STRESS TESTS TO CLIMB UP OUT OF CRUNCH CRISIS RECESSION?

Bank stocks have been rising well internationally. Wednesday (yesterday) was especially good for US financial stocks as investors expressed relief the capital shortfalls identified by the government’s “stress tests” at large banks such as Citigroup and Bank of America were not as big as feared.
The bank rally occurred as news of the capital needs of the 19 banks involved in the tests leaked out during the day, ahead of the official release of the results on Thursday.
Citi, BofA and Morgan Stanley were among the big names that will have to raise equity following the completion of the tests, while JPMorgan Chase, Goldman Sachs and American Express are among those that will not need additional capital, people familiar with the situation said.
Citi and BofA emerged as the banks with the biggest capital shortfalls, with Citi’s equity needs projected to be more than $50bn and BofA requiring about $34bn in fresh equity.
However, BofA’s capital deficit is more pressing because Citi has already agreed to bolster its balance sheet by converting preferred shares owned by the government and other investors and selling non-core businesses.
People close to the situation expect Citi to have to raise no more than $6bn through the expansion of its planned conversion of preferred shares – less than the $10bn-plus the market had feared. The move could decrease the government’s stake in Citi, which was expected to be 36 per cent to about 33 per cent.
New equity ratio rule
US banks will be required to hold enough equity to ensure that they would still have a common equity ratio of at least 4% of risk-weighted assets at the end of 2010 even if the adverse scenario set out in bank stress tests were to materialise, the authorities said on Wednesday 6th May. I suggest that they should consier applying an equivalent of the Dutch National Bank’s Liquidity directive.
Banks are required to report on a consolidated level on their liquidity position to the DNB monthly, on the basis of the liquidity supervision directive. The liquidity directive seeks to ensure that banks are in a position to cope with an acute short term liquidity shortage under the assumption that banks would remain solvent. In principle, the DNB liquidity directive covers all direct domestic and foreign establishments (subsidiaries/branches), including majority participations. The regulatory report also takes into consideration the liquidity effects of derivatives and the potential drawings under committed facilities.
The directive places emphasis on the short term in testing the liquidity position over a period of up to one month with a separate test of the liquidity position in the first week. For observation purposes, several additional maturity bands are included in the liquidity report (one to three months, three to six months, six months to one year and beyond one year).
Available liquidity must always exceed required liquidity. Available liquidity and required liquidity are calculated by applying weighting factors to the relevant on- and off-balance sheet items, i.e. irrevocable commitments. The liquidity test includes all currencies. Compliance reports concerning liquidity requirements of foreign subsidiaries are submitted to the appropriate foreign regulatory authorities as required. At a consolidated level, and in every country in which a bank operates, the banking group must adhere to the liquidity standards imposed by the applicable regulatory authorities.
The use of a common equity ratio – even if as a benchmark rather than a formal future standard – is a departure from normal bank regulation. It is intended to ensure that banks have good quality capital, providing permanent capacity to absorb losses and flexibility over cash distributions.
The US authorities also said that the 19 biggest US banks will also be required to hold enough overall tier one capital to ensure that they would still have tier one capital equal to at least 6% ratio to RWA. This allows their reserve capital to operate as a cushion that can depress by half.
Banks will have 30 days to present a plan to meet the demands identified by regulators. They will also be required to outline steps they will take to “address weakness, where appropriate” in their own processes for capital planning. They are tasked to outline how they will, over time, repay existing government capital injections (e.g. in payment or in preferred shares) and reduce reliance on debt issued under a government-guaranteed programme. Up to 10 of the 19 banks are likely to need fresh equity, according to various unnamed sources. Morgan Stanley is said to need $1.5bn in new equity, as a result of its buying a majority stake in Citi’s Smith Barney brokerage.
Tim Geithner, the US Treasury Secretary, said last night on PBS: “I think the results will be, on balance, reassuring.” Investors concur, with shares in BofA, Citi and Wells Fargo – expected to need $10bn-plus in new equity – rising by over 15%.
The tests aim to ensure that even in an adverse economic scenarios, such as obviously the current crisis, banks can retain tier one capital of at least 6% of risk-weighted assets RWA – loans and other exposures less collateral, with both the assets and liabilities risk-weighted and risk-graded) and tangible common equity of at least 4% at the end of 2010 (when economic recovery should be 1 year old). Each bank told to raise additional equity has until June 8 to present a plan to regulators explaining how it intends to do so. The concern here is to have clarity in time for planning the administration’s budget for budget year starting 1 October. This is required even though further government financing will be off-budget via Federal Reserve balance sheet of T-bills, and only on-budget if requiring longer term Treasury Bond issues.
These banks will also be required to remedy any “weaknesses” (governance, systems, data quality, reporting process, risk management controls, and risk mitigation measures) in their internal capital planning (liquidity risk management) and to outline how they eventually intend to buyt hemselves out of government-sponsored aid.
The revelation that BofA needs about $34bn in extra capital will increase pressure on Ken Lewis, its embattled chief executive. The banks and the regulators declined to comment to news sources such as FT or Reuters or were unavailable.
The stress tests overseen by the FDIC involved more than 150 senior bank supervisors, analysts and economists being interrogated (subject to Geneva Convention or Basel Accord Rules) in the top 19 US banks about their likely losses in the event of a deeper-than-expected recession. This is somewhat complicated and relieved by FASB relaxaion of fair value mark-to-market valuations that takes the illiquid temporary turbulence effects out of market pricing. It is also helped that 3 month LIBOR has fallen to its lowest level since the ‘80s even if longer term funding from private sources remains a desert.
Following the policy (announced February 10) these banks were asked to estimate their short term future losses against capital to meet those losses, under adverse conditions that reflect a view of current conditions shaded on the relatively more benign side of the possible range of outcomes, as defined by the FDIC.
The teams of bank supervisors – specialising in specific types of assets, bank earnings capacity and reserves – then evaluated the banks’ submissions and asked for further information. They tested banks’ projections against independent benchmarks of their own tailored to the portfolio mixes of each bank. The problem here is that the authorities do not have complete macoeconomic models with sufficient financial sector detail to produce and adequatelyrobust and complete benchmark. It is easier to benchmark the banking sector to the economy than to directly correlate any one bank to the economy. The latter is almost impossible. The problem therefore is that whatever macro-prudential and macro-economic modelling the supervisors have to check with is not availabl to the banks themselves. There is, of course, considerable scope for judgement in these matters, but the all tolled the liklihood of the banks assessments agreeing directly with that pre-calculated by the supervisor team is zero! Hence, there will be considerable interative toing and froing between supervisor team and the bank. It may take until end of June to reach consensus agreement.
Taking into account likely losses, operating earnings (repeatable and one-offs) and own-capital reserves, the supervisors make a judgment about on whether each bank requires additional capital to guard against the risks represented by the stress test, with particular concern for whether that capital may be obtained from private sources or must be sought from the Federal Reserve, US Treasury, FDIC, and/or Congress and the White House.
There was both an overall tier-one capital test (which virtually every bank met easily) and a common equity test (which identified the need for many banks to hold economic-capital cushions against wider market and economy risks).
Supervisors did at least tell the banks about their assessment headline terms shortly in advance of visits, i.e. only last week – giving them a few days to crunch through their spreadsheets and challenge the findings. One immense difficulty of all this is that spreadsheets are not powerful enough to turn the handle on all of banks books and do not facilitate audit-trail drill-downs. We are dealing with macro- views top-down applying credit risk, market risk and liquidity risk assessments of large portfolios, large asset classes, where the magins for error greatly exceed the margins that the supervisors ant to have precision on i.e. increments of 0.25% of ratio to RWA or 0.125% of assets. Liquidity funding covers typically 30% of assets (the funding gap) and this is a larger ‘call’ on authorities financial resource than incremental top-up to Tier capital.
With assets of say $30tn of which $20tn are less than AAA, the funding gap is say $6-9tn that will require most of it rolling over perhaps within 6 months. Federal Reserve, US Treasury and FDIC balance sheets probably already have secured half of the requirement. The government is anxious not to let the banks deleverage to satisfy the remainder, and yet reluctant to be seen delivering yet more support in the $1+ trillion region, which would severely damage confidence just when the recession is hopefully in its last 2 quarters. The FDIC had also said in advance that relaining TARP and other sources of $150bn should be more than enough to see out this year. Hence, there is concern to keep the outcome of new funding requirement to below this, hence too Geithner’s plan to leverage the hedge funds into this role by offering them cheap loans to buy toxic assets. The hedge funds know they have political leverage here despite their general unpopularity (only a few notches adrift of the mistrust of the banks, except that at least bank shares are currently rising). This leverage resulted in their generous ‘exit’ clauses should they sometime down the track doubt their ability to make double-digit returns from buying up to $500bn of the banks ‘impaired’ assets.
Bankers say the authorities were willing to update their assessments in the light of changes to asset portfolios from the fourth quarter to the first quarter (reflecting FASB dispensation), but refused to put much weight on very strong first-quarter operating earnings when reaching their judgment on future revenues (which neatly agrees with maket sentiment that at first welcomed the record profits before recognising that these were mainly accounting changes and one-off gains).
Today’s announcement will in effect put banks into one of four categories: those (if any) that need extra tier-one capital; those that need to increase their equity buffer; those that have an adequate capital buffer under the stress test standard; and those that have surplus capital and could be eligible to repay bail-out funds subject to further conditions.
Nouriel Roubini and others, who with the credit ratings agencies, share one outlook in common, which is that there are no penalties just now for being excessively gloomy, advocates in good populist manner the dstruction of some banks to allows others to flourish in their place, a kind of fast-forward Darwinianism. Roubini complains that the tests have no precise insolvency threshold. In my view this is only sensible. Insolvency for banks is not a fixed moment in time event and there are at least six different ways of assessing insolvency. And, in any case, when government stands behind the banks, more so when it owns them, the normal regulatory and insolvency critieria no longer apply as before! Quoting the IMF estimates of losses, which actually added nothing we did not know already, Roubini reiterates that since losses have doubled in six months, the stress test results cannot “be credibly interpreted as a sign of bank health”. My response is, no of course not; these are not yet healthy patients. That is not the issue. The question is have they died or are the vital signs good enough, with evidence of at least near-normal brain-function not to turn off the life support?
Roubini is like a camp-doctor. These banks are cripples, let’s top them if they need “extra capital have, in fact, failed. As a result, these institutions will not be able to raise outside capital and will immediately require government help. Once again, the question will be how the near-insolvent banks can be kept afloat, to avoid systemic risk. But the question we really should be asking is: why keep insolvent banks afloat? We believe there is no convincing answer; we should instead find ways to manage the systemic risk of bank failures.” Good luck to that as a policy prescription: the complexity is mind-boggling.
Like a Eugenicist, Roubini says simply, “Trillions of dollars have been thrown at the system, just so that we can avoid the natural process of creative destruction that would take down these institutions’ creditors. Why shouldn’t the creditors bear the losses?”
He cites as counter-arguments, the “Lehman factor” and counterparty risk, the fear of being on the other side of a transaction with a failed bank”. But this includes the fact that Government is now a major counterparty and cannot risk the banks going under and all those T-bills being presented suddenly for redemption payments. Perhaps mindful of that, he suggests “a new insolvency regime for systemically important financial institutions is passed on a fast-track basis by Congress. Problem nearly solved.” Fast-tracking anything through Congress is an operational risk. I see the problem also that instead of allowing the vacuum of major failed banks to be filled by those with unreconstructed ethics, the government and regulators should continue with supporting the troubled banks in order to clean them up and ensure the country has better, ethically sounder banking. This is economically as important as anything else for the long term. Roubini has a fond belief that there is sufficient spring in the rest of the financial markets for them to rebound even if those big banks fall over. This I very much doubt. I judge that the interconnectedness of financial institutions is far far more complex a network than Roubini realises. Finance is not a competitive market mainly. The banks chased alpha unrealistically, fooling themselves into believing they are their on performance drivers. The difference in performance among banks is minor. The major factors are the economy, nationally and globally. I think Roubini should abandon a micro-theory view and get back to macro-economics.
The stress-tests, from which bankers have to learn this is how they must manage in the future, concern managing through the vicious circle between economic and financial weakness plaguing the economy, paving the way for a reliable recovery. Once that is achieved then other tinkering, Shumpeterian perhaps, is open to debate, not before.
Just now the focus is on narrowing the information gap between what bankers think banks are worth and what investors think banks are worth, they hope to enable many banks to raise the equity they need from the private market. Banks must clean up their balance sheets to attract more equity but not at the expense of the underlying economy.
Officials privately agree that the stress test is not a worst-case assessment but they argue that by intervening relatively early by the standards of past crises they can help ensure such an outcome does not materialise. The assessments are, however, based on a banker’s rather than an economist’s analysis of losses and that is their gross realism failing. They should though avoid the accountant’s snapshot view of solvency by allowing banks to value assets held to maturity at higher than current market prices, and gives them credit for their ability to earn their way back to health over time, taking account of time to generate debt recoveries.
The Federal Reserve tries to narrow the gap between the banker’s view and the economist’s view (two disttinctly different cultures) by taking a broad view of risks and a more forward-looking assessment of loan losses and recoveries. If the strategy succeeds in restoring confidence and drawing in additional equity, it should result in a decline in risk spreads on bank debt, reducing their funding costs and encouraging them to be more aggressive in lending to households and businesses. This correlates well with UK policy that has exceeded even the total support for banks of the rest of the EU. The other OECD countries will be under pressure to follow suit with publishing stress tests of their own. The EU is seeking stress tests on 47 banks, now reduced to the top 25. But these are late. This is because everyone under-estimated the difficulties of assessing scenarios and building models across so many national economies, and the lack of models appropriate to doing this work at a pan-EU level as well as individual country levels.

Banks, Bonds, and Bond Traders

It is fair comment that a feature of investment banks and governments has long been one of incestuous mutuality or let's call it conspiratorial cooperation, from the very earliest times of loan-financing the King's Treasury as an alternative to tax-hike shocks to pay for wars or any other large investments. There is too a long history of the dangers of being a government creditor before governments became more mindful of parliaments, of laws and social responsibilities to manage better the economic impacts of government finance especially when leveraged by political democracy and economic theories that inculcated those responsibilities.
We are going through a special period when governments have been digging deep into the artistry of off-balance sheet financing via central banks treasury bills to bail out the technical insolvencies of banks. Despite this massive lender of last resort help, today there is a plethora of investment analysts notes circulating with undisguised sarcasm and cynicism about government finances. Even I am amazed at how shamelessly the financial markets can turn to savage governments that are doing so much to buy them survival time through the credit crunch and recession!
Some of this is knee-jerk mindless politicking. How easy to blame governments for the so-called 'mess in which public finances are in', on the one hand decrying historically high government deficit spending while on the other complaining about the threat of higher taxation such as the UK's new 50% higher tax rate for those earning above a quarter of a million and similar higher taxation in the US. What would it be costing those who complain if the governments stuck to balanced budget targets regardless of the underlying recession? There is a cry on many sides for government spending to be cut and tax rates to be lower. We entered the crisis with historically low direct taxes (income and corporation taxes).
Some others decry the 'crowding out' effect of governments mopping up savings by issuing a few trillion of government bonds on top of the trillions of bills issued as swaps for impaired and semi-illiquid assets held by banks to reduce their writedowns and nominal losses, to protect their capital and ensure they can retain basic solvency. Given the highest credit rating of government bonds, however, crowding out is offset by the boost to economic growth compared to what it would otherwise have been (i.e. the money is not lost to the economy, but generates multiplier effects by how it is redistributed) and the Treasury bonds help leverage bank lending and have a very high collateral value to support further investment credit. Productive investment is made more by those who borrow than by those with surplus savings. Hence, the 'crowding out' view should be replaced by a 'crowding in' theory of government borrowing. There is not a simple correlation between money supply statistics and government borrowing, certainly not one that can persuade me of the simple axioms of classic monetarist precepts. But, the reality for clear-thinking economists is that lower government spending would not help the economy anyway, not the 'real economy' so-called; it would today just make the whole of the 'economic cake' smaller and postpone recovery, possibly propelling the world's leading economies into Depression (up to a decade possibly of zero, negative or low growth as Japan in the '90s, or longer, as applied economists know, The Great Depression of 1873-1896).
I can only characterise fiscal consrvatives and 'small government is better government' pundits as blinkered, unable or unwilling to see and take responsibility for the big picture! Adam Smith's 'invisible hand' hypothetical and subjective proposition was not that everyone's selfishness should be as narrowly and individually focused as possible to produce the maximum inadvertent public economic and charitable benefits. That would be patently absurdist, since it can only be obviously true that extreme selfishness would undermine national economic integrity, and similarly at the global level; income and wealth is ultimately a social product, dependent on the quality and integrity of the total system, not of each part acting independently.
The famous national debt clock in New York shows the gross debt figure, but over a third of this is are obligations between arms of government, not tradable Treasury bonds, much of which in my view should be made tradable and sold into the secondary bond market and the proceeds used to finance social programs and a large part of the budget deficit without thereby increasing the gross national debt. The internal government part of the national debt is shown by the gap between red and blue lines. In other OECD countries this debt that is internal to government is typically about 20-25% of gross national debts.
Except for the USA in recent years unless we look only at its publicly held debt which has remained fairly constant, many governments held the line in maintaining a fairly constant gross debt ratio over the last decade, the private sectors, banks, businesses and households more than doubled their debt ratios to GDP in credit-boom high trade deficit countries. But, without that the trade-surplus countries could not have maintained their growth. Indeed, it was a boon to many emerging markets. But now we see export-led economies recessing faster than deficit-led economies. An exception to prove the rule is the Bush strategy from 2001 onwards when government tax cuts and cuts in social programs, with Adam Smith's 'invisible hand' in mind as prescribed by monetary conservatists, helped secure recovery but in a severely unbalanced way that proved to be relatively 'jobless' compared to more conventional fiscal recoveries.
The private sector should not complain now when the public sector has to do substantial borrowing now. And it is very likely, anyhow, that government deficits and debt ratios may fall as ratios to GDP sooner and faster over the medium term (3-5 years) than private sector balances, especially as it turns out that much of the financing bail-out of banks proves to be profitable for taxpayers - even if taxpayer money is scarcely involved in the bail-outs. I know it is hard for taxpayers to understand that their money is not what the government is playing with in its liquidity windows and treasury bills for bank asset swaps. They readily confuse government budget deficits with bank bailouts. The two things are not the same. Government budget deficits are almost entirely fiscal responses merely to recover economic growth, not to recapitalise or restructure the banks directly.
Had governments been less prudential over the past 20 years and done more to rein in asset bubbles, property, credit markets, including most importantly the banking bubble where banks stocks grew to dominate a quarter of stock markets and nearly half of quoted compnaies' profits, then the crisis today would be less severe.
Many commentators are now talking of the Treasury Bubble as the next bubble after
the dot-com, housing, mortgages, commercial real estate, private equity, and hedge fund bubbles. This is nonsense. We can see clearly that when government takes on the liabilities of the banking sector that there is a massive net reduction in credit insurance; the government credit risk spread goes up a few tens of basis points, but private sector and banks credit risk spreads fall by hundreds of basis points.
Commentators are happily getting on their high horses about investors chasing long-term Treasury prices to loftier and loftier levels only now to find this bubble too is leaking air fast like previously emerging markets, commodity prices and oil last year, and so on. This is not the same. The demand for government paper has utility and necessity; it is not just a speculative bubble.
Long bond futures fluctuate. They may have fallen 20bp — from 143 mid-December to 123 yesterday and yield on the benchmark 10-year Treasury Note from 2.06% to 3.11% — up 51% with technical levels all over the place, but this is just to be expected camera-shake.
There is also some staking out the market in advance of the large government auctions expected monthly this year. It is not a case of too much supply and not enough demand driving prices lower, at least not anywhere except at the long end simply because at first sight very long term paper seems unnatractive at current historically low coupon rates. This does not mean that the current volumes of government borrowing are more than the markets can willingly even hungrily absorb. All that is happening is that government is testing the outer limits before settling on the optimumally cheapest maturities they can get away with.
UK and US Treasuries are also buying in their own bonds, so-called Quantitative Easing, which just looks to me like restructuring their cost of money and reducing the availability of older higher coupon paper by a significant amount to focus buyers who need government paper on new issues. The Fed said at a policy meeting weeks ago that it would buy back up to $300bn, and it didn't alter that target at last Wednesday's gathering.
Critics lambast UK and US treasuries for buying or swapping illiquid and impaired RMBS and CMBS, toxic CDOs, credit card bonds, student loans — to loan money against anything and everything! This is much exaggerated. The Treasuries are charging substantial fees and exerting 25-30% haircuts, leaving themselves with more than adequate headroom to generate substantial medium term profit that I calculate will both finance recapitalisations of banks and pay off half of medium term government budget deficits thus relieving taxpayers of the risk of sharply higher future tax rates. Personally I'd like to see these haircuts translated into lower mortgage debt for sub-prime and other troubled mortgagees.
Some analysts fear all this is dragging down the US dollar, but that correction is welcome and to be expected anyway. However, there is the usual panic reaction too that the U.S. Treasury is borrowing and spending the country into oblivion! That is just absurd doom-mongering when this accusation had been better aimed at the private sector. Last week US Treasury sold a record $26bn in 7-year notes (reasonable), $35bn 5-year notes, $40bn 2-year notes, to be followed this next week by $71bn in longer-term debt. This all seems very sensible to me. Total net borrowing needs for the second quarter are now $361bn. But, given this is for the current budget year ending September 30 the timing is quite responsible, even if massively up from the only $13bn this time last year and double the previous estimate of $165bn.
The rumours are that the US Treasury will sell 30-year bonds every month, and start auctioning 50-year bonds! In the UK long term government bond yields always fall because there is sizeable Life and Pension fund demand. This may now be the case too in the US? The issuance is needed to fund the fiscal-deficit projected to hit at least $1.75tn in 2009 and $1.2tn in fiscal 2010. The importance can be seen in the composition of foreign holders of US government paper. The high issuance is good news for the economy as the only leverage getting the economy out of the hole it is in, but there is scarcely a news source or market commentary that says so. Negative sensationalism to rattle the cages of investors and persuade them into panic buying of gold or CFDs or Treasury bills and avoid long term bonds. But no investors except those with decades long term liabilities should be buying 30-50 year bonds anyway!
For more on this see my Obamanomics blogspot. (click to via profile)

IMF VIEW OF GLOBAL BANK LOSSES

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.

STRESS OF STRESS-TESTS

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 www.mcdowellobamanomics.blogspot.com) 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 www.mcdowellobamanomics.blogspot.com 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.

G20 ONLY EXIT OFF THE FREEWAY

Not long into the Credit Crunch and as recession beckoned, UK Prime Minister, Gordon Brown, announced an end to the "Age of Irresponsibility". This became his global statesman theme, his G20 and his Davos theme. Brown’s speech at the Davos World Forum was superb and head and shoulders above other leading politicians, and that included his technical as well as his policy grasp of the origins and necessary solutions for both the Credit Crunch and global recession. Of all political leaders, Brown found the best Churchillian-style phrases to both express the public mood and show that he can command the bigger picture. But, responsibility has to extend to politicians, and politics being politics and politicians being what they are, any big ideas, right or wrong are sniped at, argued against, and horse-traded. G20 in Washington produced a strong agenda. G20 in London should show progress in building on that and should by evidencing global agreements help enormously to restore confidence in the prospects of recovery and thereby hasten that recovery. Economies can operate relatively freely of government intervention and control when employment is low and growth is positive. With record rising unemployment and negative growth all responsibility to steer the economy falls entirely to government. But to be effective politically, financially, technocratically it needs authority and confidence. Essential to confidence is belief in the expertise of government to “do the right thing”, “to do whatever it takes” and to make a reality of “Yes, we can”! But, who is there who can validate the expertise of government when bankers, economists, regulators, accountants are all variously discredited. Not the journalists or the internet bloggers constantly seeking after sensation and scandal. Government politicians today have no-one to turn to validate their polices except other governments. Only the clearest evidence of the world’s leading governments, the G20 governments, who are in charge of 80% of the world economy, agreeing to a common set of principles, policies and priority actions, can restore confidence, provide something for everyone to place their trust in to face down the crisis.Given the seriousness of the global crisis (truly global) it is dangerously wrong therefore, not just pathetic or malapropos, of opposition parties in the UK (and USA and elsewhere) to use this crisis for domestic political point-scoring to damage the credibility of government or to put the outcome of the next election before the question of solving the global crisis. Martin Wolf in the FT made a very valuable point, which is that we need to do more than enough. The risk of doing too little is too important to economise on; the chances of doing just enough, not too much, not too little, are too remote. Jamie Dimon, CEO of JP Morgan Chase, has very valuably said, the time for new ideas is over. We have the means and the tools, maybe not the most perfect, but definitely good enough to do the job and that is all we should focus on. We can undo some of it later or worry about analysis of all the blame-game, fault-finding, engine-repair and fine-tuning later. Therefore, when the Prime Minister Mirek Topolanek of the Czech Republic, half-way through his 6 month presidency of the European Union, lost a vote of no-confidence on Thursday, and resigned, and then attacked US policy of spending trillions of dollars (and by implication UK policy seeking a $2 trillion fiscal boost to world GDP) as “the road to hell” (implying one paved with ‘good intentions’) that all EU government must avoid, he was damaging all governments. President Obama will visit Prague next week after the G20 Summit in London. White House spokesman said, "I think the Czech people and the American people can stand assured that the President of the United States of America is going to do all and everything in his power to get our economy moving again and to restore confidence in that economy."
At the G20, the USA and the UK want to push for concerted fiscal deficit spending along Keynesian economic theory lines of 8% ratio to GDP. Europeans leaders want to the USA to emphasise more measures to tighten regulatory oversight over the global financial system. The UK wants to do both. The US has some traditional concern about agreeing to international or non-US laws on anything except some basic UN rights and accountancy standards. Why there is resistence to regulatory rules and laws that it was in process of acceding to anyway i.e. Basel II, is unclear? The USA is focusing on economic stimulus, with a $US787billion spending plan, as well as the $US1trillion it plans to pump into the financial system to revive lending. Some other countries are traditionally resistent to giving up Monetarism and embracing Keynesianism, so it appears. In reality, the problem for Euro Area economies is that government do have political control of money market interventions.
Mr Topolanek said, "All of these steps, these combinations and permanency is the road to hell. The biggest success of the (EU) is the refusal to go this way. Americans will need liquidity to finance all their measures and they will balance this with the sale of their bonds but this will undermine the liquidity of the global financial market." His views are eminently disputable. Martin Schulz, leader of the Socialists in the European parliament said his comments were "not the level on which the EU ought to be operating with the US"… "You (Topolanek) have not understood what the task of the EU Presidency is." EU Commission President, Jose Manuel Barroso, said it is "not helpful ... to try to suggest that Americans and Europeans are coming with very different approaches to the crisis". Within the EU 8% budget deficits is a break with the Maastricht Agreement criteria. Several leaders, notable Germany’s Angela Merkel, are saying they will not be dictated to as to how much money to borrow and spend. Ireland may however have to embrace a 10% fiscal deficit. The ECB could do more but it is also constitutionally constrained. The structure and framework of the Euro single currency is under great strain alongside the problems for the Lisbon Treaty, the Lamafussey Framework and the Single Market in financial services. Governments are also stressed by their governance of big banks, most notably the Benelux countries re. Fortis and ABN AMRO and Ireland and its four biggest banks. Spain, Greece, Italy and all others have comparable problems. The equivalent in the USA would be if all states had to bale out their banks and negotiate for this with the regional Federal Reserves and liaise with all other states affected. I don't think the rest of the world entirely appreciates how big the US economy is, albeit Europe is just as big but in many economic power aspects much less so. Here are two views of this:- The technical issues, policy agreements and political problems, are all so complex that on these matters, and beyond them the global dimensions of the crisis, we need governments to collectively retain their credibility to work together in unison. Only agreement between governments across the world is left to validate the measures needed to get the banks working properly and for fiscal boosts to gain economy recovery soon. The best resolve therefore is simply to take the lead from whichever country appears to be managing most successfully, and it is probably the UK. And, therefore, Gordon Brown, might for perfectly commonsensical and practical reasons expect that how he has defined the problems and the solutions, working closely with the USA, should be the template for all, the common agenda. The continental Europeans cannot continue to eke political capital out of the idea that this is essentially an American or Anglo-American problem and that they, the Europeans, can diverge onto another way forward, a European way. In the globalised world all have hitherto bought into there is no American or European way, only a global one-way forward, one-way off the blocked freeway, or from Recession, next stop Depression.
The global version right now is Gordon Brown and what will survive and hopefully prosper of the moral and ethical dimensions of the G20 Agenda. Gordon Brown this week touched down in three continents. On Wednesday he faced down American scepticism over his (and that of the G20) proposals for tighter regulation of the banks, telling a Wall Street audience the financial sector had to rediscover moral principles. There was meanwhile dissenting voices in Europe from Germany and the Czech Republic about long term consequences of sharply higher government spending. It is not just that some Euro Area political leaders are doubting their political capacity to sell state imprudence as a response to the imprudence of bankers, they have another problem in that they do not have direct control over money market interventions. Issuing government bills is in the exclusive control of the quasi-politically-independent European Central Bank (ECB). Yet it is only at the treasury bill end of money markets where the US and UK have been able to leverage trillions. The Euro Area governments lost that direct off-balance-sheet financial firepower when they joined the single currency. When Mervyn King Governor of the Bank of England (BoE) said publicly that we have to be cautious about how far to go in fiscal deficit-spending, he was only referring to the Government's on-balance-sheet budget. Off-budget he (with the Debt Management Office of HM Treasury) has grown the financial balances of the BoE to $4 trillions, which is more than the ECB and even slightly more right now that the US Federal Reserve!
(Note: Moral rectitude in government finance is fine for politicians, but arguably too much of it was what allowed the private sector households, corporations and banks to grow their borrowing to over three times that of the government in only 10 years! Moral rectitude if taken to fundamentally at face value, to woodenly, is also a mask behind which there is 'can of worms'. For example, one unreported irony of moral rectitude in finance is that Bernie Madoff since his time as Chairman of Nasdaq, before he was found out to be among the most unethical practitioners of all, presided over a host of new ethical reforms to do with protecting against conflicts of interest, series 7 investment advice examinations, other such regulatory certifications and the independence of analysts and probably aspects of Sarbanes-Oxley. He was the epitome of rectitude and moral authority. He was the moral paragon deferred to when rapping miscreants and exam failures over the knuckles. "Bernie wouldn't approve of that" etc.)
Macro-economics is about seeing the world in three dimensions, not two. In two dimensions, hypocrisy and paradox are inevitable, even natural, or let's just say the aliens we all know. And, indeed, moving on to the G20 idea of a global executive on the flight-deck of the world, how these grand meetings are stageed can appear like some inter-planetary science fiction government. Do people believe in fine words and a good show, or will they now jaded and dispairing only believe in practical proven results. Will the public have the patience to wait and see? For that they need to feel confidence in governments. If national political leaders squabble in public that confidence is blown. Let's expect that the London G20 (at London's Ex-cel Centre, which looks like a large airport style sea-terminal) is less stage-designed and has more of that moral and ethical down-to-earth goodness that should persuade all participants that their collective credibility is on the line if they do not all "do whatever it takes" (DWIT) to get out of the global recession sooner than later. DWIT is the political phrase of choice by the whole of the UK (economic peace?) Cabinet and has become the phrase too of the Obama administration, the businesslike end of the 'end of the age of irresponsibility' dogtag that should be inscribed in latin somewhere. Maybe we could have medals issues for good service in this cause inscribed on the back of the ones we usually wear. The more genuine article is undoubtedly the UK Prime Minister saying clearly “We have to clean up the banking system,” ...“We must give people confidence that the principles that guide their daily lives are those that also guide the markets. I know people are angry at what they see in banking bonuses.” In the US after the S&L crisis, Enron and Worldcom scandals, and the collapse of LTCM, Sarbanes-Oxley is a powerful attempt to do that - could SarBox now go global? How can such moral principles be translated into regulations, standards, financial practise laws? In all respects Basel II covers the same ground in finance but goes much further, perhaps too far only insofar as there is so much to learn and so much also to innovate to comply fully. SarBox possibly delayed the US banks from embracing Basel II by 1-2 years.
Mr Brown delivered his uncompromising viewsin the grand ballroom of New York’s five-star Plaza Hotel. As any investment banker knows this hotel is the eponymous meeting place for corporate finance deal-making. The London equivalent might be the Savoy grill-room or the Cafe Royal. Last time I was at the Plaze it was for a conference of the biggest NY hedge funds. Attendees at Gordon Brown's speech included the presidents of Citibank, Nasdaq and Goldman Sachs. The PM warned them they could not operate in a moral vacuum ruled by “avarice”. In some ways his speech, while echoed too in the view of President Obama, also had a comparable version a week earlier in the speech by Jamie Dimon, the JP Morgan Chase CEO (see 11 March blog below).
Gordon Brown said, “The principles and values we apply in our everyday lives, you have got to ask did we apply them to the running of our financial institutions?” said Mr Brown. “There is a sense that the global economy was outside these standards that we applied in our everyday lives.” It might be arguable that the whole of banking finance is being tarred and with the same brush that of structured product proprietary trading desk types. But, of course, we all know that the Gordon Gekko greed is good types became very over-dominating in banking generally - the worst sorts were attracted to and corrupted by the diea of making easy money, lots of it, fast. The culture defined the 80s, 90s and noughties, but was also defined by it, by the cult of entrpreneurial individualism that for too many card-sharps in business and politics seemed to be the only worthwhile and purest essence of capitalism and then too of neo-conservatism in politics that for now have been binned. Gordon Brown is a bruiser of a politican according to some, and a brilliant genius according to others, and ego-driven and moralistic, and in truth something of all of these, and yet also a finely-honed politician with all the understanding about timing and horse-trading that requires. He knows this is the time to head for the high ground and step severely on modern banking culture to get there. His perception is that banks were operating in a value-free hinterland, failing to adhere to basic principles of honesty and hard work, and had damaged the entire system, “Markets depend on morals in the end. A world without standards is going to be a world without stability.”
Mr Brown used the NY leg of a 5-day diplomatic tour ahead of next week’s G20 summit in London to confront American pressure for protectionist measures and scepticism about supranational financial regulation, which is the most European part of the G20 agenda. It was expected that the USA under President Obama would shift in this direction. But, clearly, there are problems for him to do so in the Senate and somewhat in Congress. If the US attitude remains reluctant to overtly abandon any protectionism or to embrace globally-overseen regulations, what is left is US insistence on all countries applying domestic fiscal measures to boost their domestic spending and consumer demand, which for many means giving up their trade surpluses and for the poorest going cap in hand to the IMF? World trade is in any case re-orientating so fast and unreliably that protectionism is a total non-issue in the short term when no-one knows how their external trading account is working out.
The PM signalled hopes that the London summit would impose a “name and shame” system to police governments that put up barriers to trade. “We will agree at the G20 to monitor any protectionism ... and report it.” This idea is easily attacked in terms of how are barriers to trade to be defined, narrowly or very broadly, and either way both US and EU could be named and shamed too? Policy makers despite the GATT and Doha and other global trade agreement negotiations operate on the basis of a narrow definition of trade barriers to do with quotas, import and export duties, government contracts, and producer subsidies. But, looking at the whole matter broadly, globally, macro-economically, then trade and protection issues can look very different. It would be a nice hope that new thinking will emerge, but the rush to decisions may not allow for that. The extreme world trade balances increasingly had to be financed by 'net acquisition of financial assets' in the trade deficit countries to be sold to the trade surplus countries. To calm fears that America would have to cede control of Wall Street under a new international regime, Mr Brown dismissed as “ridiculous” the idea the G20 would seek to impose a single global financial regulator (the IMF is planned to sit in the centre of a global network of regulatory authorities). The US doesn't want an equivalent of the International Court in the Hague for financial regulation i.e. the USA won't acknowledge a regulatory legal authority above that of its own national regulators, hence one reason why it preferred the IMF to BIS or other bodies to lead in this area. The IMF may not therefore be able to declare Basel II (or something akin to a Basel III) as a worldwide legal standard like we already have worldwide accounting standards? Why global standards for accounting but not with the same legal force for banking risk management regulations is potentially an anomaly here? Also, it probably means the global regulatory oversight of IMF becomes more of a forum of regulators but the BIS is that already, except it has more limited membership compared to the IMF. So, could the IMF membership be persuaded to sign on to Basel II as a condition of access to the IMF funding support?
One problem with Basel II is that the jury of public opinion is still out on whether it contributed to the problem or is the solution to the problem. The general assumption has been that Basel II was already in place and should have prevented the crisis, either that or its prudential capital rules meant that banks have been forced to deleverage just when the world needs them to keep their lending up? The truth is that Basel II was not even half implemented, and the half not properly implemented at all was precisely those parts that would have mitigated the crisis, liqudity risk, economic capitla model stress-testing, integrating all risks to forecast economic capital requirements etc. stuff that the vast majority of bankers don't understand, don't have the tools for, and couldn't be bothered unless there are bonuses in it for them.
It was partly to get banks to embrace Basel II that the mantra they were all told was "do this well, and you can save on your capital requirement and therefore do lots more business" (i.e. more bonus). The opposite was true. But, this shows the problem of how to incentivise banks to be more prudential and ethical and so on. The answer is, of course, there is no incentive (or not much of one unless as a bank you believe it serves to win customer loyalty) and therefore it is stick not carrot time! 'Name and shame' is not a big stick unless it means next stop nationalisation or loss of some banking licenses, or being broken up, or ordered to stop certain lines of business. The Credit Crunch Crisis has shown governments rediscovering that they have all these powers. Systemically important banks and their shareholdersnow know that their ultimate owners are national governments, whether they are wholly, partly, or not at all govern-owned in % share-holding terms. Brown stressed the “remarkable consensus” developing about the regulation of hedge funds and other shadow banks. This sounds clearly as if transparency reporting laws will be passed. The SEC under its new Director will try again to get laws passed that the Supreme Court last time rejected. New laws will probably be coordinated internationally all at the same time so that hedge funds cannot jump from one jurisdiction to another - and that means also coming down firmly on tax havens?
Brown cautioned against trying to reform America’s regulatory system in isolation, stressing the extent to which the US subprime crisis had infected European banks. It is also codespeak for the problem of Citigroup, which has most of its assets outside USA, much of them in Europe, and which seems most likely to be nationalised in the USA if only the complexity can be sorted out. And in a separate but potentially related development the prime minister revealed that Britain was in talks with Germany to agree a system for managing the withdrawal of banks, including the state-owned Royal Bank of Scotland, to their home markets. This sounds like the Single Market for Financial services going into reverse, which would be contrary to EU law and ethos! It is therefore surely about making it easier to nationalise banks when they are active in many jurisdictions - including US banks e.g. Citigroup - but also RBS giving up its AAB interests and non-core businesses outside of UK and USA. Gordon Brown called for a series of such bilateral agreements to try to prevent the exodus of banks from overseas markets exacerbating the global financial crisis.
For the FT's moving-talking graphic on the Geithner PPIP Plan see:
http://www.ft.com/cms/s/0/42f10f16-1a16-11de-9f91-0000779fd2ac.html

THE GREAT GAME: Faites vos jeux! PLEASE LAY YOUR BETS NOW!

It is not always wrong to think positively in the midst of turmoil. I have tasked my bank's analysts to come up with the 'now is time again for going long' option (and very long blogwise)and stop thinking short-selling but contrarian-wise, contra-intuitively, how we can go forward here-on-in. The 'bullet-point, psychometric, feelgood-feelbetter, we-can-make-it-happen. "yes, we can" gurus, you just gotta really want something bad enough to make it big, animal-spirits back in the front-line, can-do Yankee culture, business strategy cheerleaders, home-team, self-help psychologists' et al, cannot be all wrong. Forget saving money; let's make money, go out there, and do the deals that truly believe in the Anglo-American capitalist model, that's what I tell the money folks. It's The Great Game all over again. Readers of my columns expect mixed metaphors and slightly mad euphenisms. This one could be Central Asia's 'Great Game' where a few great heroes held off the Russian Bear at the North West Frontier in the mid-19th century that unfortunately has now lasted into the early 21st century, or the great game of making par for the course deals with businesses struggling with their golf handicaps, or spread-betting on cricket scores in Caribbean tax-havens, maybe rugby is the great game, blind-siding a ruckus to cross the line (Six Nations Championship decided Saturday by Ireland), or Spanish bullfighting, or maybe all of these, 'great games' when thinking about the team-plays needed to make vast fortunes now in Asset Backed Securities, even today, yes, especially today. Issuance in the UK has never been greater, but so far it's all being packaged for, to be 'bought in' like repo-swaps, by HM Treasury and the Bank of England. And, so far, the amounts are more than the total of UK banks 'funding gap' (at $1 trillion out of $7 trillion bank assets, or 3 times China's true GDP, or one third more than the 'funding gap' of all emerging market countries' banks put together - data source:BIS). Euro Area banks likewise are active bundling & packaging their loan-books for ECB and other central banks and finance ministries. 'Funding' is not the only gap. European banks in total have a $2 trillions 'US dollar' funding gap, but that's only one third of their customer loans to deposits funding gap and what's left of the Pfandbriefe market. 'Funding gap' between customer deposits and loans is met by borrowing 'wholesale finance' (from banks and non-banks) in the form of 3 month, 1, 3, 5, 10, 30, even 50 year covered (bank) bonds and securitised ABS loans, which are amortizing and constantly topped up i.e. rolling credit-assets (my term). But, over in the USA, where are US banks getting their new roll-over financing for their funding gaps, not so far as we can see yet from bond issuances, securitizations or covered bonds? I asked one of my analysts for a roadmap late last year (see next slide), but when I found it impenetrable I just had to let the guy go. This is no longer a spreadsheet world I told him and he forfeited his stock options. We are not bonus-friendly right now. Upside-potential revenue-earners we keep; problem-fakirs who want to short everything that moves this year like last year we don't. I told him and his team I'm much more interested in how we leverage ISDA's new global standard for credit default swap processing, the latest move by Group of 30 and others to address issues that arose after the collapse of Lehman Brothers five months back, and how we can profit from efforts with the World Bank and IMF to plug the $275bn funding gap shortfall in emerging markets banks! My ex-analyst at least provided a foretaste of the Geithner Stress-test to figure out NPV of all US banks going forward if we place all toxic assets into a big bad bank.I am still at a loss to see how the US banks are financing their funding gaps. Published data is in very short supply, zero it seems. Maybe what they get from the Fed's TALF, FDIC guarantees, and Fed Liquidity Window is enough? If so, it must be eventually become $5-7 trillions enough, out of a total funding gap someways north of that? Precise data is hard to find. It's easier to uncover banks funding gaps in Europe. My guys could go through the waste baskets of the major banks published accounts or check the Fed's and FDIC backyards. For now, let's just ask the question. Gillian Tett in the FT (see comment at end below)tells us that private sector wholesale funding has dried up. At a Dublin conference I missed the hedge fund experts surmise that Hedge investment capital has shrunk since 2006 from over $2.5tn to close to $1tn! My data says the total is still up in the $2tn region? She also says the banks have stopped their proprietary trading (prop desks) except, in Europe, Goldman Sachs. She also says market-making has retreated, especially in credit markets. So liquidity has crunched, and the question is where is the wall of carpet-bagger money building in 'distressed funds' (the slightly politer term for 'vulture funds') circling and waiting to pounce on fire-sale price deals. Recession is always the time for the cash-rich to get spectacularly richer by buying productive assets, property and securities in anticipation of massive gains when recovery begins. Vulture Funds are building fire-power in the USA, why not in Europe too? Maybe it is all about who gets the Japanese, other Asian and ME sovereign funds on board ($ funds from export-surplus countries)? Ok, so either we invest in vulture funds or we finance banks funding gaps, or we pick up discounted banking-loans assets in securitised bonds at prices where further defaults do no harm, or pick up prime property and land, or maybe all of these. The question is price, timing and getting at the carcasses before the other vultures arrive. Meanwhile, stateside, the US banks are perhaps just treading water, holding hover, suckling at the breast of the Federal Reserve's short term liquidity window? I put this question to my auto-loans liquidity specialist and foreign trips special assistant, Ms Rita Chevrolet, to consider double-entry book-keeping issues of liquidity preferences in banks balance sheet treatments under GAAP, FASB, IAS and IFRS 7. Certainly, she concluded, if US banks are funding desperately in the shortest term depo money market, we can't rely on them to invest richly in my vulture funds! Almost all new new ABS and CB issuance in the USA died off when Lehman crashed and burned. How are the US banks funding their 'funding gaps' without it and others like it, I asked? Should, I and my other fundsters try to out-compete the Fed's deals and get 9%- 12% returns that way? The answer share gave me was that, on the one hand, they (the big banks) are still making money in underlying net interest from traditional banking and, in the other hand, big banks, especially Citibank (Citigroup), JPMC and BoA and Wells Fargo (maybe?) have received a lot of support to buy other big banks, Bear, Wachovia, WaMu and Merrill-Lynch. But, she says, the US banks aren't issuing covered bonds either, or weren't in first half of 2008. U.S. financial institutions sold more than $100 billion of government-backed notes in dollars, euros and British pounds in October to December and now another $300bn back to the Fed, maybe for QE cheques? It helped the banks that FDIC guaranteed their bonds to help them cope with over $770bn of losses and writedowns (including FM&FM). U.S. banks may be doing road-shows in Asia and among sovereign funds. Sales of FDIC-backed notes maturing in more than a year may reach $450bn by the end of June 2009, according to Bloomberg. But whatever's going on, she said, it's hard to get hard data? Whereas the European banks went on issuing ABS in 2008 and a lot of covered bonds to finance their 'funding gaps between customer loans and deposits, gaps that are considerable! And yet the problems of financing the gaps are what makes the credit crunch so-called, that and the ABS and CDO write-downs.
I suspect that the Euro Area is not quite so much down in recession terms as the most recent GDP data suggested (subject to significant revisions yet to come). So, I've just returned from discussing all this with my American colleagues, and giving them a few gold-plated steers, at the Silicon Valley of structured finance on St.Patrick's Day, at IMN Clover's Distressed Points Summit: Credit Crunch Investments for Cash-rich held at 'Dan a Point', Uppermill, Seeder Valley, CA, this week, and in the sky wasn’t the only sunshine. All bared their optimism through grated teeth about the dizzying perspective on Distressed Opportunity Assets in 2009 to 2012. I presented the present situation of the UK banking sector and the value of the Government's capitalisation infusions.I spoke about the UK banks and our branch there in that context. The above graph soared to new heights in the second half of 2008 but the £300bn was almost all for the Bank of England APS, added to which there has been over £600bn in only the last few weeks. We hope to get the management contracts for the pricing and maintenance for suchlike. Interestingly, the optimism shared here echoed what I felt recently at the What's Over the Edge AI fundsters hooley in Philly, PA. My audience at both events comprised the big pension and municipal fund credit-risk p/f, debt-capital managers, and their entertaining clients. The highlights include my thoughts on RMBS described below. I concluded each time by saying, in sum, we are staring into a big dark hole with a big light at the bottom about to switch on and flood out bathing us all in golden sunshine, however artificial of course, of a 'once in several lifetimes' opportunities buying into RMBS in 2009, given the right haircut. As we all know Mark-to-Market causes illiquidity by telling everyone just how one-way the credit market is, except at the shortest end dominated by the central bank liquidity windows and now in recent months the central banks have also taken over 3month, 1 year and MT maturity term markets - it's a race to profit between Government doing ABS asset-swaps and private cash investors trying to get back in on their terms(I advise both). We need a new Big bang Theory, the Standard Theory lacks a mathematically convincing two-way theory of gravity. Time to get back to basics and reconsider what we've been taking for granted. Corporate debt is too volatile for going long or 'long' strategies, alongside CDOs and CLOs; best to surf round turning points on v.short-term 2% = 50xleverages. Bit early for Commercial MBS except for secret fire-sale deals. Government isn’t helping the credit-marketeers with mortgage cram-downs and slam-dunk liquidity window giant swaps enjoying 30% haircuts on A+ paper already at 70-80
Governments' unlimited fiat-money has changed the “rules of the game.” But so far, still a richly-rewarding, one-way buyers' market if you've no qualms depriving taxpayers of big MT gains, and don't feel moral queasiness of adding yet more mega-bonuses to your 2008 Christmas came every day and twice on Sundays shorting profits. My friends Soros, Nebachudnezzer, Ozymandius and Buffett have such moral thoughts
This I will share with King Midas (Mervyn) and tell him this is all about who is allowed to be the carpet-baggers of the credit crunch global recession (first recession where aggregate of world GDP could become negative?) - the shadow-banks & friends who profited on way down, now have far more gain on way up - it is them or the public sector who makes biggest returns (at least the latter is on everyone's behalf and that risked to bail out economy & the finance markets?)I wonder if European banks are lending to the US banks in place of paying up their dollar gap, the euro-dollar system at work? My advice to clients such as Don Di Bias (Advantus), Larry Poker (Paulson), Mikey Picko'raro (NPM), Mick 'to model' Clark (Meridian), Johnny d'Pluto (Declaration M&R), Michel Levitt (Stone Tower), Johnny 'pibroch' Morrison (Asymtotix) and his namesake at Macquarie, Phill "fill ‘em while they're hot” Baruch (Trust Co.West) are that we face immediate opportunities in selected RMBS (picked using my REvolutionary Super-Computer UE harness, caveat “get 'em cheap” and investor firms with cash can indeed.I can factor in any structure and any type of market participant. The market is ripening like Spring, with 30-40% returns on RMBS trading at postage stamp rates $0.40c. Time is now, '09 = Big Opportunity REturns in Short- to less-short term. DIStressed CREDIT over 5-6 year strategy = '08-09: Stressed housing market, '09-11: Stressed Consumer Credit, '10-13: Commercial Real Estate only if you think CRE lags economic weakness (I don't). Housing correction is 2.5 years into its peak to peak 7 year cycle. Forecasts to my investors on frequency & severity of loss, amortised run-off and cash-flow balloons sell like hot-cakes. Corporate defaults just starting look tremendous volatility for inter-day trades. Buying into RMBS with short, predictable cash flows is effective for quarterly plays, better per year than 7+ years for corporate debt coupons after knocking off the insurance. (This viewpoint on corporate debt was shared by many fellow carpetbaggers – too much volatility for self-respecting investors and too early to know where best opportunities are firmest.)Fundamentals are always a challenge, to market outsiders, finding a willing seller at these prices can only be among the over-leveraged AI merchants and disintegrated banks like Fortis and ABN AMRO, but how many more of those can we find, gold-dust, if you can trust the accounting. Asset holders subject to mark-to-market fair-value need to protect their p/l, especially banks with dominant government shareholders who want profitable exits sooner than later and aren't too anxious to wait for the bigger pay-offs, so they're swap-repo-selling small juicy portions of their bond-packaged loan portfolios at 40c/$1, down from the 60c or 70c where currently marked. To go further would require the banks (selling privately, directly, or via SIV or Warehouse intermediaries) to re-mark all remaining loan assets on the books, and risk analysts' views feeding through to the ratings agencies! This would wreak havoc on most banks’ capital ratios far more than narrow the banks 'funding gaps', causing bank regulators to step in and shut down banks for 'capital insolvency' where the 40c sale revenue equates to 40+% 'funding gaps'. No signs of improvement in the illiquid MT & 3m credit and money market – there’s not much activity right now because of the mark-to-market effects on sell-siders, only suits those of us with deepest pockets and more of them than a busy snooker club. The US banks have raised more than they've written down in 2008, half of it from government. They lost 75% of their capital reserves ($1tn) and have replaced 80% of that so they are well provisioned for some more big haircuts yet to come onstream? But, when will liquidity start to flow? Maybe when the Carpetbag Clubbers get into buying distressed ABS at sufficiently deep discounts to leverage against at negative cost? There is liquidity flowing, but right now only from government to banks. And the governments are imposing 25-30% haircut and levering big fees so it ain't cheap money, but it is money, the best kind in exchange for the worst kind of currently semi-liquid assets. Governments are taking the banks' impaired assets on am equivalent to a swap-repo basis and thereby removing the M2M market risk from banks' balance sheets, while also ensuring governments get their preference share coupons and other dividends paid plus better prospects for bank shares rebounding. The banks need the money to fund their funding gaps and that locks out the private sector from what was a lucrative business. Great time though for the insurers to buy very long term paper at good discount and high LIBOR Plus rates.
Right now, there's roughly $1.4tn RMBS currently on offer in the US, even after the Fed's $300bn slam dunk. And there'll be forced sale situations from secondary market structured product funds through '09. The Fed's purchase of FM&FM assets at Agency and sub-prime spreads is like a cheap share buy-back. Has the Fed or the Bank of England or the ECB got the analytics such as I have for valuing all forms of structured product? Carpetbagger Club members agree with me. They say stuff like, "dose depress-price RMBS don' mean dem assets is distressed f'sho', onny priced as distress' wuz like loan portfolios is priced as non-performing when deez 'ere default rates is bein' sticky between 1.5% (normal 45% recovery rates) an' 3.5% (30% recoveries)". I tell them, "that's certainly most interesting and insightful". That's the Veronica of the deal. I next show the Espada (Estoque) saying, "but lookee here this requires asset modelling at loan level, then integrating at property-level, plus macro-analysis using my super-computer right here (my Traje de luces). See, IRRBB securitized bond driver is price at sale, cash-yields, & recoveries less cost-haircuts at defaults + mitigants for smoothing like the 30% of borrower income idea and other stuff like mortgagee re-contracting and new IR settings, and principal 'aromatization' (amortization with a play-nice smell)". That Puntilla gets their attention. Then I finish with my "tercio del momento supremo".
At current price levels, 17-25% IRR is realistic and RMBS offers a good “margin of safety.” The primary risk lies in government cram-downs of sub-prime mortgages, where 60% of sub-prime loans are currently performing to 10-12% heading for 25% (representing in turn about 25% of US RMBS, but the discerning buyer can get half that first-loss protected and still come good with double-digit returns. fact is, as i tell everyone I know, it's time they caught up with the latest most modern financial products. Some fools say,“Just because it’s cheap doesn’t mean that it’s cheap, or that it won’t get cheaper.” Government’s actions introduce opportunity constraints for private buyers in the distressed credit market esp. in RMBS. Why would RMBS holders sell at 40 when they can wait for a government bailout and get 75? Well only 80% of holders can do that. They are the systemically important big banks. That leaves $2.8tn of paper out there to play for, plus what's left behind in the banks vaults, and another $1.5tn maybe available in Europe and Asia for say that looks good when you've got US dollars to buy with and want to book a US mega-profit when the dollar falls later this year and next. £ Sterling holders would be happy to sell just now for $ dollars at 40-50c.There is life in these assets! This spawned some Bohemian Grove style chats about the lack of “rule of law” in the credit markets. Most managers feel the government’s spurts of activity is unsettling. But, I just calm the anxiety by putting some numbers on outcomes for a Performing ABS Loan Portfolio whereby baseline ROI reaches 17% (or higher closer to 40s): Default rate of 10% per year; Prepayment 5% per year; Recovery Rate 50% less hc; and hey presto the AAA is back up trading at par! The greediest clients like the 17% but but hop market price will strike at 40c/$, not 50c-60c range. When stock markets crashed it was also because institutional investors sold stock and held cash (& near-cash) and some/many are cash-rich with once in lifetime opportunity to buy in at the bottom of bottoms. It was not just my short-selling friends who did the damage, though plenty of that too, but as we say where would we be if the institutions wouldn't agree to our renting their stock and sending it back trashed - just like rock bands in their hotel rooms - lot of fun for money. Short-sellers are the new rock & roll! Funds with the best actuaries have the best forecasting economists and many are public pension sector funds, though they can't work out that stock lending is foolish in turbulent markets? So what we see is rich 'jump in deep end' stuff. But, within the complex world of distressed investments, lies a labyrinth of contractual issues. With good advice, public pension funds & institutional investors can be led through the complicated legal web of the distressed arena. My firm's expertise is the practicalities of the marketplace- legal/ contractual expertise and specialized added-value-pricing trading-to-banking-book requirements. Using our analysis I evidenced the case of US big 6 banks and the different capital reserve schedules that occur whether banks discount their ABS by 25% or 50% more, and why the lower rate is obviously so much safer for them. Hence, I was saying forget about 40c on the $, take 50c-60c and wait for return to 85c. If US banks' distressed assets are therefore less appealing, I counseled the attractions (upside currency risk) of dramatic rises in distressed opportunities in Europe and Asia due to increased default rates resulting from an inability for companies to service debts. Although conditions vary between regions, both Europe and Asia are feeling the effects of the credit crunch turmoil. We have specialists who analyze why funds should consider investing outside the USA:- the driving forces behind the surge of European and Asian distressed investing - most appealing sectors and cycles to public pension funds - case studies of public pension fund investing in European and/or Asian distressed markets and of municipal bond issuers trying to trace their bondholders to buy the stock back at half price! Our Outlook for 2009: Will others follow our lead, and with how much $ and who? We quite happily will advise the public sector buyers too. Dramatic rises expected in distressed opportunities in Europe and Asia due to increased default rates (inability of companies to service debts - already S&P500 EBIDTA = only 100% of interest payments! this is not good news. I want good news. This is the time for future-perfect not past-imperfect thinking. This I fleshed out on the blackboard - good old traditional technology. Conditions lag-vary between Europe and Asia in feeling effects of credit crunch turmoil(tsunami arrival rates meeting 'surge' of 'surfers', also known as, carpetbagger investment funds). Specialists will analyze why public funds should consider investing outside United States (especially just when US $ is riding v.high +30% to £ where half of Europe's ABS resides):
• driving forces behind surge of European & Asian distressed investing
• most appealing sectors & cycles? - how to identify them?
• Case study work - public fund investing in European & Asian distressed markets
• Outlook for 2009 - how much and how many others will follow?
Which sectors afford the best prospect to leverage returns.
Analyze where next opportunities appear - look at the distressed markets - most popular sectors for distressed investments - Opportunities this quarter, this year - driving forces behind funds' decision to use Our Opportunity Funds? - positioning these assets into present strategy? - super-calc of risk/rewards of investing in OOFs? When share prices of bank stocks are the price of postage stamps (see example of the recent Bond 'forever stamps' I've invested in that will soon be showing 8% returns, and no stamp-duty or capital-gains tax?) to allocate assets to distressed investments is a matter of 1. timing; early/ middle/ later in distressed cycles? - 2. valuation - 3. performance measurement - 4. defaults & their corresponding distress-cycles - 5. relative risk - 6. upside potential - 7. plan to leverage value into the future. I surprise folks with my Stamp Bond returns compared to bank stocks. I tell clients what it is attracting them to invest early/middle/later in distressed cycles and how they plan to leverage value into the future and then hand them my T&Cs (business cards are for wimps). When Buying value under par (adage "the day you buy is the day you sell": present valuation NPV & performance measurement - Limited supply & high demand of distressed debt & equities - Future outlook: review of defaults & desire to get to the party before it’s over - Beyond timing: commitments from hedge funds & private equity firms to invest in opportunities that meet targeted benchmarks. To optimize distressed cycle & provide practical aspects of integrating distressed opportunities into the institutional portfolio: - Successfully identifying assets showing distress & maximizing on opportunities - How distressed debt investors can profit from subprime mortgage meltdown - Distressed debt development & investment opportunities in key markets - Understanding deal structures & implementing creative strategies.
Capital for leverage buyout transactions from institutional investors & pension funds (+ lease-finance style from banks) who pulled money out of the stock market in search of higher returns, some are sitting on record amounts of capital and will seek opportunities designed to meet higher opportunity OOF benchmarks - to target distress-funds for desirable takeovers. For these we provide: - Trend line: Investment cycle review - Baseline for returns-looking out onto the investment horizon - How is distressed market expanding or contracting? I gave the example of my very own private bank, Banque Rupp et cie and how 2008 impacted our funding liquidity. I explained how typical we are of the sector and on the basis of our trillion (multi-currency) balance sheet, using our own IFRS enhanced accounting standard how one third of our balance is annually refreshable after the capital has been wiped out 150%, even though we remain profitable if not for our ABS writedown that we only take on balance sheet to satisfy the investors in it how much we care albeit the tax authority has a few questions about how macro-prudentially and micro-prudently we record our P/L loss. I had to present recently to a panel of our institutional investors about our various responses to the new liquidity-distressed market conditions and why we now consider our off-balance sheet vehicles to be vulture fund opportunity for private banking HNW clients. Public and private sector pension funds are also raising capital to take advantage of current opportunities from supply/demand imbalance in market for mortgage-related and other assets like ours: - we statistically report in weekly detail on residential & commercial mortgage-backed securities and the underlying that supports our various MBS collateralized debt obligations, collaterized loan obligations (CLOs), single-name & index credit default swaps on CDOs, and how these compare to our whole-loan risk-buckets, soon to be in new CDO repo-packages and investment funding repo packs too (prospectuses mailed-out subject to your last 3 years margin call history & NSIMA series 7 SEC certifications - no prime brokers or ex- Lehmans, AAB, Fortis, UBS, Citi, RBS-GC or other ex-structured product prop-desk execs need apply). Golf footnote: in the afternoons of our conferences after the hectic breakfast sessions attendees are invited to play in IMN's Golf Invitational at Monarch Beach Golf Links' pristine location, along with abundant amenities that offer guests an enjoyable experience, truly unforgettable. The course has been host to nationally televised events with top golfers of all three capital markets with money leaders from the PGA, Senior PGA and LGPA tours with coaching tips from Arnold Palmer, Jack Nicklaus, Tom Watson, Fred Couples, Tom Kite, Julie Inkster and Dottie Pepper who have all spiritly competed on this picturesque course, where our Tees & Cees were finalised on leveraging the subprime situation, turning handicaps into par, losses into profits, water into wine!