Thursday, February 21, 2013 - the Big Coincidence

Note: I will be a speaker at the upcoming 2013 Wealth Protection Conference in Tempe, AZ on April 4^th and 5^th. Click here for details and registration information. Hope to see you there.

The Big Coincidence

by Sinclair Noe

DOW – 46 = 13,880
SPX – 9 = 1502
NAS - 32 = 3131

10 YR YLD + .04 = 1.98%
OIL – 2.23 = 92.99
GOLD + 12.10 = 1577.40
SILV + .12 = 28.78

We had a bundle of economic reports to start the day. Let's run through them. First, the CPI report, which measures inflation at the retail level, shows prices were unchanged in January for the second month. Consumer prices are up just 1.6% in the past 12 months. One striking subset of the CPI report showed energy prices dropping 1.7% in January on a seasonally adjusted basis. Of course we all know that gas prices were climbing almost every day through the month; most likely, we'll see a significant bump in the February report.

A couple of manufacturing reports showed weakness. The Philly Fed's  gauge of regional manufacturing activity fell to negative 12.5 in February from negative 5.8 in January with declines in overall activity and new orders. And Markit, a financial information services company, said its gauge of manufacturing activity dropped to 55.2 in February from 55.8. Any reading above 50 indicates expansion but the purchasing managers index showed a slower expansion, with weaker new orders and employment.

Initial jobless claims rose 20,000 to a seasonally adjusted 362,000 in the week ended Feb.16^th. The number was a smidge worse than expectations.

The Conference Board's Leading Economic Index, or LEI, rose 0.2% in January. The LEI is a forward looking weighted gauge of 10 indicators designed to signal business cycle peaks and troughs. Positive contributions came from stock prices, a leading credit index, jobless claims, building permits, and manufacturers’ new orders for consumer goods and materials. Negative contribution came from consumers’ expectations, manufacturing hours, a manufacturers’ new orders index and manufacturers’ new orders for core capital goods.

Overall, the leading indicators, and for that matter, the other economic reports, point to a relatively sound but sluggish economy.

For now, the Federal Reserve is running the economy. There are limits to their monetary policy powers, but absent any signs of intelligent life forms in Washington DC, the Fed is in charge. Yesterday, we had a glimpse into the Fed policymakers' brains. The markets were a bit rattled to learn that the masters of the economic universe were nervous about QE to infinity and beyond. QE is the Fed's experiment in buying $85 billion a month in Treasury bonds and mortgage backed securities, and flooding Wall Street with cash, in the unrealistic hope that the Wall Street crowd might spread some of the cash through the broader economy. . At the Fed's January policy meeting, some policymakers started to grouse that all those bonds were piling up on the balance sheet and the vaults were getting full, and they would have to stop buying at some point.

Wall Street's response was something like a junkie going cold turkey; shaking, trembling, and wide-eyed paranoia that the Fed would take away their free-money-fix. Of course, that's not what the Fed said; a few of them just posited the idea that maybe, someday, there might come a time when the Fed is no longer involved in the undeclared nationalization of the bond market. Then they looked around and recognized that unemployment is still high, inflation is still tame, growth is still sluggish, and the Congress likes to take razor blades and self-inflict wounds just to test their ability to feel anything.

The next self-inflicted cutting takes place March 1^st. They call it the sequester. The sequester was a result of the wrangling over the debt ceiling in the summer of 2011, when Republican leaders — who had previously passed clean debt increases 19 times under President Bush — demanded spending cuts as the price for averting a default. On the brink of default, Congress passed the Budget Control Act, which enacted immediate spending cuts and created a supercommittee tasked with striking a “grand bargain” to reduce the deficit. The Budget Control Act (BCA) of 2011, passed the House with 269 “yea” votes – 174 Republicans and 95 Democrats. In the 100-seat Senate, Democrats made up most of the 74 "yea" votes, but there were 28 Republicans in that majority, as well. Quite simply, this was both parties. Republicans walked away from the committee after refusing to consider tax increases on the wealthy, setting sequestration into motion. The sequester, which cuts from both domestic and defense spending, was designed to be painful enough that both sides would negotiate to avert it.

Congress is currently on recess until next Monday, leaving just five legislative days until the automatic cuts, known as sequestration, will take effect. The fact that Congress didn't get anything done in 1 ½ years might make you think they won't get anything done in five days. Ever since Senate Democrats unveiled their plan to avert the sequester with a mix of new revenues and spending cuts, there has been no negotiations between the Democratic and Republican leadership offices in the Senate. No discussions about any potential compromises. 

So, here's what happens if or when the sequester kicks in. Because its cuts are across-the-board, the sequester will affect most domestic programs. Jobless workers will lose access to unemployment benefits, while safety net programs for women and children and early childhood education programs will face deep cuts. The sequester will cut funding for law enforcement and border security, food safety, airline travel security, Head Start, disaster relief, and health research. Defense programs will also see reductions. These cuts will have broad ramifications for the country’s recovering economy, pushing it down the austere path Europe has followed into second recessions. Independent reports predict that sequestration would reduce economic growth by 0.6 percent over the year while also leading to the loss of 700,000 jobs. The debt limit fight that created the sequester already pummeled the recovery, and allowing these spending cuts to take effect would cause even bigger problems.

Democrats believe the real action on the sequester has yet to come, and will ramp up in earnest in March. Which means, of course, that the cuts will kick in. Democrats no longer see the sequester as sufficient to force Republicans to cave on new revenues; rather, they increasingly see the looming government shutdown deadline of March 27th as the real means for them to force a GOP surrender.

The idea is that the sequester isn’t as dramatic a deadline as the fiscal cliff and debt ceiling deadlines were. The sequester doesn’t have that immediate shock value. It’s not the kind of thing where people wake up on March 1st and realize it happened. It doesn’t have the sort of acute impact that the fiscal cliff or debt ceiling.

But a government shutdown will get your attention. So the month of March is when negotiations heat up, and right now it appears to be advantage Dems, because there is no other formulation of the sequester that is more appealing than the current formulation. The hit in defense spending is not worse than the hits from agreeing to non-defense discretionary cuts. The House Republican plan would not include any new taxes but it would gut Dodd-Frank Financial reform, and take away funding for Obamacare, and pretty much wipe out the first four years of the Obama administration. So, at the end of the day, the Dems like sequester better than the House Republican alternative, which offers no quarter, and so the Dems will stick to their demands for more revenue. Or maybe both sides will just sit back and see if the other side slices the razor blade too deep and bleeds to death.

And that brings us back to the masters of the economy, the Federal Reserve; they're watching the politicians make a royal mess of fiscal policy and they're thinking about how they will be forced to clean up the mess; especially when they've got a bit of a mess themselves. The cash spigot is flowing and gushing money over Wall Street banks while the Fed's own balance sheet is backed up. And the differential is getting a tad inconvenient.

Bloomberg ran an article yesterday which basically says the Fed is paying the big banks to be big and unwieldy. The larger they are, the more disastrous their failure would be and the more certain they can be of a government bailout in an emergency. The result is an implicit subsidy: The banks that are potentially the most dangerous can borrow at lower rates, because creditors perceive them as too big to fail. How much lower are the big banks borrowing costs?

A couple of economists put the number at about 0.8 percentage point. The discount applies to all their liabilities, including bonds and customer deposits. Small as it might sound, 0.8 percentage point makes a big difference. Multiplied by the total liabilities of the 10 largest U.S. banks by assets, it amounts to a taxpayer subsidy of $83 billion a year. To put the figure in perspective, it’s tantamount to the government giving the banks about 3 cents of every tax dollar collected. It's also the same amount the Fed is spending on QE 3; it's also the same amount of cuts required by the sequester. But I'm sure that's all mere coincidence.

Another way of looking at it; the top five US banks, with assets of $9 trillion, more than half the size of the US economy, aren't really making any money; the profits they report are essentially transfers from taxpayers to their shareholders.  The result is a bloated financial sector and recurring credit gluts. Left unchecked, the superbanks could ultimately require bailouts that exceed the government’s resources. Picture a meltdown in which the Treasury is helpless to step in as it did in 2008 and 2009.

Regulators can change the game by paring down the subsidy. One option is to make banks fund their activities with more equity from shareholders, a measure that would make them less likely to need bailouts. Another idea is to shock creditors out of complacency by making some of them take losses when banks run into trouble. A third is to prevent banks from using the subsidy to finance speculative trading, the aim of the Volcker rule in the US and financial ring-fencing in the UK. Another idea is to take the banks off Federal Reserve induced life support and instead use the money to pay down the deficit without draconian, meat-cleaver cuts to spending and without significant tax increases; and use the savings to grow the economy for everybody, except, of course, the five big banks.

I saw the video of Elizabeth Warren grilling regulators but this article from Time tells the rest of the story:

It's hard to find a serious critic of big banks in Washington. Senator Dick Durbin explained a few years ago that the big banks “own the place.” But there is a new kid in town. Massachusetts Senator Elizabeth Warren was sworn in in January and given a seat on the Senate Banking Committee. Warren is extremely well versed in finance. And last week, the committee held its first hearing of the new year to question regulators about the stability of the nation’s financial system, and to get a progress report on the implementation of post-crisis financial reform.

Warren stole the show, pointedly asking each member of the panel when the last time they had taken a large Wall Street bank to trial, where their misdeeds would be aired publicly. The regulators seemed completely stymied by the thought of actually going to trial and they couldn't give the senator a straight answer. You can see the video online; it's quite enlightening. The implication was, of course, that regulators are either unwilling or unable to take big banks to trial, that they rely too much on mutually agreed upon settlements as penalties for misbehavior, a slap on the wrist, and that this reluctance has created a dangerous culture of impunity on Wall Street.

But Warren’s second point is equally interesting, and perhaps more important to understanding what remains broken about the American banking system. She indicated that the majority of the nation’s big banks are “trading below book value.” The book value of a company is simply the total value of all the company’s listed assets minus its liabilities — in theory, that is, what shareholders would get by selling their company off for parts.

But most companies are worth more than book value. That’s because most firms are more than just a sum of their parts — they possess institutional knowledge, for example, that enables them to turn their employees, equipment, and intellectual property into profits. But lately, the stock market is actually valuing large banks like Citigroup, Bank of America, and JPMorgan, below the value of the company’s stated assets minus liabilities. 

Let’s take the example of Citigroup, which has a market capitalization of $135 billion. In other words, if you had $135 billion, you could buy up all the outstanding shares of Citigroup. But here’s the rub: If you actually add up the stated value of Citigroup’s assets minus liabilities, the bank should be worth at least $190 billion. Theoretically, you could buy up Citi, chop it up, and sell it for parts, and make a tidy $55 billion in profit.

Of course, in a competitive market, this shouldn’t be. Something is amiss, and Senator Warren thinks there can only be two reasons: 1) Banks aren’t being honest about the value of their assets; or 2) The market believes that large banks are too big to manage effectively. In his response, Federal Reserve Board Governor Daniel Tarullo added that regulatory uncertainty may play a role in pushing down the values of bank stocks. But are these the correct explanations?

It would appear that a lack of trust in bank accounting is one culprit for the discrepancy. In a recent cover story for The Atlantic magazine, Frank Partnoy and Jesse Eisenger examined Wells Fargo’s annual report. They found that the vast majority of the assets on Wells Fargo’s books are securities like derivatives and mortgage-backed securities which aren’t traded often or on public markets. These securities are difficult to value, and therefore banks must use estimates when putting together their financial reports. But Partnoy and Eisenger claim the complexity and incentives to hide risk, causes big-bank financial statements to be effectively useless.

Barry Rithotz, CEO and director of equity research at Fusion IQ, commenting upon the article summed up investor’s skepticism in the banking sector succinctly:

Banks are essentially opaque black boxes; banks have purposefully concealed what’s on their balance sheets . . . they are not merely complex, but actually deceptive; investors have no idea what they are buying when they own one of the behemoth money centers like Citigroup, Bank of America, Wells Fargo, or JP Morgan.

So it would seem Senator Warren is on to something when she accuses large banks of being dishonest about the value of their investments. Warren isn’t accusing large financial institutions of outright fraud. These institutions are following the letter of law, and complying with accounting rules from the Financial Accounting Standards Board. But accounting isn’t an exact science, and given enough resources, firms can avoid conforming to the spirit of these rules while still technically being in compliance.

You don’t need to take Warren’s word for it. Just take a look at the bank’s stock prices and decide for yourself. Bank representatives may argue that the $55 billion discrepancy between Citigroup’s market capitalization and book value are due completely to the fear that regulators will increase capital requirements, but does this explanation really pass the smell test?

Regulatory uncertainty may be a factor, but ultimately investors don’t understand what these banks have on their books — and don’t want to be holding the bag when we eventually find out. Remember when we almost had a global financial meltdown in 2008; financial institutions froze, in part because they didn't know the counterparty risk, what the other bankers had on their books. They still don't know, and you don't know, and the regulators don't know.

In a scenario like that, what could go right?