Tuesday, October 16, 2012 - Big Bank Complexity, Debate Drinking Games, Food Supplies Not a Game

Big Bank Complexity, Debate Drinking Games, Food Supplies Not a Game

-by Sinclair Noe

DOW + 127 = 13,551
SPX + 14 = 1454
NAS + 36 = 3101
10 YR YLD +.06 = 1.72%
OIL + .11 = 91.96
GOLD + 10.90 = 1749.30
SILV + .26 = 33.06
PLAT + 5.00 = 1650.00

(audio at MoneyRadio.com)

Today was the biggest gain for the stock markets since early September. What was behind the move? Was it a debate day rally? Was it a Vikram Pandit exit? Was it great earnings reports from some such company? Who knows? It's rarely any one item that moves the market significantly. It is more likely that trading has reached a certain level or a particular moment in time, and the news events catch up with the charts.

Yesterday, the earnings news centered around Citigroup which reported something I still can't figure out; lots of debt that is counted as profit. Today, Vikram Pandit, the CEO of Citi, is gone. Pandit says he left voluntarily; others think he was forced out in a disagreement with the board of directors. The strange part is that Citi has seen a rebound of about 22% in the past 12 months. Pandit has been on the job for about 5 years; he took the job as the credit crisis was about to send the economy into the abyss; now, he walks away when the company has learned to turn debt into profit and appears to be finding stable ground. Citi shares have dropped 90% under Pandit, net of stock splits. The market cap under Pandit declined from about $150 billion to around $100 billion, but the stock price has dropped 90% due to the dilution of shares; lots and lots more shares.

Wilbur Ross, the billionaire investor was on CNBC this morning and he talked about Citgroup, saying: "Think about a Citibank - myriad, complex businesses, each of which is difficult to understand, each of which has different risk matrices. And then compound that by an infinite amount of geography, languages, different regulations, different customs and different markets. It's a lot of complexity to have in any one organization, regardless of how well-run it is.”

Ross went on to say that banks have become “too complex to manage” and will probably return to a simpler business model. "The fact that customers need investment banking services doesn't mean they need to be provided by commercial banks," he said. "I think those are two different questions. I'm not aware that there was great lack of investment banking services available prior to the repeal of Glass-Steagall. I think they're going to simplify themselves, and I think that's to the better." Seems a whole bunch of people now consider the idea of repealing Glass-Steagall is a bad idea.

You might think banking is simple, not complex. You get money from the Federal Reserve, you turn around and put it into US Treasury bonds and you collect the difference. Any dolt can do that. Of course, the board of directors of a major bank demand a little more in the way of performance. You could get into the derivatives business but Jamie Dimon and the London Whale have demonstrated that even the smartest kids on the block can screw up the derivatives trades. So, you might settle into getting free money from the Fed and then loaning it out to actual customers to buy things like houses; but it turns out this can be troublesome.

The New York Attorney General is going after JPMorgan and Wells Fargo for originating mortgages back in the bubble days that were clearly written just because someone could fog a mirror. So, instead of originating mortgages to deserving borrowers, the banks responded like deer in the headlights; they froze almost all mortgage lending. Yes, I know that mortgage rates are at historic lows, but they could be lower. The banks have widened the spread, collecting bigger profits but not passing through the near zero rates granted by the Fed, and at the same time, the big banks are turning down deserving customers.

Now, federal regulators are considering giving mortgage lenders protection from certain lawsuits to encourage lending to well-qualified borrowers. The potential move, which would be a partial victory for mortgage lenders, is part of a broader effort to write new rules for the housing market in the wake of the mortgage meltdown. The proposal for the first time would establish a basic national standard for loans, known as a "qualified mortgage." And if the banks do the actual work of due diligence, they will be rewarded with a legal shield for these high quality or qualified loans. Apparently bailouts and free money from the Fed and wider spreads aren't enough to motivate banks to do the job of banking; they are demanding a “Get out of jail free” card.

News that Spain may be finally willing to request help from its European partners, probably in the form of a precautionary credit line. Despite Greece's talks with its international creditors continuing their stop-start progress, shares across Europe closed sharply higher. We'll see. Spain's many reasons for foot-dragging – which officials claim have more to do with making sure Germany and others will back the bailout than with domestic regional elections – also involve the IMF, whose influence they are welcoming.

The IMF's involvement might be more significant than the actual credit line that Spain would have to request in order to trigger the ECB's bond-buying; some Spanish officials seem convinced that the credit line itself would not have to be used, as the ECB's intervention would mean that Spain could then cheaply fund itself on the markets.

Why welcome the IMF, which is often painted as the beast that squeezes the life out of bailed-out countries? Because it is now showing greater realism than deficit hawks in Brussels, Berlin and Frankfurt about the impact of excessive austerity. In simple terms, the IMF may help ease the deficit targets.

George Soros, of Quantum Fund and Soros Fund fame says the crisis “is pushing the EU into a lasting depression, and it is entirely self-created. There is a real danger of the euro destroying the European Union.” He added: “The way to escape it is for Germany to accept … greater commitment to helping not only its interests but the interests of the debtor countries, and playing the role of the benevolent hegemon.”

In Greece, the Prime Minister expressed optimism that an agreement would be reached that would end once and for all speculation that the country will leave the euro zone and put an end to drachma phobia; but several executives at the same conference indicated they saw little sign of progress in reducing government regulations to encourage entrepreneurship, or in fixing the banking system so that companies can obtain credit; and there was still a chance that Greece would have to leave the euro zone.

Higher gas costs drove up US consumer prices in September for the second straight month. Outside energy, there was little sign of inflation. The Labor Department announced the consumer price index rose a seasonally adjusted 0.6 percent last month, matching the August increase. In the past 12 months, prices have increased 2 percent. That's in line with the Fed's inflation target. Excluding volatile food and energy costs, prices rose just 0.1 percent. In the past year, so-called core prices have increased 2 percent.

Sheila Bair the former Chair of the FDIC has 5 questions for the candidates in tonight's debate. Here are the questions:

1-WILL YOU BREAK UP TOO BIG TO FAIL BANKS?

2- WILL YOU CAP THE ABILITY OF LARGE FINANCIAL INSTITUTIONS TO TAKE RISKS WITH BORROWED MONEY?

3- WILL YOU REQUIRE WALL STREET FIRMS AND OTHERS WHO "SECURITIZE" LOANS TO RETAIN PART OF THE RISK IF THOSE LOANS DEFAULT?

4- WILL YOU END SPECULATION IN THE CREDIT DERIVATIVES MARKETS?

5- WILL YOU END THE REVOLVING DOOR?

The economy has taken center stage in the drama of the 2012 Presidential race. Yet, neither candidate's campaign script acknowledges the connection between our current economic woes and the financial crisis which caused them. Five years after the bubble, financial reform remains a work in progress. So, these are pretty good questions. They probably won't be asked, but they are good questions. Again, feel free to use this as a drinking game. If you actually hear one of these questions asked, then slam back a shot glass of single malt whiskey, and if you hear an actual answer slam down two.

I know that today is the big presidential debate but did you know that today is also World Food Day. I will celebrate by having dinner tonight. I'm lucky that way and I realize not everyone is as blessed as I am.

According to a new report from the United Nations, world grain reserves are so dangerously low that severe weather in the United States or other food-exporting countries could trigger a major hunger crisis next year, Failing harvests in the US, Ukraine and other countries this year have eroded reserves to their lowest level since 1974. As a result of record heatwaves and droughts in 2012, the US now holds in reserve a historically low 6.5% of the corn that it expects to consume in the next year. The simple math is that we are not producing as much as we are consuming.

The UN says prices of main food crops such as wheat and corn are now close to those that sparked riots in 25 countries in 2008. The latest figures released this week suggest that 870 million people are malnourished and the food crisis is growing in the Middle East and Africa. Wheat production this year is expected to be 5.2% below 2011, with yields of most other crops, except rice, also falling. According to the the Earth policy research center, the price of key staples, including wheat and rice, may double in the next 20 years, Food supplies are tightening everywhere and land is becoming the most sought-after commodity as the world shifts from an age of food abundance to one of scarcity. The geopolitics of food is fast overshadowing the geopolitics of oil.

Thursday, April 19, 2012 - Say on Pay Just Says No to Citigroup, BofA Loses by Winning, and the Risky World of Derivatives

DOW – 68 = 12,964
SPX – 8 = 1376
NAS – 23 = 3007
10 YR YLD -.03 = 1.95%
OIL -.01 = 102.66
GOLD +.60 = 1643.60
SILV + .17 = 31.90
PLAT + 3.00 = 1587.00

Vikram Pandit, the CEO of Citigroup was “this close” to a $15 million dollar payday. And then shareholders slammed on the brakes and demanded the amount be toned down. It might be a trend. Wells Fargo and Bank of America will ask shareholders to vote on executive pay in coming weeks, and the results at Citi might influence the voting at Wells and BofA. Yesterday, shareholders rejected the compensation plan of regional bank FirstMerit Corp., of Akron, Ohio. The bank gave its CEO a pay raise to $6.4 million last year from $5.5 million, while its stock fell 20 percent.

“Say-on-Pay” votes by shareholders were a requirement of the Dodd-Frank financial reform Act, and it looks like 90% of the compensation packages are winning approval, but the margin is slim. The Occupy movement plans to protest at 36 shareholder meetings this spring and the investment community seems to be waking up from a long nap of disengagement. The California Public Employees Retirement System, or CalPERS, voted no on the Citigroup pay measure because Citi “has not anchored rewards to performance.”

Unfortunately, the only reason CalPERS voted against the pay package was because Pandit's performance was beyond incompetent. What is the appropriate role for CalPERS? Shouldn't they stand up for their members? Chief executives at some of the nation's largest companies earned an average of $12.9 million in total pay last year -- 380 times more than a typical American worker. Average CEO pay rose 14% compared to 2010, when they earned $11.4 million on average. Disparity is one thing, under-performance is another.

Pandit raked Citigroup shareholders over the coals. He sold his hedge fund and pocketed $165 million, then he took a $37 million dollar signing bonus, then he lost hundreds of millions of Citi's money, and he presided over some of the worst possible performance you can imagine for a shareholder. On a split adjusted basis, one share of Citigroup stock was valued at $536 five years ago; today it is worth $34. Last month, Citigroup failed the Federal Reserve's Stress Test – that means no dividends for shareholders. The vote against Pandit's pay package was not about income inequality, it was only about the truly terrible job Pandit has done, driving share price into a ditch, failing to achieve regulatory minimums, pushing one of the biggest banks in the world to the very edge of insolvency. Citi would be insolvent right now if not for ongoing government support.

Bank of America issued a first quarter earnings report today. The report included this gem: “Results Include Negative Valuation Adjustments of $4.8 Billion Pretax, or $0.28 Per Share, From the Narrowing of the Company’s Credit Spreads.” I'll try to explain: If a bank’s own debt securities are falling in price, it effectively means its liabilities – the amount it owes — are worth less. Accounting rules say that’s positive for the balance sheet, and the decline in liabilities can therefore show up as a gain in the income statement. But in the first quarter, certain Bank of America debt securities were worth more, which means those liabilities increased in value, and that therefore produced a loss, of $4.8 billion, in earnings.

Not all of a bank’s debt gets adjusted in this way. And, yes, it seems absurd that falling debt prices – a sign that investors think a bank is less creditworthy – should lead to a gain in profit. In theory, if Bank of America defaulted on its corporate bonds, they could post a huge profit and the CEO would probably get a bonus.

At some point, there will be another major bank failure; we can't continue to allow such insane accounting to continue at the banks; we've gone from sublime to absurd to just downright stupid. And even worse, it's really dangerous. A listener passed along an article from Seeking Alpha that looks at the risk we are really exposed to.

The entire US GDP is less than $15 trillion each year. The gross notional amount of derivatives issued in the USA is more than $291 trillion. Now people say you can’t use the “notional” value, that it's misleading. Another number is the "net current credit exposure" (NCCE) which is only about $370 billion (only); this number is supposed to represent risk imposed by derivatives, but it doesn't provide the ultimate exposure to loss, it just measures the cost of unwinding the contracts. Then there are “value at risk” calculations; those are very inconsistent; the banks tried to use “value at risk” about 4 years ago to measure the fallout from the subprime mortgage market. That didn't work.

In reality, it is impossible to know the true risk of $291 trillion in New York issued derivatives. And there is more than $400 trillion more in London based derivatives. And even if nobody knows the true risk, it is highly likely that a fairly large increase in interest rates would be enough to trigger trillions of dollars in payments. And that means the Federal Reserve can’t raise interest rates. Even if the dollar comes under relentless selling pressure, the Fed can't raise rates. Even if inflation jumps, the Fed can't raise rates.

And part of the problem is where the banks hold their derivatives. All the too-big-to-fail banks are using FDIC-insured depository divisions to house derivatives, with the exception of Morgan Stanley (which uses its SIPC-insured division). That provides them with lower collateral requirements because FDIC depositary units usually have higher credit ratings than investment banks or bank holding companies. Insolvency laws provides priority to derivatives counter-parties over the FDIC. If and when a bank is liquidated, the FDIC will be on the hook to repay depositors, but the failing bank will be stripped of all assets.

Now imagine there is some event that triggers a 1 percent loss in derivatives, or about $3 trillion. The FDIC has about $40 billion in readily available funds, plus a $500 billion dollar line of credit with the Treasury, and ultimately the full faith and credit of the US government. OK, it is highly unlikely that there will be an event that would trigger that big of a problem, what about 0.1% in losses. Still plenty big enough to effectively destroy the FDIC and tip the dominoes in a long, cascading line of defaults.

And don't forget there are more than $400 trillion in derivatives written in London; those are unregulated; good luck trying to find out details on that paper, but you can bet that the US taxpayer is ultimately on the hook for those bets. Part of the exposure is held on the balance sheets of foreign, mostly European banks, including Deutsche Bank, PNB Paribas, Credit Suisse, UBS, and the other usual suspects. But, a large number of seemingly foreign derivatives is also hidden inside bank divisions, owned by American institutions, who do business in London. Such derivatives are not reported to the Fed, the OCC or the FDIC. Lenient British banking laws insure that these opaque obligations are not subject to public scrutiny.

What could go wrong?

Today, french government officials said the rumor of a credit downgrade is unfounded. There is no new information from any rating agency that would point in this direction. French bond yields jumped on the downgrade talk before recovering. The downgrade speculation comes just days ahead of the first round of voting in France's presidential elections. Standard & Poor's stripped France of its triple-A rating in January. Moody's put a negative outlook on France's triple-A rating in February. Spain's debt problems aren't going away any time soon. It just takes a small glitch to create a big problem.