IRA Bank Monitor with a second, risk-adjusted perspective on the safety and soundness of the institution.
Based on the institutions for which data has been released by the FDIC, it is pretty clear in our latest stress test that the condition of the US banking industry is continuing to deteriorate and that we are still several quarters away from the peak in realized losses for most banks. The key telltale in the Q1 FDIC data is that ROE degradation, not charge-offs, still leads the rising stress evidenced by the IRA Banking Stress Index. Remember that provisions are a leading indicator, while charge-offs lag the credit cycle. Once you see ROE performance improving, meaning a decline in the need to build loss reserves to buffer future losses, and charge-offs are the leading factor in our index, then you'll be able to test the thesis that the worst is over for US banks and valuations are beginning to stabilize.
So based on what we see now, is it time to be being financials? One IRA reader in SF named Jonathan asks: "This market for financial stocks must have some of your clients scratching their heads. What do you make of things? Is this irrational exuberance or have we turned?" We'll be addressing the Q1, post stress test valuations for the largest banks as the rest of the units in the bank universe fill in their FDIC CALL reports. No, in our opinion we have not turned the corner in financials. The current FDIC data suggests that bank loss rates may not peak until next year. We are not yet even on the right block to make the turn, in our view. Suffice to say that the composition of the Q1 loss data we see from the FDIC makes us believe that the peak in terms of losses for the US banking industry will be closer to Q4 2009 than our original target of Q2 2009. Given where large bank loss rates were in Q1 2009, just imagine where we'll be by Q4. Or put another way, now you know why regulators are pushing BAC and WFC to raise additional capital.
The bank stress tests conducted by regulators are not so much about capital adequacy through the current economic cycle as identifying enough capital to get the large zombie banks through the end of the year. While Larry Summers and the other economic seers who populate the Obama Administration actually believe that we'll see an economic bounce in Q3 2009 - a key assumption that also underlies the regulators' approach to designing the bank stress tests - we see nothing in the credit channel that suggests improvement in the real economy. Both residential real estate or "RES" and commercial real estate or "CRE" markets in the NY area, for example, are starting to see an acceleration in price declines, this as the swelling population of frustrated sellers is starting to capitulate in the face of few or no buyers.
But the chief reason for this sad tale above is that there is no financing for jumbo loans in the RES market. Indeed, as one of the bankers who participated in the "Market & Liquidity Risk Management for Financial Institutions" conference sponsored by PRMIA at the FDIC University on Monday noted, banks are not originating any RES paper that cannot be sold to Fannie Mae or Freddie Mac, soon to be merged into "Frannie Mae," as we noted earlier. During a luncheon keynote address at that event, Josh Rosner of Graham Fisher & Co. noted much of the "growth" in non-conforming real estate markets during the final years of the boom was fueled by speculative buying and that the lack of financing in the jumbo, non-conforming RES markets is forcing price compression in markets like the urban RES and CRE markets of NY, CA, MA, etc.
"The lack of attention paid to the creation of industry wide standards and a more solid legal basis for securitzation has only hindered the recovery of a financial intermediation in a market that once funded about 50 percent of all consumer revolving and non-revolving credit," Rosner told The IRA. While regulators think that stabilizing the banks was the real battle, is it in fact the dysfunction of the non-bank securitization markets and the effect of this dysfunction on valuations in the RES and CRE real estate markets that is now driving the US economic meltdown? While the Fed as a good bit to the toxic securitizations in cold storage on its balance sheet, the central bank's best efforts at adding liquidity facilities cannot replace this multi-trillion dollar market if banks won't originate paper.
If you want to learn more about the problems in the non-bank sector and how products like ARMs are about to push the US economy into a meltdown, take a look at the presentation from the PRMIA event on Monday by Alan Boyce, the former CFC executive and now chief executive officer of Absalon, a joint venture between George Soros and the Danish financial system that is assisting in the organization of a standardized mortgage-backed securities market for Mexico. Go to the last slide. This is an illustration of the Option Adjusted Duration ("OAD") of the US mortgage markets. Notice that the OAD calculated by Boyce has grown from a low of $23 trillion in Sep 05, which just happens to be the nadir of loan defaults for the US mortgage market, to $45 trillion in Mar 09. The OAD is set to grow significantly as US interest rates rise or as the slope of the interest rate curve steepens.
OAD is essentially a way to measure the economic weight of debt, basically time x money or the price response for a given move in interest rates. Using existing data and some clever suppositions, Boyce constructed an alternate explanation of "the conundrum" of 2003 to 2006. This was driven by the Fed's very predictable interest rate policy, which flattened the interest rate curve and compressed interest rate volatility. Homeowners were encouraged to refinance into ARMs and there was significant cash out refinancing into premium fixed rate mortgages. Interest rate risk was transferred to US consumers and created a ticking time bomb for US markets in terms of the future duration of the total corpus of outstanding mortgage debt.
During the PRMIA conference, Boyce echoed the view of other participants that the failure to act on securitization ensures further RES and CRE price compression. In a rising rate environment the OAD of this RES exposure in particular will grow exponentially and dwarf the "weight" or OAD of the UST debt issuance. The US homeowner will be trapped in their homes, unable to sell as nominal mortgage debt exceeds house values. Of note, in the Danish system, rising interest rates do not create negative equity for home owners, performing borrowers may redeem their mortgage by purchasing the associated bond at the prevailing market rate. Credit risk is kept out of the bond market, making the mortgage bonds a pure reflection of the associated interest rate risks. By efficiently splitting credit and interest rate risk, there are no surprises as each risk resides where it is best analyzed and hedged.
Bottom line is that securitization machine operated by Wall Street doubled the outstanding stock of mortgages during the last five years of the boom, but the falling OAD driven by Fed rate policy hid the growth. Unfortunately, in their wisdom, federal regulators actually encouraged US mortgage originators to use ARMs and other products to push interest rate risk onto the backs of homeowners and bond market investors ill-equipped to understand let along manage such risks. Boyce and many others believe that without a complete refinancing for all performing mortgage borrowers, the US real estate markets - and thus the financial industry - will in trapped in a deflationary environment for years to come.
The only way to fix this mess, Boyce suggested at the conference, is to refinance the entire performing mortgage market into standardized, transparent, callable, fixed rate loans, which allow the homeowner to value his liability at the market price. The interest of the mortgage originator needs to closely aligned to that of the borrower via a minimum 10% first loss risk sharing. Rosner told The IRA he doubts that America's political and business sectors are ready or willing to embrace the transparency and consumer-friendliness of Denmark's mortgage sector, but the fact that Boyce and George Soros are advancing this example as a solution may be significant - especially as the year-end deadline for resolving the conservatorships of Fannie Mae and Freddie Mac approaches. Rosner and Boyce believe that the restructuring of the housing GSEs presents an opportunity to set a new, consistent standard for securitization in the US.
Should The Government Stop Dumping Money Into A Giant Hole?