Thursday, February 07, 2013 -

Waiting for the Apocalypse

by Sinclair Noe

DOW – 42 = 13,944
SPX – 2 = 1509
NAS – 3 = 3165
10 YR YLD -.02 = 1.95%
OIL - .74 = 95.88
GOLD – 6.30 = 1672.00
SILV - .39 = 31.56

Some day this war will end. Some day we will have an apocalypse, not in the terrifying version of the word but in the original Greek definition of “apokalypsis”, meaning an “uncovering”, a “lifting of the veil”, or “the disclosure of something hidden”. One day we will wake up and realize that money is printed out of thin air and it is not a store of wealth but a vessel of debt; the veil will be lifted and we will see the debt masters for what they truly are. Until then we get little surprises in the form of troves of emails revealing the reality that the financial markets are not bastions of cool rationalism, nor are they temples to integrity; and the lubricant of commerce may be nothing more than a tar pit.

We have been reading the emails from Barclays, UBS, and S&P describing how they would rig rates or rate deals for a cow if only they could get their cut. Sometimes the language is clipped in an instant messaging style of prose, sometimes it is profane in a way that would make Tony Soprano blush, and it seems to be flowing forth in a never-ending stream of culpability. Some day this war will end. But not today.

Today we learn of the emails from JPMorgan Chase and they show that executives at the firm knew there were problems; an outside analysis discovered serious flaws with thousands of home loans; the executives responded by slapping lipstick on a pig. Rather than disclosing the full extent of problems like fraudulent home appraisals and overextended borrowers, the bank adjusted the critical reviews. As a result, the mortgages, which JPMorgan bundled into complex securities, appeared healthier, making the deals more appealing to investors.

We learn this because of a lawsuit against JPMorgan filed in Manhattan by the French-Belgian bank Dexia, which went belly up after buying into the lipstick slathered securities which of course, ultimately imploded. Documents filed in federal court include internal emails and employee interviews. After suffering significant losses, Dexia sued JPMorgan and its affiliates in 2012, claiming it had been duped into buying $1.6 billion of troubled mortgage-backed securities. The latest documents could provide a window into a $200 billion case that looms over the entire industry. In that lawsuit, the Federal Housing Finance Agency has accused 17 banks of selling dubious mortgage securities to the two housing giants, Fannie Mae and Freddie Mac. At least 20 of the securities are also highlighted in the Dexia case.

The Dexia lawsuit centers on mortgage-backed securities created by JPMorgan, Bear Stearns and Washington Mutual during the housing boom. As profits soared, the Wall Street firms scrambled to pump out more investments, even as questions emerged about their quality. JPMorgan scooped up mortgages from lenders with troubled records. In an internal "due diligence scorecard," JPMorgan ranked large mortgage originators, assigning Washington Mutual and American Home Mortgage the lowest grade of "poor" for their documentation. The loans were quickly sold to investors. One executive at Bear Stearns told employees "we are a moving company not a storage company." As they raced to produce mortgage-backed securities, Washington Mutual and Bear Stearns also scaled back their quality controls.

Washington Mutual cut its due diligence staff by 25 percent to prop up profit. A November 2007 email from a WaMu executive described the cutbacks as steps that "tore the heart out" of quality controls. The email said: executives who pushed back endured "harassment" when they tried to "keep our discipline and controls in place.” Even when flaws were flagged, JPMorgan and the other firms sometimes overlooked the warnings.

JPMorgan hired third-party firms to examine home loans before they were packed into investments. Combing through the mortgages, the firms searched for problems like borrowers who had vastly overstated their incomes or appraisals that inflated property values. An analysis for JPMorgan in September 2006 found that "nearly half of the sample pool" - or 214 loans - were "defective," meaning they did not meet the underwriting standards. The borrowers’ incomes, the firms found, were dangerously low relative to the size of their mortgages. Another troubling report in 2006 discovered that thousands of borrowers had already fallen behind on their payments.

And what did JPMorgan do when confronted with the defects? They ignored them or they whitewashed the findings or they just lied about them. Certain JPMorgan employees, including the bankers who assembled the mortgages and the due diligence managers, had the power to ignore or veto bad reviews. In other words, they knew the mortgage backed securities they were bundling and selling were full of garbage loans and they just didn't give a damn about it as long as they could sell it. Of course we all know that employees and analysts and due diligence directors say the darnedest things in emails, but if the emails reveal what the investigators think they reveal; then JP Morgan actually defrauded its clients, and the bank and its executives should obviously pay a big price for that.

Jamie Dimon, the CEO of JPMorgan has tried to differentiate his bank from the rest of Wall Street. He recently lashed out at what he called the “big dumb banks” that “virtually brought the country down to its knees.”

If this sounds like yesterday's news or the news from 5 years ago; well, it is but it is also tomorrow's news. Some four years after the 2008 financial crisis, public trust in banks is as low as ever. Sophisticated investors describe big banks as “black boxes” that may still be concealing enormous risks, the sort that could again take down the economy. In the fall of 2008, when the meltdown hit, all the banks stopped, well they stopped pretty much everything, they stopped lending to each other; they stopped trading with other banks, and the reason they stopped was because after Lehman Brothers was allowed to collapse, no one understood the banks' risks. There was no way to look at a bank's disclosures and determine whether that bank might implode.

Was any given bank the next IndyMac, was it the next Northern Rock, the next Dexia? Did JPMorgan have toxic assets on their books or had they already dumped their trash on Dexia? JPMorgan was supposed to be one of the safest and best-managed corporations in America. Jamie Dimon, the firm’s charismatic CEO, can charm the cufflinks off journalist in New York or high rollers in Davos, and he had kept his institution upright throughout the financial crisis, and by early 2012, it appeared as stable and healthy as ever. And then the London Whale washed up on the banks of the River Thames.

The London Whale ran a little bit of a trading desk, and he had gambled away $6 billion, maybe more; investigators are still investigating; still the losses are not enough to destroy the House of Morgan, even though it wiped out one-third of the market capitalization. After all, JPMorgan is considered to have the best risk management operations in the industry.

And what this really tells us is that they haven't learned how to manage the risks; in part because the culture is corrupted. JPMorgan started reporting small losses, then they had to admit that its reported numbers were false. Federal prosecutors are now investigating whether traders lied about the value of the London Whale's trading positions as they were deteriorating. JPMorgan shareholders have filed numerous lawsuits alleging that the bank misled them in its financial statements; the bank itself is suing one of its former traders over the losses. Jamie Dimon didn’t understand or couldn’t adequately manage his risk, or maybe he knew and just slapped some lipstick on the pig. Investors are now left to doubt whether the bank is as stable as it seemed and whether any of its other disclosures are inaccurate.

And of course, it's not just JPMorgan; that is just the biggest player. Toss in Libor rate rigging from Barclays, UBS, and RBS. Toss in money laundering from HSBC and Standard Chartered, and don't forget robo-signing from a host of banks more concerned with being moving companies than storage companies; more concerned with their own profits than with pesky legal details like due process. And only after the fact do we see the emails that provide the colorful stories of how the banks misled clients, sold them garbage and then bet against them.

So, the question is: do you trust the banks? Chances are you answered “no”. Depending upon the survey, about 4 out of 5 people say they have no trust in our financial system; and I doubt the fifth person holds the banks in high regard. And four-and-a-half years after the meltdown, the Too Big To Fail banks are bigger than before, and because they've received get out of jail free cards they operate with impunity and disregard for the rule of law or requirements for transparency. The Geithner Policy insured the banks did not have to change their wicked ways; they were too big and too systemically important to be bothered.

Do you know what the banks have on their books? Are the assets vintage or toxic? You don't know because the banks are a black box of disclosure. And guess what? Jamie Dimon doesn't know how much risk JPMorgan is taking. And if he doesn't know how much risk his own bank has, then there is no way he knows about the garbage the other banks hold on their books. And here is the big problem. All it takes is a bump in the road and the financial institutions will freeze up once again.

Some day, the veil will be lifted. Some day the we will learn the secrets. Some day the war will be over.

Not today.

Last summer, Boeing's top management axed the engineer CEO who had been turning around BCA, [Boeing Commercial Airplanes, and making it better again. They replaced him with a non-engineer CEO. Then, management got into a confrontation with the engineer's union (which may also partly be the union's fault, but it's not a battle management can afford right now). Then the top management indefinitely postponed, in other words they killed off, the very promising 777X , new long-range, highly efficient model. These moves were on top of a 787 development model that de-emphasized in-house engineering and relied on industry partners for much of the development work. Since the 787 appeared to be out of the woods, there wasn't much need for R&D and engineers and new-fangled planes.

Then a 787 Dreamliner caught fire, and then another; batteries exploded and it was a bit of a problem. Back in Seattle, engineers, represented by a disgruntled union and forced to report to multiple layers of non-engineer management, are working overtime on the problem, but after several weeks, nobody appears to be close to a solution. And once they do find a solution, they will have to go through a process of re-certification. That process might take 6 months, maybe longer.

That is the background for Boeing's fourth quarter earnings report this month. The 787 problem wasn't discussed, except that the investigation was continuing and couldn't be discussed and 787 production was continuing full speed ahead, despite uncertainties about what needed to be done for the battery system, or any other aspects of the plane's design. If these planes being built need major retrofitwork in the future, well, that's for the engineers to worry about.  Apparently, the executives in Chicago didn't get the memo that the entire fleet of 787's has been grounded.

American Airlines' parent AMR Corp. and US Airways Group are within a week or two of finalizing a merger that would create the world's largest airline by traffic. The new company would be worth more than $10 billion, and the deal would be an all-stock transaction that would take place as part of the reorganization that would take American Airlines out of its Chapter 11 bankruptcy protection. The deal under discussion would give American Airlines creditors about 72% of the new entity and US Airways shareholders about 28%. There would be huge expenses with integrating the two companies and the merger process might cause some disruptions to customer service; and after a merger it's unclear if they will have a significant competitive advantage over the other big competitors, now whittled down to just three, but it would keep the new American-slash-US Air in the arena. And it would likely mean higher airfares for the rest of us.

For most of 2012, small-caps and large stocks slogged through the market ups and downs like white on rice. But since the market began to move off its November bottom, the Russell 2000 small-cap index has outpaced the Dow Jones Industrial Average by a wide margin. The Russell is up an impressive 18% since its November lows, while the Dow has risen about 11.5% during the same timeframe. Risk on.

Last month, 11 European countries, including France and Germany, moved forward on introducing a minuscule tax on trades in stocks, bonds and derivatives. The tax goes by many names. It's often called a Tobin tax, after the economist James Tobin. In Europe it goes by the more pedestrian financial transaction tax. In Britain, it goes by the wonderful Robin Hood tax.

A transaction tax could raise a huge amount of money here in the US and cause less pain than many alternatives. It could offset the need for cuts to the social safety net or tax increases that damage consumer demand. How huge a sum? An estimate from the bipartisan Joint Committee on Taxation, which scores tax plans estimates the tax could raise: $352 billion over 10 years.

The money would come from a tiny levy. A bill that might be introduced next month calls for a three-basis-point charge on most trades. A basis point is one-hundredth of a percentage point. So it amounts to 3 cents on every $100 traded. Critics claim the tax will harm our capital markets and won't raise that much money. They argue that such a tax cannot be enforced; that it will depress trading, leading to lower asset prices; and that it will ultimately be passed on to retail investors. If some kind of increase in taxes is inevitable, one that takes aim at high-frequency traders doesn't seem so bad.