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.