The Problems in the Financial Sector Are Nowhere Near Over

From IBD:

It's the 5th bank [Wachovia] to agree to repurchase auction-rate securities under pressure from federal and state regulators who said the banks misled investors. It'll buy $8.5 bil worth that investors couldn't sell. Citi, (C) UBS, (UBS) JPMorgan Chase (JPM) and Morgan Stanley (MS) also have agreed to buy back the securities. N.Y. may sue Merrill Lynch over the issue and is probing Fidelity and Charles Schwab. (SCHW)

Here's a list from CNBC of who has settled and for what amounts:

UBS agreed on August 8 to buy back $18.6 billion of debt securities, starting with $8.3 billion from retail and charitable clients beginning on October 31, and as much as $10.3 billion from institutional clients beginning in June 2010. It also agreed to pay a $150 million fine.

CITIGROUP agreed on August 7 to buy back $7.5 billion of its investors' auction rate paper at par to settle charges by the SEC and New York State Attorney General Andrew Cuomo. That would cover an estimated 40,000 retail customers. By November 5, Citigroup plans to have fully reimbursed retail investors. It also plans to try by the end of 2009 to liquidate $12 billion of debt held by more than 2,600 institutional investors. Citigroup will pay a $100 million fine.

MORGAN STANLEY settled with New York State Attorney General Mario Cuomo on August 14 and agreed to buy back $4.5 billion of auction-rate securities from individuals, charities and small- and mid-sized businesses by Dec. 11 and pay a $35 million fine. It will also reimburse customers who sold debt at a loss.

JP MORGAN CHASE settled with New York State Attorney General Mario Cuomo on August 14 and agreed to buy back $3 billion in debt by Nov. 12 and pay a $25 million fine, and reimburse customers who sold debt at a loss.

At a time when everybody in the financial sector is writing down the value of a bunch of these assets, we're seeing some of the largest firms buy-back more trash. This will make the next few quarters of earnings releases that much more interesting.

All of these firms settled these ARS cases very quickly -- as in within a few months of the investigation opening. As a lawyer this signals one point very clearly: somewhere all of the companies have a gaping liability somewhere. And that liability is industry wide. The lawyers looked at this situation and said, "you have no choice but to settle this thing." Bottom line: there was some serious misrepresentation/misdirection going on with all of these firms and they were caught red-handed.

But that's not where the problems end. In fact --- the problems are still really bad:

Let's look at this week's Baron's article on Fannie and Freddie:

Similarly, the balance sheets of both companies have been destroyed. On a fair-value basis, in which the value of assets and liabilities is marked to immediate-liquidation value, Freddie would have had a negative net worth of $5.6 billion as of June 30, while Fannie's equity eroded to $12.5 billion from a fair value of $36 billion at the end of last year. That $12.5 billion isn't much of a cushion for a $2.8 trillion book of owned or guaranteed mortgage assets.

What's more, the fair-value figures reported by the companies may overstate the value of their assets significantly. By some calculations each company is around $50 billion in the hole. But more on that later.

.....

Note, too, that Fannie and Freddie have nonpareil lobbying operations and formidable political strength, owing to their hefty donations and penchant for hiring former political operatives. Besides, the agencies claim they've landed in their current predicament through no fault of their own. As Freddie Mac Chairman and CEO Richard Syron recently put it, the GSEs have been hit by a "100-year storm" in the housing market, accentuated by some higher-risk mortgages that they were forced to buy to meet government affordable-housing targets.

The latter contention is more than disingenuous. A substantial portion of Fannie's and Freddie's credit losses comes from $337 billion and $237 billion, respectively, of Alt-A mortgages that the agencies imprudently bought or guaranteed in recent years to boost their market share. These are mortgages for which little or no attempt was made to verify the borrowers' income or net worth. The principal balances were much higher than those of mortgages typically made to low-income borrowers. In short, Alt-A mortgages were a hallmark of real-estate speculation in the ex-urbs of Las Vegas or Los Angeles, not predatory lending to low-income folks in the inner cities.

.....

The cost of selling new preferred stock, meanwhile, would seem to be prohibitive for Fannie and Freddie. The dividend yields on their preferreds have soared to around 14%, in part because of a recent rating downgrade by Standard & Poor's. Yields that high would blight the future earnings prospects of both concerns.

Should the agencies fail to raise fresh capital, the administration is likely to mount its own recapitalization, with Treasury infusing taxpayer money into the enterprises, according to our source. The infusion would take the form of a preferred stock with such seniority, dividend preference and convertibility rights that Fannie's and Freddie's existing common shares effectively would be wiped out, and their preferred shares left bereft of dividends. Then again, the administration might show minimal kindness to preferred shareholders; local and regional bankers have been lobbying the Bushies not to wipe out the preferred since the bankers own a lot of that paper and rely on the bank preferred-stock market for much of their own equity capital.

An equity injection by the government would be tantamount to a quasi-nationalization, without having to put the agencies' liabilities on the nation's balance sheet, and thus doubling the U.S. debt. Treasury would install new management and directors at both, curb the GSEs' sometimes reckless investment and guarantee operations, and liquidate in an orderly fashion the GSEs' troubled $1.6 billion in on-balance-sheet investments. Then the companies could be resold to the public without their explicit government debt guarantees, or folded into government agencies like Ginnie Mae or the FHA.

Let's look at the above mentioned bullet points with the following fact in mind: Fannie and Freddie touch some 70% of the US mortgage market. In other words, they are vital to the current US housing market -- now more then ever. They are simply too big to fail.

1.) They are essentially worthless entities based on immediate liquidation value. This is not the first article to make this claim. Mish has been all over this story, and I pointed out last week that there were serious questions regarding Fannie and Freddie's balance sheet valuation.

2.) They are making political claims (all this regulation made us do this) when in fact they were like everyone else in the financial sector over the last cycle. Company X engages is risky lending behavior and increases their earnings for a few quarters. Now their competitors have to engage in the same behavior in order to "keep up with the Jonses". The bottom line is Fannie and Freddie bought crap loans in order to protect their market share.

3.) The Treasury Department asked for essentially an unlimited bailout facility from the government to deal with Fannie and Freddie:

First, as a liquidity backstop, the plan includes an 18-month temporary increase in Treasury's existing authority to make credit available for the GSEs. Given the difficulty in determining the appropriate size of the credit line we are not proposing a particular dollar amount. Flexibility is the best means of increasing market confidence in the GSEs, and also the best means of minimizing taxpayer risk.

Second, to ensure the GSEs have access to sufficient capital to continue to fulfill their mission, the plan gives Treasury an 18-month temporary authority to purchase - only if necessary - equity in either of the two GSEs.

Basically, the Treasury can inject however much money they think is necessary. The only reason they would ask for a facility of this magnitude is if they thought the problems with both GSEs were really large.

4.) We've seen the financial sector raise a ton of cash in the last 6-12 months, only to see all of that money go up in smoke. How many more times can Wall Street go to investors -- hat in hand -- and ask for more money? Take a look at the charts:

Notice the following points on the five year chart of the financial sector ETF:

Prices consolidated in 2004 and 2005, essentially moving sideways between $27 and $30 (roughly). Prices rallied from the end of 2005 until the beginning of the third quarter 2007. Also notice the index formed a double top in 2007 with the first top occurring in the first quarter and the second top occurring at the end of the second quarter/beginning of the third quarter. Then came the beginning of the financial market problems when Bear Stearns (remember them?) announced they lost $6 billion in two hedge funds. That's what started the giant cliff-diving move down.

Also note the following

-- The average is trading near the lowest level in 5 years.

-- The average is clearly moving in a lower low/lower high pattern.

On the daily chart notice the following:

-- The 200 and 50 day SMAs are moving lower--

-- The 10 and 20 day SMAs are moving higher. These SMAs have done this several times over the last year. However, the 50 day SMA has rebuffed these move convincingly.

-- Prices are in a clear lower high/lower low pattern

The daily charts longer-term indicators (50 and 200 day SMA) are down while the shorter-term indicators (10 and 20 day SMA) are up. This tells us the current moves are temporary.

But the fun doesn't end there (click on link for a video snippet):

Merrill Lynch, Wachovia and other financial companies are at risk of failure as the cost of raising capital soars at a time when the banks need to pay settlements over auction rate securities, David Kotok, chairman & chief investment officer from Cumberland Advisors, told CNBC Monday.

The cash companies need to shore up bad investments, "is up to about $50 billion and will probably top $100 billion before it's over," he added.

Refer back to point number three from the above discussion of Freddie and Fannie's problems.

Here's the real bottom line: the problems in the financial sector aren't over by a long-shot.

Comments

[rogerP]

The way I see it.
Financial sector: This sector manages & supplies the medium of exchange
Manufacturing & farming sectors are the sources of real wealth.
Retail sector: buys sells buys for profit only. This sector is the primary source
for the accumulation of money witch in turn is entrusted to the finance sector.
This sector is not satisfied with just managing it also sells money (interest)
and creates new money (credit) A wonderful machine for creating BUBBLES
the source of DEPRESSIONS
Consumers (this is all of us) produce absolutely nothing no wealth of any kind.
Corny isn’t it!

[leftLibertarian]

The banks gave credit to anyone with a pulse - this included not only mortgages for homes, but loans for cars, boats, RVs, you name it. Housing is just the tip of it all.

[CharlesMac]

Part 1

The Wall Street Casinos jumped on their settlements because the legal boundaries have been set, and at a small fraction of the ARSs they were involved with. there are $380billion out there.

A great deal of the total story of these ARSs lies beyond the Houses.

These Houses are not the issuer of the original ARSs, unless it was a ARPreferredS used in a closed end fund for additional leverage (won't discuss these). The vast majority of the issuers are municipalities (let's include hospitals etc in this group) and your not-for-profit State Tuition Assistance Agency (about $90B). The Houses would securitize the ARS (it is actually a long term bond, with maturities as long as 50 yrs), run (and grease) the auctions, and only collect fees.

The real $100s of billions are on corporations' balance sheets. The Houses offered the "same-as-cash" ARSs to companies to park cash. they could get it back quickly, 7 days, until the Houses stopped holding and supporting the auctions. Plus, debtbacked securities died in general.

Companies had to move $billions, from lifeblood "Cash and Equivalents" to "Long Term Investments" on their balance sheet. (Check AEO's and BBBYs financials as examples). And at some point they will have to mark-to-market these illiquid assets, for which there is no primary market.. Yikes.

Obviously widget companies aren't in the longterm investment business, And the economy is making free cash flow a challenge. But that is only half the damage.

[CharlesMac]

Part 2

When an ARS "bond" fails at auction, its interest yield can jump substantially (some older ones asmuchas 12%) for the guy stuck with it. Which is a plus on a list big list of minuses. Who is going to have to service that?

The municipality or the Tuition Aid Agency. Municipality ARSs jump higher, because the Tuition Aid Agency is passing out gov't guaranteed loans. The municipalities with falling tax base can't afford a huge interest accrual. And the Tuition Agency operates on a razor thin margin to provide inexpensive money and can't afford a couple of extra points . In 14 states, these agencies are now forced to get private money. Which is why your kid's college loan is at a sucky rate.

This is barely skimming the issue. If they knock off the 250 word thing, I 'll give you 1500 words to show how the destruction of these ARS's is only beginning.

[TooLooze]

Oh this just can't be true. My Morgan Stanley guy was just telling me that the economy's recovery is just around the corner. I hope to work alongside him as a greeter at Walmart soon. I'm planning on investing in Chinese made blue vests.

[Rokjok777]

"Watering the tree from the top..."
That is a lovely metaphor, just perfect.
What needs to happen first in my view is a total repudiation and utter discrediting of the governing philosophy that got us here in the first place. Reagan started it; Repubs embraced it; Dems enabled it as it became like Received Wisdom: Just Give Corporations Everything They Want and It Will All Work Out.
Like communism, now utterly discredited as a truly failed philosophy and ridiculed across the world, this Republican philosophy needs to be "outed' and needs to get what it deserves as it is assigned to the trash heap of history.
Foxes cannot be trusted to guard henhouses, it's as simple as that. If allowed to, all they do is eat all the chickens in one sitting. Then they starve, too.

[olephart]

My apologies for this novel:

This is in some ways like the inflation Carter faced in 1977. The models used did not account for the increase in income that many in the middle class received from the sale of their inflated houses. They therefore fought a non existent recession for three years and let the inflation they inherited explode.

Today the Fed has lowered interest rates and printed money while the Government is spending money and handing out cash like drunken sailors. Both the monetary and fiscal stimuli are maxed out. Liquidity is flowing into the dry sponge of the corrupted Financial Institutions not into the economy. Cash from debt derived Government spending goes through the hollowed economy once and then goes out the door into our current accounts deficit. The engine of growth is still stalling and the economy threatens to go into a tailspin. Once again they are fighting the wrong problems. This is not just a monetary or fiscal dilemma. This is a fundamental structural problem years in the making. In Einsteinium terms, this is a rip in the fabric of space time.

[olephart]

2

Three converging policies have created this Perfect Storm of disaster.

The supply side theory of watering the tree at the top has again proven to be a charade to simply transfer wealth up the income ladder. The monies that flowed to the top had no directed purposes except the exponential increase in wealth of its recipients. The corollary to this scheme was giving earnings from non productive investments a tax preference over earnings from both productive investments and labor. As was the case in the 1980s, the only lasting commodity of supply side economics is debt.

The Conservative theory that regulations impede business and therefore productivity has again proven to yield the same results as in preceding economic catastrophes. The deregulation of Financial Institutions is the 1980s yielded the Savings and Loan debacle. The absence of regulations in the 1920s led directly to that financial meltdown. Now hundreds of billions of dollars are required to fix a system that is inherently corrupt, devoid of scruples and can ONLY function effectively with the guidance of strong third party oversight.

[olephart]

3

The stake through the heart of the middle class came from Reagan's push to destroy the Unions, the outsourcing of manufacturing jobs via one way trade treaties and the total capitulation of Government to Corporate America. This has resulted in the stagnation of wages in the lowest four income quintiles of the economy. What Corporatists failed to understand was that each downsized, wage starved recipient of their policies was somebody's customer. By collectively reducing their costs they collectively reduced their own incomes. The only reason that it has gotten this far is an unremitting accumulation of consumer debt to make up for the loss of viable income. Now that the merry go round of "equity" spending has come to an abrupt halt the feces has hit the air handling device. To add injury to insult, the Bush policy of not enforcing immigration laws or more specifically the laws against the hiring of the undocumented has "insourced' millions of people out of jobs. This together with keeping the minimum wage stagnant for 10 years has crushed to bottom two income quintiles. The price of hard, semi skilled labor has been cut in half while hard unskilled labor is barely paying over the minimum wage. With 24 million extra hands to hire there is NO incentive for an improvement in wages, benefits or working conditions. The purchasing power of the bottom has fallen to third World levels. The poverty created in Mexico by their oligarchs has been exported to us.

[olephart]

4

The cherry on the whip cream is the criminal energy policies of this Administration. It's as if they are trying to destroy the Nation. Whether through creating tensions in the Middle East, allowing speculators to run amok or blocking alternatives to oil this Administration has directly caused the outflow of trillions of dollars to pay for this commodity. Seventy cents of each dollar spent on oil leaves the country immediately.

Therefore, no amount of monetary or fiscal tweaking will have any effect on the basic problems. Financial and Corporate integrity must be instilled into the equation. What seems oxymoronic must be made a reality. It may require the failure of many of the now present players to force the remaining into a common order for their own survival. It is only when America can once again generate good paying jobs that the problems will begin to be solved. It is only when policies are in place that reward American Companies to produce in America for Americans that money will circulate through the economy instead of out of the economy. When Americans build and create alternate energy sources that allows the monies spent on energy to remain in America jobs will multiply. When those on the bottom can once again do more than just survive on a day to day basis and have something to move up to then we will turn around.

[zizyphus]

What we are heading for is an America where the working poor are trapped in our country, with only low paying jobs, up to our necks in debt for our whole lives. The system won't work to the corporatists' satisfaction until everyone is broke, and willing to take any crappy low wage job to avoid starvation. Most jobs by then will involve security-keeping the poor under surveillance and control.

Even now, illegal checkpoints are being set up in cities, where randomly, without probable cause, people in cars are pulled over and asked for their papers. They want all state IDs to contain RFID tracking devices in them so that Americans can be tracked like dogs. And if we don't stand up for our constitutional rights, we will be treated like curs.

The deliberate decimation of our economy has hurt only the workers. It is time for a resurgence of the unions, without which we are headed for the ultimate totalitarian society. I know, the unions are often corrupt. What isn't? What to do?

[FogBelter]

Bonddad ... from the Federal Reserve Bank of New York: Fedpoint Reserve Requirements page:

"Reserve requirements, a tool of monetary policy, are computed as percentages of deposits that banks must hold as vault cash or on deposit at a Federal Reserve Bank.

Reserve requirements represent a cost to the banking system. Bank reserves, meanwhile, are used in the day-to-day implementation of monetary policy by the Federal Reserve.

As of December 2006, the reserve requirement was 10% on transaction deposits, and there were zero reserves required for time deposits."

I read that as the Banks having 10% of their reserves on hand or at the Fed for immediate access if needed. That sounds like 90% of their assets can be used for investment.

My question is, Bonddad, in light of the current mess with exotic securities (CDOs, CMOs, CLOs) where do you think we stand in terms of Bank solvency in general?


http://www.newyorkfed.org/aboutthefed/fedpoint/fed45.html

[joebhed]

Maine-ah ?

I think the most useful resource out there for understanding the fractional reserve banking system is the recently updated and revised edition of the FED's "Modern Money Mechanics".

You are right that the COMMERCIAL BANKS are tied to the more-or-less 9 to 1 debt-to-equity leverage ratios.

But the unregulated, so-called, investment banks have no such limitation.
They often create debt at a ratio of 20 or 30 times the amount of their equity holdings.

Once commercial banks use their power to create the debt of the mortgage, they sell it to "whomever", usually an IB, and restore their own ability to re-lend.

As to those reserve requirements representing a cost to the system, without them there would be no monetary base, and you could see where that might go.
Besides, I believe that these reserve deposits receive interest payments - subject to check.

I hope Bonddad tries an answer to your question on overall banking solvency.

[themodernleader]

The banks have speculated with derivatives and othere innovative financial instruments. These instruments are bringing down these banks 'too big to fail." This Treasury Department and Fed's policy is to use American currency to back stop worthless debt. Now Bernacke is beginning to wonder how much backstopping our currency can absorb. He has already backstopped up to about 500 billion. Yet, the economy keeps contracting and the financial system remains dysfunctional.
Bernacke and the Treasury Secretary's false assumption that this economic, financial crash is of the same nature as the 1929-34 crash results in the puzzling unanticipated anomaly that flooding the financial system with liquidity is having virtually no influence on incipient decline. These despicable leaders message the facts and operate from a doctrine of fanatically-held-crack-pot economic theory. They will leave their offices in shame and therir country in a more weakened condition than any civilized country in the history of human enterprise. Bondad, how does this assessment match with your conclusions and predictions?

[Robert59]

Bonddad,

Thanks for another informative post. You need to be syndicated. I think Wall Street, the Fed, and the Treasury Department all know we have a tidal wave offshore headed straight at us. Their strategy is to delay its arrival until after the election.

Are they trying to influence the outcome of the election? You bet. Republicans fear Obama.

What I don't understand is why? Warren Buffet is backing Obama. And why isn't the Obama campaign making this part of their advertising campaign?

[kimyo]

bonddad, at several points in your coverage of the financial crisis you have reassured your readers that a collapse is very unlikely.

would you please provide your take on the royal bank of scotland warning referenced below? why don't you consider a 'full fledged crash in global stock and credit markets' to be possible?

"The Royal Bank of Scotland has advised clients to brace for a full-fledged crash in global stock and credit markets over the next three months as inflation paralyses the major central banks."

"The RBS report warns that the S&P 500 index of Wall Street equities is likely to fall by more than 300 points to around 1050 by September as "all the chickens come home to roost" from the excesses of the global boom, with contagion spreading across Europe and emerging markets."

from the telegraph, 19/06/2008:
http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/06/18/cmstockmarket18.xml&CMP=ILC-mostviewedbox

[zizyphus]

Those of us at the bottom of the food chain, closest to the earth, have been predicting a depression the likes of which our nation has never seen. We are planting more fruit trees, turning lawns into gardens now. Should you pull your cash out of the bank and hide it somewhere, before your bank collapses? Something to consider, as even the local credit unions are starting to fold now.

The fantasy world we have all been living in, that denies the fact of it's unsustainability, is about to come to it's ignominious end.