Building a Big Giant Enron

Option ARMageddon is claiming that a large portion of Wells Fargo's celebrated earnings report last week is due to accounting changes (ht Naked Capitalism). In other words, there has been no change in the underlying profitability of the firm.

And over at Goldman Sachs, who, praise be, have also returned to profitability. NYT blogger Floyd Norris suggests how they have done this

Goldman Sachs reported a profit of $1.8 billion in the first quarter, and plans to sell $5 billion in stock and get out of the government’s clutches, if it can.

How did it do that? One way was to hide a lot of losses in not-so-plain sight.

Goldman’s 2008 fiscal year ended Nov. 30. This year the company is switching to a calendar year. The leaves December as an orphan month, one that will be largely ignored. In Goldman’s earnings statement, and in most of the news reports, the quarter ended March 31 is compared to the quarter last year that ended in February.

The orphan month featured — surprise — lots of write-offs. The pretax loss was $1.3 billion, and the after-tax loss was $780 million.

Would the firm have had a profit if it stuck to its old calendar, and had to include December and exclude March?

This, of course, was Enron's scam -- to use accounting sleight of hand to turn losses into profits. And now the U.S. is doing it for their whole economy. And there is a good possibility that with changes to accounting rules in Canada, we are doing it to.

Recovery? Not Quite Yet.

From Naked Capitalism, a guest post by Edward Harrison of Credit Writedowns entitled "The Fake Recovery" -- to my mind as good a summary of our present predicament as I have seen.

I include it in its entirety.

I last posted on "Credt Writedowns" on Thursday before the Easter Holidays in two posts very much at odds with one another. The overall thrust of the first post was that the financial services industry in the United States was due to gain from some very advantageous circumstances in 2009. Meanwhile, the later re-post pointed out the continued fragility of the U.S. economy and banking system and focused on liquidity and solvency as unresolved issues. I would like to bring these two posts together here because I believe the concept behind the dichotomy is best described as the Fake Recovery.

Why 'Fake'? This is a fake recovery because the underlying systemic issues in the financial sector are being papered over through various mechanisms designed to surreptitiously recapitalize banks while monetary and fiscal stimulus induces a rebound before many banks' inherent insolvency becomes a problem. This means the banking system will remain weak even after recovery takes hold. The likely result of the weak system will be a relapse into a depression-like circumstances once the temporary salve of stimulus has worn off. Note that this does not preclude stocks from large rallies or a new bull market from forming because as unsustainable as the recovery may be, it will be a recovery nonetheless.

The real situation
In truth, the U.S. banking system as a whole is probably insolvent. By that I mean the likely future losses of loans and assets already on balance sheets at U.S. financial institutions, if incurred today, would reveal the system as a whole to lack the necessary regulatory capital to continue functioning under current guidelines. In fact, some prognosticators believe these losses far exceed the entire capital of the U.S. financial system. Witness a recent post by Nouriel Roubini:

The RGE Monitor new estimate in January 2009 of peak credit losses (available in a paper for our RGE clients) suggested that total losses on loans made by U.S. financial firms and the fall in the market value of the assets they are holding would be at their peak about $3.6 trillion ($1.6 trillion for loans and $2 trillion for securities). The U.S. banks and broker dealers are exposed to half of this figure, or $1.8 trillion; the rest is borne by other financial institutions in the US and abroad. The capital backing the banks’ assets was last fall only $1.4 trillion, leaving the U.S. banking system some $400 billion in the hole, or close to zero even after the government and private sector recapitalization of such banks and after banks’ provisioning for losses. Thus, another $1.4 trillion would be needed to bring back the capital of banks to the level they had before the crisis; and such massive additional recapitalization is needed to resolve the credit crunch and restore lending to the private sector.

Now, obviously, if we were to face up to this situation, there would be no chance of recovery as the capital required to recapitalize the banking system would mean a long and deep downturn well into 2010 and perhaps beyond. This is not politically acceptable as 2010 is an election year. Nor is the nationalization of large financial institutions acceptable to the Obama Administration. Moreover, bailing out banks to the tune of trillions of dollars while the economy is in depression is equally unacceptable to the American electorate. The Obama Administration is keenly aware of this fact.

These constraints, some artificial and others very real, leave the Administration with limited options.

Engineer recovery
With the preceding constraints in mind, we should remember that the first priority of elected officials in Washington is not necessarily to make the best long-term choices for the American people, but rather to get re-elected in order to have the opportunity to make those choices. It should be patently obvious that a downturn which began in December 2007 would be fatal to many politicians if allowed to continue well into 2010. This is why recovery of some sort must take place before that time - irrespective of whether it is sustainable.

How to engineer recovery is another question altogether. Here again there are a set of political constraints which make things more challenging. First, there are large swathes of the population that are uncomfortable with the huge debt load and deficit spending that a stimulus-induced recovery creates. Moreover, a government-sponsored nationalisation or recapitalisation plan would only increase this deficit spending and these debts.

As a result, the Obama Administration has crafted a plan to circumvent these obstacles.

1. Moderate fiscal stimulus. The Obama Administration decided not to seek massive stimulus earlier this year because they deemed it non-viable politically.This clears the first obstacle: deficit hawks. Most economists understand that the output gap that has opened up in the American economy is $2 trillion or more whereas the Obama stimulus package was only $800 billion. That leaves a massive hole in output in the U.S. Moreover, the immediate effective stimulus is less. Much of this 'stimulus' will be saved or will not come into play until months from now. Obviously, this is not going to meet the grade (See my comments on this from February).


2. Quasi-fiscal role for the Fed. Having partially assuaged deficit hawks, Obama still needed to close the output gap. Enter the Federal Reserve. You will have noticed that the Federal Reserve has added legacy assets as eligible for the TALF program. In effect, this allows banks to slip tens or even hundreds of billions of dollars in so-called toxic assets off their balance sheets. Mind you, these are assets already on the books impairing banks' ability to loan money. Under normal circumstances, one would expect the Federal Government to take these assets out of the system (bad bank, good bank, nationalization) after being given legislative approval to do so. However, as I have previously stated this approval is not going to be forthcoming. This is why the Federal Reserve is taking these assets on. In so doing, the Federal Reserve is taking on a quasi-fiscal role that re-capitalizes the banking system in order to stimulate the economy by increasing credit availability.


3. Quasi-fiscal role for the FDIC. The new PPIP is a similar end-run around Congress. After all, the role of the FDIC is that it "maintains the stability and public confidence in the nation’s financial system by insuring deposits, examining and supervising financial institutions, and managing receiverships." Meanwhile, the PPIP has the FDIC guaranteeing dodgy assets in a massive transfer of wealth from taxpayers to banks and select investors. (See my previous comments on this issue).


4. End of mark-to-market as we knew it. You should have noticed that most of the assets written down in the past two years have been marked-to-market. Securities traded in the open market are marked to market. Loans held to maturity are not. This is one reason that large international institutions which participate in the securitisation markets have taken the lion's share of writedowns, despite the low percentage that marked-to-market assets represent on bank balance sheets. But, this should end because of new guidelines in marked-to-market accounting. However, the new guidelines do have two major implications. First,there are still many distressed loans on the books of U.S. banks that if marked to market would reveal devastating losses. Second, there will also now be many distressed securities on bank balance sheets that if marked-to-market would reveal yet more losses. In essence, the new guidelines are helpful only to the degree that it prevents assets being marked down due to temporary impairment. If much of the impairment is real, as I believe it is, we are storing up problems for later.


5. Interest rate reductions. One reason often given for a large increase in writedowns at financial institutions had been the coming reset of Alt-A adjustable-rate mortgages in 2009. With the subprime writedowns mostly accounted for, a souring of the much larger pool of Alt-A and Prime residential mortgage loans is the real Armageddon scenario. Well, part of this problem has been temporarily relieved because the Federal Reserve has reduced short-term interest rates to near zero and has begun trying to manipulate long-term interest rates lower by buying long-dated treasury securities.


6. Bank margin increases. Key to the whole program is banks' ability to earn massive amounts of money and re-capitalize themselves through retained earnings as opposed to shedding assets or receiving additional paid-in capital (see post from last April on these three methods of recapitalizing). The market for bank assets is distressed and few banks can get enough capital from private sources or investors. Therefore, Obama's plan hinges on the ability to allow these banks to earn shed loads of money as quickly as possible. If the banks cannot do this, we are going to have a big problem very quickly (Of course, I think the can).

The stimulus to come from these measures is still in the pipeline and, by the end of this year, will probably add a big kick to the economy. You should note that only the fiscal stimulus required legislative approval. All of the other 'stimulus' has been done without Congressional approval and largely without Congressional oversight. These activities have been specifically designed to be opaque. The government's claims of wanting to increase transparency ring hollow (see my post on Bloomberg's suit against the Fed as an example of what is really happening).

I should also mention that the Federal Reserve has been a large factor here. It is acting in concert with the executive branch in a non-arms length fashion which I believe will have consequences regarding Fed independence down the line.


Other positive economic factors

There are a number of so-called green shoots (a phrase coined by Norman Lamont) of note.

• Jobless claims have plateaued and comparisons to last year are actually declining (see post).


• The U.S. trade deficit is declining significantly as U.S. import demand has fallen off a cliff.


• Inventory liquidation will put U.S. manufacturers in a better position by Q4 and help make quarterly and yearly comparisons favourable.

I linked to the first two bullets of these other factors. And I wanted to spend a little time on factor number three because I think it is important. Niels Jensen of Absolute Capital Partners has a very solid write-up on this in his most recent newsletter: (do sign up for his free newsletter because it is quite informative. Click here to see the newsletters and sign up.)

Turning my attention to the global economy, after a rather muted beginning, manufacturers around the world have now begun to react aggressively to the economic downturn and inventories are falling aggressively. Chart 5 below depicts US manufacturing inventories as published recently by the Census Bureau. Inventory changes can have a meaningful impact on GDP. There is one example from the 1981-82 recession where the inventory correction subtracted 5% (annualised) from GDP in just one quarter. The current inventory correction is very negative for GDP in Q1 and possibly also in Q2, but it is very difficult to quantify the effect it is going to have. We will have to wait and see.

However, as we must remind ourselves, the stock market is not trading on what is going to happen in Q1 and Q2 of this year. Projecting at least 6-9 months ahead, the stock market is probably already looking ahead to Q4 and possibly even Q1 of next year. And the inventory adjustment currently underway is very bullish for GDP growth later this year and into next. The reason is simple. Manufacturers always overreact. Come Q3 or Q4, they will suddenly sit up and realise that inventories have fallen too much and that they need to produce more. There is no reason to believe that this recession will be any different.

Obviously, this means that U.S. Q1 and perhaps even Q2 GDP will be very low due to the subtraction of inventories now being purged. However, when we get to Q3 and Q4, this effect will be gone and quarterly and yearly comparisons will look favourable. So the inventory purge may mean a huge upside surprise to GDP in the second half of the year and early 2010 - potentially enough to see positive GDP numbers.

A brief reminder of what lurks beneath
Despite the positives from the previous section, there are significant headwinds which may even preclude a positive GDP number. They include:

• Rising joblessness


• Increased savings as households rebuild balance sheets


• Spending cuts by local and state governments


• Decreased capital spending by companies


• A calamitous GM bankruptcy

Moreover, credit availability --and hence GDP will be constrained by numerous factors including the following:

• Declining home values


• Increasing foreclosures


• Commercial property writedowns


• Credit card-related writeoffs


• Junk bond defaults

All of this means that a cyclical rebound is not a foregone conclusion at all.

Tying the threads together
You should be under no illusion that the coming rebound is permanent. Much of it is not. What we are seeing is the makings of a cyclical recovery that might begin as early as Q4 2009 or Q1 2010. How long or robust that recovery is remains to be seen. Moreover, it is still questionable whether we will get any meaningful recovery at all in spite of the 'green shoots' because the banking system in the United States is severely undercapitalised and more asset writedowns are coming due. This is a fake recovery underneath which many problems remain.

Nevertheless, banks are going to earn a lot of money and that is bullish for their shares - at least in the medium-term. Yes, the stock market is overbought right now. However, if banks put together some decent earnings reports over the next few quarters, their shares will rise.

Furthermore, if the banks can earn enough, this cyclical recovery will have legs as banks will then have enough capital to resume lending and that is supportive of the broader market as well. It is still too early to tell how this will play out over the longer-term. For now, I am much more positive on financials, and somewhat positive on the broader market as well.

Taking a Step Back

I haven't commented much on the debate swirling around the vast increase in the profitability of the financial sector, and the contribution to this sector to the greater public good. Though I am still searching for comparable Canadian figures, in the U.S., at the onset of the current crisis, financial sector profits had risen from 20% to 40% of all profits in just a few years. It seems likely that Canadian figures are not all that different.

Why, then, do we allocate so much to this sector? The baseline function of any financial sector is to aggregate resources and efficiently allocate these. But more and more, the corporate sector raises its own resources. Or perhaps it is to develop innovative investment vehicles, but we all know how that has turned out.

I think Yglesias hits the nail on the head

Could it really be the case that so many people were naive enough to trust their monies to institutions that were only claiming to have brilliant investment models? Well, it seems to me that it could. And that this would explain why it might make sense for a firm financial firm to pay Larry Summers $5 million a year for a one-day-a-week job. When your company’s underlying product isn’t necessarily sound, it’s important to invest a lot in marketing. Summers is like a celebrity endorsement. This is also a reason, I think, why having gone to a fancy college seems to have been very helpful for getting a job in finance. The firms’ business models very much depend on putt (ing a certain image of themselves forward.

In other words, as I commented earlier, trust in elite MBAs, buttressed by relentless image building and a unified message (invest for the long haul, don't lock in your losses) have led investors to naively trust financial advisors and to stay with them through a devastating downturn. Our lack of financial superstars in Canada is more than offset by our deference to authority -- even incompetent authority.

Those Amazing, Magic Bank Profits -- II

From Floyd Norris of the NYT. Barclays Bank has discovered another route to instant profitability -- make a loan to yourself! Oh those clever banks.

As Norris describes it:

Barclays, the large British institution, announced a $3.1 billion loan today. And it also promised to keep the loan on its own balance sheet for a year, rather than sell off parts of it to other banks. Even after the year is up, it promises to keep most of the loan.

And who will get the cash from that loan? Barclays itself. It will also be able to report a large profit, of $2.2 billion, which is something every bank needs these days. And Robert E. Diamond, Barclays’ president, stands to take home $6.9 million of the money.

Barclays is selling its iShares business, which puts together exchange-traded funds, to a private equity firm for $4.4 billion, and financing the deal itself. So the cash stays right where it is, but a profit is posted. Mr. Diamond owns a stake in the business, so he gets to share in the bounty. (The bank says he was not involved in the negotiations.)

As with their American cousins, shares leaped on this news. One begins to feel less and less sorry for bank shareholders.

Those Amazing, Magic Bank Profits

Slate is reporting today what the markets told us yesterday: U.S. banks are somehow returning to profitability. But not so fast.

Scroll back less than two weeks to Congressional pressure on the Financial Accounting Standards Board to retreat on fair-value accounting, particularly mark-to-market requirements. On March 30, Bloomberg reported that

Four days after U.S. lawmakers berated Financial Accounting Standards Board Chairman Robert Herz and threatened to take rulemaking out of his hands, FASB proposed an overhaul of fair-value accounting that may improve profits at banks such as Citigroup Inc. by more than 20 percent.

So now, Wells Fargo is reporting a 27% rise in profits. As Howard Cosell used to say: amazing!

Of course, as I noted on March 4, Canadian banks achieved a similar miraculous return to profitability following changes in fair value accounting standards, issued last fall but backdated to the summer, so that fourth quarter profits would shine.

What I cannot understand is how and why sophisticated investors believe this. Putting lipstick on the pig of toxic assets does not alter their pig-like character.

The Three Stooges Meet Wall Street

I couldn't make this stuff up.

One facet of U.S. efforts to inject life into capital markets is a provision in which, for payment of a fee to the Federal Deposit Insurance Corporation (FDIC), financial institutions can have their bonds backed and thus obtain a coveted AAA rating.

On March 9, the FDIC announced that it would be raising this fee for the largest banks effective April 1. And the banks didn't miss a beat in bellying up to the bar before happy hour ended.

Since that time, the banks, led by Bank of America, Goldman Sachs and General Electric, have issued $29.8 billion in bonds, the second highest weekly amount on record (see Bloomberg). Disappointing, but hardly surprising.

What might raise some eyebrows is the rationales offered by the banks. Goldman Sachs said the sale was

consistent with our long-term funding strategy

While Keycorp opined

[the] bond issue was part of our normal funding strategy and not predicated on any change or proposed change in FDIC structure

These folks make Curly, Larry and Moe look like models of sobriety and probity.

Why We Don't Trust Markets -- My Morning Rant

On Tuesday, I had some harsh comments on Citigroup's claim to seemingly miraculous profitability, and the market's uncritical acceptance of the bank's story.

So imagine my chagrin this morning when Bloomberg ran a story that Citigroup executives had pocketed a quick $2.2 million U.S. on the rise resulting from the announcement. And the profits were on shares purchased last week -- i.e. prior to Tuesday's announcement by CEO Vikram Pandit. Surely this is insider trading.

The hapless American taxpayer has watched countless billions thrown at these institutions to avoid financial Armageddon. While this may be necessary, surely the same government that grants these gifts has a moral obligation to investigate, and where necessary prosecute this type of behavior. Bernie Madoff will be a guest of the state for the rest of his life, why not these guys (and they are guys) too.

In my Tuesday comment I said that Citigroup's actions bespoke desperation. I was wrong. If Citigroup executives were long on this trade, one wonders if they had short positions as well when the stock dropped 95% over the past five quarters. In fact, one wonders whether they, or their "masters of the universe" colleagues in general are capable of subordinating self interest to any greater good.

Yglesias on the Banks

Some solid common sense from Matthew Yglesias on bank bailouts, in response to a WSJ piece. Key quote:

You don’t rescue banks by “tak[ing] distressed assets off the balance sheet of Citigroup or other troubled financial institutions.” The problem isn’t the assets, it’s the debts. You can deal with the problem by giving the banks vast sums of money in exchange for their toxic assets but in this case what’s solved the problem isn’t that the assets came off the balance sheet, it’s that the money you gave them got on the balance sheet.

And the key lesson for Canada? You are either paying more than market value for the assets or you aren't doing much to help the banks.

Adam Posen on lessons from Japan

Paul Krugman quotes Adam Posen talking about lessons we should learn from Japan's efforts to recapitalize their banks during the lost decade of the 1990s. Posen underscores the risks involved when these efforts are not accompanied by equity stakes or enhanced regulation:

The result then, and the emerging result now, is that the banks’ top management simply burns through that cash, socializing the losses for the taxpayer, grabbing any rare gains for management payouts or shareholder dividends, and ending up still undercapitalized. Pretending that distressed assets are worth more than they actually are today for regulatory purposes persuades no one besides the regulators, and just gives the banks more taxpayer money to spend down, and more time to impose a credit crunch.

Indeed.

Given depressed share prices, the big five Canadian banks are currently paying historically high dividend rates. Andrew Willis of the Globe and Mail tells how BMO is paying an historically high 10.8% that will capture 80% of earnings. Why?

What about Canada, eh?

One frustration I have had following the economic crisis in Canada is any strong sense of what shape our banks are in. Clearly our banking system is fundamentally different than that of the U.S.. But if the rest of the world was beating a poorly regulated path to these toxic assets, we must have been too. So where are they? And how do they affect the balance sheets of our admittedly more risk averse banks? And what about the non-bank sector, particularly hedge funds and the like?

Is anyone blogging this here in the GWN?