Thursday, May 17, 2012

Thursday, May 17, 2012 – Banks Start to Run – by Sinclair Noe

DOW – 156 = 12,442
SPX – 19 = 1304
NAS – 60 = 2813
10 YR YLD -.06 = 1.70%
OIL +.17 = 92.73
GOLD + 34.00 = 1575.30
SILV +.78 = 28.15
PLAT + 19.00 = 1459.00

The Dow Industrials have now dropped for 11 out of the past 12 trading sessions, giving back all the gains going back to the start of the year.

Greece's caretaker Cabinet was sworn in this morning and they'll hold power at least until next month's election.  The European Central Bank has stopped providing funds to Greek banks. People have been pulling euros out of the Greek banks, concerned about a possible exit from the Euro-zone common currency and a return to the Drachma, which would be an effective devaluation. So Greek citizens take their money out the front door of the bank and the ECB refuses to replenish supplies, and something has to give. There will be an election in about one month. There will be attempts to find a resolution. German Chancellor Merkel is even considering lifting the jackboot of austerity from the necks of the Greeks. It is one thing to demand fealty, it is another to consider the very real possibility of a Greek exit from the Euro-union. Germans are starting to realize that a Greek exit from the Euro-union will be very expensive. Everybody is now doing a study to determine how much a Greek exit might cost; the numbers seem to run in the trillions. So, why not find a cheaper solution?

Which takes us to Spain. Bankia, one of the largest banks in Spain, has already been taken over by the government. Today, a rumor started that depositors were pulling money out; a classic bank run; Spain's top economic offical announced this was not a Greek-style bank run. Shares of Bankia slipped 29%, and closed down 14%. Bankia was clobbered by bad real estate loans. The problem in Spain goes straight back to a real estate bubble. We are constantly told the problem in Europe is profligate spending by the crisis countries. Fans of arithmetic know that Italy’s debt to GDP ratio, although high, was actually declining in the years just before the crisis. Spain and Ireland were both running budget surpluses. What did happen was that these countries, especially Spain and Ireland, had unsustainable housing bubbles that were fueled by foolish bankers in Germany and elsewhere in northern Europe. 

The drama served to drive up interest rates on bonds auctioned in Madrid. The situation in Spain is tenuous and the threat of financial contagion is palpable. Unemployment is around 25% and it's estimated that the black market now accounts for about 20% of all economic activity. The underground economy is a double edged sword; it robs the government of revenue but it keeps otherwise unemployed people afloat. Without the underground economy Spain would probably have violent social unrest.

Meanwhile, JPMorgan is having a hard time moving on. Earlier this week, they announced a $2 billion dollar loss in proprietary trades in the derivatives market. The loss has now grown to $3 billion. The trade involved credit default indexes or basically long positions in investment grade corporate bonds and short positions in high yield or junk bonds. This kind of trade is now very illiquid, and now that other traders know JPMorgan needs to unwind their position, they can apply the screws. It is becoming clear that the Value at Risk assessments were wrong, they are losing money faster than they thought possible. How much more will they lose? Nobody seems to know the potential liability, but it seems fair to say things are getting worse, at least for now.

Meanwhile, there are a few investigations into what is going on. The FBI, the DOJ, and the SEC are trying to figure out if any laws have been violated. We don't know what they're investigating. The unregulated world of derivatives would seem to be fertile ground for money laundering and tax evasion but a better guess is something more mundane, such as failure to certify internal controls or improper disclosures. The things CEO Jamie Dimon has said about Value at Risk just aren't adding up. And we learn the Chief Investment Office, the unit responsible for the loss had a separate VaR system. It used a less stringent calculation that gave a lower risk assessment of its trades. The unit also reported directly to Dimon, a factor which allowed it to maintain a separate risk monitoring set-up to other parts of the investment bank. Despite repeated warnings from executives inside the firm as long ago as 2005, the CIO unit remained notably free from oversight. And if there were indeed repeated warnings, then Dimon had a legal obligation to make that information public. He didn't.

The descriptions of the trades as hedges, not speculative trades, don't make sense. They had about $15 billion in distressed European debt. Europe has been in trouble, so those investments were losing value. Their story, which does not make sense, is that they decided to hedge this position with a derivative of a derivative. In this case, it was an index of credit default swaps, which is the form of derivative that blew up AIG. JP Morgan's story is that instead of offsetting the risk, the hedge increased the losses dramatically. They woke up one morning, and they had a $2 billion loss; and 4 days later it grew to $3 billion. If you have distressed European debt, you are supposed to have already reserved against the losses in it. So why hedge the position at all? Just sell it. Get rid of these incredibly risky assets before they can suffer any additional losses. If you already have losses, it is not necessary to recognize a loss, because you have already reserved for it. So, you should not have had to hedge, period.

You may recall that after the Enron debacle, there were laws written to require that financial statements contained truthful information. There are civil penalties for filing false certifications and criminal penalties for fraudulent filings. The law is known as Sarbanes-Oxley, but the reality is that nobody gets prosecuted. Still, if you were investigating Jamie Dimon, it might be a consideration. The problems at JPMorgan appear to be more than a mistake, it looks more like a material breakdown of internal controls and misrepresentations. And it just might be illegal. Not that it will matter much.

Treasury Secretary Tim Geithner said the trading loss by JPMorgan “helps make the case” for tougher rules on financial institutions, as regulators continue to think about the possibility of implementing the Dodd-Frank Reforms and the Volker Rule aimed at policing Wall Street. This would be funny except it isn't. It's dangerous. Geithner made the remarks after it was revealed the White House has been putting pressure on the Treasury Department to push for tougher rules on banks, which would be funny except, earlier this week President Obama was interviewed on the View and he talked about how: “JP Morgan is one of the best-managed banks there is. Jamie Dimon, the head of it, is one of the smartest bankers we got and they still lost $2 billion.” Which would be funny except it isn't. I guess the idea is to force JPMorgan to act responsibly by complimenting them excessively. It's an interesting strategy.

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