Monday, March 30, 2009

Alarming News: Bank Losses Spreading!

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Monday, March 30, 2009









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Alarming News: Bank Losses Spreading!
by Martin D. Weiss, Ph.D.


Martin D. Weiss, Ph.D.

For the first time in history, U.S. banks have suffered large, ominous losses in a giant sector that, until now, they thought was solid: bets on interest rates.

In a moment, I'll explain what this means for your savings and your stocks.

But first, here's the alarming news: According to the fourth quarter report just released this past Friday by the Comptroller of the Currency (OCC), commercial banks lost a record $3.4 billion in interest rate derivatives, or more than seven times their worst previous quarterly loss in that category.1

And here's why the losses are so ominous:

Until the third quarter of last year, the banks' losses in derivatives were almost entirely confined to credit default swaps — bets on failing companies and sinking investments.

Next major risk area: Interest Rate Derivatives

But credit default swaps are actually a much smaller sector, representing only 7.8 percent of the total derivatives market.

Now, with these new losses in interest rate derivatives, the disease has begun to infect a sector that encompasses a whopping 82 percent of the derivatives market.2

Thus, considering their far larger volume, any threat to interest rate derivatives could be far more serious than anything we've seen so far.

Meanwhile, time bombs continue to explode in the credit default swaps as well, delivering another massive loss of nearly $9 billion in the fourth quarter.

And remember: These represent the aggregate total for the entire banking industry, after netting out the results of banks with profitable trading.

Why This Crisis Could Be Nearly as
Bad as the Banking Crisis of 1929-31

Yes, I know the standard argument: In 1929, bank regulation and depositor protection was primarily run by state governments. Now, with the FDIC, the OCC, and more direct Federal Reserve intervention, it's far more centralized.

But offsetting that strength are serious weaknesses in the banking system that did not exist in the 1930s:

• In 1929, there were fewer giant banks. They controlled a smaller share of the total market. And they were generally stronger than the thousands of community banks around the country. Today, by contrast, the nation's high-roller megabanks dominate the market.

• In 1929, derivatives were virtually nonexistent. Not today! U.S. banks alone control $200.4 trillion; and it's precisely in this dangerous sector that the megabanks dominate the most.

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According to the OCC's Q4 2008 report, America's top five commercial banks control 96 percent of the industry's total derivatives, while the top 25 control 99.78 percent. In other words, for every $100 dollar of derivatives, the big banks have $99.78 ... while the rest of the nation's 7,000-plus banking institutions control a meager 22 cents!3

This is a massively dangerous concentration of risk.

The large banks are exposed to the danger that buyers will vanish, markets will suddenly become illiquid, and they'll be unable to unload their positions without accepting wipe-out losses. Has this ever happened? Unfortunately, yes. In fact, it's the primary reason they lost a record $3.4 billion in the last three months of 2008.

The large banks are exposed to the danger that, with exploding federal deficits and new fears of inflation, interest rates will suddenly surge, delivering a whole new round of even bigger losses in the months ahead.

Worst of all, the five biggest banks are exposed to breathtaking default risk — the danger that their trading partners could fail to make good on their gambling debts, transforming even the best winning trades into some of the worst losers.

Here's our chart on these risks, updated to reflect the new data just released on Friday:

Major U.S. Banks Overexposed to Default Risk

Specifically, at year-end 2008,

  • Bank of America's total credit exposure to derivatives was 179 percent of its risk-based capital;

  • Citibank's was 278 percent;

  • JPMorgan Chase's, 382 percent; and

  • HSBC America's, 550 percent.4

What's excessive? The banking regulators won't tell us. But as a rule, exposure of more than 25 percent in any one major risk area is too much, in my view.

And if you think these four banks are overexposed, wait till you see the super-high roller that the OCC has just added to its quarterly reports: Goldman Sachs.

According to the OCC, Goldman Sachs' total credit exposure at year-end was 1,056 percent, or over ten times more than its capital.

The folks at Goldman think they're smart, and they are. They say they can handle large risks, and usually they can. But not in a sinking global economy! And not when the exposure reaches such stratospheric extremes!

Major Impact on the Stock Market

In the 1930s, the banking crisis helped drive the economy into depression and the stock market into its worst decline of the century.

The same is happening today. Whether the nation's big banks are bailed out by the federal government or not, the fact remains that they're jacking up credit standards, squeezing off credit lines, and even shutting down major segments of their lending operations.

And regardless of how much lawmakers try to arm-twist banks to lend more, it's rarely happening. With scant exceptions, bank capital has been reduced, sometimes decimated. The risk of lending has gone through the roof. And many of the more prudent borrowers don't even want bank loans to begin with.

Those credit shortages, both acute and chronic, have a big impact on the economy and the stock market. Moreover, unlike the 1930s, banks themselves are publicly traded companies whose shares make up a substantial portion of the S&P 500.

The big lesson to be learned: Don't pooh-pooh comparisons between today's bear market and the deep bear market of 1929-32.

From its peak in 1929, the Dow Jones Industrials Average fell 89 percent. Compared to the Dow's peak in 2007, that would be tantamount to a plunge of more than 12,600 points — to a low of approximately 1500, or an additional 81 percent decline from the Friday's 7776.

Even a decline of half that magnitude would still leave the Dow well below the 5000 level, which remains our current target.

Does this preclude sharp rallies? Absolutely not! From its recent March 6 bottom to last week's peak, the Dow has already jumped a resounding 21 percent in just 20 short days. And the rally may still not be over.

But this is nothing unusual. In the 1929-32 period, the Dow enjoyed even sharper rallies, and those rallies did nothing to end the great bear market. My father, who made a fortune shorting stocks in that period, explains it this way:

"In the 1930s, at each step down the slippery slope of the market's decline, Washington would periodically announce some new initiative to turn things around.

"President Hoover would give a new pep talk promising ‘prosperity around the corner.' And often, the Dow staged dramatic rallies — up 30 percent on the first round, 48 percent on the second, 23 percent on the third, and more.

"Each time, I sought to use the rallies as selling opportunities. I persuaded more of my clients to get rid of their stocks and pile up cash. I even told them to take their money out of shaky banks."

Your approach today should be similar. Specifically,

Step 1. Keep as much as 90 percent of your money SAFE, as follows:

  • For your banking needs, seek to use only institutions with a Financial Strength Rating of B+ or better. For a list, click here. Then, in the index, scroll down to item 13, "Strongest Banks and Thrifts in the U.S."

  • Make sure your deposits remain comfortably under the old FDIC insurance coverage limits of $100,000. The new $250,000 per account limit is temporary and, in my view, not something to rely on long term.

  • Move the bulk of your money to Treasury bills or equivalent. You can buy them (a) directly from the U.S. Treasury Department by opening an account at TreasuryDirect, (b) through your broker, or (c) via a Treasury-only money market fund. For further instructions, click here and review sections 1 through 3 — "How to Buy Treasury Bills or Equivalent," "How to Use Your Treasury-Only Money Fund as a Bank," and "How to Set Up a Single, Safe Account for Nearly All Your Savings and Checking."

Important: You may have seen some commentary from experts that "Treasuries are not safe." But when you review their comments more carefully, you'll probably see they're not referring to Treasury bills, which have virtually zero price risk. They're talking strictly about Treasury notes or bonds, which can — and probably will — suffer serious declines in their market value.

Step 2. If you missed the opportunity to greatly reduce your exposure to the stock market in 2007 or 2008, you now have another chance. And the more the market rises from here, the more you should sell.

Step 3. If you are still exposed to stock market declines, seriously consider inverse ETFs, ideal for helping you hedge against that risk. (For more background information, see my 2007 report, How to Protect Your Stock Portfolio From the Spreading Credit Crunch.)

Step 4. If you have funds you can afford to risk, seriously consider two major profit opportunities in the months ahead:

  • To profit handsomely from the market's next decline. The best time to start: When Wall Street pundits begin declaring "the bear is dead." They'll be wrong. But their enthusiasm can be one of the telltale signs that the latest rally is probably ending.

  • To profit even more when the market hits rock bottom and you can buy some of the nation's best companies for pennies on the dollar. The ideal time to buy: When Wall Street is convinced the world is virtually "coming to an end." They will be wrong, again. But that kind of extreme pessimism could be one of your signals that a real recovery is about to begin.

Good luck and God bless!

Martin





1 For the banks' $3.42 billion loss in interest rate derivatives, see OCC's Quarterly Report on Bank Trading and Derivatives Activities Fourth Quarter 2008, table at the bottom of pdf page 17, "Cash & Derivative Revenue," line 1. As you can see, that was 7.2 times larger than the previous record — the fourth quarter of 2004, when the nation's banks lost $472 million in interest rate derivatives.

2 See OCC table at the bottom of pdf page 11, "Derivative Contracts by Type." In it, the OCC reports total U.S. bank-held derivatives of $200,382 billion at year-end 2008. Among these, the single largest category is interest rate derivatives, representing $164,404 billion, or 82 percent of the total. In contrast, credit derivatives are only $15,897 billion, or 7.93 percent of the total. Within the credit derivative category, the OCC reports (page 1, fourth bullet) that nearly all — 98 percent — are credit default swaps, which have proven to be the most toxic and damaging category of derivatives so far. But they represent only 7.77 percent of all derivatives (7.93 percent x 98 percent).

3 OCC. In Table 1, pdf page 22, "Notional Amount of Derivatives Contracts."

4 OCC, table at bottom of pdf page 13.





About Money and Markets

For more information and archived issues, visit http://www.moneyandmarkets.com

Money and Markets (MaM) is published by Weiss Research, Inc. and written by Martin D. Weiss along with Tony Sagami, Nilus Mattive, Sean Brodrick, Larry Edelson, Michael Larson and Jack Crooks. To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended in MaM, nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MaM are based upon data whose accuracy is deemed reliable but not guaranteed. Performance returns cited are derived from our best estimates but must be considered hypothetical in as much as we do not track the actual prices investors pay or receive. Regular contributors and staff include Kristen Adams, Andrea Baumwald, John Burke, Amber Dakar, Dinesh Kalera, Red Morgan, Maryellen Murphy, Jennifer Newman-Amos, Adam Shafer, Julie Trudeau, Jill Umiker, Leslie Underwood and Michelle Zausnig.

Attention editors and publishers! Money and Markets issues can be republished. Republished issues MUST include attribution of the author(s) and the following short paragraph:

This investment news is brought to you by Money and Markets. Money and Markets is a free daily investment newsletter from Martin D. Weiss and Weiss Research analysts offering the latest investing news and financial insights for the stock market, including tips and advice on investing in gold, energy and oil. Dr. Weiss is a leader in the fields of investing, interest rates, financial safety and economic forecasting. To view archives or subscribe, visit http://www.moneyandmarkets.com.

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Monday, March 23, 2009

Dangerous Unintended Consequences

Dangerous Unintended Consequences
by Martin D. Weiss, Ph.D.
Martin D. Weiss, Ph.D.

I've just returned from Washington, DC, where I held a press conference at the National Press Club and a round-robin series of meetings with members of Congress ... with more to come this week.

Let me first tell you what I told them. Then, I'll explain what I think you should do about it ...

Why Banking Bailouts, Buyouts, and Nationalizations
Can Only Prolong America's Second Great Depression
And Weaken Any Subsequent Recovery

(Edited Transcript of Press Conference Presentation)

The Fed Chairman, the Treasury Secretary and Congress have now done more to bail out financial institutions and pump up financial markets than any of their counterparts in history.

But it's not nearly enough — and, at the same time, it's already far too much.

Two years ago, when major banks announced multibillion-dollar losses in subprime mortgages, the world's central banks injected unprecedented amounts of cash into the financial markets.

But that was not enough.

Six months later, when Lehman Brothers and AIG fell, the U.S. Congress rushed to pass the TARP, the greatest bank bailout legislation of all time.

But as it turned out, that wasn't sufficient either.

Subsequently, in addition to the original goal of TARP, the U.S. government has loaned, invested, or committed $400 billion to nationalize the world's two largest mortgage companies ... $42 billion for the Big Three auto manufacturers ... $29 billion for Bear Stearns, $185 billion for AIG, and $350 billion for Citigroup ... $300 billion for the Federal Housing Administration Rescue Bill ... $87 billion to pay back JPMorgan Chase for bad Lehman Brothers' trades ... $200 billion in loans to banks under the Federal Reserve's Term Auction Facility (TAF) ... $50 billion to support short-term corporate IOUs held by money market mutual funds ... $500 billion to rescue various credit markets ... $620 billion in currency swaps for industrial nations ... $120 billion in swaps for emerging markets ... trillions to cover the FDIC's new, expanded bank deposit insurance, plus trillions more for other sweeping guarantees.

And it STILL wasn't enough.

If it had been enough, the Fed would not have felt compelled this week to announce its plan to buy $300 billion in long-term Treasury bonds, an additional $750 billion in agency mortgage backed securities, plus $100 billion more in Fannie Mae and Freddie Mac paper.

Total tally of government funds committed to date: Closing in on $13 trillion, or $1.15 trillion more than the tally just hours ago, when the body of this white paper was printed.

And yet, even that astronomical sum is still not enough!

Why not? Because of a series of very powerful reasons:

First, most of the money is being poured into a virtually bottomless pit. Even while Uncle Sam spends or lends hundreds of billions, the wealth destruction taking place at the household level in America is occurring in the trillions — $12.9 trillion vaporized in real estate, stocks, and other assets since the onset of the crisis, according to the Fed's latest Flow of Funds.

Second, most of the money from the government is still a promise, and even much of the disbursed funds have yet to reach their destination. Meanwhile, all of the wealth lost has already hit home — literally, in the household.

Third, the government has been, and is, greatly underestimating the magnitude of this debt crisis. Specifically,

  • The FDIC's "Problem List" of troubled banks includes only 252 institutions with assets of $159 billion. However, based on our analysis, a total of 1,568 banks and thrifts are at risk of failure with assets of $2.32 trillion due to weak capital, asset quality, earnings, and other factors. (The details are in Part I of our white paper, and the institutions are named in Appendix A.)

  • When Treasury officials first planned to provide TARP funds to Citigroup, they assumed it was among the strong institutions and that the funds would go primarily toward stabilizing the markets or the economy. But even before the check could be cut, they learned that the money would have to be for a very different purpose: an emergency injection of capital to prevent Citigroup's collapse. Based on our analysis, however, Citigroup is not alone. We could witness a similar outcome for JPMorgan Chase and other major banks. (See Part II of our white paper.)

  • AIG is big. But it, too, is not alone. Yes, in a February 26 memorandum, AIG made the case that its $2 trillion in credit default swaps (CDS) would have been the big event that could have caused a global collapse. And indeed, its counterparties alone have $36 trillion in assets. But AIG's CDS portfolio is just one of many: Citibank's portfolio has $2.9 trillion, almost a trillion more than AIG's at its peak. JPMorgan Chase has $9.2 trillion, or almost five times more than AIG. And globally, the Bank of International Settlements reports a total of $57.3 trillion in credit default swaps, more than 28 times larger than AIG's CDS portfolio.

Clearly, the money available to the U.S. government is too small for a crisis of these dimensions.

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Fourth, but at the same time, the massive sums being committed by the U.S. government are also too much:

  • In the U.S. banking industry, shotgun mergers, buyouts, and bailouts are accomplishing little more than shifting their toxic assets like DDT up the food chain.

  • And the government's promises to buy up the toxic paper have done little more than encourage banks to hold on, piling up even bigger losses.

  • But the money spent or committed by the government so far is also too much for another, relatively less-known reason: Hidden in an obscure corner of the derivatives market is a unique credit default swap that virtually no one is talking about — contracts on the default of United States Treasury bonds. Quietly and without fanfare, a small but growing number of investors are not only thinking the unthinkable, they're actually spending money on it, bidding up the premiums on Treasury bond credit default swaps to 14 times their 2007 level. This is an early warning of the next big shoe to drop in the debt crisis — serious potential damage to the credit, credibility, and borrowing power of the United States Treasury.

This trend packs a powerful message — that there's no free lunch; that it's unreasonable to believe the U.S. government can bail out every failing giant with no consequences; and that, contrary to popular belief, even Uncle Sam must face his day of reckoning with creditors.

We view this as a positive force. We are optimistic that, thanks to the power of investors, creditors, and the people of the United States, we will ultimately guide, nudge, and push ourselves to make prudent and courageous choices:

1. We will back off from the tactical debates about how to bail out institutions or markets, and rethink our overarching goals. Until now, the oft-stated goal has been to prevent a national banking crisis and avoid an economic depression. However, we will soon realize that the true costs of that enterprise — the 13-digit dollar figures and damage to our nation's credit — are far too high.

2. We will replace the irrational, unachievable goal of jury-rigging the economic cycle with the reasoned, achievable goal of rebuilding the economy's foundation in preparation for an eventual recovery.

Right now, the public knows intuitively that a key factor which got us into trouble was too much debt. Yet the solution being offered is to encourage banks to lend more and people to borrow more.

Economists almost universally agree that one of the grave weaknesses of our economy is the lack of savings needed for healthy capital formation, investment in better technology, infrastructure, and education. Yet the solution being offered is to spend more and, by extension, to save less.

These disconnects will not persist. Policymakers will soon realize they have to change course.

3. When we change our goals, it naturally follows that we will also change our priorities — from the battles we can't win to the war we can't afford to lose. Right now, for example, despite obviously choppy seas, the prevailing theory seems to be that "the ship is unsinkable" or that "the government can keep it afloat no matter how bad the storm may be."

With that theory, they might ask: "Why have lifeboats for every passenger? Why do much more for hospitals which are laying off ER staff, for countless charities that are going broke, or for the one in fifty American children who are now homeless? Why prepare for the financial Katrinas that could strike nearly every city?"

The correct answer will be: Because we have no other choice; because that's a war we can and will win. It will not be very expensive. We have the infrastructure. And we'll have plenty of volunteers.

4. Right now, our long-term strategies and short-term tactics are in conflict. We try to squelch each crisis and kick it down the road. Then, we do it again with each new crisis. Meanwhile, fiscal reforms are talked up in debates, but pushed out in time. Regulatory changes are mapped out in detail, but undermined in practice. Soon, however, with more reasonable, achievable goals, theory and practice will fall into synch.

5. Instead of trying to plug our fingers in the dike, we're going to guide and manage the natural flow of a deflation cycle to reap its silver-lining benefits — a reduction in burdensome debts, a stronger dollar, a lower cost of living, a healthier work ethic, a better ability to compete globally.

6. We're going to buffer the population from the most harmful social side-effects of a worst-case scenario. Then, we're going to step up, bite the bullet, pay the penalty for our past mistakes, and make hard sacrifices today that build a firm foundation for an eventual economic recovery. We will not demand instant gratification. We will sacrifice our lifestyle today to assume responsibility for our future and the future of our children.

7. We will cease the doubletalk and return to some basic axioms, namely that:

  • The price is the price. Once it is established that our overarching goal is to manage — not block — natural economic cycles, it will naturally follow that regulators can guide, rather than hinder, a market-driven cleansing of bad debts. The market price will not frighten us. We can use it more universally to value assets.

  • A loss is a loss. Whether an institution holds an asset or sells an asset, whether it decides to sell now or sell later, if the asset is worth less than what it was purchased for, it's a loss.

  • Capital is capital. It is not goodwill or other intangible assets that are unlikely to ever be sold. It is not tax advantages that may never be reaped.

  • A failure is a failure. If market prices mean that institutions have big losses, and if the big losses mean that capital is gone, then the institution has failed.

8. We will pro-actively shut down the weakest institutions no matter how large they may be; provide opportunities for borderline institutions to rehabilitate themselves under a slim diet of low-risk lending; and give the surviving, well-capitalized institutions better opportunities to gain market share.

Kansas City Federal Reserve President Thomas Hoenig recommends that "public authorities would be directed to declare any financial institution insolvent whenever its capital level falls too low to supports its ongoing operations and the claims against it, or whenever the market loses confidence in the firm and refuses to provide funding and capital. This directive should be clearly stated and consistently adhered to for all financial institutions that are part of the intermediation process or payments system." We agree.

9. We will build confidence in the banks, but in a very different way. Right now, banking authorities are their own worst enemy. They paint the entire banking industry with a single broad brush — "safe." But when consumers see big banks on the brink of bankruptcy, their response is to paint the entire industry with another broad brush — "unsafe." To prevent that outcome, we will challenge the authorities to release their confidential "CAMELS ratings" on each bank in the country. And we will ask them to reverse the expansion of FDIC coverage limits, restoring the $100,000 cap for individuals and businesses.

Although these steps may hurt individual banks in the short run, it will not harm banks in the long run. Quite the contrary, when consumers can discriminate rationally between safe and unsafe institutions, and when they have a motive to shift their funds freely to stronger hands, they will strengthen the nation's banking system.

I am making these recommendations because I am optimistic we can get through this crisis. Our social and physical infrastructure, our knowledge base, our democratic form of government are strong enough to do so. As a nation, we've been through worse before, and we survived then. With all our wealth and knowledge, we can certainly do it again today.

But my optimism comes with no guarantees. Ultimately, we're going to have to make a choice: The right choice is to make shared sacrifices, let deflation do its work, and start regenerating the economic forces that have made the United States such a great country. The wrong choice is to take the easy way out, try to save most big corporations, print money without bounds, debase our dollar, and ultimately allow inflation to destroy our society.

This white paper is my small and humble way of encouraging you, with data and reason, to make the right choice starting right now.

Martin D. Weiss, Ph.D.

What You Must Do Now

There followed a vigorous debate and some of the most unique questions I've had the honor to answer in many years. (I'll share them with you when I have the transcript.)

In the meantime, here's what I recommend you do:

Step 1. As soon as you have a chance, take a look at our white paper on the banking crisis.

Step 2. In Part II (where I list a few big banks) and in the appendix, where I have all the rest of the banks and thrifts we believe are at risk of failure, make sure yours is not on it.

Step 3. If it is, I recommend shifting to a stronger institution, regardless of the size of the bank or the size of your account.

Step 4. For our list of the strongest banks in the U.S., plus instructions on where to find even safer havens for your money, see our free report available to all Money and Markets members.

Step 5. Most important, stand by for my appeal for help! I can't do this alone. I will need your support, and I'll explain exactly how soon.

Good luck and God bless!

Martin





About Money and Markets

For more information and archived issues, visit http://www.moneyandmarkets.com

Money and Markets (MaM) is published by Weiss Research, Inc. and written by Martin D. Weiss along with Tony Sagami, Nilus Mattive, Sean Brodrick, Larry Edelson, Michael Larson and Jack Crooks. To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended in MaM, nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MaM are based upon data whose accuracy is deemed reliable but not guaranteed. Performance returns cited are derived from our best estimates but must be considered hypothetical in as much as we do not track the actual prices investors pay or receive. Regular contributors and staff include Kristen Adams, Andrea Baumwald, John Burke, Amber Dakar, Dinesh Kalera, Red Morgan, Maryellen Murphy, Jennifer Newman-Amos, Adam Shafer, Julie Trudeau, Jill Umiker, Leslie Underwood and Michelle Zausnig.

Attention editors and publishers! Money and Markets issues can be republished. Republished issues MUST include attribution of the author(s) and the following short paragraph:

This investment news is brought to you by Money and Markets. Money and Markets is a free daily investment newsletter from Martin D. Weiss and Weiss Research analysts offering the latest investing news and financial insights for the stock market, including tips and advice on investing in gold, energy and oil. Dr. Weiss is a leader in the fields of investing, interest rates, financial safety and economic forecasting. To view archives or subscribe, visit http://www.moneyandmarkets.com.


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Friday, March 13, 2009

The Banking Industry's ProblemsAre Solved!

Eureka! The Banking Industry's ProblemsAre Solved! by Mike Larson

Who knew it would be so easy? Who knew we could solve the banking industry's collapse by simply changing how we account for assets. Eureka! Problem solved!
That seems to be the conclusion Wall Street came to earlier this week, judging by the reaction to Fed Chairman Ben Bernanke's comments at the Council on Foreign Relations on Tuesday. During that speech, Bernanke weighed in on "mark to market" accounting, saying the following:
"The ongoing move by those who set accounting standards toward requirements for improved disclosure and greater transparency is a positive development that deserves full support. However, determining appropriate valuation methods for illiquid or idiosyncratic assets can be very difficult, to put it mildly. Similarly, there is considerable uncertainty regarding the appropriate levels of loan loss reserves over the cycle.
"As a result, further review of accounting standards governing valuation and loss provisioning would be useful, and might result in modifications to the accounting rules that reduce their procyclical effects without compromising the goals of disclosure and transparency. Indeed, work is underway on these issues through the Financial Stability Forum, and the results of that work may prove useful for U.S. policymakers."
Fed Chairman Ben Bernanke's recent comments suggest "modifying" accounting rules might help the banking system.
What Bernanke did is shift ever so slightly toward the position of the banking industry's apologists. These lobbyists, assorted policymakers, and pundits (including folks like Steve Forbes, who wrote an Op-Ed in the Wall Street Journal the other day), are arguing — once you cut to the chase — the following ...
The problem with the banks isn't all the crappy securities and loans they're loaded up with.
It's not that they took on too much excessive risk, lending against assets whose value is plunging.
It's not that they funded asinine private equity deals, stupid commercial construction deals, and dumb home purchases.
It's that they have to mark their book of securities made up of these bundled loans to market. And they argue that the prices they could get for those securities in the markets are "artificially" low — or in some cases, that there is NO market for them.
If only they could avoid marking those assets to market, or use their super- duper net present value and cash flow MODELS — which, surprise, surprise, say the "real" value of those securities is higher — then the banking system would be fine. We could all go back to the wonderful world of yesteryear.
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There's just one problem ...
Pretending Something's Worth More Than It Is Doesn't Change Reality!Look, the problem isn't that there's NO market for these bad securities. The problem isn't that the prices are "artificially" low. The problem isn't how we account for these assets. The problem is that the industry doesn't want to acknowledge that today's prices are the REAL prices.
There are tons of bidders out there for this crappy paper ... at the RIGHT price. Vulture funds, hedge funds, private equity investors: They're all raising billions and billions of dollars to scoop up cheap real estate, inexpensive bundles of mortgage backed securities, and distressed buyout loans.
But sellers don't want to admit reality. They're not hitting the buyer's bids. They're hanging on to the garbage securities, hoping against hope that they won't have to sell at the true market prices. And the government is busy trying to figure out ways to prop up the price of the garbage rather than forcing banks to take their medicine now, even if it means the result is that they have to temporarily be nationalized or put into receivership.
There are plenty of buyers for bad paper — but too few sellers willing to hit buyers' bids.
I understand why this is occurring: Policymakers are afraid of mass insolvencies. So they're trying to figure out how to do something akin to the early 1980s use of Regulatory Accounting Principles (RAP), which papered over insolvencies in the Savings & Loan industry.Of course, papering over the problem didn't mean it went away. No surprise, then, that the unofficial nickname for RAP used to be Creative Regulatory Accounting Principles; you can figure out the acronym yourself.
Worse, many of the S&Ls that were granted forbearance were also allowed to try to grow their way out of insolvency. They increasingly gambled on new ventures, especially commercial real estate, to do so. Result: They eventually blew up anyway — at a much LARGER cost to U.S. taxpayers.
This strategy of delay, stall, and hope has another more recent analog: It's exactly what we saw in the early days of the housing market downturn. Sales VOLUME dried up, while the SUPPLY of homes for sale surged.
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Yet reported median prices didn't decline. I lost count of how many people asked me: If the market is so bad, why aren't prices falling? I answered that fewer and fewer buyers were paying inflated prices, holding up the median.
But the huge build up in supply and dramatic fall off in the sales pace meant it was just a matter of time. The TRUE, underlying market value of U.S. homes was declining; it just wasn't being acknowledged by most sellers yet. Sure enough, the numbers eventually took a dramatic turn for the worse. It's kind of like those old Road Runner cartoons, where the coyote runs over the cliff but doesn't start plunging until he looks down.
It was just a matter of time before the true, underlying market value of U.S. homes sharply declined.
My Prescription: Deal with the Problem Head On!
The longer the industry tries to push out the day of reckoning ... and the longer Washington pretends the problem is accounting rules (or even worse, short sellers, who also were cast as the latest bogeyman for the banking sector) ... the longer this recession is going to drag on. It also increases the chance we end up like Japan, with zombie institutions consuming more and more government dollars even as the economy stagnates.
Think I'm crazy? Then consider this: If institutions just bit the bullet a year or two ago, and unloaded all this crappy paper at the then-available prices, they would be in clover today. They would have gotten much higher prices for these assets.
But they followed the delay, stall, and hope doctrine — and instead of learning from that mistake and changing course, they're STILL making the same mistake today. They're still saying their modeled prices are the "real" prices and that anyone who suggests otherwise doesn't know what he's talking about. They say if the accounting procedures are modified, and the regulators forebear, everything will be fine down the road.
That strategy didn't work for the S&Ls in the 1980s. It didn't work in Japan in the 1990s. It hasn't worked so far this time around. And I don't think it will work in the future.
Until next time,
Mike
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