A distracted and preoccupied
amateur is no match for a determined, organized professional with a strategy.
Though the collapse of the shadow banking system was a near fatal miscue for
the global bankers, they have been quick to adjust their strategy. With an
army of MBAs, quants and lobbyists they have reworked their strategy at the
expense of the still comatose and shaken taxpayer.
It is the first anniversary
since April 2nd when FASB 157 was suspended and with it the suspension of
'mark-to market' accounting. The US congress held a gun to the head of the
Financial Accounting Standards Board a year ago. Congress left FASB no choice
but to change their guidelines under the perception that it was a deferral,
allowing time for the banks to adjust the toxic and devalued assets on their
books. Where are we a year later with Mark-to Market still 'on hold' and
Mark-to-Myth endorsed by the Federal Reserve Bank examiners? Frankly, the
'happy face' media doesn't want to talk about it, so I will. As an investor,
unlike politicians and the media, I must face reality or I will pay the ugly
consequences.
In January's EXTEND
& PRETEND - An Accounting Driven Market Recovery, I outlined the
accounting changes that had been implemented to ignite a market reversal and
rally from the March 2009 low. These accounting changes ranged from the
deferral of FASB 157 in March 2009, the Commercial Real Estate Loan Workout
Policy in October 2009, the three cauldrons easing in November 2009, the
deferral of FASB 166 and 167 in December 2009 and the System Wide Federal
Bank Examiner Reinforcement Training in January 2010. The changes were
executed in a controlled and almost militaristic operation. The market has
reacted with a 58.4% retracement of the 2008 decline and a 70% increase from
the lows in the DOW industrial, trumpeted eagerly by the nightly news. This
was Stage I.
Before we discuss Stage II,
which will be the manufacturing of a "Minsky Melt-Up", let's
briefly review the extent to which Stage I has created distortions in the
accounting of public traded financial fiduciaries. We will then be able to
see clearly how they have created the launch pad for Stage II.
STAGE I - AN ACCOUNTING
ORCHESTRATED RALLY
The Friday Night Lottery
Almost every Friday night the
FDIC seizes from 1 to 5
local or regional banks as insolvent failures. Saturday morning we wake
to find these bankrupt banks have been magically merged with another bank. It
all seems so normal. But does that speed and ease sound realistic to you?
According to Karl Denninger at
The Market Ticker who
follows these matters very closely, on March 6th
he reported:
I am constantly amused by
those people who claim there is some vast "conspiracy" in this
country when it comes to banks, balance sheets, and fraudulent lending and
accounting. There is no conspiracy. It is, in fact, "in your face"
fraud. The FDIC does us the courtesy of explaining it virtually every Friday
night, right on
their web page. I am simply going to take last night's bank closures,
which numbered four. One of them has no "deposit insurance fund"
estimated loss available, because they didn't find someone to take the assets
- they're just mailing checks. But the other three do.
1- Waterford Bank,
Germantown MD: $155.6 million in assets, $156.4 in insured deposits. They
were "underwater" by $800,000, right? Wrong: Estimated loss, $51
million. That is, the assets of $155.6 million were overvalued by
approximately 30% at the time of seizure.
2- Bank of
Illinois, Normal IL: $211.7 million in assets, $198.5 million in
deposits. They were "underwater" by $13.2 million (which is why
they were seized), right? Wrong: Estimated loss $53.7 million. That
is, the the assets of $211.7 million were overvalued by more than 25% at
the time of seizure.
3- Sun American
Bank, Boca Raton FL: $535.7 million in assets (so they claimed anyway),
$443.5 million in total deposits. Heh, why did you seize them - they have
more assets than liabilities? Oh wait: Estimated loss: $103.8 million,
so the actual assets are worth $443.5 - $103.8, or $339.7 million. That is, the
assets of $535.7 million were overvalued by a whopping 37% at the time of
seizure.
This isn't new, by the way. In
August of 2009 I went through Colonial Bank's failure based on BB&T's
presentation to its shareholders on the "merger" - and gift it was
given by the FDIC. It too showed that Colonial had been carrying assets on
their books at a ridiculous 37% above where BB&T ultimately marked
them as a whole.
Folks, your bank is being
assessed deposit insurance premiums to pay for these losses. You
are paying these losses through increased fees and interest expense on your
credit cards and all other manner of borrowing. You are paying for
outrageous, pernicious and endemic balance sheet fraud. There is no
conspiracy. It is right under your nose. One of these three banks, based on
their balance sheet, wasn't even underwater - it was "to the good"
by nearly $100 million dollars. The balance sheet was a flat, bald-faced
lie. You want to sit for this? Why should you?
Now let's ask the inconvenient
question:
Are the big banks -
specifically, Citibank, Bank of America, Wells Fargo and JP Morgan - all
similarly overvaluing their assets?
Why should we believe they are
not? You can go through more than a year's worth of FDIC bank seizure
information and in essentially every single case you will find that
overvaluations of somewhere from 20-50% have in fact occurred, yet not
one indictment for book-cooking has issued.
So let's be generous and
assume that the "big banks" are over-valuing their
assets by 25% - the lower end of the range of what the FDIC says is, through
actual experience, what's going on, and add it all up.
Bank
of America shows $2.25 trillion in assets.
Citibank
shows $1.89 trillion in assets.
JP
Morgan/Chase shows $2.04 trillion in assets.
Wells
Fargo shows $1.31 trillion in assets.
This totals $7.49 trillion
smackers.
The FDIC's experience with
seizing banks thus far suggests quite strongly that all four of these
entities are lying about these valuations, and that were they to be seized
the loss embedded in them (and for which you, the taxpayer would be
responsible) is somewhere between $1.49 and $2.99 trillion dollars.
Incidentally, neither the
FDIC or Treasury happens to have either $1.49 or $2.99 trillion laying
around, and it is highly questionable if they could raise it, should that
become necessary. Now
of course neither you or I can prove this is correct. However, we can look at
the FDIC's own published bank closing statements, and derive from them a
pattern stretching back more than a year now that has disclosed that in
essentially each and every case the banks in question have overvalued
their assets by anywhere from 20-40%, and that as of the day of the
seizure such an overvaluation was in fact a continuing and ongoing
practice. (1)
This was precisely what was in
the process of happening, as I outlined in EXTEND
& PRETEND - An Accounting Driven Market Recovery.
If you were a bank, why would
you lend to small business or the consumer with their inherent risks when you
could play the Friday Night Lottery? As A bank CEO you would ensure that you
have plenty of cash ready to buy and take over the depositors (whose assets
you desperately need), while having most of the bad debt written off and then
likely getting very favorable FDIC guarantees for quickly taking the banks
off FDIC's highly depleted balance sheets. I imagine every US bank CEO &
his/her Board of Directors watch these results closer than the March Madness
basketball rankings!
To facilitate these bankrupt
banks being taken over so quickly, there is obviously a considerable amount
of very secret negotiations (non transparent, non public bidding)
taking place behind the scenes. Like we saw with TARP (Troubled Asset Relief
Program), it is amazing how much money gets spilled when everyone is in a
frenzy to feed at the government trough.
It's Only Going to Get
Worse
The biggest financial issue
with local and regional banks is their commercial real estate loans with
building and construction loans being the worst.
The official government stance
as stated in the February report
from the Congressional Oversight Panel makes for sobering reading. It
forecasts $200 to $300 billion in losses coming from commercial real estate
(CRE) loans. The report notes these were not considered in the famed stress
tests, since that process looked only through 2010, when the losses from CRE
will peak later. It outlines that:
- Between 2010
and 2014, about $1.4 trillion in commercial real estate loans will reach
the end of their terms. Nearly half are presently underwater, that is
the borrower owes more than the underlying property is currently worth.
- Commercial
property values have fallen more than 40 percent since the beginning of
2007.
- Increased
vacancy rates, which now range from 8 percent for multifamily housing to
18 percent for office buildings, and falling rents, which have declined
40 percent for office space and 33 percent for retail space, have
exerted a powerful downward pressure on the value of commercial
properties.
- The largest
commercial real estate loan losses are projected for 2011 and beyond;
losses at banks alone could range as high as $200-$300 billion.
- The stress
tests conducted last year for 19 major financial institutions examined
their capital reserves only through the end of 2010. Even more
significantly, small and mid-sized banks were never subjected to any
exercise comparable to the stress tests, despite the fact that small and
mid-sized banks are proportionately even more exposed than their larger
counterparts to commercial real estate loan losses.
- A
significant wave of commercial mortgage defaults would trigger economic
damage that could touch the lives of nearly every American.
- Empty office
complexes, hotels, and retail stores could lead directly to lost jobs.
Foreclosures on apartment complexes could push families out of their
residences, even if they had never missed a rent payment. Banks that
suffer, or are afraid of suffering, commercial mortgage losses could
grow even more reluctant to lend, which could in turn further reduce
access to credit for more businesses and families and accelerate a
negative economic cycle.
- It is difficult
to predict either the number of foreclosures to come or who will be most
immediately affected. In the worst case scenario, hundreds more
community and mid-sized banks could face insolvency. Because these banks
play a critical role in financing the small businesses that could help
the American economy create new jobs, their widespread failure could
disrupt local communities, undermine the economic recovery, and extend
an already painful recession.
The Chair of the Congressional
Oversight Panel, Elizabeth Warren, in an
interview with Charlie Rose on NPR stated:
CHARLIE ROSE: Commercial real
estate, what are we looking at.
ELIZABETH WARREN: Oh golly --
2,988 banks that by the terms of their own regulators are too concentrated in
commercial real estate. These are the medium size banks. By the end of this
year, half of all commercial real estate loans will be underwater, and they
are coming in '11, '12 and '13.
The reason this is such a bad
problem anyway -- think about that, nearly 3,000 banks out of a total of
8,000 -- it's the very banks that do small business lending who are about to
get socked in the nose on real estate, commercial real estate losses.
CHARLIE ROSE: So we'll see
banks going under because they've got too many loans out there are not being
repaid?
ELIZABETH WARREN: We're seeing
banks that don't want to lend because they see every dollar that comes in the
door and say "I've got to hold on to it to try to fill my commercial
real estate hole or else I will be gone."
Home Equity Loans (HELOCS)
I find it amazing that with
all the talk about government programs to keep people in their foreclosed
homes, with government incentives to increase home sales, with new home
construction at a near standstill and home prices finally reaching some sort
of bottom (near term), we never talk about the billions of Home Equity Loans
that were taken out from 1996 onward. Does it pass your common sense test
that people would stop paying their mortgage, car payments, credit cards and
yet still pay their Home Equity Loan? I don't think so. But the banks have
written down next to nothing here. This is the issue with Mortgage
write-down. If you write down the mortgage, by definition the Home Equity
Loan is now a 100% write-off. Ouch! Doesn't anyone remember this graph which
was so prevalent only a few years ago?
This is an absolute huge
problem and is presently being hidden behind all the mortgage foreclosure
coverage. Amherst Securities, according to Reuters,
has said "commercial banks hold approximately $767 billion of the total
$1.05 Trillion of second mortgages outstanding, with the Big 4 holding over
$400 billion alone." Reuters
estimates that if the banks mark down the entire portion of home equity debt
that exceeds home value values, the net of estimated reserves would be:
$37.2 billion for Wells Fargo
$29.9 billion for JP Morgan
$28.6 billion for Bank of America
$11.5 billion for Citi
=====
$107.2 billion
If we were to write down these
unsecured home equity lines by only 40%, then the potential increase in
regulatory capital for these 4 banks increases by: $3.1B for Wells Fargo,
$1.3B for JP Morgan, $2.1B for Bank of America and $1.0B for Citigroup.
Nothing is being done, nor is anything being forced by Federal Reserve Bank
examiners to be done.
I could go on about shadow
housing inventory, 'jingle' mail and 'strategic defaults', the python in the
pipe with Option-ARMS, the failure of HAMP etc., but I am sure you have heard
all you want to hear about housing to know the banks have yet to effectively
address the issue. Like landmines the issues still lay on their balance
sheets.
Because of this situation, the
banks still minimally require 40% higher collateral values. So how are they
going to get it?
STAGE II --
MANUFACTURING A MINSKY MELT-UP
My grandfather, who was proud
to keep his farm during the depression, had an expression that I haven't
heard in a long time. He was fond of warning that: "Banks lend you an
umbrella when it is sunny and then demand it back when it starts to
rain!" It has been a long time since we have had a 'rainy' economy for
any protracted period of time, but to this prairie farm boy the economic
weather forecast doesn't look that good.
We therefore need to remember
some basics of banking. First, banks make money borrowing short and lending
long. This strategy is inherently risky. This is why banking requires
extensive regulatory laws and ever vigilant bank examiners. Neither are to be
'tampered' with, which our politicians now seem oblivious to.
Secondly, inflation and
deflation are different for banks. The Consumer Price Index and how much
food, energy, consumer staples etc have increased is not highly relevant to
banks. Inflation or deflation to banks is about asset price increases or
decreases. It is about whether their collateral positions are increasing or
decreasing. I don't mean to be too simplistic here since cost of money is
critically important, but it serves to make the point that bank strategy is
driven by their view of the direction of asset prices and whether their loans
are covered, their capital ratio requirements are secure or what a new risk
adjusted loan is worth to them. What does the chart below say about where
banks view asset prices to be headed?
Banks win on asset inflation.
Banks potentially lose on asset deflation. Rising asset prices:
1- Make Collateral more valuable or easier to secure for banks
2- Raise borrowing levels with which to finance higher priced asset prices
which increase interest payments and fees.
If banks thought collateral
values were headed lower, here is what they would do:
|
1- Freeze
new loans secured by collateral that will potentially deflate
|
In Process
|
|
2- Seize
existing loan collateral on defaulted loans before collateral falls below
book value
|
In Process
|
|
3- Demand
higher collateral levels for loans
|
In Process
|
|
4- Charge
higher rates and tighter terms
|
In Process
|
Banks need asset values to
continue to climb. Now that the markets have reached 'nose bleed' levels and
appear to be at the stage of looking for a consolidation, the banks need
another strategy to ignite asset prices further. The banks must see higher
asset prices to have any hope of achieving satisfactory Capital Ratios with
the known amounts of bad and toxic debt still on their books. Is it any
wonder banks are now making their profits primarily in their trading
operations driving asset prices higher and with their Interest Swap where
they are squeezing collateral call levels? (see: SULTANS
OF SWAP: The Get Away!)
MANUFACTURING A MINKSY
MELT-UP
If the banks wanted to get
collateral values up, and manufacture a 'Minsky Melt-Up' here is what some of
their strategy elements would call for:
I am not saying that a
successful Minsky Melt-Up will be achieved or in fact could be successfully
manufactured. Frankly, I would be very skeptical if it weren't for the fact
that former Federal Reserve Chairman Alan Greenspan specifically said this
could not happen (He also stated that market bubbles could not be identified
by the Fed nor addressed with Monetary Policy (yeh right)). His views
have typically been my contrarian indicator which has given me an investment
edge over the years. Before reading Alan Greenspan's 'Greenspeak', consider
that we presently have unstable economic policies, risk premiums have been
high and the Fed has successfully inflated a bubble in the Bond Market over
the last 20 months through QE (Quantitative Easing).
...Greenspan said
"because the markets themselves are asymmetric: they melt down, but
don't melt up!" Mr. Greenspan argues:
(1) the ironic result of successful stabilization policies is a journey to
excessively-thin risk premiums, and if
(2) history has not dealt kindly with the aftermath of protracted periods of
low risk premiums, and if
(3) asset prices do not tend to melt up but do tend to melt down, then
(4) logic implies that the fattest fat-tailed secular risk to price stability
is deflation, not inflation.
How so? If bubbles are the
ironic externality of successful stabilization policies, then those policies
can be successful only so long as there are asset classes that the central
bank can inflate into a bubble. When there are no more free and clear assets
to lever up, the game ends in a debt-deflation. As the great Hyman Minsky intoned,
stability is ultimately destabilizing! That is the logical consequence of
too-successful inflation stabilization. Don't call it a conundrum, but rather
a dilemma, if the Fed were to set and achieve a too-narrow target zone for
inflation. (2)
If according to Hyman Minsky,
protracted periods of market stability leads to instability and a market
meltdown, does this preclude therefore that protracted periods of market
instability negate the possibility of a market melt-up (per Greenspan)?
I intentionally phrased the logic for this argument in perfect 'Greenspeak'
fashion so we can all remember exactly how we got ourselves into this global
predicament in the first place.
CONCLUSION
This is a well executed
strategy. It has been almost militaristic in its execution - all the elements
from a solid communications program (i.e. CNBS hype), accounting and
regulatory changes (FASB 157, 166, 167 deferrals et al ), government
statistics (does anyone actually still believe the CPI, Labor Report or other
government statistics any more?),
and public's sentiment through the controlled market perception barometer
pumped at them every evening on how well the DOW Industrials are doing. The
US economic and financial situation has now reached a point where the
potential crisis could be referred to by our government interventionists as a
matter of national security. This is precisely why I am leaning towards a
Minsky Melt-Up being successfully manufactured.
There is an old market saying:
"Don't fight the Fed!" This market guideline has never been
truer. In fact today it is more appropriate to say:
"It is impossible
to fight central bank planning"
To fight the central party planning (i.e. shorting an artificial market)
exposes your wealth to being officially confiscated!
Sounds like something Karl
Marx would have said?
Sign Up for the next release
in the Extend & Pretend series: Commentary
SOURCES:
(1) 03-06-10 All You
Need To Know About Bank Balance-Sheet Fraud The Market Ticker
(2) 08-03-06 Paul
McCulley and Doug Noland Both Praise Hyman Minsky Economic Dreams
(3) 04-06-10 New
NYSE Options Pricing Pyramid Promotes Derivative Driven Market Melt-Up
Zero Hedge
(4) 04-08-10 Home
equity horror Reuters
The last Extend & Pretend
article: EXTEND
& PRETEND - Hitting the Maturity Wall!
