naked capitalism

Submitted by Rolfe Winkler, publisher of OptionARMageddon

So much for de-leveraging…

The Fed published its latest Flow of Funds report today. One key takeaway: While total debt is growing more slowly, it is still growing. Since Q3 ’08 households have cut their debt (slightly), but the federal government is borrowing so rapidly, overall debt continues to expand.

(Click chart for larger image in new window)

By the way, the Fed only includes publicly held debt when calculating total federal government borrowings, $6.7 trillion at the end of Q1. This excludes over $4 trillion owed to the Social Security “trust fund.” More importantly, it excludes $60 trillion of unfunded future liabilities for Medicare and Social Security.

The second chart puts the data into perspective. As a percentage of GDP, debt continues to expand, from 368% at the end of Q4 to 375% at the end of Q1.

It’s been said that the income statement is the past, but the balance sheet is the future. Our balance sheet is getting worse. Those who see “green shoots” believe the crisis is abating. But they don’t understand its origin: a credit bubble that, in the aggregate, continues to inflate. The equity value of our economy is going down—think the stock market and housing equity (see below). At the same time our debt is going up. In other words, America’s leverage continues to expand.

The only way to climb out of a debt-deflationary depression is to pay down debt or to write it off. Levering up only delays the inevitable. Unfortunately Americans, and lately the Obama administration, have shown absolutely no political will to do this. Republicans decry growing deficits, but do you ever hear them enumerate cuts they would make or taxes they would raise? Clearly our plan is to keep borrowing until our lenders cut us off.

Speaking of crashing equity…

The last chart plots the amount of equity Americans have in their homes. This figure has been crashing as house prices fall while mortgage debt stays roughly constant. At the end of 2007 the figure was 49%, at the end of last year 43%. It now stands at 41.4%.

And as CR notes: “approximately 31% of households do not have a mortgage. So the 50+ million households with mortgages have far less than 41.4% equity.”

Submitted by Rolfe Winkler, publisher of OptionARMageddon

Back in February, amidst the neo-Keynesian rage to spend our way out of recession, I argued that stimulus wouldn’t stimulate. Pointing to the graph of the 10-year Treasury vs. 30-year mortgage rates I said that the government wouldn’t be able to flood the market with Treasurys without driving up interest rates. Higher rates on government debt imply higher rates for mortgages, which would hammer house prices and other assets, blowing an ever-larger hole in bank balance sheets.

The Fed knows long-term rates can’t be allowed to rise because that would run their economic “recovery” off the rails. Enter “quantitative easing,” the policy by which the Fed prints money to buy fixed-income securities like Treasurys and MBS. By printing money to inflate demand, they hope to hold interest rates down.

Sounds great, right? Why can’t the Fed just keep printing money to buy bonds in order to hold interest rates artificially low?

Because bond investors call bullsh*t. As the Fed prints money, inflation expectations rise. When investors anticipate higher future inflation they demand higher interest rates to buy debt. After all, they don’t want to hold fixed-income securities when fixed-incomes lose their purchasing power to inflation.

And so we have a great game of chicken between the Fed and the bond market. The Fed prints money to keep interest rates down while bond investors zip tight their wallets because Fed printing makes bonds less appealing. What is the Fed going to do, become the lender of last resort to the federal government? Print whatever cash is necessary to literally displace vanishing private demand for government debt? This is no solution of course; in the long-run it implies hyperinflation.

And so we return to the question Keynesians like Krugman simply won’t address when they advocate government “stimulus:” How do we pay for it? If we run up additional debts without making some provision to pay them, then in the long-run interest rates have to rise.

You could raise taxes to pay down debt, but that would destroy the positive impact of additional government spending.

The point is there’s no way to financially engineer our way out of this crisis.

Economists love the idea that the Fed is all powerful, that it has some magic wand to wave which can rescue Americans from debt deflation. I suspect this is because, deep down, they harbor ambitions to be Fed Chairman themselves. For most economists, the Fed’s printing press is the ultimate toy….one they’ve always wanted to play with.

And it is a powerful one. Most recessions are easily “solved” because the Fed can always use that printing press to inflate a credit bubble, to inflate demand artificially. This works great until it doesn’t. Eventually the credit bubble becomes so big it’s simply impossible to sustain with more printing.

I suspect this is why Keynesians never bothered asking how we’d pay for stimulus. The answer—”we can’t”—shatters their economic theory.

Krugman offers a partial rebuttal to this argument in his column today. He argues that inflation isn’t a big issue right now. And he’s right: deflation is the real threat. He argues that Fed printing is necessary to counteract it, but he misses the larger point that, in the long-run, higher government debts imply higher interest rates regardless of what the Fed does. Debt is not a static thing. It has to be rolled over, paid down or repudiated (via default). In ascending order of economic violence, each of these implies a debt deflationary depression.

Outright default isn’t an option. Imagine the worldwide economic calamity if Tim Geithner stops making interest payments on Treasurys…

Paying down debt means running surpluses. To do so would require draconian cutbacks in spending by indebted governments, corporations and individuals. Aggregate demand would collapse, leading to depression.

Both of the above are unappealing so the Fed conspires with government to inflate aggregate demand with more borrowing. But more borrowing means more debt that has to be paid down later. More debt means bigger future cutbacks. The longer we kick the can down the road, the deeper the depression we’ll be faced with in the “long-run.”

The bottom line is that we have to pay down debt. We’ve no other choice. Yeah, it’s going to be very painful, but we should have thought of that before we inflated the credit bubble.

———

Post Script:

I can’t leave this piece without rebutting the conclusion to Krugman’s op-ed:

But it’s hard to escape the sense that the current inflation fear-mongering is partly political, coming largely from economists who had no problem with deficits caused by tax cuts but suddenly became fiscal scolds when the government started spending money to rescue the economy. And their goal seems to be to bully the Obama administration into abandoning those rescue efforts.

Because Republicans lost their fiscal bearings during the Bush years doesn’t mean that budget arithmetic somehow no longer applies. Deep down, Krugman desperately wants to support Democratic ambitions to dramatically increase the size of government. But “Republicans did it so we can too” is not an argument. PK knows this but, hyper-partisan that he is, he can’t resist getting in the dig. He should know that plenty of independents abhorred runaway government spending under Bush. We were hoping Obama would bring “change” by putting our fiscal house in order.

Needless to say, the president should not let himself be bullied. The economy is still in deep trouble and needs continuing help.

Yes, we have a long-run budget problem, and we need to start laying the groundwork for a long-run solution. But when it comes to inflation, the only thing we have to fear is inflation fear itself.

Here, for the first time that I’m aware of, Krugman acknowledges the paradox of his prescription. Spending creates a long-run budget problem! But by adding the “long-run” modifier, he gets to kick the can down the road. Deficits aren’t an issue we have to address now so Democrats shouldn’t let themselves be “bullied” into a policy of spending restraint.

But my goodness: what is the the “groundwork” we should be “laying” to provide a “long-run solution” to this “problem?” Krugman owes his readers an answer to this question.

Submitted by Rolfe Winkler, publisher OptionARMageddon

During a press conference today, FDIC Chairwoman Sheila Bair was asked about the Journal’s report that banks are lobbying to buy assets under Geithner’s toxic asset plan, the PPIP.

She says banks will not be able to bid on their own assets, but clearly leaves open the possibility that they’d be allowed to buy the assets of other banks.

This is highly problematic. If banks can act as buyers in any capacity, what’s to prevent collusion? With just a sliver of equity and a pile of non-recourse federal loans, Citigroup could fund a special purpose vehicle to overpay for BofA’s bad assets. In exchange BofA would overpay for Citi’s assets. The beauty of using non-recourse debt is that you can walk away from it. The lender, in this case the taxpayer, is stuck eating the loss on the bombed-out asset.

All banks stand to lose is their small equity investment. And even this amount could be offset if banks collude to overpay.

The ranking Republican member of the House Financial Services Committee, Spencer Bachus, previously expressed outrage that such collusion might be possible. He promised to introduce legislation to prevent it from happening. I’m not aware that he has and have a call in to the Financial Services Committee for comment.

Below, I’ve transcribed Bair’s full response to the question she was asked about PPIP….

No [banks] will not be able to bid on their own assets. I think there has been some confusion about that….There will be no structure where we would allow banks to bid on their own assets. I think there have been separate issues about whether banks can be buyers on other bank assets and I think that’s an issue that we continue to look at. There’s also a question of whether banks who come to the PPIP to sell assets, while they would not be involved in the bidding process—private investors would set the prices—whether part of the consideration they would take back once the price has been set by the private sector, would be in an equity piece in the PPIP. Those are things we’re actively discussing….

I think there are a couple of factors that are still at play here as we try to devlop this structure and look toward the launch of PPIP. One is we’re finding on both the buyer and the seller side there continues to be discomfort about Congress’s view of this program, whether the rules could potentially change. The Boxer/Ensign amendment I think is a good amendment…it addresses conflict of interest issues and we want that too. Nonetheless I think this has created some uncertainty about certain aspects of the Boxer/Ensign amendment and the Treasury will need to issue regulations I think to clarify those issues before we will have comfort by market participants.

Bair’s sentence beginning “nonetheless” was not clear. What I transcribed is what she said. It sounds as if she’s uncomfortable about the amendment (more below)…..she quickly changes the subject…..

Also the good news is banks have been able to raise a lot of new capital before taking more aggressive steps to cleanse their balance sheets. The incentives to sell [assets to the PPIP] may be less for good reasons because they’ve been able to raise new capital.

So there are still some issues we are working through…

She knows taxpayers are getting a raw deal, which is why it would be “good news” that banks’ have less incentive to sell assets to these vehicles. She also knows that banks are still swimming in so much toxic junk, it has to be flushed away somehow. But she’s apprehensive that the public might have a transparent view of the cleansing process.

Enter the Boxer/Ensign amendment, which is attached to S. 896. It reads:

To provide for oversight of a Public-Private Investment Program, and to authorize monies for the Special Inspector General for the Troubled Asset Relief Program to audit and investigate recipients of non-recourse Federal loans under the Public Private Investment Program and the Term Asset Loan Facility.

In other words, Senators Boxer and Ensign want to give Neil Barofsky oversight over PPIP in addition to TARP. Is Bair uncomfortable with this because she knows Barofsky would publicize some of the very abuses the administration is counting on to help banks push their losses onto taxpayers?

Submitted by Rolfe Winkler of OptionARMageddon

Reader Note: Last fall, I published a detailed (recent) history of BankUnited in the pages of Housing Wire Magazine. With the bank’s future likely to be settled over the next week, I thought NC readers might appreciate a look at the piece. Thanks to HW’s Paul Jackson for allowing me to re-publish.

October 2008

No Option on Financial Pain

Florida’s BankUnited Faces Tough Choices in an Even Tougher Mortgage Market

September was a bad month for BankUnited Financial, Florida’s largest regional bank (Nasdaq: BKUNA). The company’s regulatory capital status was downgraded, it fired 12 percent of its employees, and it received a cease and desist order from the Office of Thrift Supervision. BKUNA has thus far failed to raise capital to protect its balance sheet and, with its stock at 55 cents as of this writing, appears likely to join the ranks of imploded lenders.

Marked by poor quality of earnings, nepotism, self-dealing and managerial incompetence, BKUNA’s story makes a fascinating case study—one that’s highly relevant for analysts studying the financial statements of America’s big banks.

BKUNA’s lending business is concentrated in Florida, California and Arizona, states that have been hammered by the housing bust. And 60 percent of the company’s $12 billion loan portfolio is made up of pay option adjustable rate mortgages, a particularly toxic loan that put thousands into houses they couldn’t afford.

Option ARMs are like credit cards: Borrowers have the option to make a minimum payment each month, with any unpaid principal and interest added to the balance of the loan. When the borrower pays less than the interest and principal due, the loan is said to be “negatively amortizing.”

And few of BKUNA’s borrowers regularly make full payments—only 9 percent as of June 30. Eighty percent of the rest were paying the minimum.

But according to GAAP, any interest owed is earned, including any portion the borrower chooses to defer. The lender recognizes the full amount as revenue with any unpaid balance added to receivables.

During the three fiscal years ending Sept. 2007, BKUNA recognized $360 million of pretax income. Over that same period non-cash interest income was $270 million.

In a perpetually rising housing market, the lender isn’t concerned about the collectability of this revenue. Eventually the borrower will refinance his loan, paying off all outstanding principal and interest. But if house prices fall 40 percent, the borrower goes upside down, complicating collections.

BKUNA executives defend their lending practices saying they didn’t engage in “subprime lending” and that borrower FICO scores averaged over 700. But as analyst Zach Gast of RiskMetrics Group notes, “borrowers with less equity in their homes have a higher probability of default regardless of credit score.”

And this makes perfect sense. A borrower with zero equity making a minimum payment is effectively a renter with an option to buy. If the house price goes up, the borrower can refinance the original loan and capture any incremental equity. But if the price goes down, it makes more sense to mail your keys to the lender, letting the option expire worthless. The lender is left with a defaulted loan to write down and a pile of non-cash interest income to charge off.

Even if house prices stay flat, an option ARM borrower making minimum payments will have another incentive to walk away: When the loan balance grows too large, the payment schedule automatically recasts, forcing the borrower to make a (usually much higher) fully-amortizing monthly payment. Call it the option ARM emergency override. Theoretically it protects the lender by capping the growth of the loan’s balance; in reality, it’s the moment when the loan goes toxic. The borrower suffers severe payment shock and has extra incentive to default.

Fit for a Minsky

Stepping back for a moment, it’s worth pondering how negatively amortizing loans inflated the last stages of the housing bubble. For this we turn to the late economist Hyman Minksy and his financial instability hypothesis. In a nutshell, Minsky theorized that stability destabilizes because it encourages imprudent risk-taking. Stability becomes instability in three stages, with three corresponding types of debt—so-called hedge units, speculative units and Ponzi units. The debt products perpetuating the housing bubble fit this mold perfectly.

A “hedged” debt unit is one where the borrower’s income is sufficient to pay interest and principal in full each month. He should be able to pay off his mortgage on schedule, regardless of price fluctuations.

A “speculative” debt unit is one where the borrower’s income is sufficient to pay interest but not principal. The borrower is speculating that the value of the collateral will not decline, and that sale proceeds will be sufficient to pay off the principal. If prices climb, the borrower ‘s bet pays off.

A “Ponzi” debt unit is one where the borrower’s income is insufficient to pay down either interest or principal. The borrower is speculating that the house price will go up, and that sale proceeds will be sufficient to pay off principal and unpaid interest.

Over the last 10 years, mortgage finance progressed from hedge units (fixed rate, 20 percent down mortgages) to speculative units (interest-only, 10 percent down), to Ponzi units (negative amortization, zero down). Towards the end of the bubble, prices got “too high” because marginal buyers had no hope of paying off their mortgage without further price appreciation. Eventually there are no greater fools looking to buy and the Ponzi scheme implodes. Option ARM lenders bankrolled this, the last stage of the housing bubble, by pumping Ponzi-finance into the market.

And BKUNA was the “option ARM specialist extending loans beyond all others,” according to RiskMetrics’ Gast. He says other lenders specializing in option ARMs—Downey Savings and Loan, FirstFed Financial, Countrywide, WaMu and Wachovia’s Golden West Financial—slowed such lending by Fall 2006. BKUNA kept at it for another year.

And while all competing in the space played fast and loose with accounting rules, BKUNA was particularly aggressive. At the end of the June quarter, BKUNA’s loan loss reserves were a puny 2.5 percent of loans held. That compares to Downey’s six percent, and FirstFed’s four percent.

Lastly, because BKUNA’s option ARMs were largely originated through outside brokers, accounting rules allow them to defer and capitalize origination fees. As BKUNA writes down its exposure to option ARM loans, it must also expense any corresponding origination costs in one shot. This may prove a fatal hit to shareholder’s equity—35 percent of which is accounted for by deferred costs.

A question of when, not if

Much of the Florida and California property market is in full-fledged depression, and BKUNA’s financial picture is just as ugly. Consider their June 10-Q filing with the SEC:

• Non-performing loans as a percentage of total loans were eight percent, up from one percent at the start of 2007.
• Shareholder’s equity of $575 million was off 30 percent since its high last September.
• The stock, which traded as high as $28 last year, is now under a dollar.

And the situation will only grow worse. Gast says peak defaults for BKUNA’s Option ARM loan book won’t arrive until 2010.

BKUNA has managed to stay afloat with brokered deposits and Federal Home Loan Bank loans. But even these sources of capital have now been cut off. The FHLB cut BKUNA’s credit line in July and OTS eliminated its access to brokered deposits in September, downgrading the bank to “adequately-capitalized.”

Now BKUNA is racing to raise $400 million. At the current market price, they’d have to sell 700 million new shares. Only 35 million are outstanding today. Is it any wonder the stock is below $1? If the bank succeeds in raising capital, existing shareholders will be diluted to zero. If it doesn’t, the bank will likely get seized.

Until late October, BKUNA’s executive ranks had been remarkably stable, thanks to a dual-class share structure that left CEO Alfred Camner with voting control. As recently as August, Camner continued to defend his bank’s lending practices, telling the New York Times that option ARMs “for a very long time [were] an excellent performing package.” For qualified borrowers, “it was an excellent loan.”

By “very long time” does he mean the four years his bank was writing these loans?
As for borrowers’ qualifications, how would he know? According to BKUNA’s investor presentation, the company verified employment, income and assets for less than 20 percent of its residential borrowers. Incidentally, the Times also quoted him dismissing concerns about the bank’s lending practices as “completely absurd” and “idiotic.”

Back in June, Camner offered to relinquish his Class B shares if a white knight should sally forth with the $400 million. But no investors stepped up. On Oct. 20, he resigned.

He’ll receive a year’s pay, health insurance, $12,000 towards the lease on his car, $50,000 towards an office and an assistant, and up to $25,000 to reimburse legal expenses. Additionally, the company will buy back 340,000 of his Class B shares at “market value.” All of the above add up to a meaningful sum for a company desperately in need of cash, even if Camner only gets $0.55 per share for his stock.

Luckily for Camner, he has another gig to fall back on. Besides being CEO of BKUNA, he’s also senior managing director of law firm Camner, Lipsitz and Poller, which has billed BKUNA $12 million in legal fees over the last three years. (For this nugget, see “related party transactions” in the 10-K. There, you’ll also find that Camner’s daughter Errin is CLP’s managing director.)

Another of Camner’s daughters, Lauren, was a BKUNA senior vice president and board member. At 33 years old, she was the youngest director on a board the average age of which is 61. She resigned the same day as her father. A third daughter, Danielle, was BKUNA’s vice president for government affairs from 2001-2004, according to a resume published on social network website LinkedIn.

Replacing Camner as CEO is Ramiro Ortiz. As president and COO of BKUNA since 2002, Ortiz played a key role building up the bank’s option ARM loan book.

Not too big to fail

Eighteen months ago, it was thought BKUNA’s retail franchise and deposit base would help it survive the housing bust. If the situation deteriorated, an acquirer with designs on Florida would buy them out. But back then, Gast says analysts were assuming loan loss rates of 4-5 percent. Today it’s clear loss rates will be substantially higher. It’s hardly surprising that acquirer banks are waiting for targets to be seized and for the FDIC to absorb losses before they move in.

One exception is Wells Fargo, which plans to acquire Wachovia’s toxic loan book with no guarantees from the government. Before Wachovia acquired them in 2006, Golden West Financial was one of the largest purveyors of option ARMs nationwide, having pioneered the loan product 20 years ago. Wachovia’s legacy option ARM loan book from Golden West was $122 billion prior to the merger announcement, making it the largest option ARM lender by dollar volume. Concentrated in California, those loans may have to be written down 50 percent over time, according to industry analyst Mark “Mr. Mortgage” Hanson.

Perversely, Golden West’s more liberal lending policies are helping it delay write-downs. Banks like BKUNA, Downey and FirstFed typically force option ARM borrowers to make a full mortgage payment after 5 years or when the loan balance reaches 115 percent of its original value, whichever comes first. When borrowers face this payment shock, they default in large numbers.

But Golden West’s option ARMs allow the loan balance to grow for 10 years or to 125 percent of original value. Borrowers can continue making minimum payments longer so loans don’t “default” for years. Though this ultimately puts Wachovia on the hook for steeper losses, it also delays the day of reckoning.

Why would Wells Fargo take on Wachovia’s loan book with no government guarantee? According to Hanson, it’s an “all or nothing bet to make themselves too big to fail, to grab deposits, and to take advantage of both new tax laws and the potential generosity of the government with taxpayers dollars.”

Taxpayers have already been generous to Wells, to the tune of a $25 billion equity injection. The TARP will likely throw billions more their way to deal with Wachovia’s toxic paper and Wells’ own $180 billion book of HELOCs, prime jumbos and subprime. Throw in the tax benefits from the write downs on Wachovia’s assets and Wells might just come out ahead.

However the deal comes off, with $1.4 trillion of combined assets, Wells-Wachovia won’t be allowed to fail. With only $14 billion of assets, however, the same probably can’t be said for BankUnited.

Submitted by Rolfe Winkler, publisher of OptionARMageddon

In an interview with Charlie Rose on Tuesday, Tim Geithner admitted the bubble was caused by Greenspan’s easy money policy. Unfortunately, Charlie didn’t ask the obvious follow-up: “why will this time be different? Why will Bernanke’s easy money policy lead to different results?” Here was the crucial exchange:

Rose: “Looking back, what are the mistakes and what should you have done more of? Where were your instincts right, but you didn’t go far enough?”

…

Geithner: “…I would say there were three types of broad errors of policy and policy both here and around the world. One was that monetary policy around the world was too loose too long. And that created this just huge boom in asset prices, money chasing risk. People trying to get a higher return. That was just overwhelmingly powerful.”

Rose: “It was too easy.”

Geithner: “It was too easy, yes….

What makes Geithner’s admission so frustrating is that the government is engaged in the same disastrous policy today, to fight the same bogeyman: deflation.

As Geithner makes plain, a huge side effect was that investors seeking meaningful returns inflated the bubble taking flyers on overpriced, risky securities. Toxic structured products are the obvious example. Credit rating agencies get lots of blame as enablers, rating trash “AAA.” But fixed-income investors wanted an excuse to invest in riskier stuff that carried slightly higher yields; hell, artificially low interest rates meant many needed an excuse.*

Truly low risk securities like Treasurys and money market instruments were yielding so little, they were of no use to portfolio managers trying to match assets with liabilities.

But what happens when low-risk fixed-income securities yield 0% or close to that? Asset managers are more or less forced to seek higher interest rates through riskier investments.

So what are the results of our latest experiment with rock-bottom rates? Investors are piling back into risky investments across the board. Taking just one example, FT noted this week that high-yield debt is skyrocketing. The “experts” cited in the article claim this is proof that we’ve come through the worst of the recession. In their brains, markets operate efficiently, so running bulls must reflect improving fundamentals.

First of all, efficient market theory doesn’t apply to asset markets the way it applies to goods markets. But even if it did, how can folks pretend that any market with fixed prices is operating efficiently? With their stranglehold on interest rates via open market ops, central banks everywhere are engaged in a massive price fixing scheme that distorts investor incentives across all asset markets.

Geithner admits such a policy was a disaster before, that the “overwhelmingly powerful” force of low rates inflated the bubble. So how can he/Bernanke justify the same approach this time ’round? No doubt they’d argue they’ve no other choice: a ponzi system “relying on credit” needs credit to flow or else it will collapse. It doesn’t occur to these guys that the system itself is flawed, that we need a gut renovation, not just another layer of paint.

No doubt de-leveraging would be quite violent if the Fed left rates higher. But de-leveraging is the only solution to the crisis. God forbid Bernanke’s easy money policy actually “works;” God forbid he “rescues” the economy by reflating the credit bubble. De-leveraging is coming, whether we want it to or not. Better to rip the band-aid off quickly…

[The guest writer's blog can be viewed here.]

—–

*Not that CRAs are blameless. They deserve every ounce of criticism they’ve received.

Submitted by Rolfe Winkler, publisher of OptionARMageddon

Much has been said here and elsewhere about the stress test’s lack of credibility, especially after word emerged about “intense bargaining”over the results. Not to belabor the point, but some data may be of use.

Of the more promising developments early in the process, the Fed articulated the importance of tangible common equity as the proper measure of bank capital. Being the most stringent measure of its kind, use of TCE stood to give the tests more credibility.

But in the end, the Fed switched to a more favorable metric: “Tier 1 Common Capital”

Click to enlarge

This was just another of the administration’s many games to make banks look healthier than they really are.

It’s a shame regulators didn’t use the tests as an opportunity to reassert their control. Instead, they demonstrated yet again that banks have them totally captured…

Submitted by Rolfe Winkler, publisher of OptionARMageddon

Ahead of official announcements regarding stress test results, OA thought we’d publish our latest update for banks’ tangible common equity, a metric that is likely to figure prominently in the results.

A recent Reuters report said “U.S. regulators want the top 19 banks being stress-tested to have at least 3% [TCE].” In other words, regulators want leverage ratios below 33x.* Surreal, no? That the banking system has grown so bloated that 32x leverage can be considered “healthy?”

Using the 3% Test, the results for the nation’s nine largest banks are mixed…..four pass, five fail…..

And by the way, this is before “stressing” the balance sheet per future “adverse” scenarios. As you can see, most banks fail the test before they even sit for it…

(Click to enlarge)

To be clear, this is not a prediction of the government’s verdict. As Jack Ciesielski of The Analyst’s Accounting Observer points out: “there is no iconic definition of TCE. Treasury may come up with one of their own that takes into account questionable items” so that all the banks pass. That would be consistent with early reports….

The banks themselves have varied definitions of TCE. The measure is supposed to be the true acid test of bank capital, which means it should be calculated conservatively. ALL intangible assets have to be backed out.* To calculate the TCE Ratio in the highlighted column, I’m using a very conservative calculation.**

Banks’ own methodology for calculating TCE varies. The “% overstated” column is meant to show which ones have taken the most liberties. (Interested parties can contact OA via e-mail to purchase our data set containing more detailed info about each bank’s calculation methodology, as well as quarterly TCE data and Level 1/2/3 assets dating back to Q1 ’08.)

A huge caveat with this data is that these companies have off-balance sheet exposures. Some of them huge. And many have big chunks of “other assets” on balance sheet, some of which may be intangible. When there is disclosure for these, it varies. So to keep the data consistent, both are excluded. Hopefully the stress testers got a decent view of these risk buckets in order to factor them into results….though I wouldn’t count on it….

Incidentally, I added the right-most column in order to give readers a sense for the degree of vulnerability on the asset side of bank balance sheets. Level 2 (“mark to model”) and Level 3 (“mark to myth”) asset values are the ones over which management has the most discretion. These days management can’t be trusted so it’s our bet that those with the biggest discretionary buckets—JPM, BofA, C—are the ones sitting on the largest losses.

—————–

*All the banks fail to back out mortgage servicing rights from TCE, even though these are intangibles under GAAP. Some banks (BofA, Wells, Chase) have substantial MSRs, others (GS, MS) don’t. Some banks add back “def’d tax liabilities” related to intangibles (BNY Mellon, Wells, Chase, PNC). This is not conservative. Two banks (Wells, PNC) goosed TCE by reclassifying “noncontrolling minority interests” from liabilities to equity.

**TCE = shareholder’s equity (excluding noncontrolling minority interests) – goodwill – intangibles – preferred – MSRs.

Fair Disclosure: OA has short positions in companies mentioned in this post.

Submitted by Rolfe Winkler, publisher of OptionARMageddon

A hedge-funder well-known to OA—who wishes to remain anonymous—chimes in with a rather fascinating idea in our humble opinion, one that (at least in the state of Maryland) could take the foreclosure process for many houses/condos out of the hands of banks.*

We thought worthy of sharing because of the larger theme at play. Various housing “rescue” programs have all been failures because it is nearly impossible to get competing constituencies to agree on workouts. Banks, servicers, bondholders, homeowners…their interests are simply incompatible.

“Rescue” programs are absurd to begin with, of course. They amount to taxpayer-financed price fixing schemes to put a floor under house prices in order to protect Bill Gross MBS investors, bank balance sheets, and existing homeowners (in that order).

The only real solution to the housing mess is for prices to fall far enough for inventory to clear. Arbitrage opportunities like this might effect that outcome:

In lieu of buying a house I’m thinking of trying to buy some tax liens at the Baltimore auction on May 19^th. For those not familiar with tax liens, they’re property taxes that delinquent taxpayers have not yet paid the city. The city needs the cash to fund its operations so it auctions off these delinquent tax receivables every year to raise funds. In return, the holder of the tax lien gets statutorily mandated interest payments of up to 25% (annualized, paid by the property owner, not the city) as well as first lien rights. Maryland’s laws are very favorable for tax lien holders. If you haven’t been repaid by the delinquent property owner within six months you can begin to foreclose on a property to recoup your investment plus accumulated interest. Further, you can actually control the process because you’re senior to the bank in the capital structure. Essentially you just push the property into auction and then you get paid off with the proceeds before even the bank does. In very rare and complicated circumstances you can sometimes take control of the property with the bank getting nothing (i.e., you buy a property for the value of the tax lien, or really for pennies on the dollar).

I actually bought a few books and studied the tax lien market pretty closely back in 2002, the last time the economy was weak. I never acted on my knowledge, though. I can’t imagine a better environment for lien holders than the current one. There are back taxes on so many vacant condos and other properties that can’t possibly be funded by their insolvent developers. The question is just how competitive the process will be to purchase the liens on these properties. Big institutional money participates in this market because the only major risk is liquidity (i.e, it may take you six months to a year to cash in your liens).

Anyway, the point of this discussion is that I think the lien auctions could have serious ramifications for the bottoming of the housing market, both in Baltimore and nationally. As noted above, tax lien owners in Maryland have the right to begin foreclosure proceedings within six months of a lien auction. The number of liens up for auction has skyrocketed relative to last year. This would suggest that a flood of properties might go into foreclosure across Maryland late this year and in early ’10 as lien holders begin positioning to cash in their returns. Thus, there could be a spike in foreclosure auctions later this year and well into 2010. Assuming ’09 is the peak year for tax lien auctions (i.e., there will be fewer delinquent property owners next year than this year) that might mean that the Maryland housing market – especially in high delinquency regions like Baltimore city – could begin to really bottom over the course of the next year. In other words, these lien owners could force the system to purge itself of its excesses more so than the banking system or the government will.

Since bank foreclosure proceedings are interminable and banks are loathe to take write-downs quickly these days until they can allow their current wide [net interest margin] spreads to rebuild their capital base, they are not going to rush to clear their crap housing inventory. Tax lien holders, however, can take over the process from the banks and have a completely different set of incentives and timing priorities. As such, they’re likely to push the process much more aggressively…and quickly. Thus, I wouldn’t be surprised to see the Baltimore city market looking much cleaner – albeit at lower prices – a year from now as a lot this overpriced, over-built housing stock gets cleared.

Tax lien laws are less favorable for lien holders in most other states (if I recall, Arizona is the only other state with the 6-month waiting period). The vast majority of states – again, if I’m remembering correctly – require tax lien holders to wait at least two years before they can begin foreclosure proceedings. If my logic above regarding banks’ and lien holders’ varied incentives and time horizons is correct, then it’s possible housing could continue to weigh on certain markets for a couple more years until the tax lien holders are allowed to force properties into auction and clearing prices are realized…..I think the tax lien market could be a driver that brings us to the much-needed day of reckoning….

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*Nothing in this article should be construed as investment advice. The piece is provided for readers’ edification only.

Submitted by Rolfe Winkler, publisher of OptionARMageddon

The Congressional Oversight Panel released its latest report yesterday. Luckily news outlets reporting on the release (see Bloomberg and Housing Wire) are skipping Warren’s YouTube and Executive summaries–awkward exercises in establishing consensus both of them. They focus instead on the report’s more provocative suggestion, that liquidating failed banks would be a better way of solving the economic crisis.

And we’d better get a move on. The report makes a very good point that unlike Japan and Sweden, we can’t rely on international consumer demand to rescue us:

…we may in fact be more economically vulnerable to a weakened financial system than either Sweden and Japan were because we cannot rely on some larger economy to generate consumer demand for our goods and services.

Unfortunately, the report is not able to conclude that liquidation is the way to go. Three panel members—John Sununu, Richard Neiman and Jeb Hensarling—remain convinced that we’re facing a short-term liquidity problem, not a long-term solvency problem. With that in mind, they think Treasury’s plan to subsidize banks is the least bad option. Keep them stumbling along until favorable lending conditions return them to profitability. But if the banks ARE insolvent, then subsidizing them is pouring public money down the drain. We know this from Japan’s experience. They kept banks on life support for a decade, which solved nothing. They ran up stupendous budget deficits in a failed attempt to stimulate an economy weighed down by broken banks. Hard as they tried, Japan couldn’t borrow its way out of its bank crisis. And neither can we.

This point of contention is easy to spot when reading the report’s executive summary next to the John Sununu/Richard Neiman “alternative view.”

From Warren’s exec summary:

One key assumption that underlies Treasury’s approach is its belief that the system-wide deleveraging resulting from the decline in asset values, leading to an accompanying drop in net wealth across the country, is in large part the product of temporary liquidity constraints resulting from nonfunctioning markets for troubled assets. The debate turns on whether current prices, particularly for mortgage-related assets, reflect fundamental values or whether prices are artificially depressed by a liquidity discount due to frozen markets – or some combination of the two.

Were internet stocks “artificially depressed” after the bubble burst in 2001? If you think so, then I’ve got eToys stock I’d like to sell you for $50 a share. With that in mind, it’s absurd to think real estate prices are now “artificially depressed.” They are returning to valuations that are fundamentally sound, i.e. supported by actual cash flows as opposed to easy credit. “Mortgage-related assets” are secured by real estate. If houses are declining in value, the loans made to purchase them at obscene valuations must also fall. Back to Warren…

If its assumptions are correct, Treasury’s current approach may prove a reasonable response to the current crisis….

On the other hand, it is possible that Treasury’s approach fails to acknowledge the depth of the current downturn and the degree to which the low valuation of troubled assets accurately reflects their worth. The actions undertaken by Treasury, the Federal Reserve Board and the FDIC are unprecedented. But if the economic crisis is deeper than anticipated, it is possible that Treasury will need to take very different actions in order to restore financial stability.

She is bending over backwards to give Sununu/Nieman a fair shake. Here’s their view:

We affirm that it is entirely reasonable to assume that a liquidity discount is impairing these assets, and thus that the Treasury has adopted a viable plan based on this valid assumption. Further, we believe that a viable plan should be given the opportunity to work. Speculation on alternatives runs the risk of distracting our energy from implementation of a viable plan and needlessly eroding market confidence. Market prices are being partially subjected to a downward self-reinforcing cycle that could be exacerbated by unwarranted consideration of more radical solutions such as nationalization.

How Sununu and Neiman can justify this opinion is beyond me. Banks have but a fraction of tangible common equity relative to their assets, which means there’s no cushion to absorb losses. To argue that this is a liquidity problem, one needs to prove that asset values are temporarily depressed, that the values they reached during the bubble were in fact “correct.” But of course they weren’t. So why give equal weight to bullshit arguments that assets tied to real estate are “depressed?”

Winning this argument is crucial to getting through this crisis with our national balance sheet intact.

Fannie and Freddie are insolvent to the tune of hundreds of billions (so far Obama has committed $200 billion to each of them). You no longer hear arguments that these institutions are just temporarily illiquid. The banking sector has been the recipient of far larger subsidies in total yet opponents of seizing them still delude themselves that banks are still fundamentally sound.

How interesting that a Republican like Sununu is helping to lead the charge here. No doubt he justifies his opposition to “nationalization” on some sort of bastardized free market grounds. The last thing he probably wants is government control of banks. But he’s missing the forest for the trees. The socialist solution to the problem isn’t taking control of the banks, it’s having taxpayers absorb bank losses. Capitalism is about failure. Bad businesses fail and good ones rise in their place. This leads to employment volatility in the short-term but more growth and innovation in the long term.

Because economic activity is particularly sensitive to the fates of the financial sector, we have a particular way of dealing with bank bankruptcies. Receivership or liquidation as directed by FDIC. That’s the only “solution” to the bank crisis.

But it’s not fair to single out Republicans for permitting this travesty to continue. Yes, the bailout policy originated with the Bush administration, but clearly Obama has taken ownership of it. This is a shame. Having heard him speak about the superiority of the Swedish solution to the Japanese one, I think he knows that a proper bank recapitalization needs to happen. Yet he clearly doesn’t have the cojones to deliver the goods. He can’t even stand up to his own economic team; Geithner and Summers will move mountains to protect banks and their creditors. This will continue until Barack puts a stop to it.

Hopefully by firing both of them and putting Paul Volcker in charge.

(You can read this guest author’s blog here)

Submitted by Rolfe Winkler, publisher of OptionARMageddon.

[Reader note: I thought it useful to add commentary around the FDIC data. Those that would prefer to skip straight to it, see the chart and read paragraphs 4-9].

Conventional wisdom says that financial companies are having trouble borrowing because credit markets are broken. This is dangerously wrong. The credit market itself is fine. It’s balance sheets that are broken. They have so little equity relative to their assets, there’s no cushion to protect creditors from losses. With few good borrowers available and with the price of credit capped by government, naturally creditors have little inclination to lend. Washington’s solution is to “guarantee” all manner of risky investments, to use the public’s balance sheet to absorb trillions of dollars worth of private sector losses. We’re told this will “restore confidence” in borrower balance sheets, leading to increased lending. But this policy is dangerously misguided and may very well lead to economic Armageddon.

In point of fact, our fractional reserve financial system is just a gigantic Ponzi scheme. It can only survive as long as it expands, which is to say, as long as new debt is flushed through the system to finance old debt. But like all Ponzi schemes, the larger it grows the more unstable it becomes. Eventually, it too will collapse of its own weight.

With this in mind, government should be concerned with paying down debt, not expanding it. Deficit-financed bailouts and stimulus only increase the size of the Ponzi. The bigger it grows, the harder it will crash.

(click chart to enlarge)

My thoughts came back to this recently when I looked at FDIC’s 12/31/08 balance sheet. Note at the bottom of that link the estimate for total insured deposits: from Q3 to Q4 it increased only a smidge, to $4.8 trillion from $4.6 trillion.

Odd, no? Why such a small increase even though FDIC dialed up deposit insurance limits so significantly during Q4? FDIC Senior Banking Analyst Ross Waldrop told me during an interview last week that it’s because so-called “temporary” increases in deposit insurance are excluded. If included, these would boost total insured deposits from $4.8 trillion to $6.2 trillion.

FDIC’s total commitments would increase an additional $224 billion to $6.4 trillion if you include debt issued prior to the new year under FDIC’s “Temporary” Liquidity Guarantee Program.*

In early October, FDIC boosted deposit insurance limits for individual non-retirement accounts to $250k, which, according to Waldrop, added $713 bilion to total insured deposits. He also noted that new insurance on non-interest bearing transaction accounts added $684 billion to the total.

Waldrop wouldn’t comment on the validity of excluding temporarily insured amounts from the total.

It seems intellectually dubious, if only because there’s little chance FDIC will actually allow the temporary increases to expire. Doing so would risk sparking depositor panic, precisely what FDIC is trying to avoid.

What does this have to do with Ponzis? When Bernie Madoff’s scheme collapsed, he owed somewhere north of $50 billion to his investors but had only a tiny fraction left in the bank. FDIC’s potential liabilities as of Q4 were $6.35 trillion. It has but a tiny fraction of that amount—$19 billion—in the Deposit Insurance Fund. Readers might argue that comparing the two is unfair; FDIC has an open line of credit on the U.S. Treasury. So FDIC’s credit is as good as Uncle Sam’s.

But how good is his? Already, the federal government has committed $12.8 trillion to fight this financial fire (a figure that doesn’t include FDIC’s $6 trillion worth of insurance commitments). Then there’s the trillions of unfunded liabilities for private and public pension schemes that Uncle Sam may be forced to absorb. Also there’s Obama’s budget deficits, which will commit us to borrowing trillions more over the next decade. Finally and most importantly, our unfunded liabilities for Medicare and Social Security surpass $50 trillion.

At the end of the day, after borrowing and money printing have been maxed out, the federal government’s credit is limited by the taxes it can collect from the American people. No way no how can Americans pay for all of the above. It would cost every one of us hundreds of thousands of dollars today. Yet society still feeds the collective delusion that government liabilities are “risk-free” because it has a printing press. But printing is just default by another name: inflation. And the more we come to rely on government guarantees, the more unstable they become…

With this in mind, it is for government to promote debt expansion, but that is precisely what government “guarantees” are designed to do. They are designed to boost lending.

Fannie and Freddie were just the most obvious examples of how terribly this can backfire. Perhaps trillions of dollars flowed through Fan/Fred into the mortgage market as a result of the government’s implicit (now explicit) guarantee of their debt. This helped inflate a bubble that is now bursting spectacularly.

FDIC deposit insurance is an even more insidious guarantee, the “crack cocaine of American finance” as Martin Mayer put it in his definitive book on the S&L crisis. He showed how deposit insurance was to blame for that episode as risky bankers leveraged FDIC insurance to attract funding to finance ill-conceived investments. The best way to rob a bank, after all, is to own one.

Depositors didn’t care how much risk bankers took with their money. It was federally-insured. Might as well go with the bank offering the highest interest rate. One of my favorite contemporary examples is the ad I see for GMAC’s above-market CD rates in WSJ’s A section every week. GMAC is insolvent. It’s asinine for depositors to keep funding them.

The government is encouraging precisely that with $5 billion of TARP bailout money and the protective wrap of FDIC deposit insurance. GMAC now operates courtesy of the government’s promise to insure its creditors. This is true of the entire banking system at this point…

The dirty little secret, as noted above, is that the government has no reserves with which to fund its guarantees. As they become payable, its only recourse is to borrow.

This guarantee shell game continues only because Uncle Sam has borrowing capacity to keep it going. That capacity derives not from balance sheet strength (again, no reserves) but from the dearth of investors’ options. Everyone worldwide knows Uncle Sam is broke. But government-insured accounts remain the last refuge for their accumulated paper wealth, which—in a fractional reserve banking system—is largely an illusion to begin with. In such a system, paper wealth exists only to the degree that debts are serviced. And debts are serviced only to the degree that credit continues to expand. Remember, it’s just one giant Ponzi scheme.

This is not hard to grasp, actually.

The vast majority of the economy’s wealth exists only on pieces of paper that record the accumulated funds stored in financial accounts. Contemplate your own bank statement for a moment: what does the balance figure at the bottom represent? Money that you previously gave the bank that it has since shoveled out the door to borrowers. In other words, your paper wealth only “exists” to the extent that bank borrowers pay back their debts. Money and debt are mirror images of each other: your money is someone else’s debt.

Here we have arrived at the cause of the present crisis. Credit expanded so spectacularly during the recent asset bubble, paper wealth itself expanded spectacularly. But this wealth was an illusion of course. As debtors default, paper wealth disappears. The Ponzi unravels.

Ponzi schemes aren’t “solved” through continued expansion. This delays the day of reckoning, sure. But only at the cost of magnifying losses fantastically. No one would have suggested extending Madoff investors a government guarantee. Why then are we offering guarantees for customers of Chase, Citi, BofA and Wells Fargo, far larger Ponzi financiers all of them?

The answer, of course, is they are “too big to fail.” Had Madoff been sporting a trillion-dollar balance sheet, you can bet the government would have offered bailout funding to prevent a disorderly collapse.

But there’s a fine line between too-big-to-fail and too-big-to-rescue. Ask the folks in Iceland, Ireland, and most of Eastern Europe. The Ponzis at work in their financial systems grew so large there is simply no orderly way to unwind them. We risk the same fate here in the U.S. by offering open-ended guarantees to bank customers.

The fact is, a bank run can be a healthy thing as it discourages investors and depositors from allocating too much cash to unstable institutions. Unfortunately, by removing all discipline that the possibility of failure provides, we have permitted our financial institutions to grow totally unchecked. The just desserts of moral hazard you might say.

A counter-argument here is that government guarantees have actually prevented capital flight. Without all these new guarantees, the system would have crashed back in October as investors and depositors raced to cash out simultaneously. But the guarantees we’ve extended haven’t prevented that, they’ve merely delayed it.

The longer the government leaves its various guarantees in place, the more capital will flow to protected investments, much as it did to Fannie and Freddie. The Ponzi will continue to expand until confidence in Uncle Sam’s balance sheet is itself destroyed. At that point, the unwind will be far uglier that if we had paid down the national debt while executing a proper bank recapitalization, i.e. wiping out shareholders and forcing losses onto creditors.

What was true for Madoff is true for the U.S. financial system: In order to contain collateral damage, it’s best to unwind Ponzis as soon as possible.

(Readers can visit this guest author’s blog here)

——————

*Total TLGP-backed debt issuance was $321 billion through the end of March. Because data for FDIC’s other “temporary” insurance schemes is only available thru 12/31, that’s what I’ve included for TLGP in the chart.

Submitted by Rolfe Winkler, CFA, publisher of OptionARMageddon

We’re not quite as healthy as we thought we were. Oops. (WSJ)

J.P. Morgan Chase Chief Executive James Dimon said…that March was a little tougher than the first two months of the year….Bank of America…CEO Kenneth Lewis also said that March had been a tougher month for his bank. [Convenient that they dumped this on Friday afternoon, and at the close of a very good week].

Readers may recall that a few weeks ago, Dimon and Lewis—along with Citi’s Vikram Pandit—said the first two months of the year had been very good:

Pandit, March 10th: “We are profitable through the first two months of 2009 and are having our best quarter-to-date performance since the third quarter of 2007.”

Dimon, March 11th: “Jamie Dimon, the chief executive of JPMorgan Chase, said Wednesday that the bank was profitable in January and February…”

Lewis, March 12th: “We have been profitable for the first two months of the year,” Lewis told reporters after a speech in Boston today.

This was possibly the most nakedly self-serving bullshit the big bank CEOs have offered to date. (“bullshit” being a technical term of course, see Harry Frankfurt)

By February, it was understood that the big banks are all insolvent, certainly Citi and BofA. To deal with them, consensus among the cognoscenti was finally tending to a proper recapitalization: wiping out shareholders and forcing losses onto creditors via debt-for-equity swaps. Call it nationalization, call it preprivatization, call it FDIC receivership, it was clear that losses had to be recognized and by those to whom they properly belong: investors across the capital structure.

But no one really wanted to do this, not in Congress and certainly not in the Obama administration, where Timmy Geithner has made clear that his priority isn’t a cleansed banking sector, it’s a privately-owned one. For obvious reasons the banks don’t like this solution either. So they offered up their self-serving b.s. regarding January and February, buying just enough time for Congress/Bernanke to badger FASB into changing mark-to-market rules and for Geithner to roll out his private-public partnership plan.

Now whatever losses the banks can’t hide with revised accounting treatments, they can simply fob off on taxpayers via the partnerships. They got what they always wanted: A bad bank. An entity that will actually absorb losses from the asset side of the balance sheet. Shareholders and creditors don’t have to worry about further writedowns, not the ones that can’t be hidden anyway. Taxpayers will pick up the check!

Even better, the Geithner plan is so ridiculously complex—and public disclosure is likely to be so minimal—that toxic asset transfers are likely to happen largely out of view. Maybe Treasury will have to increase its borrowing substantially in order to fund the losses, but by that point everyone will be celebrating that banks have started lending again. Hooray!

By the way, are there ANY substantial protections to prevent banks from gaming this plan? What’s to stop them from acting as the equity investors in the partnerships, ponying up a sliver of equity to effect a transfer of toxic assets from their own balance sheets to the public’s? The FDIC’s FAQ for the legacy loans program doesn’t even address this particular Q. Is it not being frequently asked?

This is all of a piece. The longer CEO/policy-maker collusion can delay loss recognition, the more time they have to invent ridiculous leverage schemes (more money printing! more government borrowing to fund “stimulus”! more FDIC “guarantees”!) to inflate those losses away….and to continue looting the public’s wealth.

But losses aren’t going away. Trading smaller private liabilities for larger public liabilities in order to artificially inflate asset prices does nothing to repair the economy’s aggregate balance sheet. At the end of the day, we’re still just lending more and more against a dwindling pool of real equity. The unwind is coming. Adding more leverage to delay it will only increase the pain.

Submitted by Rolfe Winkler, CFA, publisher of OptionARMageddon.com

According to the NYT, the administration is considering all kinds of new rules in the wake of the AIG bonus scandal. These include tougher rules for mortgage lenders, new oversight powers for the Fed, and a new exchange/clearinghouse for derivatives trading. Most interesting in terms of intra-governmental politics, however, may be Obama’s proposed restrictions for executive pay (emphasis mine):

The Obama administration will call for increased oversight of executive pay at all banks, Wall Street firms and possibly other companies as part of a sweeping plan to overhaul financial regulation, government officials said…

The new rules will cover all financial institutions, including those not now covered by any pay rules because they are not receiving federal bailout money. Officials say the rules could also be applied more broadly to publicly traded companies…

No specific policy proposals have been made yet, so it’s tough to offer firm opinions about the above. Nevertheless, I’d like to chime in with early thoughts on the pay proposals. In a nutshell, I think Obama may be trying to wrest control of the pay debate from pissed off Senators and Congressman. This is a shame because Congress, in all its outrage, might actually have stumbled onto sensible policy…

The administration’s proposed pay restrictions sound to me like a rearguard action. Friday the House passed a bill that would essentially confiscate bonuses paid to all employees making over $250,000 at companies that have received $5 billion+ of bailout money. You know Timmy Geithner and Sheila Bair don’t like the sound of that. Both have made clear that Wall Streeters should get paid whatever amount appropriately incentivizes them to clean up their own mess. How to compromise with angry lawmakers that want stricter restrictions? Perhaps by cutting a wider swath in terms of companies affected while limiting the restrictions at any one company to only its most prominent corpulent felines.

The House proposal, remember, confiscates bonus income (including, potentially, non-cash bonuses!) for everyone making over $250,000. It would only impact a handful of companies in particular, but the total number of affected employees would run well into the thousands.

Contrast that with Obama’s nascent plan, which, according to the NYT, affects executive pay. “Executive” tends to be code for the top guys listed in the proxy: CEO, CFO, General Counsel, COO, those types. To placate House members who want more sweeping restrictions, the administration says it would regulate “all financials” and possibly other publicly-traded companies—not just those receiving the biggest bailouts.

The House’s version is superior for two reasons: It hits the right companies and is appropriately draconian.

First of all, government has no business making compensation decisions on behalf of the private sector, which is what Obama would do by subjecting so many companies to executive pay restrictions. The House bill doesn’t do this. By hitting only those companies that have received over $5 billion of bailout money, it dodges the private sector entirely. How so? The companies that have received the lion’s share of bailout money really aren’t in the private sector any longer. For one thing, they continue to draw breath thanks to TARP, FDIC and Fed life support; they owe their lives to forgiving taxpayers who’ve not yet chosen to pull the plug. For another, the risks on their balance sheets have ostensibly been socialized. For all intents and purposes, this makes their staffers public sector employees. As such they should be subject to whatever pay restrictions taxpayers’ representatives see fit to establish.

And the pay restrictions are so draconian they might accomplish needed banking reforms simply by driving those most responsible for the bank crisis out of the business. At the very least, it would reduce incentives to take outsized risks with vulnerable, systemically-important balance sheets.

In recent years the biggest profits—and the biggest bonuses—were generated by largely dubious activities. To take two examples, investment bankers and propriety traders have been vastly overpaid relative to the value they’ve added.

I-bankers intent on maximizing fee income often abuse their companies’ balance sheets in order drive deal flow. They leverage their leverage. They aren’t paid to care about the quality of their deals, or the risk borne by the boss’s balance sheet. And far more often than not, their deals destroy value anyway. As for prop-traders, they are little more than ultra high-stakes gamblers. It’s beyond foolish that we allow them to make their bets with the same balance sheets responsible for generating the majority of the economy’s credit. Of course some are great traders, but it’s a zero sum game. For every Boaz Weinstein (vintage 2007 and before anyway) there’s a Ralph Cioffi. The industry’s collective balance sheet isn’t strong enough to withstand the failures—counteryparty risk anyone?—so the profits earned by the good ones are largely a mirage.

Trading and i-banking need not disappear of course; they just need to be gone from the commercial banking sector, for which the only remaining charge should be the prudent allocation of credit. If bulge bracket banks face the severe pay restrictions outlined in the House bill, they probably would lose much of their rock star “talent.” Fantastic. I can think of no better indicator of progress on bank reform than to see the industry return to its stolid past.

In the old days, when Wall Street firms were still partnerships, everyone took a hit when times got tough, including top producers. They all understood it was a survival issue for the firm.

Now that survival is not a question (government: “there won’t be any more Lehmans“) these employees have the luxury to retain their sense of entitlement. “But we earned these bonuses.” Nonsense. But for taxpayers, their firms would have gone horizontal months ago. Is $250k not significantly better than $0?

Yves notes “everyone used to complain about welfare queens. What would you call this level of entitlement? They are every bit as much wards of the state as welfare recipients, and fail to recognize it. No wonder the public is furious.”

Perhaps the best indication that the House bill is good policy: bulge bracket bankers are vociferously opposed…

Submitted by Rolfe Winkler, CFA, publisher of OptionARMageddon.com

The Charlotte Observer deserves a big fat Bronx Cheer for prostituting its pages. Today the paper published excerpts of an “interview” with hometown CEO Ken Lewis of BofA. The quotes read like the standard puffery one finds in corporate press releases. If the interviewers asked any tough questions, there’s no record of it; instead they gave Lewis carte blanche to recite his corporate talking points.

The article is topped by a cheery and totally misleading headline: “Lewis: BofA may pay back TARP money by 2010.” Um, really? Losses on the left side of BofA’s balance sheet are bleeding the bank to death while the bank’s ridiculously high tangible leverage ratio suggests it has no cushion on the other side to absorb these losses. In other words, isn’t BofA actually starved for capital? Aren’t TARP cash, loose Fed lending and other government backstops the only reasons the bank still draws breath? Perhaps the interviewers just don’t know enough to ask pertinent questions. Or maybe they’re just not inclined to interrupt their subject’s train of thought. But Lewis, anticipating his critics, makes sure to add a caveat:

“The bank could turn over the money now if it weren’t maintaining higher-than-normal capital cushions because of the “fragile” state of the financial system, he said.

You see what he’s doing here? Lewis has the chutzpah to argue that he’s doing us a favor by using Treasury’s money—our money—to maintain a “higher-than-normal” capital cushion. So $1 of tangible common equity for every $38 of tangible assets is supposed to be “higher than normal?” This begs the question: what is a “normal capital cushion?” 1:50?

This reminds me of the standard b.s. we hear from bank execs who complain they were “forced” to take TARP money. And of course, they’d all love to give it back, but they can’t because the big bad regulators are making them keep reserves on their balance sheet to protect from losses. Never mind that without taxpayer cash, all would have gone bust months ago…

Lewis also said he expects his Charlotte-based bank to be profitable this year “absent some unexpected meltdown” and to pass the government’s stress test.

Here again Lewis ducks responsibility for BofA’s financial misfortune. If for any reason the bank isn’t profitable, Lewis can chalk that up to The Fates, rather than his terrible management and acquisition strategy, which left the bank with a very weak and very vulnerable balance sheet. Oh, and did anyone actually think Timmy Geithner was going to fail any of the big banks when it comes to the stress test? Don’t count on it.

As for his biggest regret in recent months, Lewis said he made a mistake in taking so much TARP money. The bank could have accepted $5 billion to $10 billion in January, instead of $20 billion, and kept its capital ratios in reasonable shape, he said.

Wait a minute. Didn’t Lewis just say he didn’t need the TARP money to begin with? That he was doing us a favor by keeping it on hand?

[Taking $20 billion] “put us too far away from the mainstream, and it did lump us together with Citigroup,” he said, referring to the institution regarded as the most damaged of the big U.S. banks. “We did it in an abundance of caution because you just don’t know how bad things could get, but that was a mistake and that caused us to be painted with a broad brush in ways that we don’t deserve.”

Taxpayers have committed $45 billion in TARP money and agreed to backstop $118 billion of BofA’s toxic assets after the bank made two ridiculously ill-advised acquisitions. Yet Lewis argues his bank is being unfairly maligned. Unbelievable.

The article concludes with the ultimate softball:

Asked whether the bank has been unfairly criticized for anything in recent months, he said: “I would need some time to compile a list.”

We feel for you Ken. Really, we do.

What gets me so worked up is The Observer’s total lack of journalistic integrity in this case. The Fourth Estate has a responsibility to the general public to report the truth. To the extent it can enrich investors, corporate executives have a responsibility to obfuscate the truth. Selling 20 column inches on the front page directly to BofA’s PR dept. would be less harmful than what was done here. Calling this piece an “interview” suggests the reporters did their duty to ask tough questions and filter fact from corporate fiction. But they did nothing of the sort. The result is that readers are badly misled.

Submitted by Rolfe Winkler, CFA, publisher of OptionARMageddon.com

Policy-makers not only misunderstand the economic crisis, they continue to underestimate it. Consequently, solutions to date have not only failed to “fix” anything, they have made the problem worse. The problem isn’t falling asset prices, it’s not rising foreclosures, it’s too much debt. With an assist from mark-to-market accounting,* too much debt inflated the asset bubble in the first place. Yves has it exactly right that the only “solution” to this crisis is price discovery, to allow asset prices to fall to whatever level they need to in order for markets to clear. This is bad news for over-levered balance sheets, but there’s nothing else to be done.

And yet American policy-makers appear convinced that more debt can rescue an economy already drowning in it. If we can just keep the leverage party going, all will be well. $787 billion to fund “stimulus,” another $9 trillion committed to guarantee bad debts, 0% interest rates and quantitative easing to drive more lending, new off balance sheet vehicles to hide from the public the toxic assets they’ve absorbed. All of it to be funded with debt, most of it the responsibility of taxpayers.

If I may offer just one reason this will all fail: rising interest rates. Interest rates need only revert to their historical median in order to hammer asset values, and balance sheets, into oblivion.

A simple present value calculation suggests that house prices could fall another 30% if mortgage rates get back to 8%.** Enough to wipe out a 20% downpayment made today and still leave the buyer upside down on his mortgage. Given the pile of Treasurys the Obama administration plans to dump on the market, it seems logical to assume interest rates are headed up.

Some might argue that deleveraging is SO violent that a couple years of “stimulus” and other debt-financed rescue measures are needed to cushion the blow. Unfortunately, any positive impact is likely to be offset by upward pressure on interest rates. Perhaps the Fed can monetize a lot more debt. But that will have its own negative consequences.

Picture it if you will: the economy stabilizes, money flows out of Treasurys, which drives interest rates back to normal. Asset values that had appeared to stabilize fall again. More writedowns ensue, more balance sheets turn up insolvent. The debt deflation conflagration ignites again, burning up what’s left of the economy.

If our experience to date has taught us anything it should be that kicking losses up to bigger balance sheets solves nothing. Losses have to be taken. The balance sheets on which they reside will end up insolvent. Why compound our problems by piling up more debt and concentrating all of it on the public’s balance sheet? Is American arrogance so great that we believe our Treasury and our currency will survive the trillions of $ worth of losses and stimulus we’ve already agreed to fund? To borrow Martin Wolf’s wonderfully evocative phrase, we are a python that has swallowed a hippopotamus.

At the end of the day, flushing more debt through the system is the only lever policy-makers know how to pull. Lower interest rates, quantitative easing, deficit spending, it’s all the same. It’s all borrowing against future income. Each time we bump up against recession, we borrow a bit more to keep the economy going. With garden variety recessions, this can work. Everyone wants the good times to continue, so no one demands debts be paid back. Creditors accept more IOUs and economic “growth” continues apace. If it sounds like Bernie Madoff’s Ponzi scheme, that’s because it is.

Each time Bernie’s scam got a few too many investor withdrawals, he’d simply plug the hole by raising more investor cash. The guys at Fairfield Greenwich were making so much in fees, they were happy to funnel more his way. But at a certain point, Ponzis get too big. There simply aren’t enough new investors to pay off older ones. In the aggregate, the same is true for Western economies. Their debt loads are now so huge, they are simply unpayable.

Naturally, policy-makers sound just like Ponzi-schemers: Just give us a little more cash to get us through this rough patch and everything will be copacetic. Ben Bernkanke at the National Press Club alluded to the famous quote by St. Augustine: “Oh Lord, give me chastity, but do not give it yet.” President Obama convened his “fiscal responsibility” summit days after passing the stimulus bill and days before proposing huge increases in health care spending.

So the question becomes, can we keep our Ponzi going? Or has it grown too large? Have we reached the moment when, like the Depression, there’s just no escaping the great unwind?

There has been much protest from economists that whatever economic funk we find ourselves in presently, it’s not as severe as the Depression. One data point suggesting otherwise is Household Debt vs. GDP. A favorite example of mine, though, was the chart at right featured in the Congressional Oversight Panel’s January report. (Click to enlarge)

The COP’s chart downplays our current crisis by comparing the number of failed banks during the Depression with the number today. But the number of bank failures misses the point. The banking system is far more concentrated today. What makes our current banking crisis totally unprecedented is the size of bank failures relative to the overall economy. A better way to compare the two crises is to look at deposits in failed banks relative to GDP. (click to enlarge)

As you can see, I’ve taken the liberty of adjusting FDIC’s figure for 2008. This chart includes the $2.0 trillion worth of deposits at BofA, Citi, and Wachovia as of September 30, 2008.***

Last year WaMu was the only ultra-large bank that officially “failed” according to FDIC. But in the absence of government intervention, it’s likely the entire U.S. banking system would have gone under. Certainly the “failed” list would now include Citi, BofA and Wachovia.

Adding these three banks to the list still understates the scale of the crisis. Can anyone seriously argue that Chase and Wells would have survived the year in the absence of taxpayer largess?

What about non-deposit taking financials? AIG, Fannie, Freddie, Goldman Sachs, Morgan Stanley, GE and—at some point soon—a few of the Federal Home Loan Banks. Then there’s the insurance industry. With leverage worse than the banking system’s and balance sheets chock-full ‘o toxic assets, it too owes its survival to TARP cash and publicly-subsidized lending.

Also FDIC’s Deposit Insurance Fund. The $19 billion it has in reserve is but a drop in the bucket compared to the $5 trillion worth of deposits and bank debt it now “guarantees.” Naturally, the Fund needs replenishing.

Public and private pension systems are drastically underfunded. California is on the verge of bankruptcy. The unfunded liabilities for Medicare and Social Security are north of $50 trillion.

European economies face even more oppressive debt loads.

The great Ponzi scheme that is the Western World’s economy has grown so big there’s simply no “fixing” it. Flushing more debt through the system would be like giving Madoff a few billion to tide him over. Or like adding another floor to the Tower of Babel. To what end? The collapse is already here. The question is: How much do we want it to hurt?

Using the public’s purse to finance “confidence” in a system that is already kaput may delay the Day of Reckoning, sure, but at the cost of multiplying our losses. Perhaps fantastically.

Bottom line….We can bankrupt ourselves propping up a system that is collapsing anyway, or we can dig ourselves out of debt, if not with higher interest rates then certainly with fiscal austerity. That would be a hard sell to the American people, I know. But deep down, Summers and Geithner know it is the right thing to do. It is, after all, the prescription they wrote for emerging markets facing financial crises.

It’s long past time we took our own medicine. If we don’t take it voluntarily, the bond market will stuff it down our throat anyway.

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*As asset values increased, so did the value of collateral to support new lending. More lending inflated asset prices, increasing the value of collateral yet again, encouraging still more lending. Since house prices never fall, everyone imagined this cycle could continue ad infinitum. And even if they didn’t, no one was going to get in the way. Too much money was being made. I wonder: did any of the current critics of MTM’s pro-cyclicality complain on the way up?

**Imagine mortgage rates jump from 5% to 8% tomorrow, with no corresponding increase in buyers’ incomes. A representative consumer has $3,000 to spend on housing today and tomorrow. Increasing interest rates 300 bps drastically reduces the principal value of the loan he can support with that monthly payment. (Admittedly, this is a simplistic way of looking at house prices. But it serves to demonstrate asset price sensitivity to interest rates.)

• Monthly payment = $3,000, # of mortgage payments = 360 (30 years * 12 months = 360), future value of mortgage balance = $0, IntRate = 5% over 12 months or .42% per period, Present value of asset = $558k

Now increase the interest rate to 8% while holding other variables constant.

• payment = $3,000, # of payments = 360, Future Value = $0, IntRate = 8% over 12 months or .67% per period, Present Value = $409k
• 409/558 – 1 = -27%

***Caveat: to the extent government intervention allowed insolvent financials to survive the S&L crisis, they wouldn’t be included in this list.