Major Banks May Report Toxic Assets As Profits

Banks that bought "toxic assets" from failed financial companies like Wachovia, WaMu, and Countrywide may be able to report huge profits on their financial statements due to an accounting loophole. This loophole allows banks to report income based on projected future earnings on these loans. Investment Director of Money Morning, Keith Fitz-Gerald explains why this window-dressing could make the major banks look much healthier than they actually are.

Remember the infamous leaked Vikram S. Pandit memo we wrote to you about awhile back that suddenly saw Citigroup Inc. (NYSE: C) turn a profit on nothing more than vapors?

Stay tuned: We’re about to see more of these puffed-up profits. JPMorgan Chase & Co. (NYSE: JPM), Bank of America Corp. (NYSE: BAC) and PNC Financial Services Inc. (NYSE: PNC) will reportedly be booking as much as $56 billion in windfall profits using similar financial chicanery in the months ahead.

Sadly, millions of investors will likely interpret this as a sign that the U.S. financial sector is once again a viable “profit” play - when the reality is that Wall Street hasn’t learned a single darned thing from the financial crisis and is up to its old tricks once again.

This time around, the biggest U.S. banks - including JPMorgan, BofA, and PNC - will employ an obscure accounting rule to magically transform the “toxic debt” that they obtained from such “zombie banks” as Wachovia Corp., Countrywide Financial Corp., National City Corp., and Washington Mutual Inc. (OTC: WAMUQ) into actual income.

Yes, you heard me correctly - income. It makes me furious. This is kind of a corporate accounting version of “the dog ate my homework.” Only this time around, the joke is on us - the taxpayers - since we’re the ones who are bailing these bozos out.

Called “accretable yield,” these mega banks will book income on loans that have “reduced credit quality” by recognizing - hang with me on this one, it’s tough to believe - the value of the bonds on their balance sheets and the cash flow those securities are expected to earn. Please understand, we’re not talking about cash that’s already been earned, and not cash in the bank … we’re talking about cash flow those banks are expected to earn.

Talk about making a silk purse out of a sow’s ear. This is an obscene abuse of the accounting system - whether it’s legal or not. No wonder nobody ever went broke using accrual accounting. These guys need to be forced to recognize the money they have actually earned - not the amount they can account for using clever financial trickery.

To understand just how absurd this actually is, let’s take a close look at JPMorgan Chase - which alone reportedly stands to reap as much as $29 billion in windfall income. It started when JPMorgan literally bought WaMu from the dumpster (technically acting as something called “the receiver”) last year for $1.9 billion, and was allowed to mark the toxic debt that came with it down to “fair value” - which was 25% less than the $118.2 billion it was officially carried on the books for, or $88.65 billion. But now, the bank says that those same debts may appreciate by some $29.1 billion over the life of the loans. That’s before taxes and expenses, of course.

According to Financial Accounting Standards Board (FASB) rules, buyers such as JP Morgan Chase carry these loans on their books at fair value. Then, as borrowers repay those loans they are allowed to book profits. Therefore, by keeping the value of the loans low, the profits on such a small base are obviously king-sized.

The incentive, as I noted when I reviewed a similar tax loophole regarding BofA’s Countrywide Financial purchase back in February, is to write down the value of the loans so aggressively that they are practically worthless. That way, when the buyer folds them into its business, the returns are huge.

JPMorgan’s spokesman, Thomas Kelly, told Bloomberg News that “the accretion is driven by prevailing interest rates.” That said, JPMorgan said first quarter gains from the WaMu loans resulted in $1.26 billion in interest income and made it possible for the bank to reap additional potential income of $29.1 billion.

The other factor that’s not being talked about - at least openly - is the impact that an economic turnaround could have. You see, the eroding economy contributed to the erosion in the value of the securities. Conversely, when U.S. economic activity picks back up, we could see an accompanying improvement in the value of these securities being carried on the company’s balance sheet.

In an April 22 interview with Bloomberg, Wells Fargo & Co. (NYSE: WFC) Chief Executive Officer Howard I. Atkins said that “to the extent that the customers’ experience is better or we can modify the loans, and the loans become more current, that could help recapture some of the write-down.”

That will lead to massive “profits.”

In other words, if the government is successful in reducing mortgage rates and the housing markets stabilize, the banks get to make up entirely new numbers and “bring more of [the loans] current” which is bank speak for being able to assign whatever brand new values they can to the very same toxic slime these same banks wrote down only months ago during the purchasing process.

Naturally - and I think you can see where I’m going with this - the more these guys wrote down these securities as part of the acquisition process, the higher they can write them “up” in the months ahead - and the more powerful the “profit” surge we’ll see.

Not surprisingly, JPMorgan wouldn’t comment when I called - nor would any of the other big banks - so it’s especially difficult to get to the bottom of exactly when this will come to a head and how much of an outsized “manufactured” profit we could be looking at.

But we can guess as to their motivation:

• First, the banking industry remains in a state of chaos. Despite widespread attempts to calm things down, the banks don’t trust each other and the public trusts them even less. So profits - whether illusory or not - would go a long way to reestablishing some sense of the ordinary.

• Second, to the degree that the banks remain on the federal dole and their balance sheets a wreck, the ability to add new earnings is a lifesaver. Not only does this practice give them the ability to smooth out earnings, but it also arguably makes their stock more attractive because of the apparent “growth” potential that exists going forward. Never mind that the growth is nothing more than a paper shuffling and some fancy accounting; under FASB regs, this practice is completely legal.

• Third, because newly accreted earnings will flow directly to income and the banks have stockpiled a huge war chest of write-downs, financial institutions maintain a substantial buffer that can be used at their discretion whenever they need to goose their earnings. One brokerage house chief financial officer told me privately years ago that it was his goal to maintain enough of a buffer that he could swing earnings by as much as 10% in any given quarter - depending on what the company “needed.”

Now for the trillion-dollar question: What can we do about this?

Sadly, when it comes to changing the legally approved accounting nonsense component, the answer right now is “not much.”

While an investor wanting to capture this “growth” could buy shares in the banks or in any one of a half a dozen financial exchange-traded funds (ETFs), I think a better choice is to buy LEAP options on each of the banks. Not only are long-term options frequently mis-priced, but the risks for any investor buying them are strictly limited to the capital used to buy them and the returns can be proportionately higher for options buyers than for the straight-stock alternatives available at the moment.

And those profits are real enough for me - even without accretion.

This article has been reposted from Money Morning. You can view the article on Money Morning's investment news website here.

European Banks Offer Another Potential Problem

Here in the U.S. we just finished the widely publicized "stress tests," which showed us a great deal of capital shortfalls with the major banks. This was more or less to be expected, but what is getting less press here at home are the potential problems over in Europe. Many people had mistakenly thought Europe was buffered from the financial problems being experienced in the U.S., but the more we look into it the more we see that is not the case. Many European banks were exposed to the same products and other issues that brought down the U.S. financial system, and the struggles these European banks are facing could bring down the global financial system even further. For more on this, read the following article from Money Morning.

Now that the results of the U.S. bank stress tests are finally in the books, the extent of the capital shortfalls are known and – in many cases – are actually being addressed.

But there’s now another problem looming – one that could ultimately weigh down the global financial system.

The problem: Europe’s banks.

As economies slow in other parts of the world, rising joblessness and plunging housing prices and escalating loan losses are putting banks under pressure. That’s especially true in Europe, where consumers and companies are continuing to run into trouble.

Royal Bank of Scotland PLC (NYSE ADR: RBS), now 70% state-owned, fell to a loss in the first quarter and wrote down $3.17 billion in risky assets after its bad debts quadrupled to $4.37 billion.

Bank executives "[expect] a slowdown in financial-market activity compared with the very buoyant conditions seen in Q1," Chief Executive Officer Stephen Hester told Reuters.

In Germany, Commerzbank AG (OTC ADR: CRZBY) had to take a $1.61 billion charge from its investment bank and a $72.38 million charge from commercial real estate initiatives, resulting in a $1.2 billion loss for the quarter.

In late December, the Institute of International Finance released its global economic outlook for 2009, and estimated that banks around the world had collectively lost nearly $1 trillion – $678 billion from U.S. banks and $300 billion from their European counterparts.

That was in December. We know it got worse – a lot worse – for U.S. banks after that point. Thanks to a mix that included lots of government bailout and an injection of new capital from investors, U.S. banks have experienced an improvement in their outlook.

Indeed, U.S. Federal Researve Chairman Ben S. Bernanke stated that the banks tested are all solvent and the results should provide "considerable comfort about the health of the banking system.”

But in the five months since that Institute of International Finance report was issued, it’s likely that European banks have experienced a major decline in their fortunes.

Last week’s release of the bank stress tests results removed significant uncertainty about the U.S. banks, since it created a blueprint of what the troubled institutions needed to do to stabilize their finances. Morgan Stanley (NYSE: MS) and Wells Fargo & Co. (NYSE: WFC) have announced plans to raise an aggregate $15 billion in capital. Bank of America Corp. (NYSE: BAC) plans to sell assets and issue more common stock after being told by the federal government that it must raise $33.9 billion to adequately guard against “more adverse” economic conditions.

Bank of America was one of 10 banks told by the government to raise more capital following the so-called stress test. The government concluded that BofA faces a potential $136.6 billion in losses from troubled loans and investments in 2009 and 2010. The bank’s $34 billion capital shortfall was more than twice that of Wells Fargo, which had the second greatest capital need.
Are we destined to see this all play out now in Europe?

Market Matters

Shifting back to autos, General Motors Corp. (NYSE: GM) lost $6 billion in the first quarter and is shopping Saturn to Renault SA of France as it moves closer to its restructuring deadline (and potential bankruptcy). China’s Geely Automobile Holdings Ltd. (PINK: GELYF) has interest in GM’s Saab unit, and Fiat SpA (OTC ADR: FIATY) may look to complement its Chrysler LLC line with the German Opel (also late of GM). Meanwhile, Ford Motor Co. (NYSE: F) claims to be on track with its restructuring plan and still believes it can manage just fine without any government assistance. On the earnings’ front, The Walt Disney Co. (NYSE: DIS) and Kraft Foods Inc. (NYSE: KFT) bested estimates, while Cisco offered some mixed results as its better than expected numbers actually prompted some profit-taking among techs.

A poorly received 30-year Treasury auction sent bond prices tumbling as fixed income investors focused on the massive programs the government will need to finance over the next few years. Oil prices surged above $58 a barrel for the first time in six months as traders seemingly failed to consider rising inventory levels and instead bought on signs (feeble as they are) of an economic recovery that would lead to enhanced energy demand.

The Standard & Poor’s 500 Index pushed beyond the crucial 900 level and ended the week in positive territory for the year. Techs struggled late as investors realized any economic rebound would not translate into capital expenditures overnight. Still, the Nasdaq Composite Index has outperformed the other indexes on a year-to-date basis. With stress tests out of the way, where will the next leaks come from?

Market/ Index	Year Close (2008)	Qtr Close (03/31/09)	Previous Week (05/01/09)	Current Week (05/08/09)	YTD Change
Dow Jones Industrial	8,776.39	7,608.92	8,212.41	8,574.65	-2.30%
NASDAQ	1,577.03	1,528.59	1,719.20	1,739.00	+10.27%
S&P 500	903.25	797.87	877.52	929.23	+2.88%
Russell 2000	499.45	422.75	486.98	511.82	+2.48%
Fed Funds	0.25%	0.25%	0.25%	0.25%	0 bps
10 yr Treasury (Yield)	2.24%	2.68%	3.17%	3.29%	+105 bps

Economically Speaking

U.S. retailers released same-store sales data for April and the results were actually quite promising. As usual, Wal-Mart Stores Inc. (NYSE: WMT) led the charge with a 5% increase in activity, while Children’s Place Retail Stores Inc. (Nasdaq: PLCE), Stage Stores Inc. (NYSE: SSI), Gap Inc. (NYSE: GPS), and The TJX Cos. Inc. (NYSE: TJX) were among those stores that posted better-than-expected results and beat analysts’ expectations. A late-Easter holiday (April instead of March) helped many retailers as consumers waited until the last minute (as has become the norm) for their related holiday shopping.

On the global front, the European Central Bank dropped its key lending rate by 25 bps to 1%, and initiated other monetary moves to stabilize its (16-country) economy. Likewise, the Bank of England announced a plan to buy up government and corporate bonds, thus, increasing its money supply.

Speaking of the labor market, the U.S. unemployment rate climbed in April to 8.9%; however, only 539,000 jobs were lost from the economy. The contraction represented the smallest in six months and was below most analysts’ expectations. Still, since December 2007, about 5.7 million domestic jobs have disappeared and businesses continue to be slow to hire until they see additional signs of greater stability in the economy.

Construction spending climbed in March after five consecutive monthly declines, though the gains were attributed to non-residential activity and the housing sector remains sluggish at best. In more promising news, the National Association of Realtors reported a 3.2% increase in pending homes sales, the second straight monthly gain. Because the release is considered a predictive indicator, analysts took it as a favorable sign that sales activity may pick up in the months ahead.

This article can also be found on moneymorning.com.

Fed Delays Release Of Bank Stress Test Results

The Federal Reserve has decided to delay the release of results from its recent stress test on banks. It appears that the Fed is trying to limit damage to the banks who will appear weak based on the results, and allow them more time to figure out how they will raise the necessary funds. It will no doubt be interesting to see how investors react to the information provided by the stress test. For more on this, read the following article from Money Morning.

The results of the bank stress tests are in, but instead of releasing them today (Monday), the U.S. Federal Reserve is holding them close to its chest until after the markets close Thursday.

The amount of information awaiting disclosure seems to have grown, as have the reasons to postpone the potentially damaging data.

Not only will the government unveil which banks require more capital, it will also disclose potential loss estimates for certain loan categories and the banks’ ability to “absorb those losses” assuming economic conditions worsen through 2010, a government official told The Wall Street Journal.

Negative results could deal a huge blow to both the banks and government, as a sub-par grade may be viewed as an indictment not only of the failed management of the banks, but the government’s decision to loan them billions of taxpayer money. The banks also are concerned that anything but a tactful release of the results will cause internal and investor panic.

Government and banking industry officials told Bloomberg that both sides needed the extra time to debate preliminary results, as well as plans regarding how banks can recover capital.

On April 24, the government showed the tests’ preliminary results to the 19 U.S. firms it reviewed – from behemoth banks like Bank of America Corp. (NYSE: BAC) and Citigroup Inc. (NYSE: C) to the smaller GMAC LLC (NYSE: GMA) and MetLife Inc. (NYSE: MET). The banks involved in the stress tests hold more than half the loans in the U.S. banking system and two-thirds of the assets.

“Everybody understands they’ve got a tiger by the tail here,” Mark Tenhundfeld, a senior vice president at the American Bankers’ Association in Washington, told Bloomberg. “If they don’t let him go gently, there will be a lot of mauling going on.”

Already, reports have leaked that two specific banks need more capital, and reaction hasn’t been pleasant.

After showing Bank of America and Citigroup test results, the government told the banks to raise more capital despite receiving a combined total of $95 billion in bailout loans.

At least three more banks need more capital, either from converting common shares to equity and/or receiving more government cash, sources told Bloomberg.

Sensing blowback from Congress, as well as the public, Federal Reserve chairman Ben S. Bernanke said that banks requiring more capital will have to attempt to raise it on their own before receiving another lifeline loan from the government.

Confusion On Evaluation’s Methodology

Debate over the results isn’t the only reason for the postponement. Disputes and confusion over the Fed’s methodology has also erupted.

According to a Fed’s test criterion, common shareholder equity should be the “dominant” portion of Tier 1 capital. Officials favor tangible common equity of about 4% of a bank’s assets and Tier 1 capital worth hovering around 6%.

But The Wall Street Journal reported last week that some bank executives got mixed signals during a meeting with regulators.

The regulators are asking “a million questions” and it’s “very unclear what they’re aiming at,” a senior executive told The Journal. “We can’t discern a pattern.”

Citigroup officials argued that regulators haven’t given the bank enough credit for its efforts to offload large asset chunks, such as Smith Barney and its Japanese brokerage arm Nikko Cordial Securities.

On Friday, Citigroup agreed to sell Nikko Cordial Securities, its Japanese brokerage arm to Sumitomo Mitsui Financial Group (OTC: SMFJY) for about $5.5 billion. The deal, which is to be completed by Oct. 1, also includes a transfer of about $2 billion in excess cash from Nikko Cordial to Citigroup.

The deal will boost the bank’s Tier-1 capital ratio by approximately 27 basis points.

Individual Result Releases

One insider told Reuters that the government is leaning toward releasing individual results for each bank involved in the stress test – a move away from issuing a summary of results.

The source said the plan “is not very far along,” and that regulators also aim to disclose a lot of confidential supervisory information about the banks.

One analyst says that test results could be so specific to a bank’s portfolio that it’s not wise to use them as a litmus test for the overall health of the banking sector.

“Once you try to take that information and extrapolate it, it gets very complicated and it’s dangerous," Kevin Petrasic, who served at the Office of Thrift Supervision from 1989 to 2008 and is now an attorney at law firm Paul Hastings in Washington, told Reuters.

Whatever the results – or how they are disclosed – Money Morning’s Shah Gilani, a former Wall Street hedge fund manager, said the evaluation process has several flaws.

“What’s missing, unfortunately, is an assumption of how much additional capital would be necessary to facilitate credit expansion – which, in turn, would serve to fuel economic growth. That, after all, should be the ultimate stress-test objective,” he wrote.

And the end result is more stress added to an already stressed banking sector, as too much information and/or misinformation only makes a sound assessment more difficult.

Money Morning’s Stress Test

The government’s pushback of stress test results only made the public more hungry for the their release. But you don’t have to wait until Thursday to know which of the 13 biggest U.S. banks are diamonds or duds.

Last week in “Money Morning’s Bank Stress Test,” Martin Hutchinson highlighted the four secrets that will let you separate the winners from the losers in the U.S. banking system

• Banks that made profits in the very difficult fourth quarter of 2008 and first quarter of 2009 are probably in good shape, especially if their loan-loss provisions exceeded their charge-offs (the amount actually lost.)
• Banks that lost money in the fourth quarter and first quarter may or may not be in terminal trouble; it depends on the amount of those losses and whether the red ink is expected to continue to flow going forward.
• With the run-up in bank stocks in recent weeks, there’s been an accompanying rise in the ratio of share price to book value (stock price per share/book value per share). If that ratio is still below 30% - even after the recent price increases - the market lacks confidence in the bank’s ability to solve its own problems. Unfortunately, the market currently appears to be overly optimistic about some of the banks that still have considerable ongoing problems.
• Management’s dividend policy is less of an indicator than it was just a few short months ago; several banks have sharply cut their dividends in order to repay the Troubled Assets Relief Program (TARP) capital they got in late 2008. Reasonably, profitable banks don’t want the government meddling in their business or compensation structures

Hutchinson also gave an individual analysis of each bank, highlighting their strengths and pulling a curtain on their weaknesses.

This article can also be found on moneymorning.com.

We Need A Root-And-Branch Reorganization Of The Financial System

Some people are open to the government handing over trillions of dollars to the banks, but no taxpayers want the money handed over without proper controls in place that will ensure it goes to good use. This has been one of the biggest issues the public has had with the bailout efforts thus far. For that reason Steve Waldman is calling for a root-and-branch reorganization of the financial system. For more on this, read the following blog post from Mark Thoma.

Steve Waldman says "we need a root-and-branch reorganization of the financial system":

Value for value, Steve Waldman: Would it have been better if Timothy Geithner had had the power to guarantee all bank debt early on? As James Surowiecki reminds us, that was part of the Swedish solution. Justin Fox plausibly suggests that we might have avoided a lot of pain with a fast, full guarantee.

But that's not the point. The question isn't whether we could have avoided this crisis, if only we had cut a big check. We could have, and that was not lost to any of us debating these issues more than a year ago. (See e.g. me or Mark Thoma.) Had we done so, the near-to-medium term fiscal costs might have been less than they probably will be now. So, with 20/20 hindsight, would it have been a good idea?

How you answer that question depends upon how you view the crisis. Is it an aberration, a shock to a basically sound financial system, or is it a painful symptom of an even more dangerous condition? ...

If you think that our financial system just needs some tweaks, some consolidation of regulators' organizational charts and sterner supervision, then you should prefer that we had just cut a check, passed Sarbanes/Oxley Book II, and moved on. But that is not what I, or most proponents of temporary receivership for insolvent banks, believe.

If you believe, as I do, that we need a root-and-branch reorganization of the financial system, which must necessarily involve the dismemberment and intrusive restraint of deeply entrenched institutions, does that mean pain is the only way forward, "the worse the better" in the old revolutionary cliché? It need not mean that. But it does mean that palliative measures, like giving the banks money, would have to be attached to curative measures, like enacting capital requirements and imposing regulatory burdens that would force financial behemoths to break themselves up or become boring narrow banks. For almost two years, policymakers at the Fed and the Treasury, including Secretary Geithner, have offered bail-out after bail-out and asked for nothing serious in return.

Do I regret that Henry Paulson was not empowered to issue a blanket guarantee of bank assets early on, as the Swedes did? No, I don't regret that at all. Why not? Because I think that "Hank the Tank" was a crappy negotiator... He would have offered the financial system sugar without requiring it to make the medicine go down. He may believe, quite sincerely, that a cure would be worse than the disease. He may believe that, but he is wrong. ...

You may believe that we have learned our lesson, that if we can just get some stability and comfort for a while we are prepared to do what must be done. That's a respectable position. But I don't share it, and neither do the majority of Americans who are unwilling to allow their representatives to sign off on any more expensive aspirin. We want value for value, an ironclad commitment of root and branch reform in exchange for the unimaginable sums of money we are being asked to hand over. ... Congress would, because the public would, support large, explicit transfers, if they were attached to reforms sufficiently radical to prevent a recurrence, and suitably punitive towards the people who managed the system that brought us here. Value for value. ...

I ... would be willing to hold my nose and tolerate a Swedish-style guarantee of bank creditors. I'd acquiesce to that even without formal nationalization. Nationalization is ... a means to an end, and the desired end is a world in which too big to fail is too big to exist for any financial institution that originates or holds credit risk in any form. Secretary Geithner could send a bill to Congress today that would put all banks with a balance sheet of over $50B into run-off mode... I'd fax my Congressman and support a $2T on-budget buyout of bank creditors as part of that bill, as long as it had teeth. ("Teeth" would imply making sure that off-balance-sheet and derivative exposures were included in the size cap, etc.)

It's not that us pitchfork-totin' populists are unwilling to pay the bill. It's that we want to know that in exchange for writing a very, very large check, the people that we are paying will actually deliver the goods. Given the behavior of bankers before the crisis and of shifty policymakers during, we have every reason to watch warily and to insist upon every precaution while we hand over suitcase after suitcase of freshly printed Federal Reserve notes.

This post can also be found on economistsview.typepad.com.

Stress Tests Reveal Three Banks In Need Of Additional Funding

The controversial stress tests commissioned by the government on the 19 largest financial institutions have revealed at least 3 in need of additional funding. These stress tests were meant to ensure that banks have enough capital reserves to last through the recession. For more on this, read the following article from Housing Wire.

At least three of the 19 financial institutions with assets in excess of $100bn may face pressure to build up capital reserves after failing to meet desired operational projections through the government-mandated stress tests, unnamed sources told the Wall Street Journal. The identities of the three firms remained confidential at the time this story went to press, but analysts told the Journal they likely include regional banks with commercial real estate exposure in the Midwest and Southeast.

The stress tests aimed to determine whether major US banks retain enough capital to weather even the more adverse economic projections. Federal officials offered three alternatives to banks that lack sufficient reserves: raise private investor funds, receive additional government aid or convert the government’s existing preferred shares into common shares, effectively placing part of the firm in government ownership.

The Federal Reserve, in reporting stress test methods late Friday, say most banks retain enough capital to weather a longer, more severe recession, although deteriorating economic conditions affect the reserve capital held among some banks.

This article can also be found on housingwire.com.

What Will The Government Do With Goldman Sachs?

Storied investment banking firm, Goldman Sachs, is preparing to pay the government back around $5 billion in borrowed TARP funds, but whether or not the government will allow it to happen is the real story. Goldman no longer wants to be burdened with the rules and regulations being imposed on them by the government, and thanks to a $12 billion windfall from the AIG bailout the firm is in a position to return the funds. If they are allowed to return the funds, though, there is worry that it will put the other bailed out banks in a precarious position. For more on this, read the following article from Money Morning's Shah Gilani.

Not a fan of socialism? Me either. But, if the federal government has to backstop free market excesses with taxpayer dollars, how will it eventually unravel the veil, or tarp of intervention? Or should it? The answers are about to unfold before our eyes.

In the case of the government and Goldman Sachs Group Inc. (GS), a decision on whether Goldman can repay government bailout money and be freed to pay its employees whatever it wants, may determine the winners and losers coming out of this financial collapse, and what kind of government Americans will end up with.

In her extraordinary 1999 book, “Goldman Sachs the Culture of Success,” Lisa Endlich vividly chronicles the “history, mystique and remarkable success of the world’s premier investment bank.” That same year, the storied partnership structure of Goldman was junked in a wildly successful initial public offering (IPO).

I still keep three pages of notes distilled from Endlich’s book on how to create and foster a culture of success, a la the Goldman model. They now seem quaint in light of the winner-take-all at the expense of the shareholders mentality that eviscerated the old-school standards.

That’s not to say that Goldman isn’t still wildly successful. On Monday, Goldman pre-announced first quarter net income of $1.81 billion. Record net revenue of $6.56 billion from trading fixed income, currencies and commodities was offset by losses in stock trading, real estate, investment banking and money management. Nonetheless, earnings were almost twice analysts’ expectations.

Yesterday (Tuesday), on the heels of its good performance, Goldman announced that it had priced a public offering of 40,650,407 shares of common stock at $123 per share. Goldman will be its own sole underwriter and total gross proceeds are expected to yield approximately $5 billion.

Ironically, $5 billion is what Goldman needs to pay back the U.S. government in order to escape the salary and bonus caps imposed on bailout recipients.

A brief history.

On the remarkable day of September 15, 2008 Lehman Brothers Holding Inc. announced its intention to file a Chapter 11 bankruptcy petition. On the same day, venerable investment bank Merrill Lynch disappeared into the waiting arms of Bank of America Corp. (BAC). Six short days later, on a Sunday afternoon, the U.S. Federal Reserve announced approval of expedited applications by Goldman Sachs and Morgan Stanley (MS) to change their status from investment banks to bank holding companies. The rapid approval of their applications would, the Fed said, “provide increased funding support” allowing both banks to borrow directly and permanently from the Fed’s Discount Window and its other capital liquidity enhancing facilities.

But that wouldn’t be enough. As the crisis mounted, on Sept. 23, Goldman raised $5 billion from billionaire investor Warren Buffet’s Berkshire Hathaway Inc. (BRK.A, BRK.B). And with the storied investor now onboard, Goldman rushed to raise another $5.75 billion in a common stock offering.

On Oct. 14, with the mushrooming cloud of the crisis enveloping seemingly every major bank in the country, then-Treasury Secretary Henry M Paulson (formerly Goldman Sachs’ Chairman and CEO) and Federal Reserve Chairman Ben S. Bernanke summoned the nine largest bank chief executives to Washington where they were told that they would each take a piece of government capital. Only Wells Fargo & Co. (WFC) is on record as saying it didn’t need the money, but the handout was forced on it too. Goldman itself took $10 billion.

On Wall Street, and nowhere more so than at Goldman, it’s about compensation. But recipients of bailout money are now facing the full disclosure of their executive compensation deals, as well as having to obtain nonbinding shareholder voting on compensation issues.

The Treasury is advocating a salary ceiling for recipient senior executives of $500,000 and any additional compensation to be paid in restricted stock that vests only when government funds have been entirely repaid. And there are restrictions on golden parachutes and threats that Congress will impose a 90% bonus tax.

It’s enough to make Wall Street quake in its canyon.

With the public backlash against the taxpayer-funded bonuses paid to executives and traders at crippled firms, banks are desperate to return government bailout money so they can be freed from government salary and bonus oversight.

But unfortunately for many of these banks, oversight is mandated for any recipient of “exceptional assistance,” which is defined as assistance of more than $5 billion.

No wonder Goldman wants to pay back $5 billion of the $10 billion it got.

I have nothing against the free market setting compensation benchmarks, or private companies paying successful executives whatever their shareholders vote to be acceptable. And I’m not singling out Goldman Sachs. But, nowhere else in the U.S. economy - or at the highest levels of government - is there anything like Goldman’s visible and invisible hands at work. And they’re working in the open and more insidiously, behind the scenes and through lobbyists, to make themselves a lot of money.

There is simply not enough space in any book, let alone any article, to list the power, placement and influence of current and former Goldman Sachs alumni pulling the levers of hedge funds, corporations, politicians and governments. If you want to enlighten yourself about what you don’t know about these players, simply Google: “List Goldman Sachs alumni.”

Goldman, as much as any investment bank, got its hands dirty in the subprime securities business and the credit default swap business. As to its influence and its claim to premier bank status, the first question that comes to my mind is: Would Goldman even exist today if Hank Paulson hadn’t had Goldman’s current CEO Lloyd Blankenfein in on meetings about saving American International Group Inc. (AIG)?

Out of the $185 billion that AIG received from taxpayers, Goldman got $12.5 billion for exposure it had to credit default swaps written by AIG. I’ve been told by some of my hedge fund and investment banking friends that Goldman deserved that money and that the entire counterparty structure related to almost every credit default swap was a risk.

But I like to point out that Goldman is only smarter than its peers because its trading desks are lighter on their feet. I remind them that Goldman stuffed the pipelines with toxic structured collateralized debt obligations (CDOs), and then was nimble enough to cover themselves better by buying credit default swaps to hedge their exposure to their own toxic slime and institutions that are too-big-to-fail, exactly like AIG.

What happens now with Goldman Sachs will set the precedent for everything else that the government will do or allow in the future with bailout recipients and industries. Will Goldman be freed up to overpay its risk takers and to make greater wagers as it also seeks to become too-big-to-fail? Will impositions be made on the corporate level, industry level, systemic level? Will free markets be free to leverage taxpayers indefinitely?

The argument, most recently made in yesterday’s Wall Street Journal op-ed page by Jonathan Macey, a law professor at Yale, that “demonetizing executive pay will also drive the best managers out of private companies and into hedge funds and other boutique investment firms” implies that there is a limited amount of talent available in America, which is a supposition that I find myopic, at best.

Besides, aren’t these the same people that got us into this mess?

And while letting public companies be run by shareholders - as Macey suggests - is supposed to work in principle, shareholders have been marginalized by the same Wall Street system that protects the institutions whose stocks and bonds they sell, trade and profit from.

All eyes should be on the curious relationship between government and Goldman for clues as to what shape the landscape will take when we eventually exit this calamity.

I don’t want our companies, our institutions or our economy socialized any more than Adam Smith would. But I do want to see the public tail wagging the dogs of Wall Street and government.

This post can also be viewed on moneymorning.com.

From Money Morning:

"I'd rather have this than gold." That's what one well-known fund manager recently told Barrons. Why? This special group of investments is set to pay out $4,201 guaranteed cash next month. And they pay out juicy cash sums all year long. But they're not income trusts, corporate bonds, or foreign bonds. In fact, only Martin Hutchinson is talking about them. Read his full report here...

Longing For The Days Of Boring Banking

When the financial industry gets too creative, bad things tend to happen. The current financial crisis was not the first example of this either. If you look all the way back to before the Great Depression, whenever the financial industry was loosely regulated, and overly creative, things would eventually blow up. Paul Krugman is calling for us to return to the days of boring banking, but wonders if that is going to happen anytime soon. For more on this, read the following blog post from Mark Thoma.

Does congress have the will to pursue serious financial reform?:

Making Banking Boring, by Paul Krugman, Commentary, NY Times: Thirty-plus years ago, when I was a graduate student in economics, only the least ambitious of my classmates sought careers in the financial world. Even then, investment banks paid more than teaching or public service — but not that much more, and anyway, everyone knew that banking was, well, boring.

In the years that followed, of course, banking became anything but boring. Wheeling and dealing flourished, and pay scales in finance shot up... And we were assured that our supersized financial sector was the key to prosperity. Instead, however, finance turned into the monster that ate the world economy. ...

Thomas Philippon and Ariell Reshef ... show that banking in America has gone through three eras over the past century. Before 1930, banking was an exciting industry featuring a number of larger-than-life figures, who built giant financial empires (some ... based on fraud). This highflying finance sector presided over a rapid increase in debt: Household debt as a percentage of G.D.P. almost doubled between World War I and 1929.

During this first era of high finance, bankers were, on average, paid much more than their counterparts in other industries. But finance lost its glamour when the banking system collapsed during the Great Depression.

The banking industry that emerged from that collapse was tightly regulated, far less colorful than it had been before the Depression, and far less lucrative.... Banking became boring, partly because bankers were so conservative about lending: Household debt ... stayed far below pre-1930s levels.

Strange to say, this era of boring banking was also an era of spectacular economic progress for most Americans.

After 1980, however, as the political winds shifted, many of the regulations on banks were lifted — and banking became exciting again. Debt began rising rapidly, eventually reaching just about the same level relative to G.D.P. as in 1929. And the financial industry exploded in size. By the middle of this decade, it accounted for a third of corporate profits.

As these changes took place, finance again became a high-paying career... Indeed, soaring incomes in finance played a large role in creating America’s second Gilded Age. Needless to say, the new superstars believed that they had earned their wealth. ... And many economists agreed.

Only a few people warned that this supercharged financial system might come to a bad end. Perhaps the most notable Cassandra was Raghuram Rajan... But other[s]..., including Lawrence Summers..., ridiculed Mr. Rajan’s concerns.

And the meltdown came.

Much of the seeming success of the financial industry has now been revealed as an illusion. ... Worse yet, the collapse of the financial house of cards has wreaked havoc with the rest of the economy, with world trade and industrial output actually falling faster than they did in the Great Depression. And the catastrophe has led to calls for much more regulation of the financial industry.

But my sense is that policy makers are still thinking mainly about rearranging the boxes on the bank supervisory organization chart. They’re not at all ready to do what needs to be done — which is to make banking boring again.

Part of the problem is that boring banking would mean poorer bankers, and the financial industry still has a lot of friends in high places. But it’s also a matter of ideology: Despite everything that has happened, most people in positions of power still associate fancy finance with economic progress.

Can they be persuaded otherwise? Will we find the will to pursue serious financial reform? If not, the current crisis won’t be a one-time event; it will be the shape of things to come.

This post can also be viewed on economistsview.typepad.com.

Why Dropping "Mark to Market" Rules Won't Solve Anything

In an effort to shore up the balance sheets of banks the government decided to drop the "mark to market" rules that have been causing so much trouble in the financial industry. As Peter Schiff points out in his article, though, this won't solve anything. The rule was created in order to give investors a better idea of the true value of bank assets — basing the valuations on market activity rather than arbitrary assessments by the bank's accountants. Letting the banks decide how much their assets are worth, rather than the market, is a recipe for deception and ultimate failure. Read about what Schiff has to say in the article below from Money Morning.

When elementary school kids want to escape the confines of their circumstances, they pretend to be pirates, princesses and Jedi knights. Now, with the relaxation of "mark to market" valuation rules announced by the accounting trade’s self-regulatory body, our bankrupt financial institutions can escape their own reality by pretending to be solvent.

The unraveling of our fairytale economy over the last few months has not yet convinced us that the time has come to put away childish things. The applause that greeted the Financial Accounting Standards Board’s (FASB) ruling on Wall Street is a clear sign that we still have some growing up to do.

The imaginative conceit that lies behind the accounting change is that the toxic assets polluting bank balance sheets are not really toxic at all. They are in fact highly valuable assets that for some irrational reason no one wants to buy.

Using the "mark to market" accounting method, mortgage-backed securities were valued relative to the latest prices fetched by the sale of similar assets on the open market. Currently, those bonds are being sold at deep discounts to their original value. By "marking" their unsold bonds down to those prices, the insolvency of our financial institutions had been laid bare. But the new accounting changes will allow the nervous owners to assign more "appropriate" (i.e. higher) values. Problem solved.

It is important to note that the FASB made its rule modifications only after both Washington and Wall Street applied intense pressure. In their heart of hearts, I can’t imagine that there are too many bean counters happy with the outcome.

The banks and the government have argued that the assets should be valued based solely on current cash flow. Most mortgages, after all, are not delinquent. Therefore, a few bad apples should not spoil the whole bunch, and those that are not yet delinquent should be valued at par. This method assumes we have no ability to look into the future and make assumptions about what is likely to happen, which is presumably what the market is already doing by valuing the assets lower than the banks wish.

All kinds of bonds (corporate, government and municipal, etc.) that are not in default frequently trade at discounts. In fact, the reason agencies such as Moody’s Corp. (MCO) and Standard & Poor’s rate bonds is to assess the probability of default. The higher that probability, the lower the value placed on the bonds, regardless of their current cash flow.

For example, General Motors Corp.’s (GM) 10-year bonds currently trade for only 8 to 10 cents on the dollar, despite the fact that GM is current on all interest payments. The 90% discount reflects investor awareness that GM will likely default long before the bonds mature. By the new logic, financial institutions with GM bonds on their balance sheets should be able to ignore the market and value these bonds at par.

Some argue that the comparison is invalid because GM’s bonds are liquid while mortgage-backed securities are not. However, if sellers of GM bonds were holding out for 70 or 80 cents on the dollar, those bonds would be illiquid too. The reason GM bonds are trading is that sellers are realistic.

The same should apply to bonds backed by mortgages. To assume that a 30-year, $500,000 mortgage on a house that has declined in value to $300,000 has a high probability of remaining current to maturity is ridiculous. The borrower could lose his job, his adjustable-rate mortgage (ARM) might reset higher, or he may simply tire of paying an expensive mortgage for a house that is unlikely to be sold at a profit.

Any bond investor with half a brain will factor in these probabilities and look for deep discounts. The only way to accurately assess a real present value is to let the market discover the price.

Despite the pleas from bankers and politicians, mortgages are not plagued by a lack of liquidity but a lack of value. If sellers would be more negotiable, there would be plenty of liquidity. Who knows, at the right price I might even buy a few. The problem is that putting a market price on these assets would render most financial institutions insolvent, which is precisely why they do not want to let that happen.

Simply pretending that all these mortgages will be repaid does not solve the underlying problems. It may keep some banks alive longer, but when they ultimately do fail, the losses will be that much greater. In the meantime, solvent institutions are deprived of capital as more funds are funneled into insolvent "too big to fail" institutions - hiding their toxic assets behind rosy assumptions and phony marks.

Going from the sublime to the completely ridiculous, in a speech at the just-concluded Group 20 summit in London, President Barack Obama urged Americans not to let their fears crimp their spending. It would be unwise, he argued, for Americans to let the fear of job loss, lack of savings, unpaid bills, credit card debt or student loans deter them from making major purchases.

According to the president, "we must spend now as an investment for the future." So in this land of imagination (where subprime mortgages are valued at par), instead of saving for the future, we must spend for the future.

I guess Ben Franklin had it wrong too – apparently a penny spent is a penny earned.

This post can also be viewed on moneymorning.com.

Banks Believed To Be Holding Around 600,000 Foreclosure Properties Off Market

RealtyTrac believes that banks are keeping around 600,000 foreclosure properties nationwide off the market. This number would represent a huge portion of the available housing stock, and it is believed that banks could be strategically withholding these properties in order to prevent the housing market from collapsing even further. For more on this, read the following blog post from Tim Iacono.

If ever there were a "squishy" data set, one that is quite difficult to get a good handle on due to the paucity of reliable, publicly available data, it is the inventory of foreclosed homes that have yet to make it onto the resale market.

A report by Carolyn Said in the San Francisco Chronicle provided the first graphic on the subject that I've seen, an image that was splashed across the front page of yesterday's paper.
With bank repossessions and notices of default set to pick up dramatically in some parts of the country as detailed by Mr. Mortgage the other day, all the prognosticators with rosy housing outlooks for 2009 may be in for a wake up call come summer time.

If the Alt-A and Option ARM loans begin to sour in large numbers (as many predict) at about the same time that banks look to unload some of their inventory after all the recent optimism, there could be another big leg down in home prices.

Some details from the SF Gate story:

A vast "shadow inventory" of foreclosed homes that banks are holding off the market could wreak havoc with the already battered real estate sector, industry observers say.

Lenders nationwide are sitting on hundreds of thousands of foreclosed homes that they have not resold or listed for sale, according to numerous data sources. And foreclosures, which banks unload at fire-sale prices, are a major factor driving home values down.

"We believe there are in the neighborhood of 600,000 properties nationwide that banks have repossessed but not put on the market," said Rick Sharga, vice president of RealtyTrac, which compiles nationwide statistics on foreclosures. "California probably represents 80,000 of those homes. It could be disastrous if the banks suddenly flooded the market with those distressed properties. You'd have further depreciation and carnage."

In a recent study, RealtyTrac compared its database of bank-repossessed homes to MLS listings of for-sale homes in four states, including California. It found a significant disparity - only 30 percent of the foreclosures were listed for sale in the Multiple Listing Service. The remainder is known in the industry as "shadow inventory."

You have to wonder about a bank like BofA, after having acquired Countrywide and their stable of bank owned properties, as to exactly how these properties are being valued in light of changing mark-to-market rules and critical earnings announcements.

Everyone seems to be sooooo anxious for the banking sector to show some stability so we can all get on with our stock investing lives again but, if it is coming via the accounting "sleight of hand" that some believe is the real reason for holding back these properties (i.e., valuing them much higher than today's market would), we may all be in for a big letdown.

This post can also be viewed on themessthatgreenspanmade.blogspot.com.

Mark-To-Market Rule Change Controversy

The new mark-to-market rule changes are very controversial. On one hand they have the potential to help stem some of the mounting losses being reported by financial institutions, but on the other hand there is the potential for some ambiguity in relation to the use of “judgment”. For more on this, read the following post from Mark Thoma.

John Berry likes the recent changes in the rules for valuing distressed assets:

Mark-to-Market Rule Gives More Clarity, Not Less, by John M. Berry, Commentary, Bloomberg: Mark-to-market accounting rules are being brought a little closer to economic reality -- accompanied by misplaced howls of outrage. ...[T]he standards have forced many financial institutions to overstate losses on trillions of dollars worth of assets, intensifying the global financial crisis.

Defenders of the rules say they protect bank investors and changing them will allow institutions to hide future losses. To the contrary, they have helped drive down the value of bank stocks, made shorting the shares much easier and caused bank stockholders to lose hundreds of billions of dollars in such companies as Citigroup Inc. and Bank of America Corp. ...

The problem with mark-to-market accounting is that it officially has presumed there’s a functioning market in whatever asset is being valued -- and that means a deal between a willing buyer and seller that isn’t being forced to sell. Actually, no such market exists for many mortgage-backed securities.

Nevertheless,... accountants have required many banks to calculate values based on distressed sale prices. That has meant large writedowns even on mortgage-backed securities that the institutions intend to hold to maturity.

Take the case of the Federal Home Loan Bank of Atlanta. Following the mark-to-market rules, it wrote down the value of its portfolio of mortgage-backed securities by $87.4 million in last year’s third quarter. Its actual projected loss on the securities: $44,000. For the fourth quarter the bank recorded a further $98.7 million loss on the securities.

That result makes no sense when the bank doesn’t trade such assets. ... A writedown might still be required under the changes FASB approved yesterday. Yet auditors can now use “significant professional judgment” when valuing illiquid securities. That’s what they should have been allowed to do all along. ...

The key points in this example are that almost all the mortgages involved are still performing and the bank plans to hold the securities to maturity -- and yet large writedowns were required. ...

Now accountants are supposed to use their judgment... That’s a big improvement over just using the last transaction price, as many auditors have been doing. ...

Here's an opposing view.

This post can also be viewed on economistsview.typepad.com.

More Economists Predicting A Depression

According to a couple economists our present financial crisis looks like a recipe for a depression. The main difference they see between a normal recession and a depression, is that a depression originates in consumer debt. If these economists are correct in their theory, the recent positive market movement will only be a suckers rally. Tim Iacono looks closer at the recent article published by these economists, and adds some of his own thoughts, in his blog post below.

In this commentary in today's Wall Street Journal, economists Steven Gjerstad and Vernon Smith offer a theory about why we could again be going from a bubble into a depression.

Over the years, there have been quite a few bubbles, but not all of them cause the sort of economy-wide damage that was seen in the 1930s or over the last year or so. Why?

Why does one crash cause minimal damage to the financial system, so that the economy can pick itself up quickly, while another crash leaves a devastated financial sector in the wreckage? The hypothesis we propose is that a financial crisis that originates in consumer debt, especially consumer debt concentrated at the low end of the wealth and income distribution, can be transmitted quickly and forcefully into the financial system. It appears that we're witnessing the second great consumer debt crash, the end of a massive consumption binge.

Most people forget that it wasn't just a stock market bubble in 1929 that led to America's last lost decade. There was an enormous housing and credit bubble in the mid-1920s during which Groucho Marx and others lost a good deal of money on Florida swampland.

As has been the case thoughout history, you can't get a really good bubble going until you get broad participation from the public - preferably lots of people at the lower end of the socio-economic scale levered up courtesy of a banking system that is gushing with easy money.

That pretty much described the situation in the 1920s and in the 2000s.

The entire piece is worth a look as they go through the recent history of financial bubbles in the U.S., a sequence that really accelerated about 20 years ago when you-know-who started sitting in the big chair at the Federal Reserve boardroom.

Interestingly, they touch on one of my all-time favorite subjects since this blog began a few years ago - how owners' equivalent rent duped the Fed.

During the 1976-79 and 1986-89 housing price bubbles, the effective federal-funds interest rate was rising while housing prices rose: The Federal Reserve, "leaning against the wind," helped mitigate the bubbles. In January 2001, however, after four years with average inflation-adjusted house price increases of 7.2% per year (about 6% above trend for the past 80 years), the Fed started to decrease the fed-funds rate. By December 2001, the rate had been reduced to its lowest level since 1962. In 2002 the average fed-funds rate was lower than in any year since the 1958 recession. In 2003 and 2004 the average fed-funds rates were lower than in any year since 1955 when the rate series began.

Monetary policy, mortgage finance, relaxed lending standards, and tax-free capital gains provided astonishing economic stimulus: Mortgage loan originations increased an average of 56% per year for three years -- from $1.05 trillion in 2000 to $3.95 trillion in 2003!

By the time the Federal Reserve began to slowly raise the fed-funds rate in May 2004, the Case-Shiller 20-city composite index had increased 15.4% during the previous 12 months. Yet the housing portion of the CPI for those same 12 months rose only 2.4%.How could this happen? In 1983, the Bureau of Labor Statistics began to use rental equivalence for homeowner-occupied units instead of direct home-ownership costs. Between 1983 and 1996, the price-to-rental ratio increased from 19.0 to 20.2, so the change had little effect on measured inflation: The CPI underestimated inflation by about 0.1 percentage point per year during this period. Between 1999 and 2006, the price-to-rent ratio shot up from 20.8 to 32.3.

With home price increases out of the CPI and the price-to-rent ratio rapidly increasing, an important component of inflation remained outside the index. In 2004 alone, the price-rent ratio increased 12.3%. Inflation for that year was underestimated by 2.9 percentage points (since "owners' equivalent rent" is about 23% of the CPI). If home-ownership costs were included in the CPI, inflation would have been 6.2% instead of 3.3%.

Yes, "an important component of inflation remained outside the index" - that sort of thing almost always ends badly as noted here on many occasions before.

After years of writing on this subject, yours truly still comes out high in a simple Google search on the phrase owners' equivalent rent - right there in second place, behind the Bureau of Labor Statistics with "How owners' equivalent rent duped the Fed" and then again in fifth place with the memorable "The complete and utter failure of owners' equivalent rent".

This post can also be viewed on themessthatgreenspanmade.blogspot.com.

America's Tarnished Reputation Threatens Global Response To Financial Crisis

One of the biggest casualties from the financial crisis — and our handling of it — has been the loss of America's reputation on financial matters. As far as most of the world can tell we are the ones who started this financial mess — which is enveloping much of the world — and even worse we have appeared incompetent to fix it. Why then would the rest of the world listen to us when we try to piece together an effective global response? As Paul Krugman points out in his recent article, America quite possibly could have lost one of its most valuable assets — its reputation — right when they — and the world — need it most. For more on this, read the following blog post from Mark Thoma.

The financial crisis has damaged our global authority, credibility, and leadership, and that will make it much harder for the world to accomplish the essential task of coordinating a common response:

America the Tarnished, by Paul Krugman, Commentary, NY Times: Ten years ago the cover of Time magazine featured Robert Rubin,... Alan Greenspan,... and Lawrence Summers... Time dubbed the three “the committee to save the world,” crediting them with leading the global financial system through a crisis..., although it was a small blip compared with what we’re going through now.

All the men on that cover were Americans, but nobody considered that odd. After all, in 1999 the United States was the unquestioned leader of the global crisis response. ... The United States, everyone thought, was the country that knew how to do finance right.

How times have changed..., ... our claims of financial soundness — claims often invoked as we lectured other countries on the need to change their ways — have proved hollow.

Indeed, these days America is looking like the Bernie Madoff of economies: for many years it was held in respect, even awe, but it turns out to have been a fraud all along. ...

Simon Johnson..., who served as the chief economist at the IMF..., declares that America’s current difficulties are “shockingly reminiscent” of crises in places like Russia and Argentina — including the key role played by crony capitalists.

In America as in the third world, he writes, “elite business interests — financiers, in the case of the U.S. — played a central role in creating the crisis, making ever-larger gambles, with the implicit backing of the government, until the inevitable collapse. More alarming, they are now using their influence to prevent precisely the sorts of reforms that are needed, and fast, to pull the economy out of its nosedive.”

It’s no wonder, then, that an article in yesterday’s Times about the response President Obama will receive in Europe was titled “English-Speaking Capitalism on Trial.”

Now, in fairness ... the United States was far from being the only nation in which banks ran wild. Many European leaders are still in denial about the continent’s economic and financial troubles, which arguably run as deep as our own... Still, it’s a fact that the crisis has cost America much of its credibility, and with it much of its ability to lead.

And that’s a very bad thing... I’ve been revisiting the Great Depression,... one thing that stands out ... is the extent to which the world’s response to crisis was crippled by the inability of the world’s major economies to cooperate.

The details of our current crisis are very different, but the need for cooperation is no less. President Obama got it exactly right last week when he declared: “All of us are going to have to take steps in order to lift the economy. We don’t want a situation in which some countries are making extraordinary efforts and other countries aren’t.”

Yet that is exactly the situation we’re in. I don’t believe that even America’s economic efforts are adequate, but they’re far more than most other wealthy countries have been willing to undertake. And by rights this week’s G-20 summit ought to be an occasion for Mr. Obama to chide and chivy European leaders, in particular, into pulling their weight.

But these days foreign leaders are in no mood to be lectured by American officials, even when — as in this case — the Americans are right.

The financial crisis has had many costs. And one of those costs is the damage to America’s reputation, an asset we’ve lost just when we, and the world, need it most.

This post can also be viewed on economistsview.typepad.com.

Renter's Rights When Landlord Is In Default

As CNN reports, renters are definitely at risk in today's collapsing real estate market. In the event a home goes into foreclosure the lease agreement on said property is typically voided. The good news is that new laws have recently been passed that help renters in situations like this, but so far only Freddie Mac and Fannie Mae loans are required to be part of the program. If your landlord has their mortgage with a different provider, you may be out of luck. With 40 percent of all foreclosures happening to homes with renters in them, sadly there are a lot more people who are going to be in the same situation as the lady in the video. For more on this, read Tim Iacono's blog post below:

Wow! About 40 percent of all foreclosures are for properties that are being rented. We'll have to keep this in mind when looking for a new place - a report the other day said there are ten new foreclosures every day in Deschutes County, Oregon, where we're headed.

This post can also be viewed on themessthatgreenspanmade.blogspot.com.

Produce The Note: A New Way To Fight Foreclosure

Thanks to a recent TV spot on Good Morning America (along with other press exposure) banks are going to be hearing these words a lot, "Produce the note." A new movement is under way that is causing banks a lot of pain and grief. Essentially how it works is that a homeowner in foreclosure will submit paperwork requesting that the bank produce a copy of the original note. Sounds easy enough, but with the number of times these notes have been bought, sold and transferred, the paper trail can be hard to follow. Desperate homeowners are finding that if nothing else this tactic is buying them a little more time in their home. Tim Iacono looks at this new tactic in his blog post below:

The little guy fights back by making a simple request - prove that the borrower owes the money to the bank before foreclosing.

It really is hard to have much sympathy for the borrower, at least in this case - the lady borrowed $140,000 against a house for which she paid just $39,000.

It does, however, add great irony to the situation.

This post can also be viewed on themessthatgreenspanmade.blogspot.com.

Why We Should Break Up The Big Banks

Last week there was a lot of speculation that the US government would privatize mega banks, Citigroup and Bank of America, but now it appears that they are going to be happy with large stakes in the banks. The government believes that nationalizing the banks would ultimately cause more harm than good, and would like to avoid that path. Simon Johnson has a different view, though, he believes that the best course of action is to nationalize the big banks causing us so much grief, and then sell them off again in smaller pieces. This would ultimately remove much of the political power these monsterous institutions have over the government and our economy as a whole. Mark Thoma from the Economist's View looks at Johnson's article and adds some thoughts of his own in his blog post below:

Simon Johnson:

Privatize The Banks Already, by Simon Johnson: ...In some important and not good ways, we have already nationalized the financial system.

There’s the direct ownership that the government received through TARP and the reupping with Citi, BoA and some others. These stakes are obviously not (yet) voting stock, but the taxpayer certainly has capital at considerable risk.

Then we have the lines of credit provided by the Federal Reserve which, without a doubt, were instrumental to the survival of almost all major banks during the fall - and arguably remain critical today. The taxpayer has further downside risk here.

And, most importantly perhaps, we have the expansion of the Fed’s balance... In effect, the Fed is becoming a commercial bank as well as a central bank.

The government is essentially taking over the role of intermediation - take funds in and lend them out - for the US economy. This is a form of nationalization, and it will lead to all the lobbying and politically directed credits we have seen in other nationalized financial systems; taking away this credit once the economy starts to recover will not be easy. We have state control of finance without, well, much control over banks or anything else - we can limit executive compensation (maybe) but we don’t get to appoint directors (or replace entire boards) and we have no say in who really runs anything. Responsibility without power sounds accurate. ...

How then do we really privatize? By exercising leadership: take over insolvent banks and immediately reprivatize them. ... The taxpayer retains a significant number of shares (or the option to buy common stock) as a way to ensure upside participation...

Above all, we need to encourage or, most likely, force the large insolvent banks to break up. Their political power needs to be broken, and the only way to do that is to pull apart their economic empires. It doesn’t have to be done immediately, but it needs to be a clearly stated goal and metric for the entire reprivatization process.

No argument here. If there are good reasons to have banks so large their failure could bring down the entire system, a situation that gives them quite a bit of political leverage, I haven't heard them. There are questions about whether having many small banks as opposed to a few big banks reduces systemic risk, and if not, whether having lots of small banks makes policy intervention to stabilize and clean up the system more difficult when problems do arise - having just a few banks might be easier. But breaking up the banks does reduce political and economic power and I see no reason not to make this "a clearly stated goal and metric for the entire reprivatization process."

This post can also be viewed on economistsview.typepad.com.

Secret TARP Bailout Details To Be Released By Court Order

It appears that we finally (hopefully) will be able to see where our tax dollars are going, thanks to a recent court ruling. This court order will force the Treasury to release some of the information that they have been concealing from the American public in regards to the massive bailout of the country's financial system. Anthony Freed provides us with more information on this development in his blog post below:

Advocates of an open Government and transparent allocation of taxpayer funds celebrated the news late Friday afternoon (2-20-09) that the U.S. District court has moved to enforce a Freedom of Information Act (FOIA) request to release more details about exactly how TARP bailout funds have been and are being used.

The TARP was passed in early October, 2008, in an effort to stem the damage to the nation’s financial industry incurred during a decade of lax risk-abatement that pervaded the banking culture after the legislative emasculation of the Glass-Steagall Act.

FOX Business sued Treasury on Dec. 18 over failure to provide information on the bailout funds or respond to FBN’s expedited requests filed under the FOIA. The initial request, filed on Nov. 25, sought actual data on the use of the bailout funds for American International Group (AIG) and the Bank of New York Mellon (BK), and an additional request, filed on Dec. 1, sought similar data on the bailout funds for Citigroup (C).

FBN asked the Treasury Department to identify, among other issues, the troubled assets purchased, any collateral extended, and any restrictions placed on these financial institutions for their participation in this program.

The Treasury Department - along with the other banking regulators like the FDIC, OTS, and the Federal Reserve - are notoriously secretive concerning the data they collect and their subsequent analysis of the viability of any particular institution, preferring to operate instead behind closed doors.

This tendency often leaves investors in the dark, which generally tends to work in the banks’ favor. Regulators would argue that they are not in the business of moving markets, and that some data may be misinterpreted and inadvertently cause a run on funds at named institutions, evidenced by Schumer’s now infamous disclosure of details that may have led to the collapse of Indy Mac Bank in 2008.

That argument may have held some water until the TARP bailout effectively made the U.S. taxpayer a shareholder in any number of as yet identified institutions, and the owner of any assortment of exotic financial instruments which have proved toxic to Global capital markets.

Judge Richard J. Holwell of the U.S. District Court for the Southern District of New York said in a decision Friday that the government is directed to comply with FOX Business’s request under the FOIA “within 30 days and to produce a Vaughn index with 45 days.” That means Treasury must comply with FOX Business’s request by Monday, March 23, and must produce a Vaughn index by Monday, April 6.

The Treasury will have the chance to withhold some documents and information they deem too sensitive, but now have to provide an itemized “Vaughn index” of which documents and information have been redacted, and for exactly what reason.

“A Vaughn Index must: (1) identify each document withheld; (2) state the statutory exemption claimed; and (3) explain how disclosure would damage the interests protected by the claimed exemption.”

This may open the door to further FOIA challenges to release the remaining information if the Treasury fails to convince the courts that their vetting of information was reasonable.

I don’t think Treasury has realized that they are not the only ones who have new powers and responsibilities in the implementation of this historic bailout - the courts have yet to weigh-in on much of this, including who is ultimately going to be held responsible for the mess that is the economy, even if it is still taxpayers who have to foot the bill to clean it all up.

My guess is that the courts feel very differently about full disclosure than does the insider Wall Street elite who regulate themselves from Washington D.C. in seeming perpetuity.

Frank Rich of the New York Times wrote a good op-ed piece called What We Don’t Know Will Hurt Us, which helps further the argument that it is time to get to bottom of exactly what is going on with our economy, and why their seems to be so little consequence for the perpetrators of so much devastation.

Americans are right to wonder why there has been scant punishment for the management and boards of bailed-out banks that recklessly sliced and diced all this debt into worthless gambling chips. They are also right to wonder why there is still little transparency in how TARP funds have been spent by these teetering institutions. If a CNBC commentator can stir up a populist dust storm by ranting that Obama’s new mortgage program (priced at $75 billion to $275 billion) is “promoting bad behavior,” imagine the tornado that would greet an even bigger bank bailout on top of the $700 billion already down the TARP drain.

Remember, the fundamental point of the TARP bailout is to funnel incredible amounts of taxpayer money - debt, actually - to the very institutions and people who are responsible for driving the markets off the cliff in the first place.

And they got paid handsomely for doing it.

It is time for our nation’s financial machine to drop the self-righteous arrogance they have cloaked themselves in for too long, for all of those paper-pushing money lords to release their false sense of entitlement, relinquish their ill-gotten wealth from the last 10 years, and to return to their proper place in the economic landscape as facilitators of capital creation, not the creators of capital.

Accountability in the largest disbursement of public funds in history is not only a good idea, it is essential to our democracy, as is ending the revolving door between corporate boardrooms and the regulatory offices of our government.

The Fox Business FOIA request and the court’s decision to release more information should serve as a warning to the Wall Street good ol’ boys that their orgy of omnipotence is truly over, and that the era of accountability is in.

This post can also be viewed on yourmortgageoryourlife.wordpress.com.

Nationalizing Banks Will Harm The US Dollar

The buzz in the financial industry right now is whether or not the government is preparing to nationalize Citigroup and Bank of America, the two largest US banks. The government denied that they are even considering this measure, however, we wouldn't expect them to say anything else. The amount of liabilities that these banks have is staggering, and as Kathy Lien explains in her blog post below, a nationalization of these banks will have a dramatic impact on the US dollar.

I want to share my piece on How Nationalization of Citigroup and Bank of America could impact the US dollar if you haven’t caught it already (so I’m am posting his before I head to the NY Traders Expo).

The rally in gold prices tells us one thing and one thing only, which is that the fear has returned to the market. There is currently a lot of speculation that Citigroup and Bank of America could be nationalized by the US government. Although this would drive equities lower, it could also trigger capital flight out of the US dollar.

When Northern Rock was nationalized by the UK government in February of 2008, the British pound fell from 1.9638 to a low of 1.9363 over the course of 3 trading days. Although the dollar initially rallied on the news that the US government was taking over Fannie Mae and Freddie Mac in September 2008, it quickly gave back those gains to end the week lower against the Japanese Yen.

Nationalization will ultimately be negative for the US dollar because it increases the debt and liabilities of the US Federal Reserve and hence taxpayers. Nationalization is by no means a foregone conclusion especially since it is not a part of the US Treasury’s Financial Stability Plan. Senate Banking Committee Chairman Christopher Dodd floated the idea of short term nationalization around but it will probably be the last option for the US government if the Financial Stability Plan fails to work quickly. In fact, the rebound in US equities was triggered by speculation that the Treasury could release more details regarding their plan to rescue the financial system next week. Also keep an eye on Bernanke’s Humphrey Hawkins Testimony on the US economy and Monetary Policy.

This post can also be viewed on kathylien.com.

Should We Create Government Sponsored Shadow Banks?

According to Paul McCulley from Pimco, to revive the economy the government simply needs to create government sponsored shadow banks. Naturally this idea is a little controversial, especially considering the recent demise of this type of system. Tim Iacono from The Mess That Greenspan Made looks at an article written by McCulley in his blog post below:

Paul McCulley of Pimco thinks the new kind of shadow banking system is just swell:

The United States government now has both the tools and the will to save the private banking system, and more importantly, the real economy, from its own debt-deflationary pathologies. Not that it will be easy. But it can be done, notwithstanding the catcalls that greeted Secretary Geithner last week.

And the essential game plan is clear: use the power of the Fed, the FDIC and the Treasury to create government-sponsored shadow banks, such as the Term Asset-Backed Securities Lending Facility (the TALF) and the Public-Private Investment Fund (the P-PIF).

The formula? Take a small dollop of the Treasury’s free-to-spend taxpayer money (there is still $350 billion left) to serve as the equity in a government sponsored shadow bank, and then lever the daylights out of it with loans from the Federal Reserve, funded with the printing press.
...
Yes, there will be subsidies involved, sometimes huge ones. And yes, the process will seem arbitrary and capricious at times, reeking of inequities. Such is the nature of government rescue schemes for broken banking systems, while maintaining them as privately owned.

You might not like it. I don’t like it, because regulators should never have let bankers, both conventional bankers and shadow bankers, run amok. But they did.

So it’s now time to hold the nose and do what must be done, however stinky it smells, not because it’s pleasant but because it is necessary.

Pragmatism takes on a whole new meaning at Pimco.

This post can also be viewed on themessthatgreenspanmade.blogspot.com.

Gold Prices And US Dollar Both Rising

Those who keep up with gold and currency prices have probably noticed that things are a little strange right now. Typically the gold prices work inversely, however, right now they are rising almost instep. Currency expert Kathy Lien explains more about this phenomenon, and offers some insight into what is likely causing it in her blog post below:

If you haven’t caught it already, in my Daily Currency Focus on FX360, I talked about What the Rally in the US Dollar and Gold is Telling Us. As both the Dollar Index and Gold Prices press higher, it important to know what this means:

It is not very often that we see the US dollar and gold prices move in the same direction. Since gold is priced in dollars, the value of the yellow metal tends to fall when the dollar rises and rise when the dollar falls. However this has not been the case since January 14th as the rally in the US dollar corresponds with the rise in gold prices, which closed today at a 7 month high of $970 an ounce.

The last time we saw this traditionally negative correlation turn into a positive one was in 1982. At that time, recession hit many countries including the US. Although the rise in gold prices can be partially attributed to future inflation problems, the cohesive movement in the value of gold and the US dollar suggests that central banks around the world are losing credibility. There are growing concerns that a time bomb could explode in Europe leading to more troubles for the region as a whole. If that is the case, there may not be any safer form of investment than gold.

The rally in the US dollar and gold is telling the market that investors are worried about global economic stability outside of the US and therefore they are preparing for the worst.

This post can also be viewed on kathylien.com.

How To Prevent Another Depression

We are no where near a depression yet, but many people are worrying that we are heading for one. So what can the government do to prevent another depression? According to Brad DeLong we have 4 options. Mark Thoma from The Economist's View looks at DeLong's 4 options in his blog post below.

What can governments do to try to keep the economy out of a depression?:

Depression economics: Four options, by J. Bradford DeLong, Commentary, Project Syndicate: When an economy falls into a depression, governments can try four things... Call them fiscal policy, credit policy, monetary policy, and inflation.

Inflation is the most straightforward to explain: The government prints lots of banknotes and spends them. The extra cash in the economy raises prices. As prices rise, people don't want to hold cash... - its value is melting away every day - so they step up the pace at which they spend... This spending pulls people out of unemployment..., and pushes ... production up to 'potential' levels.

But sane people would rather avoid inflation. It is a very dangerous expedient, one that undermines standards of value, renders economic calculation virtually impossible, and redistributes wealth at random. ... But governments will resort to inflation before they will allow another Great Depression. We just would very much rather not go there, if there is any alternative...

The standard way to fight incipient depressions is through monetary policy. ... The problem with monetary policy is that ... the ... nominal interest rate on government securities is zero. ... And this is too bad, for if we could prevent a depression with monetary policy alone, we would do so, as it is the policy tool for ... stabilisation that we know best and that carries the least risk of disruptive side effects.

The third tool is credit policy. We would like to boost spending immediately by getting businesses to invest... Risky projects are at a steep discount today... No one is willing to buy assets and take on additional uncertainty... Although the world's central banks and finance ministries have been devising many ingenious and innovative policies to stimulate credit, so far they have not had much success.

This brings us to the fourth tool: fiscal policy. Have the government borrow and spend, thereby pulling people out of unemployment and pushing up capacity utilisation to normal levels. There are drawbacks: the subsequent dead-weight loss of financing all the extra government debt..., and the fear that too rapid a run-up in debt may discourage private investors from building physical assets...

But when you have only two tools left, neither of which is perfect for the job - credit policy and fiscal policy - the rational thing is to try both, at the same time. That is what the Obama administration ... and other governments are attempting to do right now.

This post can also be viewed on economistsview.typepad.com.

Political Lobbying Behind TARP Funding Decisions

In case you need more examples of how the Troubled Asset Relief Program (TARP) has failed us, a recent article in the Wall Street Journal describes several instances where politicians were able to directly influence the decision of whether or not to provide TARP funds to banks. States that have had the most political lobbying or representatives in the right committees have enjoyed the highest success rates for getting help for their local banks.

It probably should go without saying, but shouldn’t the decision of whether or not to allocate funds to these banks be based on something more fundamental than the lobbying efforts of politicians? Remember that they are using taxpayer money to make these capital injections. By offering money to these banks, we are betting that they will turn around, and if they go on to lose the TARP funds, taxpayers are just out of luck. However, if they are able to use the funds to turn their operations around and once again become profitable, then taxpayers will get their money back, and possibly even a little extra. With this in mind, shouldn’t our goal be to identify those banks which we believe can and will revitalize their operations with this borrowed capital? It appears that instead of creating a system with the goal of achieving highest taxpayer return (both monetary and economic), the program has turned into a display of political lobbying power.

I hope that the new administration fixes the TARP before the second round of funding is spent in the same fashion as the first round. This whole program was hastily put together to begin with, and we are now paying dearly for the lax regulation that was included with the bill. Due to the lack of direction, politicians and regulators are able to lobby for their own best interests. President Obama and Treasury Secretary Timothy Geithner need to step up and fill these holes in the program. The U.S. government doesn’t have $350 billion more to waste. We have to ensure that every dollar is used in the most effective manner possible, and I think it is safe to say that we aren’t anywhere near maximum return. Here’s hoping that we figure out a way to keep politics out of this program and focus on how we can allocate this next $350 billion to best help the economy and taxpayers.

Buying A New Home? You Better Be Careful...

Just in case you needed one more thing to worry about, a recent article published in the New York Times should have you thinking twice about buying a home in a new subdivision. The article is titled, “Banks Foreclose on Builders With Perfect Records.” The article talks about how banks are starting to do such things as call for extra collateral from builders—even if they have never missed a payment—essentially dooming them to failure. If you have purchased or are planning to purchase a home in a new subdivision that has not yet been completed, this could be horrible news for you.

Builders rely heavily on credit to function, and now that credit is being restricted even for the best borrowers, builders are in serious trouble. According to the New York Times article, already we have seen more than 20,000 builders nationwide go out of business. Before the carnage is finished, the total will likely swell to more than 50,000, according to Ivy Zelman, a housing analyst quoted in the article. That total would represent more than half of all U.S. builders. So why exactly should new home buyers be worried?

When you purchase a home in a new subdivision, part of the purchase price is based on community features and factors. The subdivision might have a nice park for the kids, or just great, overall family appeal. These are things that sell people on wanting to move into that particular neighborhood. The problem in new subdivisions is that typically people buy homes before the community is finished. If the builder were to go out of business, it is possible that the community might not be finished for a long time, if ever. Not only is it possible that early homebuyers might not ever see the clubhouse that they were promised, or that neighborhood park, but they may also be forced to look at partially built, rotting homes for a few years. In case you didn’t connect the dots already, that means that resell values of existing homes in those communities are likely to plummet.

The worst part about this is that these buyers could be completely blindsided. It doesn’t even matter if they went so far as to make sure that the builder looked financially sound and was current on payments to the bank. The banks are so scared about the collapsing real estate market—especially in the sun belt region—that they are prematurely foreclosing on these builders right now. If the banks are prepared to go to these dramatic lengths, regardless of payment history, who knows what they will do next? It seems that as a homebuyer, you can only protect yourself by paying for nothing but what you see. Don’t bother looking at the master plan with the salesperson. Just walk outside, look around and ask yourself whether this house is worth its price, even if nothing else gets finished. If it isn’t: Move on.

Why The "Bad Bank" Is A Bad Idea

There is a lot of momentum gaining right now behind the idea to create a so called, "Bad Bank." This bank would be set up by the government and would be used to take toxic debt off of the balance sheet of the banks like Citigroup and Bank of America. Paul Krugman thinks this "Bad bank" is simply a bad idea. Economics Professor Mark Thoma revisits Krugman's article in his blog post below.

Are policymakers about to take another wrong turn?:

Wall Street Voodoo, by Paul Krugman, Commentary, NY Times: Old-fashioned voodoo economics — the belief in tax-cut magic — has been banished from civilized discourse. The supply-side cult has shrunk to the point that it contains only cranks, charlatans, and Republicans.

But recent news reports suggest that many influential people, including Federal Reserve officials, bank regulators, and, possibly, members of the incoming Obama administration, have become devotees of a new kind of voodoo: the belief that by performing elaborate financial rituals we can keep dead banks walking.

To explain..., let me describe ... a hypothetical bank that I’ll call Gothamgroup, or Gotham for short.

On paper, Gotham has $2 trillion in assets and $1.9 trillion in liabilities, so that it has a net worth of $100 billion. But a substantial fraction of its assets — say, $400 billion worth — are mortgage-backed securities and other toxic waste. If the bank tried to sell these assets, it would get no more than $200 billion.

So Gotham is a zombie bank: it’s still operating, but the reality is that it has already gone bust. Its stock isn’t totally worthless — it still has a market capitalization of $20 billion — but that value is entirely based on the hope ...[of] a government bailout.

Why would the government bail Gotham out? Because it plays a central role in the financial system. ... Gotham has to be kept functioning. But how can that be done?

Well, the government could simply give Gotham a couple of hundred billion dollars... A better approach would be to do what the government did with zombie savings and loans at the end of the 1980s: it seized the defunct banks, cleaning out the shareholders. Then it transferred their bad assets to ... the Resolution Trust Corporation; paid off enough of the banks’ debts to make them solvent; and sold the fixed-up banks to new owners.

The current buzz suggests ... policy makers aren’t willing to take either of these approaches. Instead, they’re reportedly gravitating toward ... moving toxic waste from private banks’ balance sheets to a publicly owned “bad bank” or “aggregator bank” ... “The aggregator bank would buy the assets at fair value.” But what does “fair value” mean?

In my example, Gothamgroup is insolvent... The only way a government purchase of that toxic waste can make Gotham solvent again is if the government pays much more than private buyers are willing to offer.

Now, maybe private buyers aren’t willing to pay what toxic waste is really worth... But should the government be in the business of declaring that it knows better than the market what assets are worth? And is ... paying “fair value,” whatever that means,... enough to make Gotham solvent again?

What I suspect is that policy makers — possibly without realizing it — are gearing up to attempt a bait-and-switch: a policy that looks like the cleanup of the savings and loans, but in practice amounts to making huge gifts to bank shareholders at taxpayer expense...

Why go through these contortions? The answer seems to be that Washington remains deathly afraid of the N-word — nationalization. ...Gothamgroup and its sister institutions are already ... utterly dependent on taxpayer support; but nobody wants to recognize that fact and implement the obvious solution: an explicit, though temporary, government takeover. Hence the popularity of the new voodoo, which claims, as I said, that elaborate financial rituals can reanimate dead banks.

Unfortunately, the price of this retreat into superstition may be high. I hope I’m wrong, but I suspect that taxpayers are about to get another raw deal — and that we’re about to get another financial rescue plan that fails to do the job.

This post can also be viewed at economistsview.typepad.com.

Risk Strategy In Uncertain Times

You always hear people quoting the great Warren Buffet, "Buy when there is blood in the streets." But today's investment climate seems to be different than anything we have ever seen before. Should we still be buying, or is now the time to go ultra-conservative? What about something in between? At this point who honestly knows? There are a lot of smart people out there that have entirely different views about which direction the economy is heading, and ultimately about how things will turn out. This is beyond a doubt a difficult time to be a successful investors, but one thing we do know for certain is that when all is said and done there will be winners and losers in the investment world. James Picerno from The Capital Spectator dialogs about a recent roundtable discussion between some investment bellwethers, and helps us evaluate some of the current investment risks in his blog post below.

The future is always unclear, and therein lies the chief source of risk in the investment challenge. The degree of risk isn't continuously steady. It ebbs and flows, like market prices and the careers of Hollywood actors.

The fact that risk levels are dynamic suggests a connection. But our ability to model the connection and draw lessons is limited. In fact, at some points the relationship between risk and expected return is especially foggy.

This is one of those times, a state of affairs that creates unusually large opportunities and equally above-average risk. As such, all the usual caveats, and then some apply. Yet recognizing this condition is the first step toward exploiting the opportunity and/or defending oneself against the higher risk.

Macroeconomically speaking, a major risk overhanging the capital and commodity markets relates to the question of deflation and inflation. That is, which one will prevail? Moreover, will one dominate only to give way to the other? And if so, what will the timing be? Being on the wrong side of this uncertainty will be painful, perhaps financially fatal, and so it's the rare investor who can afford to make an all-or-nothing bet. Regardless of your view, a bit of hedging never looked better—just in case.

Certainly there are strong arguments for each possibility, including deflation first, then inflation, which happens to be your editor's bias. But others argue that deflation will linger for a lengthy stretch and so the practical risks of inflation are virtually nil for the foreseeable future. Still others forecast that inflation remains the imminent risk, even if it's not obvious in current data. The chief evidence for this outlook comes from the massive surge in the Federal Reserve's balance sheet, i.e., the printing of money on a scale rarely seen in order to combat the current economic slowdown/contraction.

The fact that intelligent analysts and economists can debate the future on such starkly different terms only highlights the higher levels of risk of late. That's in sharp contrast to debates of the recent past, when dismal scientists were arguing if the economy was set to grow by 2.0% vs. 2.3%.

A telling example comes in the current issue of Barron's and its roundtable discussion. Consider this exchange between Fred Hickey (High-Tech Strategist); Mario Gabelli (Gamco Investors); Marc Faber (Marc Faber Ltd.); Oscar Schafer (O.S.S. Capital Management); and Bill Gross (Pimco):

Hickey: It's hard to predict the market when you don't know what the Fed will do. The Fed has tripled the size of its balance sheet and is plowing ground we have never seen before. Here are my facsimiles of deutsche marks from Weimar Germany [holds up sheaf of papers]. They collapsed in value when Germany started printing money after World War I. It happened very quickly and it can happen again.
The Germans were successful at reflating. But they weren't successful in saving their economy. [Federal Reserve Chairman Ben] Bernanke is on record saying, "I will not make the mistakes of the 1930s. I will not make the mistakes of Japan in the 1990s." He is pushing the limit right now.

Gabelli: So you're saying he's going to make the mistake of the Weimar Republic?
Hickey: There is a possibility of that. Every month that there is a horrible employment, report the government prints more money.

Gabelli: It took Weimar Germany a brief time.
Faber: The worse the economy, the more they will print. It is like in Zimbabwe now, and Latin America in the 1980s. They had large deficits and printed money, and in local currency everything went up. But the currency collapsed.

Schafer: Isn't the federal government increasing its balance sheet to offset the private sector?

Gross: Exactly. The situation isn't similar. The Weimar Republic basically reflated to get out from under its wartime debts. Zimbabwe is a situation unto itself. In the U.S. there has been asset destruction in the trillions of dollars that has to be repaired. To say the Fed's balance sheet has expanded by a few trillion dollars and that this will create hyperinflation is a miscalculation.

Faber: I'm prepared to bet Bill that in 10 years the U.S. has very high inflation. With growing fiscal deficits that may reach as high as $2 trillion next year, it will be hard for the Fed to lift interest rates in real terms. Once they push up rates again, there will be another disaster.

Gross: Marc, you're smarter than that. You know that credit creation is at the heart of economic growth, and to the extent that credit creation has been thwarted, stultified, basically cut by 10% or 20%, economies can't grow.

Faber: The U.S. economy is credit-addicted. In a sound economy, debt growth doesn't exceed nominal GDP growth. Would you agree with that, or do you think debt should always grow at a faster pace than nominal GDP?
Gross: I'm with you there.

Faber: We come at this from different perspectives. You run a company that manages money, and I'm an outside observer of the U.S. financial scene, though I have to admit I bought some U.S. stocks for the first time in 30 years.

The fact that smart people can see such wildly divergent possibilities on inflation and deflation reminds that the potential for instability is alive and kicking. As Abby Joseph Cohen, senior investment strategist at Goldman Sachs, explained in the roundtable talk, "It is important to recognize that we are not starting from a point of equilibrium, where the economy and the credit markets are working properly. Instead, the Federal Reserve is acting aggressively to provide liquidity not just to the U.S. economy but the global economy." She added: "In many ways, the Fed is acting as the central bank to the global economy."

It doesn't take a genius to recognize that the Fed's not designed for such a broad increase in its mandate. Yes, to a certain extent the U.S. central bank has, for some time, been dispensing monetary medicine for the globe. That's one thing, when the global economy was humming along nicely; it's something else in a time of severe asset deflation and recession, the likes of which we haven't seen in decades.

So, yes, there are huge opportunities in the current climate, but those are tempered with huge risks. As such, a prudent risk management strategy is essential. For strategic-minded investors, that begins with taking advantage of sharp discounts on price at those times when available. In fact, the discounts were unusually large about a month ago. Prices have since popped. Did you take advantage of the pessimism? Or are you inclined to jump on the bandwagon now?

The macroeconomic risks are unusually large these days, but the biggest threat to investment success remains a familiar monster that dwells inside each of us: emotion that favors running with the crowd for, say, asset allocation decisions. Taming that beast is still the greatest challenge.

This post can also be viewed on capitalspectator.com.

America's Ponzi Scheme Era

There has been a lot of talk lately about ponzi schemes, and of course this can be directly attributed to the recent Madoff scandal. As Paul Krugman points out in his article, though, there isn't all that much difference between Madoff's actions and the actions of the entire investment industry. After all the end result was the same, the investors lost a bunch of money while the facilitators ran off with the spoils. Mark Thoma from The Economist's View shares the Krugman article in his blog post below.

The costs of "America's Ponzi Era":

The Madoff Economy, by Paul Krugman, Commentary, NY Times: The revelation that Bernard Madoff — brilliant investor (or so almost everyone thought), philanthropist, pillar of the community — was a phony has shocked the world, and understandably so. The scale of his alleged $50 billion Ponzi scheme is hard to comprehend.

Yet surely I’m not the only person to ask the obvious question: How different, really, is Mr. Madoff’s tale from the story of the investment industry as a whole?

The financial services industry has claimed an ever-growing share of the nation’s income over the past generation, making the people who run the industry incredibly rich. Yet, at this point, it looks as if much of the industry has been destroying value, not creating it. And it’s ... had a corrupting effect on our society as a whole.

Let’s start with those paychecks. ... The incomes of the richest Americans have exploded over the past generation, even as wages of ordinary workers have stagnated; high pay on Wall Street was a major cause of that divergence.

But surely those financial superstars must have been earning their millions, right? No, not necessarily. The pay system on Wall Street lavishly rewards the appearance of profit, even if that appearance later turns out to have been an illusion.

Consider the hypothetical example of a money manager who leverages up his clients’ money..., then invests the bulked-up total in high-yielding but risky assets... For a while — say, as long as a housing bubble continues to inflate — he (it’s almost always a he) will make big profits and receive big bonuses. Then, when the bubble bursts and his investments turn into toxic waste, his investors will lose big — but he’ll keep those bonuses.

O.K., maybe my example wasn’t hypothetical after all.

So, how different is what Wall Street in general did from the Madoff affair? Well, Mr. Madoff allegedly skipped a few steps, simply stealing his clients’ money rather than collecting big fees while exposing investors to risks they didn’t understand. ... Still, the end result was the same (except for the house arrest): the money managers got rich; the investors saw their money disappear.

We’re talking about a lot of money here. In recent years the finance sector accounted for 8 percent of America’s G.D.P., up from less than 5 percent a generation earlier. If that extra 3 percent was money for nothing — and it probably was — we’re talking about $400 billion a year in waste, fraud and abuse.

But the costs of America’s Ponzi era surely went beyond the direct waste of dollars and cents.

At the crudest level, Wall Street’s ill-gotten gains corrupted and continue to corrupt politics... Meanwhile, how much has our nation’s future been damaged by the magnetic pull of quick personal wealth, which for years has drawn many of our best and brightest young people into investment banking, at the expense of science, public service and just about everything else?

Most of all, the vast riches ... undermined our sense of reality and degraded our judgment. Think of the way almost everyone important missed the warning signs of an impending crisis. How was that possible? ... The answer, I believe, is that there’s an innate tendency on the part of even the elite to idolize men who are making a lot of money, and assume that they know what they’re doing.

After all, that’s why so many people trusted Mr. Madoff.

Now, as we survey the wreckage and try to understand how things can have gone so wrong, so fast, the answer is actually quite simple: What we’re looking at now are the consequences of a world gone Madoff.

This post can also be found on economistsview.typepad.com.

Flurry Of Fed Moves Could Lead To Hyper Inflation

In what was a surprising move yesterday, the Fed dropped the Fed funds rate basically to zero, surpassing market expectations. Everyone fears deflation, and the Fed is willing to do whatever it takes to avoid it. But as Toni Straka from The Prudent Investor points out, these drastic moves could soon lead us to hyper inflation.

Share and bond markets rallied on Tuesday after the Federal Reserve announced that it will give away new money for almost free, lowering the Fed Funds target range to a historical low of 0% to 0.25%. The Fed had cut the Fed Funds rate in late October by 50 basis points. The new record low rate is a reaction to to the de facto status quo in treasury securities where short maturities of up to 6 months trade at yields below the upper end of the target range.

In a most unusual move the Fed provided publishable background on its decision, writes the WSJ blog, detailing it all here. The Fed has not held press briefings until now.

While markets welcomed the bold move, gold, the canary in the mine of inflation, advanced as well, piercing the important resistance at $850. Investors are obviously pricing in that all Treasuries yield less than the inflation rate of currently 3.7% YOY.

But the move to a zero interest rate policy will come at the cost of higher inflation in 2009 and 2010, it can be safely predicted. Chairman Ben Bernanke and his fellow Federal Open Market Committee (FOMC) members pulled out all stops in order to jumpstart the economy and assured market participants that the Fed would continue to engage in the dubious game of printing fresh money for collateral it does not want to talk about.

Once more proving their image of inflationistas par excellence the FOMC said the Fed can be expected to hold on to its free money policy for quite some time and use all tools to promote a return to growth.

The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.

But money for nothing alone will not help, the Fed reasoned, preparing markets for more growth in the Fed's balance sheet after it has exploded from $800 billion to $2.2 trillion since last summer. Expect the Fed to continue to buy more worthless MBS (mortgage backed securities) while substituting the banking sector in the commercial paper market.

The focus of the Committee's policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve's balance sheet at a high level. As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant. The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities. Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses. The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity.

I translate this into "we will throw (fiat) money (that costs us next to nothing) on every problem as we did in the past 2 decades." See more worthless money created that will be exchanged for more MBS that are valued on a theoretical basis, i.e. not the market price which may be only a tiny fraction of the initial face value.

The announcement that the Fed is looking into buying longer term US Tresuries raises immediate fears that the Fed will be monetizing the federal debt again after a portfolio shift towards MBS in the recent past. Any talk about deflation misses the point of unprecedented monetary inflation that will show up in the real economy 2009/10.

Eric de Carbonnel argues at DollarDaze that monetary inflation does not even have to pump up money supply - my favorite theory - but that it is a loss of confidence that increases the velocity of money, resulting in the dange of hyper inflation.

The record low official Fed Funds rate may be elusive though. Jake at EconomPicData sees a disconnect between municipal bonds and Treasuries, reflecting the horrendous outlook for cash strapped communities which had invested heavily in property debt. Now they are broke.

GRAPH: The yield spread between Munis and 5-year Treasuries soared to a record high of 325 basis points. Graph courtesy of EconomPicData.

DollarDaze draws a historical comparison that shows deflation can be a hazy illusion.

As an example of deflation leading to hyperinflation, consider the case of the Weimar Republic. In 1920, Germany experienced a deflationary collapse, with the average citizen finding it harder and harder to get enough money for necessities. Banks, short of money, could not honor checks, and businesses were strapped for cash to buy materials and meet payroll. Fearing a collapse that would throw millions of workers out on the street, the German government desperately printed money in an attempt to re-inflate the economy. During this period, despite the government's money printing, the mark actually gained in value against foreign currencies, so that prices of imported goods fell by some 50%.

Eventually, as a result of the money supply's rapid expansion, the nation's massive foreign debt, and the shrinking economy, German citizens lost all confidence in their currency, and the Weimar Republic experienced one of the worst cases of hyperinflation in modern economic history.

Check out the time series of the Weimar hyper inflation - with the interim "correction" before it went parabolic - here.

The new policy to lend money to banks for free shows that the Fed is obviously willing to monetize all debt problems that come along. With its seven new financing tools introduced since the beginning of the crisis in August 2007 the Fed is already intervening in MBS markets and tries to keep the commercial paper market afloat.

But after all these attempts are nothing more than new fiat money with a different ribbon. The road to hyper inflation is clearly visible as were most problems already more than 3 years ago.
Time will show whether the Fed has been correct in its view of current conditions. Taking it from the past 15 months the Fed has been behind the curve despite its fast moves. It is to be doubted that the increasing readiness to prop up all markets with new money will mitigate the crisis. It will rather delay it but the point of no return comes closer with every day. Central banks have a bad record of containing inflation once they set the process into motion willingly.

But these facilities have not brought the liquefying effect the Fed had hoped for. So far all attempts to revive credit markets have failed, observes not only Bloomberg, which has all the details on Tuesday's rate decision.

This post can also be viewed on prudentinvestor.blogspot.com.

So Why Do We Want To Bail Out This Homeowner Again?

I was reading through some blog posts this morning and came across one on housingdoom.com that just reaffirms my anti-bailout position. The blog post is simply a rental listing that was posted on Craigslist in Tampa, and while a rental listing in itself is nothing to rant about, you really need to read this particular one.

Here it is:

I HAVE A 3 BEDROOM HOUSE THAT I AM LETTING GO, IT SHOULD BE ATLEAST ANOTHER YEAR BEFORE THE COURT WANTS THE KEYS, SO I AM RENTING OUT THIS HOUSE WITH NO CREDIT CHECK AND ON A MONTH TO MONTH TERM, SO NO ONE IS LOCKED IN, IT IS A CHEAP WAY FOR YOU TO SAVE MONEY. THE HOUSE HAS NO APPLIANCES BUT YOU CAN GO TO CRAIGS LIST AND GET FREE ONES UNDER THE FREE STUFF. CHECK OUT THE LINKS BELOW. IF YOU ARE INTRESTED PLEASE E-MAIL ME. ALSO THERE IS NO SECURITY DEPOSIT AND THE HOUSE IS ON A 1/4 ARCE. YOU CAN E-MAIL ME DIRECTLY AT JOEYCARLO@******** FIRST COME FIRST SERVE.

THANKS JOE

The actual listing can be found here: http://tampa.craigslist.org/hil/apa/958697241.html

This guy Joe is asking $499 a month for this house, which is ridiculously low, so I’m sure that he won’t have a problem finding a tenant to take him up on his offer. Obviously he has no intention of using the rental proceeds to pay his mortgage, and is planning to take full advantage of the system for as long as he can.

This is one of the reasons why I am so adamant that a foreclosure moratorium is a bad idea. Sure a lot of homeowners really want to stay in their homes. However, many have no intention of staying in a house that is thousands underwater, and a majority of those homeowners who do want to stay in their homes probably can’t afford it, so they would just be delaying the inevitable. Then you have guys like this, who plan to milk the system for every dime they can get. He already stole the appliances, and now he plans to take advantage of the lenders some more. Since taxpayers are basically on the hook for many of these lenders, he is also taking advantage of taxpayers.

If we can figure out a way to limit the bailout to only those homeowners who actually want to stay in their homes and who can afford to do so, I might be more inclined to support it. But any bailout, or other measure, that supports guys like this, will never get my backing. This guy may be an extreme example of the potential problems at hand, but I can’t help thinking that there are tens of thousands of people out there doing this exact same thing. They probably just aren’t disclosing the situation outright like Joe here. Just reading this listing makes me angry. If Joe isn’t going to live in the house or at least try to make the payment, then he needs to return the keys to the lender. Anything short of that should be illegal, especially when taxpayers are ultimately on the hook for the bill.

Subprime Defaults Are Just The Beginning

If you thought we were almost done with the collapse of the mortgage market, you are sadly mistaken. Last night 60 minutes did a piece about the looming wave of mortgage defaults, Alt-A and option ARMs. While, as Scott Wilson outlines below in his guest post on Your Mortgage or Your Life, 60 minutes did not do a fabulous job on this story, they did reveal some very interesting facts and figures. One that was especially scary occurs 3 minutes and 40 seconds into the video. This shows how most of the subprime mortgages have already reset, but what is looming over the next few years is a huge number of Alt-A and option ARMs due to reset. The graphic will definitely make you change your tune if you think this carnage is almost finished.

by guest author and good friend Scott J. Wilson

I know that I am just smart enough to get by, and I know am not a genius by any stretch of the imagination. I have just been in the mortgage industry - working everything from mortgage sales to secondary markets - for more than fifteen years.

I happen to be watching CBS’s 60 Minutes tonight (12-14-08) and they had a piece called Mortgage Meltdown: Where’s the Bottom? with Scott Pelley, who did the story, and not a very good job of it. Either he or his writers need to better research their topic before they to such a report.

Mr. Pelley failed to note that POA’s qualified borrowers with “teaser” interest rates, and not the actual “payment” interest rates. But that is not what I am griping about. My complaint lay in Pelley’s false assumption that no one but a few sage individuals could see these consequences of poor lending standards coming.

All of my experience is in the explosive Orlando, Florida area, so I know a thing or two about exotic mortgage products like the soon to be infamous Pay Option ARM (POA), ticking time-bomb of the mortgage world, and the subprime’s little brother ALT A.

During the bubble from in 2004-2006, I worked for one of the biggest lenders in the nation (one of the survivors thus far) and I doing a truckload of Condo-conversions. I sold a hell of a lot POA’s to borrowers during that period, and most will all be recasting over the next two years.

I tried to always do one thing when I did sell a POA, I tried to explain to the borrowers exactly what these loans were intended for - people with season variances in income like construction and tourist trades, or for those whose income is mostly delivered from quarterly bonuses like sales people.

I did my best to point out to the borrower advantages and traps in POA’s. That being said, I am no “expert” by 60 Minutes standards, let alone “one of (only) six experts in the nation who saw this (tsunami of foreclosures) coming,” as 60 Minutes called Mr. Eagan in tonight’s story.

I knew way back when in the bubble, as did most of the loan officers that I worked with, that these were potentially bad products if they were sold to the wrong borrowers, and that most would probably fail if they allowed more than 80% loan to value (LTV), or made them available to speculators and subprime borrowers.

I also know that most of these loan officers were not geniuses either. Could we have been the only ones to know? I doubt it. So to say that the banks that offered them had no idea that POA’s had a high risk of potentially failing is just completely incorrect.

The bank’s own greed got the best of them; all they saw was the dollar signs in their eyes, as fees and points that filled their coffers.

The borrowers were really no less greedy- like I said, I did my best to explain, even tried to talk some borrowers out of using a POA to buy the property that they were interested in. But most times, it was to no avail. They either didn’t care about the risks or worse yet, their Realtor “over talked” me and told them that I did not know what I was talking about, and that the POA was their best choice:

Real estate always goes up, remember? It’s different here! No need to worry about that negative amortization loan if you stick with the only payment you can really afford, the one with the 1% teaser, your house will be worth double what you paid for it in a year or two!

But, unfortunately, the problem as the banks saw it wasn’t that these loans were going to fail in droves, nope.

The problem the banks saw was that the people were using these loans as short-term real estate investment loans with a really low initial payment, giving the investors time to remodel the property in order to “flip” the house and then move on to the next investment without having to sink so much capital into principle and interest with a higher interest commercial loan payment.

The banks were not making enough money, so they started tacking on prepayment penalties, which investors took as a cost of doing business and the banks thought of as a new revenue stream.

So the big banks and mortgage lenders had to have done some sort of analysis of these POA loans (I know Anthony did when he worked for them, whether the executives ever really read them I don’t know).

Did they not anticipate that the loans would be bad? That if someone who was taking this completely unaffordable loan out for a long period of time they would get burned, especially if the borrower had a two or three year pre-pay penalty on it and the market took a quick downturn, leaving them unable to refinance - just like it did.

Come on though, everyone can’t be so smart that we all saw this coming, but the leadership at Corporate of these mega-institutions did not - especially when they were offering No Income/No Asset options as well - now commonly know as “Liar-Loans” for their lack of any documentation in exchange for a higher interest rate.

Again, profit driven.

At one point, I told people that it was not a matter of if you can qualify or not for an Option ARM or not, if you had below-average or sub-prime credit, you would qualify , with no problems. All I had to do, was run their credit and if they had a 620 credit score (below average credit at the time), then I told them that they were approved with out even having an underwriter look at it.

Underwriters could approve even lower scores with the advent of “risk-based” and “exception” pricing add-ons, basically charging more for the additional risk posed by a riskier borrower, hence the birth of the ALT A loan, among other expanded approval products meant to sell more loans to more people.

So to have Mr. Pelley and 60 Minutes do this completely un-researched and absolutely baseless story that has little or no semblance to the truth is a more than a shame - lots of people knew this crisis was headed our way.

Hell, I wouldn’t be surprised if close to a million people knew that these loans were problems and a lot of them were going to fail. Do you think that any of them just might have worked in upper management of a these now failing banks?

Or are we really all just geniuses after all?

Well in that case then, I’d say my superior intellect makes me really doubt it.

This article has been reposted from Your Mortgage or Your Life The full post can also be viewed on yourmortgageoryourlife.wordpress.com.

This post is brought to you by OnlyInsurance.com, your car insurance headquarters.

The True Cost Of The Bailout

So how much is the bailout really costing us? Figures have ranged from a few hundred billion to over $7 trillion, what are we to believe? Economics professor Mark Thoma looks at a couple views on the topic and adds some additional insight in his blog post from the Economist's View below.

With respect to estimates concerning the total cost of the various bailouts, etc. for the financial system, in particular whether the spending should be treated as an expenditure or an investment, Steve Waldman says:

Expenditure vs investment — thinking clearly: ...Paul Kedrosky is a reasonable fellow, and takes care to note that the numbers "are in current dollars, and all treat expenditures and investments as equivalent." Kevin Drum is even more reasonable:

This stuff has gotten completely out of hand, with "estimates" of the bailout these days ranging from $3 trillion to $7 trillion even though the vast bulk of this sum comes in the form of loan guarantees, lending facilities, and capital injections. The government will almost certainly end up spending a lot of money rescuing the financial system (I wouldn't be surprised if the final tab comes to $1 trillion over five years, maybe $2 trillion at the outside), but it's not $7 trillion or anything close to it. People really need to stop throwing around these numbers as if the bailout is comparable to World War II or something. That's not reality based, folks.

But reasonable and right are sometimes different... We have some idea what we paid for, for example, with the $851,000,000,000 for NASA. We bought space shuttles, satellite systems, a moon shot, planetary probes, a lot of research and development, some air bases and research facilities.

What are we buying when the government purchases mortgage-backed securities, or buys preferred shares of banks that can only pay if a portfolio of real-estate loans does not totally sour? We are buying "paper", right?

No. We are not buying paper. ... All of the iffy securities that are weighing down the banking system represents money already spent on real projects or consumption. When the government purchases a security, it is taking the place of the party that originally fronted money for that expenditure. Every penny of government "investment" is retroactive expenditure on housing, real-estate, consumer credit, whatever.

If a government were to borrow funds in order to build a new stadium, we'd call that an "expenditure", even if we fully expect use fees and incremental tax revenues to eventually turn a profit for the fisc. Politicians supporting the project would call it an "investment", quite justifiably. But the project would still count as government spending.

If a private party builds the same stadium, and then is reimbursed by the government in exchange for rights to future revenue, that doesn't change the economic substance of the transaction at all. But in the second case, the government would buy "paper" — it would enter into a contract trading current government funds for future revenues. That "security" doesn't make the transaction any more or less an investment than if the government had purchased the stadium itself.

So, in economic substance, the government is currently spending through a financial time machine on the exurban subdivisions and auto loans of several years past. ...

I hope that the infrastructure we build next year turns out to be a wise investment, both in financial and use-value terms. It might be, but just because we hope to recoup the cost, we won't pretend that no money was actually spent. We'll call the whole thing an expenditure, even though that will probably overstate the ultimate burden. But if a power grid counts as an expenditure on government books, so should a security derived from a mortgage or credit card loan made two years ago. You ... can't claim that securities are "investments" while a power grid, or NASA, or even World War II are mere "expenditures". ...

Figures of 7 or 8 trillion dollars recently bandied about by the Communists at Bloomberg are overstated, since they do not distinguish between expenditures and guarantees, which are contingent liabilities. The government's contingent liabilities aren't usually counted as spending until the contingency has been triggered. But the amount of money already spent or committed on "financial investments" to date is more than $3 trillion dollars, and it is perfectly right to call that government spending on the financial bail-out.

The scale of the largely unlegislated current government program to save the financial system is breathtaking and quite unprecedented. Taxpayers might be made whole, in financial terms, or might reap sufficient dividends in terms of suffering avoided to justify the program. But don't let anyone convince you that the scale of this intervention is "overstated" because it is all "investment". NASA and the Marshall Plan were investments too, and pretty good ones.

But shouldn't the example be a little different? If the private sector builds, say, a stadium and then the government buys it, then yes, that is expenditure. But suppose the government purchase comes with a clause that says it will sell the stadium back to the private sector at a date certain (or by a date certain). It's still an expenditure of the same amount in the present, but the purchase price does not represent the expected long-run burden of the transaction, and isn't that what we really care about? The government plans to sell the financial paper, not hold it forever, and what really matters is how much the paper will be worth in the future (if the stadium value falls to zero, then the current expenditure does represent the long-run burden; however, the value of the government holdings will not fall to zero or anything even close to that).

So I don't care what you call it, expenditure, investment, a repo, temporary custody of a volatile asset, whatever, what I care about is how much the bailout will cost once the government has disposed of all of the assets it has purchased. That's not something we can know with certainty, but unless the value of the securities the government is holding falls much, much further than anyone expects, the amount of the current expenditure greatly overstates the long-run burden.

This article has been reposted from the Economist's View. The full post can also be viewed on the Economist's View.

$2 Trillion In Consumer Credit Lines Could Be Cut, Spelling Disaster

It is no secret that the U.S. economy runs on credit, and has for some time. When credit flowed freely, our economy boomed. When credit became restricted, our economy started crumbling and turned into what we see today. As we attempt to rebuild our beleaguered economy the last thing we need is a cut in available consumer credit. But according to at least one analyst we could soon be faced with that reality. Prominent banking analyst Meredith Whitney was quoted by Reuters as projecting consumer credit to be cut by as much as $2 trillion over the next 18 months.

To make matters worse, the outlook for the job market isn’t looking any better. People are losing jobs right and left, and now they could be faced with cuts to their credit lines as well. From the bank’s perspective, it makes sense to cut credit lines now. With people racking up record debts, and some having no means to repay them, the risks are extremely high. The responsible thing for banks to do is to cut credit lines for those consumers who show any signs of causing trouble down the road.

From an economic view, though, we need to boost spending any way we can. Consumer spending makes up the largest portion of economy and consumer spending must improve before the economy can rebound. The fact that jobs are being lost and credit lines cut means that consumer spending will be likely to tank. When that happens business will suffer, leading to more layoffs and an even bigger hit to consumer spending. I think you can see the vicious cycle that is being formed here.

You can bet that Obama and the new administration will do whatever they can to jump start spending. This would include the stimulus package that is being considered, as well as placing added pressure on banks to increase lending.

The Bank Life: Isn't It Swell

With banks getting preferred treatment by governments across the world, one wonders what life as a bank might be like. Toni Straka from The Prudent Investor dreams of a better life, a life as a bank.

Flirting with the Hindu theory of reincarnation I have decided to do my utmost that may give me a chance to be reborn as a bank.

Just imagine what life must be like. Compare it maybe to a video game where the drunk driver can crash into a wedding party, killing most attendees and wrecking the car. At that point Uncle Sam comes around, saying "no problem boy, never mind all the mangled corpses around you. Here's a bundle of cash so you can get a new car and mess around again."

No. Let's get serious. When being a bank, one does not need to draw on outdated analogies. Reality is already a paradise and this is a true story from cloud nine.

Let's begin with working hours. As the only industry in the world retaining a 5-day workweek, banks have an easy life. In contrast to all other businesses that have to stay open to fill the till banks have an enormous advantage. The money they lend out collects interest for at least 360 and in most cases 365 days. Not bad for working only 250 days. That's as close as one can get to "money for nothing and chicks for free," at least for the first part of this former Dire Straits hit.
Does a bad credit score hike your borrowing costs in real life? Again, better become a bank eligible for central bank refinancing. No matter what crap spoils a bank's asset portfolio, your central bank will be a most reliable buddy, lending you as much money as you want at negative real interest rates and far below what they charge for the risk associated with a client.
As a bank you are basically getting paid for borrowing.

Doesn't that sound like paradise? No, it is not paradise, this the very real world of banks these days, almost entirely free from any consequences for all its acting participants.

Are Banks Except From Common Sense Thinking?
This does not apply to the clerical workers level of course. A bank just needs to fire a couple of hundred secretaries etc. in order to keep its masters of the universe happy with gazillion bonuses. Sssshhhh, nobody wants to be reminded that the suipposed masters of the universe did nothing else than a herd of sheep: Staying together while stampeding in the same direction most times.

While mere mortal humans are told to save up for a nest-egg in case times turn to the worse, banks are again exempted from such profane common sense thinking.

Skimming the profits off shareholder's dividends in order to pay themselves bonuses in the good years banks apparently felt themselves expected from the need to create reserves for loans going bad. OK, they were not the first ones but only followed examples set by companies in many other industries where the aim to create shareholder value led to a short term oriented strategy that was dominated by the desire to raise the share price and not the strength of the company in the long term. Call the game by its true name: CEO compensation roulette.

The years in the casino with freely flowing champagne that came from selling increasingly risky products to clueless customers have created a resistance to change in the banking industry. While other drunks are thrown into the locker cell to sober up, a bank can instead stumble into its concerned parliament and tell a few horror stories about the importance of the credit industry.

Incompetent politicians may feel like heroes when they throw billions after the banks they do not have in the first place. But this recipe for hyper inflation is so old that it has been long forgotten by today's caste of international leaders. They will find out together with revolting populations when Europe and the USA follow the nasty path of monetizing the debt that has reduced Zimbabwe from Africa's bread basket into a lawless impoverished society depending on food aid from abroad.

The common man meanwhile is told that banks deliver an important function to the public by guaranteeing the smooth and efficient flow of funds. What the public is not told is the sour reality that it will be them who will pick up the bailout bill of the banks with its future tax payments.
Declining property prices, the prime driver behind the global debt boom of this millennium, will chip away more of the prosperity the West has become used to in the past 2 decades of surging home values that have financed many luxuries people probably would not have bought had they had to use their savings.

A shrinking business base at least on the consumer level where a sudden change to frugality out of necessity means fewer loans may bring what politicians are so far eager to avoid with their donations to the banking sector: A resizing of the industry to the level needed to service other industries and consumers without dominating them. After all banks profits have seen a higher growth rate in the past 4 decades than all industries.

All attempts to rein banks under stronger regulatory umbrellas were squashed in the past by them. Voicing their commitment to free market ideology it was argued that only self-regulation was sufficient and the state's hands would only hamper business. As the world now finds out that this was not the case, to be polite, banks have turned into super socialists at the same speed they saw their business model of taking on too much risk for lavish profits disappear because we cannot all get rich at the same time.

After all, it may still be most comfortable to be reborn as a bank in the near future. History shows a repeating pattern after bank crises. The bigger the excesses of the banks were the stronger the regulation they were relegated to.

It will not be different this time and for a while banking may become what it was for most of the time: A 3-6-3 business. Borrow at 3%, lend at 6% and be on the golf course at 3 PM. Life could be worse.

This article has been reposted from The Prudent Investor. The full post can also be viewed on The Prudent Investor.

Loan Loses Continue To Mount: A Look At FDIC Graphs

You're probably not surprised to hear that loan losses are continuing to mount at financial institutions, but just how bad are things getting? Anthony Freed from Your Mortgage or Your Life looks a little closer at some FDIC graphs and helps paint the grim picture in his blog post below.

More Institutions Report Declining Earnings, Quarterly Losses:

Troubled assets continued to mount at insured commercial banks and savings institutions in the third quarter of 2008, placing a growing burden on industry earnings. Expenses for credit losses topped $50 billion for a second consecutive quarter, absorbing one-third of the industry’s net operating revenue (net interest income plus total noninterest income). Third quarter net income totaled $1.7 billion, a decline of $27.0 billion (94.0 percent) from the third quarter of 2007. The industry’s quarterly return on assets (ROA) fell to 0.05 percent, compared to 0.92 percent a year earlier. This is the second-lowest quarterly ROA reported by the industry in the past 18 years. Evidence of a deteriorating operating environment was widespread. A majority of institutions (58.4 percent) reported year-over-year declines in quarterly net income, and an even larger proportion (64.0 percent) had lower quarterly ROAs. The erosion in profitability has thus far been greater for larger institutions. The median ROA at institutions with assets greater than $1 billion has fallen from 1.03 percent to 0.56 percent since the third quarter of 2007, while at community banks (institutions with assets less than $1 billion) the median ROA has declined from 0.97 percent to 0.72 percent. Almost one in every four institutions (24.1 percent) reported a net loss for the quarter, the highest percentage in any quarter since the fourth quarter of 1990, and the highest percentage in a third quarter in the 24 years that all insured institutions have reported quarterly earnings.

Lower Asset Values Add to the Downward Pressure on Earnings:

Loan-loss provisions totaled $50.5 billion in the quarter, more than three times the $16.8 billion of a year earlier. Total noninterest income was $905 million (1.5 percent) lower than in the third quarter of 2007. Securitization income declined by $1.9 billion (33.0 percent), as reduced demand in secondary markets limited new securitization activity. Gains on sales of assets other than loans declined by $1.0 billion (78.7 percent) year-over-year, and losses on sales of real estate acquired through foreclosure rose by $518 million (588 percent). Among the few categories of noninterest income that showed improvement, loan sales produced net gains of $166 million in the third quarter, compared to $1.2 billion in net losses a year earlier, and trading revenue was up by $2.8 billion (129.2 percent). Sales of securities and other assets yielded net losses of $7.6 billion in the third quarter, compared to gains of $77 million in the third quarter of 2007. Expenses for impairment of goodwill and other intangible asset expenses were $1.8 billion (58.6 percent) higher than a year ago.

Loan Losses Continue to Mount:

The industry reported year-over-year growth in net charge-offs for the seventh consecutive quarter. Net charge-offs totaled $27.9 billion in the quarter, an increase of $17.0 billion (156.4 percent) from a year earlier. Two-thirds of the increase in charge-offs consisted of loans secured by real estate. Charge-offs of closed-end first and second lien mortgage loans were $4.6 billion (423 percent) higher than in the third quarter of 2007, while charged-off real estate construction and development (C&D) loans were up by $3.9 billion (744 percent). Charge-offs of home equity lines of credit were $2.1 billion (306 percent) higher. Charge-offs of loans to commercial and industrial (C&I) borrowers increased by $2.3 billion (139 percent), credit card loan charge-offs rose by $1.5 billion (37.4 percent), and charge-offs of other loans to individuals were $1.7 billion (76.4 percent) higher. The quarterly net charge-off rate in the third quarter was 1.42 percent, up from 1.32 percent in the second quarter and 0.57 percent in the third quarter of 2007. This is the highest quarterly net charge-off rate for the industry since 1991. The failure of Washington Mutual on September 25 meant that a significant amount of charge-off activity was not reflected in the reported industry totals for the quarter1.

Growth in Reported Noncurrent Loans Remains High:

The amount of loans and leases that were noncurrent (90 days or more past due or in nonaccrual status) increased to $184.3 billion at the end of September. This is $21.4 billion (13.1 percent) more than insured institutions reported as of June 30 and is up by $101.2 billion (122 percent) over the past 12 months. The percentage of total loans and leases that were noncurrent rose from 2.04 percent to 2.31 percent during the quarter and is now at the highest level since the third quarter of 1993. The growth in noncurrent loans during the quarter was led by closed-end first and second lien mortgage loans, where noncurrents rose by $9.6 billion (14.3 percent). Noncurrent real estate C&D loans increased by $6.9 billion (18.1 percent), while noncurrent loans secured by nonfarm nonresidential properties rose by $2.2 billion (18.1 percent). Noncurrent C&I loans were up by $1.8 billion (13.7 percent) during the quarter.

Nine Failures in Third Quarter Include Washington Mutual Bank:

The number of insured commercial banks and savings institutions fell to 8,384 in the third quarter, down from 8,451 at midyear. During the quarter, 73 institutions were absorbed in mergers, and 9 institutions failed. This is the largest number of failures in a quarter since the third quarter of 1993, when 16 insured institutions failed. Among the failures was Washington Mutual Bank, an insured savings institution with $307 billion in assets and the largest insured institution to fail in the FDIC’s 75-year history. There were 21 new institutions chartered in the third quarter, the smallest number of new charters in a quarter since 17 new charters were added in the first quarter of 2002. Four insured savings institutions, with combined assets of $1.0 billion, converted from mutual ownership to stock ownership in the third quarter. The number of insured institutions on the FDIC’s “Problem List” increased from 117 to 171, and the assets of “problem” institutions rose from $78.3 billion to $115.6 billion during the quarter. This is the first time since the middle of 1994 that assets of “problem” institutions have exceeded $100 billion.

Failure-Related Restructuring Contributes to a Decline in Reported Capital:

Total equity capital fell by $44.2 billion (3.3 percent) during the third quarter. A $14.6-billion decline in other comprehensive income, driven primarily by unrealized losses on securities held for sale, was a significant factor in the reduction in equity, but most of the decline stemmed from the accounting effect of the failure of Washington Mutual Bank (WaMu)2. The WaMu failure had a similar effect on the reported industry totals for tier 1 capital and total risk-based capital, which declined by $33.6 billion and $35.3 billion, respectively. Unlike equity capital, these regulatory capital amounts are not affected by changes in unrealized gains or losses on available-for-sale securities. Almost half of all institutions (48.5 percent) reported declines in their leverage capital ratios during the quarter, and slightly more than half (51.2 percent) reported declines in their total risk-based capital ratios. Many institutions reduced their dividends to preserve capital; of the 3,761 institutions that paid dividends in the third quarter of 2007, more than half (57.4 percent) paid lower dividends in the third quarter of 2008, including 20.7 percent that paid no dividends. Third quarter dividends totaled $11.0 billion, a $16.9-billion (60.7-percent) decline from a year ago.

Source FDIC: http://www2.fdic.gov/qbp/index.asp

For more on what the graphs are telling you, read What are CAMELS ratings? Is My Bank Okay?

Graphs From Q2-2008: Graphs - Not Laughs - From the FDIC Report

More: Graphs show Gaffes - More from the FDIC Report

This article has been reposted from Your Mortgage or Your Life. The full post can also be viewed on yourmortgageoryourlife.wordpress.com.

Another $800 Billion Committed: Crisis Tally Tops $8 Trillion

Yesterday on Bloomberg, I saw a disturbing article that disclosed that the government had already committed $7.76 trillion to fix the credit crisis. This number was staggering to me. I write about this stuff every day and yet even I didn’t realize the tally had gotten that high. The $7.76 trillion number includes the over $300 billion committed to Citigroup, but another $800 billion to free up the credit markets was announced this morning. So far this week—which isn’t even two days old yet—the tally has already surpassed a trillion dollars. This is absolutely insane, and you can bet that there will be more where that came from once the new administration takes over.

I don’t know about you, but these numbers are freaking me out. Sure a lot of these commitments have an investment component, but I don’t believe claims that we will make a bunch of money from these deals. I would consider us lucky if we are able to recover the principal. Things have only gotten worse of late, and we seem prepared to throw as much money at the problem as needed, so what will the final tab be? When will this spending spree stop?

Obama is prepared to open up the taxpayer checkbook when he takes office, recently announcing plans to roll out a new stimulus package estimated to cost $500 billion to $700 billion according to CNN. In addition, his selection for Treasury Secretary, Geithner, has had a huge part in the economic decisions made by Treasury Secretary Paulson, and it seems unlikely that he will stray far from the current path. With these combined factors, we could face countless trillions more before all is said and done. Where is this going to leave our children?

The answer to that question of course is that our children will be unfairly burdened by an absolutely enormous debt. Their financial prospects will be dim as they are forced to deal with higher taxes and other restrictive policies. Personally I find this completely unacceptable, and I hope beyond hope that it doesn’t come to that. I’ve mentioned this before in some of my posts, but to knowingly leave a burden such as this on the future generation is immoral to the fullest extent. We need to pay for our own mistakes, and our own excessive lifestyles. Our children have enough to worry about, and paying for the previous generation’s debt shouldn’t be one of them.

Citigroup Bailout, Deflation And The Worldwide Financial Epidemic

The news of Citigroup's $300 billion bailout seems like déjà vu, and the scary word "deflation" that is being thrown around seems distant compared to everything else we are dealing with. The U.S. is not the only country with problems either, this is without a doubt a global financial epidemic. James Picerno from The Capital Spectator wonders, though, if the cure might be worse than the disease.

Have we seen this movie before? It certainly sounds familiar.

Once again, the government steps in to bail out a financial institution and Mr. Market takes kindly to the idea. Initially. But then reality sets in and the process starts anew. Perhaps it'll be a true sign of a bottom when the Feds engineer a bailout and the market tanks on the news.

But not yet. The latest installment of rescue revolves around the once mighty Citigroup. A giant among giants, this behemoth of financial behemoths surely fits the bill as too big to fail. If such a thing exists as a financial institution that must be saved at any cost, Citigroup looks like the poster boy for this idea.

Total assets for Citigroup were a bit more than $2 trillion in September. For those who like to keep score, that's roughly 14% of the annualized value of U.S. GDP for this year's third quarter.

The days of pulling another Lehman and letting a big bank fail are history. Better to bailout more rather than less and deal with the consequences later. The grand strategy here is that if the government bails out enough banks (and perhaps an auto company or two) while spitting out stimulus in various forms as far as the eye can see, the system will correct itself, or at least stop bleeding. At a time when deflationary risks are rising, this plan is considered prudent and timely by a growing swath of economists and voices from the peanut gallery, including yours truly. The risk of an even deeper implosion of prices and confidence must be avoided lest the vortex of deflation pull everything down the rat hole. Preventing deflation is the last battle in this horror film because once the big "D" takes hold, in sentiment and prices, the challenge becomes much, much tougher.

The problem is that no one's really quite sure if deflation with a big "D" is on our doorstep. Quite possibly it is, or so one could reason after witnessing consumer and wholesale prices fall last month on a scale unmatched since the government began keeping tabs on such things in the late-1940s. Waiting for definitive signs risks letting the monster out of the cage. Decisions, decisions. Nonetheless, there's a strong case for assuming deflation is coming. If we're wrong, we'll have more inflation on our hands than we otherwise would. But the world knows how to fight inflation, even if the political will is sometimes lacking. Attacking deflation, on the other, is another story.

Any way you slice it, there's bound to be more than a little disappointment and finger pointing in the months and years ahead. Indeed, no one should think that the necessary but risky strategy of preventing deflation is destined to end in triumph, or quick results. The stakes are high, in part because the government's moving quickly toward betting the house on a fiscal/monetary solution. On the opposing shore is the unwinding of excess, some of which has been decades in the making. When an immovable force meets government printing presses, the outcome isn't entirely clear.

All the more so if the world is looking for signs, one way or the other, by next Wednesday. It's difficult to gauge expectations as we run from one crisis to another. But this much is clear: the financial and economic problems will take time--years--to solve, and to the extent that the crowd thinks otherwise, the seeds of disenchantment have been planted.

The U.S. economy is sick, and getting sicker. Europe has the disease and Asia is at risk of contracting the same, albeit in a milder form. Looking back on the past five decades offers no clue for what may be coming. Growth has been a constant, according to GDP numbers from economist Angus Maddison, emeritus professor, University of Groningen (Netherlands). As the chart below shows, outright contraction is unknown in the postwar era.

Fifty years is a long time, virtually an eternity for mere mortals studying the past in search of clues about the future. It's all too easy to look at this track record and conclude that real declines in global GDP aren't possible, or are so unlikely as to be unworthy of considering. The IMF forecast, for one, still imagines more of the same with next year's estimate for real global GDP rising by a respectable if not impressive 2.4%.

Of course, the crowd used to think in persistent-growth terms for housing prices, and how they never fall on a year-over-year basis. Oh, sure, that happened in the Great Depression, but such episodes were dismissed as a thing from the past.

Perhaps it's time to consider the unthinkable. We've all received a crash course in just that over the last few months. But has the education so far been sufficient? Or do we still need to spend more time studying?

There are many dangers stalking the global economy, and at the top of the list is the assumption that the governments of the world can spend their way out of the slump on our collective doorstep. In the U.S. alone, the government now stands at the ready to spend $7 trillion--yes trillion with a "t"--to bring financial salvation to the system, according to Bloomberg News. That's the equivalent of three-and-a-half Citigroups, or half the U.S. economy. Scale no longer looks to be a stumbling block.

By spending enough money, governments are likely to keep inflation-adjusted global GDP floating somewhere above zero, if only slightly. That would still bring a fair amount of pain and repricing, but embedded in the expectation is the notion that a floor can be built under the crisis.

Perhaps, although at some point one might wonder if the cure will be worse than the disease. There are some awkward questions that will accompany the mother of all spending sprees now underway. First up: Is there some point at which additional government spending becomes counterproductive because a) it encourages future inflation on a scale that will be excessively burdensome; and/or b) the prospect of the government owning ever-larger chunks of the economy risks institutionalizing mediocrity or worse in the economy?

There are two great episodes of deflation in modern history, and each continues to raise questions about the associated lessons. Yes, spending is the only hope of sidestepping the beast, and if that means artificially engineered demand from the government, so be it. But it's not clear that the strategy leads to happy results all around. Meantime, there's more than one way to fight deflation.

That's not to say we shouldn't try to spend our way out of a deflationary trap. We should. We must. And we will. The risk is real this time, unlike the previous worries over deflation in 2001-2003. But the details of how we engage our anti-deflationary war may matter as much, if not more, as the decision to wage the war in the first place.

The dismal science has precious little experience with fighting deflation and so we must recognize that we may soon be caught up in an economic experiment on a scale that has little or no precedent. By all means, let's fight this war ferociously. But it also needs to be fought intelligently. What exactly do we mean by "intelligently"? We can't say for sure. No one can, and therein lies the greatest risk.

This article has been reposted from The Capital Spectator. The full post can also be viewed on The Capital Spectator.

16,000 Homeowners Get Early Christmas Present From Freddie and Fannie

In an attempt to stop the flow of foreclosures that is ravaging the companies, Freddie Mac and Fannie Mae have decided to put a temporary hold on new foreclosures and evictions. This hold will last till early 2009 and is meant to give homeowners the chance to work out loan modifications, hopefully allowing them to stay in their homes. Between the two companies this move is expected to affect around 16,000 homeowners facing foreclosure, according to the Wall Street Journal. So it seems that these 16,000 homeowners are getting a nice little Christmas present from Freddie and Fannie, as well as from taxpayers I presume.

If nothing else, it will be interesting to see how this idea works. I was skeptical at best when the foreclosure moratorium was discussed during the presidential debates, and I still don’t think this will work as well as they are hoping. Nevertheless, this shall give us an opportunity to test the program on a smaller scale, which it could open up the door for similar action by other lenders if it works.

My problem with this strategy: I predict that ultimately the homeowners will still be foreclosed on, but they will enjoy some free time in their homes. If the homeowner doesn’t stay in the home, or somehow sell it, then the delay will just put the lender in even worse shape than before. Because in the case of Freddie and Fannie this equates to taxpayers taking on the burden, I’m not too fond of the idea. It will work out better if the companies are selective about who qualifies for a foreclosure delay, but if they offer it to all owner occupants it is doomed to failure. The problem is most people are in foreclosure for a serious reason: Some people lost their jobs, some can’t afford the payment (with or without loan modification) and some people are choosing to enter into foreclosure because they are so far underwater on the house. The last reason is becoming a huge problem, and really should be the one most feared in this scenario. At least I can feel bad for the people who lost their jobs, or possibly even the poor sucker who got an interest only ARM sold to them that they couldn’t afford, but it is hard to feel bad for someone who can afford the payment and just wants out of their contract. Why on earth would we want to give these people another month, two or three of free housing? If they aren’t going to pay their mortgage and just plan on working the system, why should taxpayers be stuck with the bill? We already have to deal with the fact that we are going to lose money on the foreclosure, so why add anything else?

It will be interesting to see how this all plays out. I have my doubts, and I hope that I’m proven wrong and that this plan saves taxpayers a bunch of money. But unless we are able to create a method to accurately identify the homeowners who want help and can be helped, this is doomed to fail.

Does Anyone Know How To Fix This Financial Crisis?

I read a couple interesting articles this morning that I thought I’d share. One article talks about how no one, including President-elect Obama, knows how to fix the financial crisis. The other offers a potential solution that will cost more than $1 trillion. I’ll summarize the two articles below:

The first article was written by Russell Roberts, economics professor at George Mason University, and published in Forbes. In his article, Roberts equates this financial crisis to raising children, saying that each one is different and there is no official manual on how to raise the perfect child. He goes through the measures that have already been enacted, saying how each one thus far has failed miserably. Many people have this belief that Obama will miraculously save the day, but Roberts points out that the only solution Obama has really posed thus far is to offer another stimulus package, and idea that has already been tried and failed. Paulson is lost at this point, and he doubts Obama will be the answer either. He ends his article saying:

“What if doing whatever it takes means doing less, rather than more?

That is the conundrum for Obama and the successor to Paulson. The more options there are, the harder it is to know which one is the right one. The more options you try, the more uncertainty is injected into the economy, and the more cautious are investors and employers and consumers.

Nobody knows what it takes to move the economy forward right now.”

The second article was written by Neha Singh and published by Reuters. This article is about the findings of Paul Miller, an analyst for Friedman Billings Ramsey. Miller has come up with a plan to save the U.S. financial system, and it will cost only $1 trillion to $1.2 trillion in additional capital. Basically, he says that in order to restore confidence and improve liquidity in the credit market, this injection needs to happen. In addition, rather than the investments being made via preferred shares or long term debt mechanisms, Miller thinks that in order for the plan to work the investments need to be common equity injections. The following is a quote from Miller: “Debt or TARP capital is not true capital. Long-term debt financing is not the solution. Only injections of true tangible common equity will solve the current crisis.” Miller says that even his plan will take a few years to fix things.

Obviously these two articles have very different views, but one thing they have in common is that they agree that the solutions proposed or enacted thus far have failed.

Of the two views, I tend to side with Roberts, author of the first article. I think that pretty much we are lost in the forest and going around in circles trying to get out, and as they teach you in Boy Scouts, when you get lost sometimes it is best to wait it out.

Miller’s suggestion, on the other hand, I find completely ludicrous. So instead of the government (i.e., taxpayers) getting preferred treatment for their extremely risky investments into struggling companies, they should settle for common equity investments that would surely lose a ton of taxpayer money? Sorry, but that sounds pretty dumb to me. And I’m certainly not willing to lose $1 to $1.2 trillion of taxpayer money to find out that this crazy idea isn’t going to work. There are a lot of ways that we can help the economy with that kind of money that would have a bigger impact. Besides, there is no way that plan would ever get approved without people rioting in the streets and threatening rebellion. People are already outraged at the current investments we are making into these companies, and if we were to take even lesser terms in exchange, look out. The only people who would support this plan would be shareholders in these institutions, and I don’t think anyone feels bad for them at this point.

Bailout Plan Changes Again

All the hype about Treasury Secretary Henry Paulson’s wonderful plan to save Wall Street and the financial system by purchasing troubled assets is now officially over; the plan has changed. Officials have apparently come to the conclusion that buying these assets will not help in the immediate future, and they need results now. Instead, they plan to continue buying stakes in the financial institutions and encourage them to resume lending, according to the Associated Press. I don’t know about you, but I think this is just a way for the administration to save face while admitting they were wrong in the first place.

I don’t think too many people were thrilled about Paulson’s original plan to buy up the toxic assets from banks--well, other than the bank executives and shareholders. That plan was severely flawed because it offered little upside to taxpayers and required too little accountability on the part of banks. Many people have speculated that Paulson cares more about the banks then taxpayers. I’m not going to make an argument for that one way or another, but I think the current plan of buying bank shares is much better. At least this offers taxpayers some level of upside and allows us to have a say in things such as executive bonuses and so on.

It will be interesting to see how the bailout continues to morph. They have been holding out on offering aid to the auto makers and financiers thus far, but how much longer can they hold out? What about other companies? American Express was allowed to become a bank and is now seeking $3.5 billion in government assistance (everyone should have seen that one coming). Where will they finally draw the line? Many companies and industries are going to be hit hard during this recession and they will all want a piece of the government handouts. I would imagine that this won’t be the last time we are talking about a change in strategy for the bailout, especially considering that we will be looking at a new administration soon.

Iceland’s Collapse: Magical Elves Lose Toyshop; Will Enchant For Food

Global credit crisis or not, I’m sick of reading (and typing) the words “crumbling” and “tumbling”, “freefall” and “meltdown”, and “bottomless pit of despair and agony”. So I’ll start this post by saying that I will use “Reykjavik” as a noun and verb to describe all of these concepts (and a few others), all in honor of Iceland: the first major casualty of this totally Reykjaviked financial situation on our hands.

Iceland has always been an insular place. The lush, little ball of lava was first colonized by Vikings and magical elves who didn’t much care for the stodgy mainlanders. Their tradition of aloofness and fondness for haddock has remained to this day. This aloofness survived even during the past few years as the island became a tourist spot known for its unique art scene, stunning natural beauty and lively nightlife. Meanwhile, the inflated economy and high interest rates drew millions in foreign capital from investors hoping for a better return on their deposits. This created two illusions for Icelanders: 1) the illusion of wealth and 2) the illusion that the rest of the world gave a Reykjavik about them.

Were Icelanders wealthy? Everyone seemed to think so because of the expansive assets that the three major Icelandic banks acquired throughout Europe over the last decade—Hanley Toys being one, because you know elves and toys are inseparable—all totaling 100 billion Euros. In a country whose GDP is less than 10 billion, that presents a slight problem when liquidity freezes: Like a shiny, spinning top, the tiny base that the government offered was only enough to support the floating island of wealth if enough hands kept it in motion. Those hands drew back very quickly when two of there three major banks, Glitnir and Landsbanki , were seized one after the other. Alas, no amount of geothermal hot springs and/or elf magic was enough to thaw the hearts of authorities in London and the Netherlands, who froze the assets of Iceland’s last major bank standing, Kaupthing, when it became clear that depositors from the two countries had no guarantee on their assets should the bank collapse. The move ironically sealed the fate of the institution, and perhaps of the country at large.

Icelandic PM Geir Haarde was less than pleased by this pre-emptive move, and it’s only by the good (and ever-sinister) graces of Vladimir Putin that Iceland has any continental support at all. The country received a four-billion Euro loan from Moscow, but with the value of the Krona now less than half of what it was at the beginning of the year, one must wonder how they ever intend to repay Russia. It may not be with cash...

Russia and Iceland do have one thing in common: a sense of isolation from the rest of Europe, though the Icelandic dislike of authority doesn’t quite mesh with war-mongering (and perhaps secret-assassination happy) Putin. Iceland’s isolation is a little more innocent. For example, their decision to remain outside the E.U. was largely motivated by the restrictions that inclusion would have placed on their fishing and whaling industry, which is one of their only major exports aside from twee, nonsensical music. Now some are suggesting that they be given a fast-track to E.U. citizenship to stabilize the country—Strike one against Iceland’s culture. Iceland’s decision to expand its assets into new territories allowed its young entrepreneurs—and louts, alike—to adopt the mantle of hip jetsetters and hypertrophic consumers without making cultural concessions at home. Now, in major debt to Mother Russia—and perhaps soon to the IMF as well, though Iceland has not yet officially requested aid from the Washington-based institution—the question is: What will be left of Iceland after the bill-collectors have taken their due?

Iceland has many natural resources, and Russia may find the prospect of tapping them increasingly attractive as Putin’s regime pawns off much of their own to China. However, sacrificing the island’s ecological integrity is in complete conflict with Iceland’s national pride as well as with their other major draw: eco-tourism. The pristine and dramatic landscape is home to the breeding grounds of many European birds, and spoiling the land would draw conservationist ire from around the globe. Despite clinging to their small and—I grudgingly admit—relatively responsible whaling industry, Iceland has until now been a beacon for environmental progressiveness. Sadly, sacrificing the land to save the economy may be unavoidable at this point, depending on how scrupulous the country’s saviors choose to be with their stake in the economy. An IMF loan would be the first offered by the agency to prop up the economy of a developed nation. As of Thursday morning (October 23) the rumored figure was in the area of 6 billion dollars, much of which would go towards loans held by banks in Japan. At least Japan—with their mutual penchant for whale meat, isolationism and living around active volcanoes—is a far better bedfellow for Iceland than Russia.

In short, Iceland’s tale is that of the classic, rakish decadent, who in a short time squandered his wealth, his reputation and perhaps his future for a few cheap thrills. And the worst is not over; the spending spree in the good times and the high interest rates at local banks encouraged the citizens to seek loans abroad, which they must now repay with a deeply devalued currency. Even the cheap labor force—Poles and Lithuanians—have packed up and left as they no longer profit by sending their meager paychecks home. There is no telling how Iceland will dig itself out of this fumarole, but one can be certain that the country will change dramatically as they dig and dig and dig—all on their own, for now. At least they’ll always have the Aurora Borealis—or perhaps it too will be blotted out by the smoke of industry that may yet be coming. That would be a Reykjaviking shame.

Bad Mortgages Are Just The Beginning

Yesterday I talked a bit about how, through the bailout bill, the government was given the authority to invest the $700 billion in things outside of mortgage debt, the requirement being that the investment be critical to supporting the U.S. economy. This has led to auto finance companies to lobbying the government for aid. I also threw out that we could soon be looking at credit card companies such as American Express following suit. I thought that I should expand a bit on this and explain that mortgages are by no means the only problem assets for banks right now, and even though the other debt out there hasn’t received the same type of publicity, the threats are serious.

Mortgage debt has been the poster child for this financial crisis, and rightly so, considering the sheer size of the market and the juicy stories about people getting swindled and then losing their homes. With property prices falling across the country and borrowers defaulting at record paces, banks began to see losses mount beyond their worst case projections. We all know where that has led. Now we have passed bailout after bailout and are desperately trying to fix this mess before all the troubled debt out there brings down the financial system as we know it. Unfortunately for us, there are some other factors that could contribute to this degradation as well.

Americans have almost $2.6 trillion in consumer credit outstanding, according to the Federal Reserve. Credit card defaults rose 45 percent for JP Morgan Chase in quarter three, according to a Washington Post article, and they are expecting things to only get worse. Auto finance companies are echoing the sentiment. This has me worried.

Typically, owner-occupied mortgage borrowers are going to pay their mortgages above every other bill they have. That means they will default on their credit cards, car loan and whatever else before they stop paying their mortgage. They know that if they stop paying their mortgage, they will lose their home, whereas if they stop paying their credit card bill, all they lose is their credit rating. So the fact that credit card defaults are rising as quickly as they are tells me that people are at the end of their ropes. Before they might have been able to get by with using one credit card to pay another, but with banks actively reducing the credit lines of existing borrowers, and being more selective about new borrowers, this option is running out. What happens next is that these people are going to stop paying their mortgages, which will mean a double whammy for banks.

To make matters worse for banks, when people don’t pay their credit card bills, they essentially are out of luck because it is unsecured debt. When people default on their mortgages, at least the bank can go after the house. With car loans banks can go after the car, but since cars depreciate so fast they really are left with little (sounds kind of like the real estate market in some areas).

Despite the attempts by the government to “rescue” the industry it appears things might be getting even worse, and I think it is pretty clear by now that $700 billion isn’t going to be close to enough to actually right this ship.

U.S. Learning From Mexican Financial Crisis

While it is nearly impossible to accurately compare the largest economy in the world to that of a developing nation, there are many lessons to be learned by the U.S. from the Mexican financial crisis of 1994 and 1995. Ben Bernanke realized this and met with Mexican Central Banker Guillermo Ortiz last week to talk through Ortiz’s experience with their financial crisis, according to the Wall Street Journal. While Mexico certainly did not do everything perfectly to exit their crisis, they were able to restore order and return to growth within a couple years, which sounds much better than some of the doom scenarios being thrown around right about the U.S. economic forecast. The Wall Street Journal did an excellent piece about the lessons we can learn, so let’s look at some of the things they brought up:

“Don't be ruled by ideology -- stay flexible and act decisively. Help those with mortgages they can't pay. Take stakes in troubled banks. Don't expect to turn a profit on government investment.”

“’Do whatever it takes to restore confidence,’ Mr. Ortiz said in an interview. ‘Once you lose it, it's very difficult to get it back.’”

“In today's globalized financial markets, once trust is blown, the markets will often overreact and the crisis will spin out of control. As a result, policy makers may need to take steps they never imagined taking. The longer they wait, the worse the pain. We are already learning this lesson the hard way.”

“Mr. Ortiz said in remarks Sunday to the Institute of International Finance in Washington. ‘It's better to err on the side of doing too much rather than doing too little.’”

“In the end, Mexico acted directly to tackle the underlying problem of bad debt by launching a program to restructure mortgages, with banks, borrowers and the government all sharing loses.”

“The key to a mortgage restructuring: ‘Keep it simple,’ says Vicente Corta, who led Mexico's bank bailout program for several years. ‘We tried fancy schemes that didn't work.’”

“The Mexican and U.S. bank rescue plans have both involved the government taking bad loans from bank books in order to get credit flowing again. Much like Washington, the Mexican government expected to break even and possibly make some money on the bad loans that it purchased.”

“The reality: The government lost money -- lots of it. The bailout's final price tag of about $75 billion was three times what the Mexican government expected. In other words, the $700 billion U.S. rescue plan could be just the beginning of the final cost.”

“A government stake in banks might help ease the inevitable political fallout.”

The last one here is a lesson Mexico learned after taxpayers nearly revolted. Mexico had basically kept to buying up the bad assets from banks (Paulson plan) without taking equity positions. Years later when these banks got healthy and sold for billions of dollars, taxpayers got nothing. Since the banks wouldn’t have stayed in business without taxpayer money, this was understandably not looked highly upon by taxpayers.

I think the biggest lesson we can learn from all this, though, is that the $700 billion bailout package is just the beginning. Some people just don’t get this point, and even think we are going to turn a profit from all of this. I’m hearing all sorts of people say that this isn’t a bailout deal, it is an investment, and we are going to make loads of money. When I hear that I just chuckle to myself, because I know that it isn’t going to happen that way. Of course that won’t stop politicians and supporters from telling people that in an effort to ease objections, but hopefully you see through these false hopes. This isn’t an investment where we hope to make money; it is an investment to stave off danger and save our financial system. The final price tag is likely to be in the trillions and we are going to be paying for this for years.

With Controlling Interests In Banks, Britain Forces Lending

We talked a little last week about how Britain bailed out several large banks and, in the process, took large equity positions in them. Now the U.S. is looking to do the same thing. In the latest turn of events, though, Britain is exercising their newfound power in these companies by forcing them to increase their level of lending. In fact, these banks are being required to meet or exceed their 2007 lending level for the next three years, according to Bloomberg. To give you an idea of how far lending has fallen this year, the amount of new mortgages created this August was one third the amount created in August 2007, according to Bloomberg. Along with the new lending requirements, these banks will be required to cut board level bonuses for the year as well.

This is an interesting strategy and you can bet the U.S. is watching closely. The main problem with the U.S. strategy is that it will not guarantee that banks are going to start lending again, and if they don’t, then all of the new measures would have been taken in vain. Our economy in its present form cannot function without credit, and right now it just isn’t available. The British have the same problem that we do and they decided to force the issue now that they have control over the banks.

The U.S. has control over Fannie Mae and Freddie Mac, so conceivably they should already be able to pump up mortgage originations just by making some adjustments there. Getting desperately needed funds to small businesses is a little more difficult, but they could utilize the SBA and make those loans easier to get. Forcing banks to lend more, though, would definitely jumpstart things. It will be interesting to see how the British plan works out, and whether other countries, including the U.S., follow suit. I definitely see why the British are taking these steps, but I also see the potential for it to backfire if things keep getting worse. After all, there is a reason why everyone is scared to death of lending money right now.

U.S. Prepared To Buy Into Banks

Following in the footsteps of the Bailout plan crafted by the British, the U.S. Treasury has announced that they are prepared to buy ownership interests in Banks in order to help ease the financial crisis. The original plan for the $700 billion allocated for the Bailout was to buy up the toxic assets that are in effect bringing down the bank’s financials. As part of the Bailout Bill, though, the Treasury now has the authority to buy up bank stock, and it appears that they are prepared to do just that. This move is being hailed by many as they would much rather see the taxpayer funds purchase bank stock opposed to toxic debt. Others see potential problems with this strategy.

The main problem that people are foreseeing with this strategy is that banks won’t agree to sell their stock to the government. In addition to the new regulations that would be placed on the banks who utilize this measure, including executive compensation restrictions, there would also be market perception to deal with. According to the New York Times, “Treasury officials worry that aggressive government purchases, if not done properly, could alarm bank shareholders by appearing to be punitive or could be interpreted by the market as a sign that target banks were failing.”

In my mind, though, if we are going to bail these banks out, in the interest of taxpayers this is probably the best plan of action. By purchasing shares in these banks there is the potential that the government’s investment could be recaptured, or potentially we could even make some money on the deal. That would be a nice little bonus, although, at this time the bigger concern is saving the system from complete collapse. Capitalizing these banks should help just as much, if not more, than buying toxic debt from them, and I think the risk/reward scenario for taxpayers favors the bank stock plan.

Banks Increase Lending Standards Across The Board

The July 2008 Senior Loan Officer Opinion Survey on Bank Lending Practices released by the Federal Reserve describes a lending environment that has gotten worse across the board. I won’t bore you with all the details; feel free to click on the above link if you want those (or you can read Mish’s blog post--he does a great job of summing up this report), but I do want to make the point that these numbers are not encouraging. Sure, residential lending standards have increased--I think most people understand that-- but we need to realize that this credit tightening is not confined to just residential real estate. Banks are hesitant to lend to pretty much everyone right now. That includes businesses loans, commercial real estate loans and consumer loans.

Our economy is driven by lending and borrowing--it has to be because we don’t have any savings. It is pretty safe to say that if Americans started buying only what they could afford our economy would collapse. In order to stay afloat, we have to keep borrowing; it is the only way to keep the train chugging in the short term (which is all the government cares about, but I’m not going to get into that). That being said, when lending becomes tighter, our economy pays the price. Borrowed money is our lifeblood, and right now the flow is being restricted. The Fed is trying to do their part by making the money cheaper and more abundant, but unless banks start actually lending out this money, it isn’t going to do them much good.

While lending is the lifeblood of our economy I should also add that it most definitely is toxic. We need to understand that we cannot go on borrowing more money forever. Right now the U.S. economy is acting more or less like a ponzi scheme. Basically that means that they are taking money from investors and the only way to pay these investors back is by bringing on more investors. As long as there is a steady stream of new investors coming in with their money then there are no problems. However, if anything happens to restrict the supply of new investors so that the money they bring in doesn’t cover the payments due to the old investors, then all hell breaks loose. The U.S. government obviously has the trump card in that they can print money at their whim, but we all know where that leads.

Those who want to know more about the U.S.’s addiction to borrowing should check out the new movie I.O.U.S.A. I don’t imagine that the Fed will take these tightening lending standards lying down, though; it will be interesting, to say the least, to see what they come up with to combat them next. They say that inflation is an overriding concern right now, but that shouldn’t keep them contained for too long. The thing investors need to remember is that this party can’t and won’t go on forever. They can drag it out, but at some point people will start heading for the doors.

Time For The Next Wave Of Loan Defaults And Bank Failures

If you thought we were almost through the subprime mess and that things are going to start getting better, you might want to consider this news: According to some financial experts, the subprime problems are only the beginning. Alt-A (low document and stated-income-type loans) and even prime mortgages are starting to see dramatic upticks in their default rates. Alt-A loan defaults have quadrupled to 12 percent from April 2007 to April 2008, and delinquencies on prime loans doubled during that same period, according to the New York Times. The chairman of JP Morgan Chase, James Dimon, called the outlook for these mortgages “terrible” and said he expected losses on the company’s prime loans to triple in the coming months, according to the New York Times. Economist and New York University Professor Nouriel Roubini went so far as to say in a Reuters article that hundreds of banks were going to fail, and the ultimate price to tax payers would likely be between $1 and $2 trillion.

If these Alt-A and even prime mortgages start to go bad, we are going to be in for financial trouble far worse than we’ve seen so far from the subprime meltdown. Subprime mortgages make up only a small percentage of total mortgage loans, and the government was hardly on the hook for any of them. If prime loans start going bad in large numbers, though, we had better watch out. Now that Fannie Mae and Freddie Mac have an unlimited line of credit--and official backing of the U.S. government--taxpayers could potentially have to foot the bill on trillions of dollars of mortgage loans. Worse, though, if either one of these companies--or any of the big banks for that matter--have to seek government assistance it will likely send a tremor through the entire financial industry and economy. How many foreign governments, or anyone, are going to feel good about buying U.S. treasuries when our financial system is falling down around us? And we have to take into account that the government has been trading U.S. treasuries for mortgage debt in order to prop up these financial institutions, so now our economy and dollar are being supported by these mortgage instruments. Not exactly the pillar of safety and security that we would like be supporting our currency.

Jobs are declining, inflation is rising, and now this. I’m not sure exactly how we are going to get out of this mess, but I’m sure the ol’ government has something up their sleeves. I’m sure it will involve some sort of bailout and printing of money, so basically some variation of the status quo. The good news for us is that the world is addicted to U.S. debt, the same way we are addicted to being in debt, and as long as we have our foreign friends paying our way, we will be good. Kind of like the former movie star or sports hero who never has to buy their own meals. We all know what happens to them when they get too old, though, and people stop remembering their greatness. How much longer our run will go on, I don’t know, but I can tell you I certainly am not buying treasuries or financial stocks right now.

So What Happens Now With IndyMac?

Yesterday I wrote about the failure of IndyMac bank and how it was seized by federal regulators on Friday, but I didn’t cover the “what’s next?” aspect. There are a couple of things in particular that investors who have IndyMac loans need to know, and for those without IndyMac loans it is still good information to understand in case you deal with other bank failures in the future.

Some of the most important things that could be impacted by IndyMac’s failure are construction loans. For those who are not familiar with construction loans, typically banks pay out the loans based on certain milestones. So, after a builder gets the foundation done, they receive a payment which covers the expenses until the next milestone, and so on. Well, now all the builders who rely on these distributions to fund the construction of their homes might have some problems. Because the FDIC (who now controls IndyMac) has certain protections, they are able get out of these loans if they so choose.

One developer’s concern was captured in The Wall Street Journal: "’I don't know what's going to happen,’ says Raymond Pacini, chief executive of Hearthside Homes, a small builder based in Irvine, Calif., that has two loans totaling $34 million from IndyMac. ‘We are just waiting for the dust to settle.’” According to the same article, a FDIC representative was quoted as saying the FDIC was prepared to do a case-by-case review of the construction loans. So, if you are a developer with an IndyMac loan, you had better cross your fingers and hope for the best. But if I were you, I would start looking for a backup plan just in case.

Another interesting development, which is not necessarily part of a typical FDIC bank seizure, is that the new IndyMac is putting all foreclosures on hold. The FDIC chairman Sheila Bair has been one of the most outspoken parties about how banks should cut borrowers some slack and really try to work things out before proceeding to foreclosure. Now that the FDIC has taken control of one of the biggest mortgage lenders in the country, Bair has a chance to test out some of her ideas and seems ready to do so. They didn’t specify whether or not they were willing to work out deals with investors who have bad loans with them but, chances are, if you were ever going to be able to cut a deal now is the time. The FDIC is actively trying to sell off IndyMac’s assets and it is very likely that the purchasing party will not be as friendly as Bair wants IndyMac to be.

Lastly, it appears that the FDIC is prepared to let depositors withdraw up to 50 percent of their uninsured deposits at this time according to the Wall Street Journal. This is probably a welcome surprise to most depositors, given the circumstances. The FDIC is hoping that the balance of those deposits will be covered eventually, but that is not guaranteed.

IndyMac Bank Failure: The Latest Casualty Of The Subprime Fallout

On Friday federal regulators seized IndyMac Bank, making it the third largest bank failure in U.S. history according to the Wall Street Journal. The largest bank failure in U.S. history was the $40 billion failure of Continental Illinois Bank & Trust Co. back in 1984. IndyMac Bank held about $32 billion in assets, and it is estimated that the failure will cost the Federal Deposit Insurance Corp. (FDIC) between $4 and $8 billion, amounting to around 10 percent of the fund’s total reserves according to the Wall Street Journal.

If you were to ask why the bank failed you might get various answers, but here is what a couple key players had to say as reported by the Wall Street Journal:

“The director of the Office of Thrift Supervision, John Reich, blamed IndyMac's failure on comments made in late June by Sen. Charles Schumer (D., N.Y.), who sent a letter to the regulator raising concerns about the bank's solvency. In the following 11 days, spooked depositors withdrew a total of $1.3 billion. Mr. Reich said Sen. Schumer gave the bank a ‘heart attack.’”

Schumer responded by saying, “’If OTS had done its job as regulator and not let IndyMac's poor and loose lending practices continue, we wouldn't be where we are today,’ Sen. Schumer said. ‘Instead of pointing false fingers of blame, OTS should start doing its job to prevent future IndyMacs.’”

Personally, I prefer the idea that the bank is reaping the rewards of all the dumb loans they made. How can one possibly justify making high LTV loans to people without verifying their income? Do you think people might stretch the truth a bit if they know you aren’t going to double-check their numbers? Duh. If they actually had proof of their income, then they wouldn’t even need to come to IndyMac: They could get a better loan somewhere else.

The question now looms of whether IndyMac is just one more in a line of many banks which are to fail, or if the carnage is done. If the outlooks of banking regulators are any indication, it is worth noting that they are hiring more examiners and prepared to take a tougher line towards risky banks according to the Wall Street Journal.

I don’t believe that IndyMac will be the last bank to fall at the hands of the subprime crisis, but they very well may be the largest. If you start dealing with anything much larger than IndyMac, the government would likely get more involved in fixing problems before it came to this. I said it after the NetBank failure, and I’ll say it again: If you are depositing money in a bank right now, then make sure that it is an FDIC insured account. Not all deposit accounts are FDIC insured, and the insurance only covers the first $100,000 (and $250,000 for retirement accounts). About 10,000 depositors of IndyMac, with deposits of approximately $1 billion, learned that lesson the hard way, and may receive little if anything. If you have more than $100,000 sitting in a smaller bank deposit account, I would suggest transferring the excess over $100,000 to either a very large bank, or several insured accounts at different banks. Really though if you are going to put your money at risk, you might as well invest it in something that will return a little more than deposit accounts do.

Safe Deposit Boxes: They Aren’t As Safe As You May Think

Safe deposit boxes, kept in bank vaults behind thick layers of steel, are widely believed to be one of the most secure ways to store valuables. However, people should make certain considerations and be aware of certain misconceptions before placing their valuables in a safe deposit box.

One major misconception is that valuables placed in a safe deposit box are covered by FDIC insurance. The FDIC only insures bank deposits in FDIC-insured banks, but safe deposit boxes are not considered to be bank deposits and are not covered. In addition, only banks found to be negligent are legally required to cover losses in the event of damage or theft of a safe deposit box’s contents. Some homeowner insurance policies will cover losses, so check with your insurance provider. Bank robberies and major natural disasters happen more in the movies than they do in real life, so these aren’t huge concerns, but safe deposit box holders should understand the limits of their protection.

An interesting story was published in the BBC today that should be of interest to people who keep their valuables in safe deposit boxes. The story is about a man in India who kept his life’s savings inside a safe deposit box in a bank that developed a termite problem. The bank posted a notice warning customers, but the man did not visit the bank on a regular basis and never saw it. On his next visit to the bank, all he found in his safe deposit box was a pile of termite dust where once there had been money and investment papers. Because the bank posted a notice, and because the safe deposit box itself was not damaged, the bank was not found liable.

The lessons of this story are 1) Make sure you understand exactly what is and is not covered by the bank when you open the safe deposit box, and 2) Make sure you have insurance to protect whatever is not covered by the bank. If you put your entire life savings in one spot, make sure it is 100 percent safe and secure.

Safe deposit boxes have their place. Your valuables are certainly much safer in a safe deposit box than they would be in your home, and many insurance companies will charge lower premiums for coverage of certain valuables if they are held in a safe deposit box. If you are storing investments such as gold or other precious metals, a safe deposit box will probably be your best bet. However, it is important that people understand exactly what they are getting with a safe deposit box, so they do not enter the arrangement with any preconceived notions. If you want to make sure your valuables are protected, ask questions and then get additional insurance if necessary.