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Wednesday, 22 April 2009


The deteriorating global economy means financial institutions now face total losses globally of $4,100bn on loans and other assets, the IMF said yesterday, urging governments to take “bolder steps” to shore up institutions – including nationalising them. The IMF says many loans sitting on institutions’ balance sheets are eroding in value, no longer just the toxic sub-prime securities which first triggered the crisis. But, this is expected and not news. But that does not stop the media exaggerating this as if it is shockingly new.
Banks would bear about two-thirds of the losses, with insurance companies, pension funds, hedge funds and others the rest. Efforts to cleanse these bad assets from balance sheets and replenish viable institutions with capital had so far been “piecemeal and reactive”, the IMF said, calling for more decisive government action. I beg to disagree. In my view the IMF is being irresponsibly alarmist and under-estimates the money-market operations of the world's central banks and the effects to be expected from fiscal and monetary measures. The IMF states, “The current inability to attract private money suggests the crisis has deepened to the point where governments need to take bolder steps and not shrink from capital injections in the form of common shares even if it means taking majority, or even complete, control of institutions.” Complete share ownership and the renewed threat of it will of course totally undermine shareholder confidence and this plus bank shares becoming untradable both further damages the banks' capital reserve and takes away the share gains that should eventually emerge to greatly help restore bank capital. The IMF is not thinking the matter through properly over the medium term. Even though the IMF's writedown estimates are lower than those of some private economists, its global stability will further unnerve investors and governments. On Monday traders were so alarmed by news of rising delinquencies on consumer and business loans at Bank of America that they triggered a stock market sell-off despite its doubling of quarterly profit. US banks have so far taken about half of the writedowns they face, which I agree with, while European banks have only taken one-fifth, which I think is an under-estimate. But if banks took all the writedowns they face immediately, the IMF calculates it would wipe out all their common equity. But this has been eminently predictable for a long time and government measures are cognizent of that. Therefore, the IMF is overstepping a line here for the sake of sensationalism and it also under-estimates internal capital generation, asset swaps with central banks, funding gap financing, and the element of loan-loss provisions that can return to capital reserves once losses are finally crystallised.
To restore their balance sheets to the state they were in before the crisis – defined by the IMF as a tangible common equity ('own capital') to tangible asset ratio of 4% (ratio to gross assets, not risk-weaighted assets) when regulators are insisting now on 6%. The IMF say that US banks need $275bn in capital injections, and Euro Area banks need $375bn, and UK banks $125bn.
The IMF expressed concern that taxpayers are weary of supporting the financial sector. This neglects to see that the banks have only in very small amounts been supported if at all by taxpayers' money; the support is almost all off-budget via T-bills for heavily discounted and profitable fee-based asset swaps, taking banks' assets as collateral, but leaving the central banks with a generous risk ceiling. The IMF says, “there is a real risk that governments will be reluctant to allocate enough resources to solve the problem.” This is a silly statement and flies in the face of the exact opposite being stated by governments in words and deeds.
One possible step would be for governments to convert their preferred shares in banks into common equity, the IMF suggests assomething that the US government, Fed and Treasury are considering, as a senior IMF official told the FT. The logic for this conversion is completely missing when the banks are generating capital and the cycle upturn is expected within a year and further large asset swaps to clean out the balance sheets are in train.
Even if governments do take bold action to shore up the system, according to the IMF, the credit crisis will be “deep and long-lasting”, another 'surpise', another piece of sensationalising that falls flat. All this does not add credence to the IMF's expected role in the G20 New Financial Order! The IMF says said that deleveraging and economic contraction can cause credit growth in the US, the UK and the eurozone to contract and even turn negative in the near future, and only recover after a number of years. By stating this the IMF are effectively stating that all measures to shore up the banks including ordering them to maintain loan levels are useless because even when GDP recovery comes, the banks will continue to drag GDP down, as if there is no gain, no systemic multiplier, in them doing otherwise?
The IMF was also most gloomy about the prospects for emerging markets as foreign investors and banks withdraw FDI and other funds. It estimated the refinancing needs of emerging markets are around $1.8tn.
Reshaping global financial regulation is the G20 topic in the IMF report. It suggests two tiers of regulatory oversight: one to gather information, and a smaller one for (globally) systemically important institutions with “intensified” regulation. It also mooted the idea of levying an extra capital surcharge as a way to deter companies from becoming “too-connected-to-fail” in the first place. This assumes that it knows how to calculate the systemic or network risk of financial instiutions measured globally - now that model would be interesting, does it exist, has it been conceived, designed, is there the theoretical and empirical data basis for building it, the ultimate global stress-test model... er, no, of course not. The next global financial crisis will probably be upon us before then.
The IMF pall of gloom coincided with that of Bank of America. After its shares fell 10% on positive results, BofA shares fell 24.3 per cent, contributing to a 4.3 per cent decline in the S&P 500. This was a response to its economic analysis that was also further insight into the bleeding obvious, led by BoA CEO saying, “We understand that we continue to face extremely difficult challenges primarily from deteriorating credit quality driven by weakness in the economy and growing unemployment.” But, this is just a 'pro-forma' statement that is required to go along with any results publication and is really meaningless. Yet, Asian shares followed Wall Street’s cue, with shares in financial companies sinking across the maiden. Monday’s US stock market falls were the steepest one-day setback since... oh, March 9th (when the S&P closed to a 1996 index level) since when US equities rallied 30% to last Friday.
“The guidance from BofA was not great,” said one head of trading, “Credit costs and foreclosures are still rising.” My view is "of course, so what! It would be a huge unexpected even worrying shock if this was not so!"
Some BofA shareholders are agitating for Lewis to be ousted at next week’s shareholder meeting and over at FDIC the board are considering who to send in as replacemen for the head of Citigroup. Part of the cleaning out and restructuring all banks balance sheets is that all senior bank officers from before the credit crunch and recession crisis must go and be replaced with clean hands and new brighter faces.


According to Turner Radio Network on Monday, the results of the banking "Stress Tests" demanded by Tim Geithner, US Treasury Secretary, of the top 19 US banks, which include HSBC and RBS Citizens and other foreign banmks' US subsidiaries, have been unofficially leaked to the media and thereby to the public. And, in short, the results are supposedly disastrous. The stress-tests results were not due for some months yet and therefore some doubt may be exercised as to the completeness or truth of this story.
As you know, (see my various essays on the subject at the stress tests were conducted to determine how the top 19 banks in the USA could withstand future economic hardship in terms of loss of capital, by which is meant loss provisions as a % of the bank's core Tier 1 and total reserve capital (also called 'Economic Capital') which are the unencumbered 'own-capital' liquid reserves of the banks to absorb loan losses. Regulators at the Treasury, FDIC and The Federal Reserve were reported earlier this month to be haggling over how and when to release these results, which did not have to be released until September at the latest. The economic drivers proposed by FDIC for these tests were in my opinion relatively mild, but realistic. The story is being treated as 'shock-horror' but coincides with positive multi-$billion profit results of Citi, JPM and Wells Fargo, and others, reporting record quarterly net earnings ('internal capital generation'). In response, the market in financial stocks extended gains. The problem of the stress-test results seemed temporarily solved until the Turner Radio Network obtained the leaked stress test results.
The bullet-point summary of the findings is that of the top nineteen banks in the nation, sixteen (are already technically insolvent, meaning that defaults requiring loan loss provision exceed capital reserves. This is however before watchlist impaired loans of half a $trillion have been sold at heavy discounts to hedge funds and others via the Fed's equivalent of the Bank of England's £575bn Asset Protection Scheme (also see for details). The leaking of the results, if they are the true results, may serve to dissuade banks from seeking to engage as buyers as well as sellers of distressed assets, and may also serve short-sellers, in both cases the gainers being the hedge funds?
Of the 16 banks that are already technically insolvent (when note should be taken that insolvency is an ambiguous concept with at least six variants of how this may be measured), not even one bank can withstand any disruption of cash flow or any further deterioration in non-paying loans. This is no surprise to readers of my blog essays, as I have long forecast that bank capital will be wiped out twice before the crisis is over.
If any two of the 16 insolvent banks go under, however, they will totally wipe out all remaining FDIC insurance funding. Of the top 19 banks in the US, the top five are apparantly so under-capitalised that there's serious doubt, according to some doom-merchants about their ability to continue as ongoing businesses. But this is predicated on the dubious assumption that five large U.S. banks have uncovered credit exposure related to their derivatives trading that exceeds their capital e.g. Bank of America's total credit exposure to derivatives at 179% of its risk-based capital, Citibank 278%, JPMorgan Chase 382%, HSBC 550%, and Goldman Sachs a whopping 1,056%. That's the big players. In addition, 1,800 regional banks are reportedly currently at risk of failure.
Thisis apparently a sneak preview summary of a "leaked" report of the stress tests. But I personally believe that these findings are wholly innaccurate, for reasons that range from exaggerating the derivatives market exposures, inadequate stress-test models, and misunderstanding the reality of liquidity risks and insolvency measures. The news is guaranteed however to create panic that the entire US Banking system runs the risk of total collapse, while Gold will soar, the dollar weaken and stock markets will fall aggressively lower.
No matter if these results are true or not, the damage and any damage-limitation measures are now urgent concerns. All the big banks are putting out very positive results, like the first-quarter profit for Bank of America Corp, which more than doubled. But a surge in troubled loans caveated the bank's earnings report. Chief Executive Kenneth Lewis nevertheless said on a conference call that "we absolutely don't think we need additional capital," which is not an ambiguous statement. Just one quarter after losing nearly $2bn, BoA reports a profit of $4.2bn last quarter, seven times greater than expected. But shares of BOA opened down 10%. Why? Because BoA had rallied high enough already, and a cursory look at BoA’s earnings shows over $4bn in profits came from selling a stake in China Construction Bank and “debt adjustments” on Merrill Lynch’s balance sheet.
Citigroup reported $4.69bn profit in fixed income trading last quarter, which allowed it to eke out a $1.6bn bank-wide profit. Citigroup's other major operating segments reported fallen revenues for the quarter. Its global credit card revenue fell 10%, consumer banking down 18%, Global Wealth Management down 20%. Fixed income trading revenues were boosted by a net $2.5bn positive CVA on derivative positions, excluding monolines, due to the widening of Citi's CDS spread. A CVA is a ‘credit value adjustment’, the credit risk premium of a derivative contract i.e. Citi ‘made’ $2.5bn on derivatives positions designed to profit when its own credit default swaps spreads widen i.e. worsened - and not the only bank to do this. You may view this as clever and prudent or just another aspect of the looking glass topsey turvey world of high finance; Citi profited because it bet the cost of insuring against its own liquidity risk would rise, the closer it gets to insolvency, the more money it will ‘make’ on its derivatives.
Despite all the hemming and hawing at congressional hearings and the issue of whether to convert TARP preference share holdings into banks common equity (nationalisation), according to a WSJ study, new loan origination from US banks (the top 21 TARP recipients) fell 4.7% since the last credit crunch crisis period (a crisis for banks wholesale funding) began in September/October '08 from $226bn then to $174bn in February. Personally, I think this is a good result in the circumstances.