Politics of Exiting from Support for banks.

The difference between book value assets swapped by banks at the Federal Reserve and the Treasury Bills obtained (created by 'valuation margin' plus fees) provided the liabilities side of the ledger for purchase of preference shares in the banks and for Quantitative Easing - and the same is exactly true in the UK. How much and from precisely whom what has been pledged and swapped is unclear except in abstract at high level, with details kept off the reported balance sheet of the central banks. As Ben Bernanke said Nov. 18, '08 to the House Financial Services Committee.“Some have asked us to reveal the names of the banks that are borrowing, how much they are borrowing, what collateral they are posting. We think that’s counterproductive.” Similarly, in the UK, the 2009 banking Bill made disclosure entirely a matter of Bank of England and HM Treasury discretion. There has been partial disclosure in both countries.
There are four purposes served: one, for Government to replace private sector funding of banks' 'funding gaps' (roughly difference between deposits and loans financed on medium term basis by banks rolling over MTN programs that could not be continued when private sector sources dried up in the credit crunch); two, to replace banks' reserve capital eaten away totally by asset writedowns and credit losses; three, to replace ordinary equity with Government-owned preference shares; four, to take troubled assets off the banks' balance sheets for up to 3 years. All this is facilitated by 'buying' in banks' loan assets in exchange for high interest repayable loans and treasury bills paying almost zero coupon. If the banks fail to be able to repurchase their pledged assets when the 3 years is up then Government buys these outright and retains flexibility to pursue for the loan balance, keep or sell the assets.
All this can be very profitable to Government if it retains the holdings well into economic recovery when the loan assets will have gained in value and over a number of years of bank paying interest and fees. But, with signs of junk bonds recovering in market value and banks share values trending up the banks are keen to pay off and take back what they can to enjoy as much as they can of this profit for themselves, and thereby also avoid direct controls and direction from Government. They are beginning with buying back government shareholdings.
Government is anxious to prove politically that the financial measures to save the banking system are only temporary and remunerative for 'taxpayers' and that the federal budget deficit can be narrowed, even though the support for banks was 'off-budget' and never actually a direct cost to taxpayers, except for one early cost items, TARP. Voters remain dismayed at the disconnect between several $trillions Government aid support for 'Wall Street', which seems to be restored to underlying profitability ahead of 'Main Street' i.e. the rest of the economy, which received it seems much less in loans and deficit investment.
Hence, with mid-term elections in mind in 2010, TARF will close to new deals in March and several repayments of government preference share holdings can be headlined. Citigroup and Wells Fargo this week unveiled a total of $30bn in stock raising to return $45bn to Government. This trades off reducing government supervision (seen as intereference in bonuses and lending levels) at expense of diluted shareholders and short-term profits (hitting shareholders and tax payable to Government). While the values are small in terms of obligations to Government (worth circa $3-5.5 trillion depending on how one looks at it or even up to $8 trillion when insurance guaranees are crudely factored in), but large in terms of shareholders' equity. Arguably, this is another blow to the myth of 'shareholder value' at least in short to medium term, and may be seen as bankers protecting themselves and their bonus culture at the expense of shareholders?
The repayments first by bank of America and now by City and WF are intnded to blunt government restrictions on pay and operations – and herald the beginning of the end of a period of extraordinary federal support for leading banks.
On Dec-02..President Barack Obama told bankers assembled at the White House that they should help boost the economy – particularly by helping finance “creditworthy small and medium-size businesses” – in return for the government assistance. “The way I see it, having recovered with the help of the American government and the American taxpayers, our banks now have a greater obligation to the goal of a wider recovery, a more stable system and more broadly shared prosperity.”
For several reasons it is difficult for banks to comply with this as it means switching off their credit risk systems and even pushing loans when borrowers are deleveraging and small businesses seeking to borrow more are viewed as likely to be heading for failure even if only because they are being squeezed to death in many cases by big business customers.
The Citi offering, which could be the biggest yet by a US bank, is another unexpected and unwished-for test of shareholder medium to long term faith in the company’s future. Under the agreement, US Treasury will sell up to $5bn of the bank’s shares, reducing its 34% stake to below 30%. The authorities have agreed to sell the rest of the government’s stake within the next year! Citi will also terminate an agreement with FDIC to backstop $250bn in toxic assets. As a result, Citi will cancel $1.8bn-worth of preferred securities held by the FDIC, leaving the regulator with $5.4bn of preferred shares. Adding insult to injury, as shareholders are diluted Citi will issue $1.7bn in stock to staff in lieu of bonuses and might sell $3bn in preferred securities in 2010. The measures may result in a $10.1bn pre-tax loss in 4th quarter but save Citi $2.2bn a year in interest and amortisation expenses, much of it to Government!
Citi’s stock issue will be accompanied by selling $3.5bn in convertible bonds to bolster its balance sheet but this dilutes the equity of existing shareholders (private $50bn, government $25bn, roughly) by roughly 5%, causing Citi shares to close down 6.3% on the announcemtn to $3.70. But total shareholder dilution could be far more than this?
Wells, which bought Wachovia last year will sell assets worth $1.5bn and save a further $1.4bn by paying employees in stock not cash. Once Citi repays the Tarp funds, Wells Fargo will be the only major bank still in TARP, which helped bail-out capital reserve equity shortfalls in 700 US banks, after Bank of America recently returned its $45bn bail-out TARP funding. But the banks are still heavily obligated to the Government in other programmes including TARF.
All US banks have received balance sheet support worth more than twice all US banks' reserves including support for mortgage assets via Ginnie, Freddy and Fannie agencies, plus other programmes via FDIC. Banks may not be able to repay more than half i.e. about $1 trillion within 3 years, hence another up to $1 trillion is envisaged being sold to Hedge Funds and similar 'Shadow-banking' investors supported by soft loans from the Federal Reserve - why? because shadow banking's normal leverage source has been the banks via prime brokers but they've dried up their risk appetite.

Federal reserve balance sheet

In the USA many commentators are having a panic reaction to the spectacular spike in the federal Reserve's balance sheet e.g. Dr Martin Weiss's newsletter essay titled Bernanke gone Beserk! from which the above and following chart come from. Anyone could say the exact same about the UK's Bank of England (HM Treasury & DMO) balance sheet growth that is more imposing relative to GDP even before the massive £585bn ($936bn) awaiting approval to grow the Bank of England balance sheet dramatically (with the innovation that the assets will be swapped for Bank of England unencashable cheques that the banks cannot remove from the premises - a dangerous innovation only if banks start writing unencashable cheques to each other and treating them as balance sheet items!) There is no comparison with earlier Fed balance sheet hikes; none were of this magnitude or persistence. What is different this time is that the Fed (like the the Bank of England & HM treasury) is substituting for private funding sources to supply funding of banks' 'funding gaps' (previously filled by Medium Term Note & securitization programs). The liabilities that balance the central bank assets growth are heavily discounted securitised loanbooks (discounted below their mark-to-market and/or actual gross defaults impairment), subject to large fees, and with substantial interest margin in favor of the Fed (or Bank of England/ HM Treasury in the UK, or the ECB in the Euro Area). Terms & conditions are renewable every time the Treasury Bills (government securities with less than 1 year maturity) that the assets are swapped for are rolled over. In essence these are major repo swaps but with unusual informal as well as formal conditions attached.
Informally, if no less imposing, the banks must treat the T-bills as reserves they cannot encash except to buy back their pledged assets but must continue to roll-over until the private sector wholesale funding sources are again available at a near to normal price i.e. whatever banks consider safely affordable, though this is a high threshold given the profitable charges & rates asserted by Fed & FDIC. The Fed can sell the assets on as and when it chooses to, whether via the awkward subsidised TARF scheme or any other better one it can come up with. We need not worry this is 'printing money' as if new money injections into the economy and thereby boosting banks' lending capacity and the money supply. It is replacing private funding sources (of 'funding gaps' between deposits and assets much of whose private funding capacity has evaporated. It is a liquidity injection into a falling money supply. This too is very much the conscious awareness of the Bank of England's 'liquidity measures' (including APS, often mistakenly terms asset insurance, when that is the least of it). But net increase in money supply is hard to judge. When banks are shrinking their balance sheets(and hedge funds also) it does not appear in aggregate to be a "printing money frenzy" as Dr Weiss states (& many others) - all else in the monetary context has not remained stable but receded/ fallen. The Fed is filling a gap that has appeared as private wholesale funding capacity has receded, not adding on top to what was there in order to maintain monetary growth stability. It is only by looking only at the surface data of the central banks' balance sheets one can imagine there must be a money supply explosion - not so, and especially not in very low or begative general price inflation.
The superficial impression is that the Fed (Bank of England especially too & others) are behaving totally without precedent, somehow thoughtlessly or carelessly - but is that a realistic presumption? Do they not know what it is they are doing?
It is easy in a 'Federal Tax Dollar' obsessed USA to create panic over this as if the whole amount of Fed balance sheet explosion is tax dollars at risk - much as there is enormous misunderstanding already about the size and affordability to taxpayers (and to the exchange rate of the dollar) of Federal Debt looked at gross. In fact it is not hard to also calculate looking forward that the net returns to the Fed as all this unwinds medium term will generate profit to the central budget or via the Fed debt balances sufficient to pay for more than half of federal budget deficits in the coming years!

10 DAYS UNTIL BUDGET RUNS OUT - not healthy

Congress is behind schedule for passing the bills that authorise spending for the 2010 fiscal year, which starts on October 1st. Congress was to have been well through the process in early summer, but several factors intervened:
1) stress-tests of the major banks to see what capital requirements they will need that could involve some items on-budget (most bank aid being off-budget)?
2) vituperative partisanship over Health Care plans?
3) waiting to see if predicted end of recession has arrived?
4) Republican legislators testing their minority power to see if a possible re-run of Republican stymying of Clinton's 1995/6 budget that partially shut down Federal Government in November and December 1995. This was the culmination of a process that began in '93 around both budget and health care and is being repeated as the tactic against the Obama administration today. The risk today as then is that Democrats lose their slender majorities in one or both houses of Congress as they did in '94.
In 1993, when Clinton squeezed his budget through in June, Republicans were a minority in Congress, but by galvanising their revolt, they recaptured Congress in the '94 year's interims. By failing to pass the '95 budget, and by insisting on a constitutional amendment to enforce a balanced budget by 2000 (which Clinton achieved 3 years earlier much to republican chagrin) the US economy had some growth shaved off and this coincided in '95 with one of the coldest hardest winters on record. Globally, the effect was to panic many OECD countries into thinking another recession dip was imminent in 1995/6 and consequently many, especially, the UK, upped their fiscal stance to compensate. Balancing the US budget and the political power struggles in Congress forced other countries into higher deficit spending.
We may face this in the next 2-3 years again when recovery globally remains fragile! By May '09 it looked like Congress would complete budget appropriations on time. The House passed all 12 of its spending bills. But, then, the Senate passed only four, and all twelve had to go to conference, where House & Senate versions are reconciled. That cannot happen now in the next 10 days, and the struggle to get the budget passed may also be employed to topedo the health care reform bill, on which so much of Obama's political capital is invested!
What happened in the early '90s? In Spring '91 - Minority Whip Newt Gingrich, predicted the "next great offensive of the Left will be socializing health care." He called on hardline Republicans to position themselves to stop Democrats from winning on this. The same strategy has been re-conditioned for use against Obama. In November '91 - arguing that every American should have the right to a doctor, Harris Wofford defeated Dick Thornburgh to become the first Democrat to win a U.S. Senate seat in Pennsylvania in 30 years. In January '92, the Clinton campaign issued a health care white paper as its opening salvo for the 8-month long campaign. In June '92, Clinton began using a new jargon for health care reform called "managed competition." In July, Clinton accepted the Democratic nomination vowing to "take on the health care profiteers and make health care affordable for every family." (Obama, and also Hillary Clinton adopted similar platforms in 2008.) In August '92, when the election was in full swing, Clinton was warned by campaign aides that his position on health care is too unstructured; too unclear to be easily defended. The same has now been said to President Obama, 8 months into his presidency! By end of August '92, partly as a result of political pressures from incumbent George Bush and a deal negotiated between the two candidates (one that also included no prosecutions over Iran-Contra) and partly as a result of internal debates among rival advisers, a major effort was launched to reposition health policies, to merge Democratic left and right, and shed the "pay-or-play" label that was the focus of hysterical attacks. A policy-broker was Dem Sen Jay Rockefeller who argued against changing "pay-or-play", while warning that "Americans deserve or have a right to health care" (which is echoed today in Obama's current moral crusade that relies on the last public policy letter written by Sen Edward Kennedy). back in '92 Rockefeller said the policy presented problems in that "Although many Americans may initially react positively to this statement ("pay-or-play"), over time it can make them uneasy. Before long they will be asking: How would we pay for all that care for all those people? Won't it require a huge new government bureaucracy?"
Today, this dovetails with fanning flames of anxious ire about budget deficit spending (that also internationally encourages fiscal Conservatives to grossly exaggerate the lilihood of higher tax rates). Long term budget issues are being confused with short term crisis management. Long term health care reform in the USA is being sized up as if it it could be a burden long term similar to bailing out the banks, when in truth both matters rapidly become self-financing! But, opposition politicians are not averse to under-estimating voter intelligence about the long term in search for short term plitical advantages. Saving the Obama health reform bill may cost delay in passing his budget and in turn undermine economic recovery measures short to medium term. His response to being cornered is similar to Clinton's in '92 and '93. In September '92, Clinton pulicly revised his health reform, dropping the term "managed competition," to contrast his approach with the wholly private sector plan of President Bush. Obama did the same in '08. In November '92 and '08 Clinton and Obama respectively won the election. In both years, polls showed voters ranking health care far behind the economy behind the budget deficit. The majority of the public has only the fuzziest notion of what either Clinton or Obama had in mind for health care reform.
Clinton and Obama both addressed Congress a month after taking office.
President Bill Clinton's focus was on the economy, budget and taxes, he used the speech to make the policy link between health care reform and deficit reduction. The initial positive response bred false optimism in the White House. Advisers argued for a one-two punch: First, win a great budget victory by May; then follow up immediately with the introduction of the health care plan. But the consensus among Democratic congressional leaders was that there's not support for going to the well twice for difficult votes on health care and on budget cuts. Clinton then made the error of proceeding to put health care into the main budget bill.
President Barack Obama's focus was on the economy, budget and taxes, he used the speech to make the policy link between health care reform and deficit reduction, but not in a single budget appropriations bill. Obama is not doing this. The Health bill (650 pages) is hoping to get passed by year-end. He told Congress in February that an era of extravagant spending must end; the roots of the economic crisis is short-term gains prized over long-term prosperity. "And all the while, critical debates and difficult decisions were put off for some other time on some other day. Well, that day of reckoning has arrived, and the time to take charge of our future is here." He praised Congress for passing the economic stimulus plan, which he said would create millions of jobs and revitalise the US, and promised to deliver a tax cut to 95% of Americans by 1 April (that some said is April Fools Day). "We will recover," replaced "Yes, we can!" The recovery package, signed after compromises debated in both houses, was designed to channel federal money toward infrastructure projects, health care, renewable energy development and conservation programmes. The first month of Mr Obama's presidency also included a banking bail-out worth at least $1.5 trillion plus a plan to support "responsible homeowners" struggling with mortgages. He popularly told his audience that banks and bankers taking public money will be fully accountable, vowing that tax dollars would not be frittered away (bravery about hostages to fortune). "Those days are over... It's not about helping banks, it's about helping people." The speech came days before the unveiling of the first Obama budget, with a deficit at roughly $1 trillion. President Obama said the vast deficit and the "crushing cost" of healthcare made the need for wide-ranging reform more urgent than ever, and he pledged to reform and improve the nation's schooling and boost the numbers of students in higher education, restating a pledge to cut the deficit in half by the end of his first term, and to eliminate wasteful and ineffective schemes. Over 6 months later, President Obama had to address both houses of Congress again, after a struggle to pass his budget and serious obstacles in the way of health reform on which the Republican Opposition was now focuses much as it had been back in '93 against Clinton. Obama (9 Sept.) put the moral argument, which while gaining over 60% public support according to the pollsters, nevertheless has a hard climb to overcome medical insurers' and pharma companies' campaign contributions. His fighting talk called for serious proposals from Democrats and Republicans to address chronic health care problems and rising costs, warning that he would not "waste time with those who have made the calculation that it's better politics to kill this plan than improve it. I will not stand by while the special interests use the same old tactics to keep things exactly the way they are (to great applause from Democrats). If you misrepresent what's in the plan, we will call you out. And I will not accept the status quo as a solution. Not this time. Not now." In January '93, Clinton formed The President's Task Force on National Health Reform to "prepare health care reform legislation to be submitted to Congress within one hundred days of our taking office" with his wife, Hillary Clinton, heading it up. A blanket of secrecy was imposed on task force operations. Obama, like Clinton, has placed much of his political credit on Health Care. In both cases, such priority commitment instantly limits how far cabinet secretaries and White House aides can go in pressing alternate views.
In order to meet their hundred-day deadline and win swift congressional passage the Clintons sought to fit the health care into the presidential budget and pass it all in one gigantic package, seeking the advantage that under Senate rules the reconciliation bill can be debated for only 24 hours before it comes to an up-or-down vote.
Obama has even less time to try this, and has achieved little if any bipartisanship. Not one Rep legislator appears prepared to vote for Obama health care overhaul! Obama confronted the concern of opponents by pledging that any health care bill approved by Congress won't increase the federal deficit, repeating past statements that savings in the existing health care system will cover most of the cost of an overhaul bill. He also said, "not a dollar of the Medicare trust fund" would pay for the bill, but provided few details of exactly how, saying the plan will eliminate "unwarranted subsidies in Medicare that go to insurance companies" and create an independent commission of doctors and medical experts to identify further waste. In an emotional conclusion, Obama invoked the late Sen. Edward Kennedy citing a letter in which Kennedy called providing health care to all Americans "above all a moral issue." "'At stake are not just the details of policy, but fundamental principles of social justice and the character of our country...'". "I've thought about that phrase quite a bit in recent days -- the character of our country," Obama said to the hushed chamber. "One of the unique and wonderful things about America has always been our self-reliance, our rugged individualism, our fierce defense of freedom and our healthy skepticism of government." - adding that Kennedy recognised that with all of the drive of Americans to stand strong, there comes a time when government must step in to help. "When fortune turns against one of us, others are there to lend a helping hand," citing "a belief that in this country, hard work and responsibility should be rewarded by some measure of security and fair play; and an acknowledgment that sometimes government has to step in to help deliver on that promise." The opponents are claiming that while half of all personal bankruptcies in the US may be partially the result of medical expenses, the rising costs also mean the government is spending more and more on Medicare and Medicaid, and US government spending on the two schemes is expected to rise from 4% of GDP in 2007 to 19% of GDP in 2082, making rising healthcare costs one of the biggest contributing factors to the spiralling US budget deficit long term. This is similar to the hysteria that a Republican-dominated Congressional Budget office created in '94 about the long run cost of an ageing population, claiming, also very one-dimensionally, that the burden of old folk would absorb half of the Federal Budget and a quarter of GDP by 2050!
In March '93, the chairman of the powerful Senate Appropriations Committee, blocked the Clinton reconciliation bill strategy, calling it "a prostitution of the process" by pushing through "a very complex, very expensive, very little understood piece of legislation." We can expect the same tactic attempted now.
In April '93, media leaks were a problem, indicating that a value-added tax increase is under consideration. Hillary Clinton met with Republican and Democratic senators, imploring them to tell her what she is doing wrong and that she is having trouble getting dialogue with Republicans (Senate Minority Leader Bob Dole told Republicans not to meet with the First Lady). In May '93, a chart was leaked to the New York Times detailing health reform impact on national spending, altered to appear as if $150 billion is required in new taxes. private White House meetings are leaked to the newspapers. The Health Insurance Association of America (HIAA), restates support for universal coverage but complains of attacks on health insurance industry for "price-gouging, cost-shifting and unconscionable profiteering." Similar, brickbats were thrown this year in '09, also to diminish public support for reform. By the end of May '93 The Clinton Health Care Task Force is disbanded.
The health insurers started an advertising campaign with straplines "They choose, you lose" and "There's got to be a better way." And, the National Federation of Independent Business (NFIB) tried to kill a key element of the reform plan with mailouts and state by state meetings, to stop the "employer mandate" that would require all businesses to provide health insurance for their employees. This aspect is not in the Obama Plan.
In June '93, worried at having no effective political support team, the Clinton administration set up a "War Room" to monitor media, orchestrate responses to attacks on the Clinton health plan, and schedule administration and congressional visits to forums being held around the country. Obama may be doing the same today.
There was in '93 loss of left-wing Democratic support as the original principles were becoming less universalist.
In June '93, Clinton's budget got through only the Senate only with Vice President Gore's casting vote. Health care reform is therefore shunted off until another day. In early Summer '93President Clinton told the DNC (Democratic National Committee) to make grassroots efforts to support health reform. The DNC first tried to set up a tax-exempt "educational" foundation, separate from but allied to the DNC. When word of that leaked, critics said it will allow power brokers with their own agenda to curry favor with Clinton by secretly financing his pet project. The DNC backed off and offered to run the program itself, but they lacked a budget for any serious grassroots efforts, which was then junked in favour of a media campaign. Some called for the health care plan be delayed until '94, but others saw this as a death sentence for health care reform. Similar thoughts are the case today, for the next year means health care is a central part of mid-term Congressional elections.
Advisers are in disagreement, and President Clinton decided not to make any decisions until after his vacation. Obama did similarly, but returned to the fray with renewed vigour, except late in the Congressionl diary. In August '93 a plan is presented to a meeting of US state governors, but agreement is not found!
Ironically, while Clinton planners privately stress a conciliatory, middle-ground approach for reform, the public and many on Capitol Hill are beginning to gain an impression painted by opponents that the plan is a liberal, secretly concocted, Big-Government scheme to dictate how people get their health insurance and medical treatment. A rough draft of a plan embodying decisions on alliances, proposed price ceilings on insurance premiums, and Medicare cuts is used to brief members of Congress, but the supposedly secret plan is leaked to the press and to anti-bill lobbyists.
One difference this time is that number of congressional committees have been working on healthcare reform bills. The outlines of all competing bills are similar, and compatible with that of the White House. All favour tougher regulations for insurers, establish an individual mandate, set up insurance exchanges for those who do not have employer-provided coverage, offer subsidies for the less well-off (although the exact size of the subsidies varies from committee to committee), pay for most of the reforms by cutting waste in the Medicare programme. The major points of disagreement are on the "public option" and on how to pay for the remainder of reform. The Senate Health committee was the first to pass a healthcare reform bill
The House of Representatives bills propose to pay for reform by levying a surtax of up to 5.4% on families earning over $350,000 a year. In the Senate, the Health committee also backed the idea of a public option, but cannot rule on financial matters, the jurisdiction of the Senate Finance Committee, which has yet to produce a final bill. The Finance Committee has gathered together an informal, bipartisan group of senators - known as the "Gang of Six" - in an attempt to hammer out a compromise that will attract support from both parties. Will this work?
In September '93, President Clinton's advisers agreed on an explicit congressional strategy. Rather than start from the centre, writing a bill to appeal to conservative Democrats and moderate Republicans (while telling the liberals this is the best they can expect), they start from the left and moving as far to the centre only as needed to reach a majority. But, Newt Gingrich is determined there be no Republican support for any Clinton-designed reform and the whole effort be derailed.
The media ran stories describing and analysing Clinton's secret draft plan. Decisions are made, unmade, revised, and remade about what TV shows cabinet members and Democratic members of Congress will appear on. The result, according to one of those involved, is "piss poor planning and disastrous conflicts." Not unlike how fiscal policy and bank bailout schems are discussed today, back in September '93, opponents dismissed the economic calculations as "fantasy numbers" even to the extent of saying there is "no health care crisis."
Trying to replay the similar tactics in the run-up to next year's mid-term elections, not only health care bill but the general federal budget faces a struggle to pass in the Senate, for which very little time is left. That means Congress has to pass a “continuing resolution,” or a series of them, to temporarily fund the government, which would be a replay of '93, '94' and '95. That’s bad for a couple of reasons: One, a full federal budget for the year, federal agencies and sub-agencies can’t plan. They literally hold up recovery plans and programs because they don’t know if there’s money for them. Two, when Congress passes these bills in haste, lots of shenanigans will happen. Recall that it was in 2000, a provision was slipped into one of these big bills to remove Glass-Steagal that many claim ultimately helped cause the 2007-09 financial meltdown. That can be what Congress is playing with when it fails to get its work done on a regular schedule, and the rest of the world hanging on the economic and policy guidance teats of the USA!

US CORPORATE PERFORMANCE

As we know corporates are like households de-leveraging if they can to reduce their exposure to financial markets and cut costs especially investment, to defend margins and business models, and maximise profits to restore share values or push up their shares in the current rising market, which may prove a temporary centre of a W or double-dip. But in the interests of recovery, are US profit margins unsustainably high? FT's Lex argued that US corporate profit margins are too far above their long-run average and should "return to the mean relatively quickly", implying significant risk to current earnings path. US corporate profits before depreciation, tax & interest amounted to about 35% of corporate output in 2Q '09 compared with a long-run average (since 1947) of 29% (which seems at first glance very high?)
The margins are indeed odd (spotted by Simon Ward at Henderson) in that pre-depreciation profits have been compared with net corporate output after deducting depreciation i.e. inconsistency in treatment of depreciation between numerator & denominator of the ratio. Two credible measures of profit margins are:
1) profits before depreciation, tax & interest as % of gross output, i.e. before depreciation; and 2) profits before tax & interest as % of net output.
These gross and net measures are shown in the first chart. The gross measure behaves similarly to the series in the FT Lex column, but net margins are much less extreme relative to history – 19.4% in Q2 '09 versus an average since 1950 of 18.1%.
The widening gap between the two measures reflects a trend increase in depreciation as a proportion of output, related to a rising economy-wide capital-output ratio and a shortening average life-span (working life - at least in theory) of capital goods, whether or not simply for "tax efficiency", and alo pressure in many quarters of industry to replace systems (IT etc.) and processes.
If gross margins were to mean revert, as Lex thinks likely, net margins would fall to the bottom of their historical range. Economic theory suggests that the income share of capital-owners should be stable over the long run but this refers to return rewards after costing for the erosion in value of assets (argument for using net rather than gross margins).
The FT focused on domestic profits, ignoring 25% share of total US profits accounted for by foreign earnings. The first chart (also from Simon Ward) compares total profits net of taxes and adjusted for inflation with a log-linear trend. This suggests that profits were 8% below trend in the second quarter after a 10% first-quarter shortfall – similar to the 13% deviation at the bottom of the last recession. The slope of the trend-line implies real profits growth of about 3.5% per annum. Assuming 2% inflation, nominal trend profits will be about 18% above the second-quarter actual level by the end of 2010. Consensus hopes of a significant earnings recovery next year are therefore not irrational, providing a near-term economic pick-up can be sustained.

GEITHNER'S G20 AGENDA

Although analytically it is convenient to think of the real economy and financial sector as two subsets of capitalism, in reality, they are inseparable parts of the modern
political-economy, with a lot of two-way interdpendencies; finance sector is not just another boat bobbing up and down on the waves and tides of capitalism, but something as ubiquitous and powerfully a third as large in output but much larger in finabcial balances and cash-flows than government. The differences is of course that banking finances are private and dispersed and it is easy for bankers to duck political responsibilities. As we move into an era where banks have to be more macro-economic astute, they will become more politically active. At present that activism is weakened somewhat by needing government generosity of financial support.
The Credit Crunch has been a wake-up call to all to recognise that the interaction between the financial sector and the real economy is strongly influenced by
inter-government policies. The continuing financial turmoil is like a big stress test for theories on the interaction between the financial sector and the real economy and that stress-test is centred on the G20 agenda, about how our preconceptions about how the crisis will play out - the increasingly heard term "exit strategy". The US Treasury Secretary, Tim Geithner, other than Federal Reserve Chairman Ben Bernanke, may be the most important single person in the world of banking, if there is any such individual? At London's G20 agenda meeting the balancing trade-off (of private/public, individual star-players/ regulatory systems) seems to be between gaining France's agreement - and with Germany and ECB that of the EU and Euro Area - for the US & UK priorities in exchange for accepting a French (& EU) priority on reining in bankers' bonuses to pre-empt excessive remuneration from blinding bankers to excessive risk-taking i.e. a change in culture; a halt on where the 'star-culture' is leading, which is also about whether investment banking arms of large banks can continue to do competitive business with Hedge Funds and Goldman Sachs and attract and retain similar deal-makers. Do individuals or systems make the most difference to financial performance and social-economic benefits of banking, and can the governments who have saved banks from collapse dictate a new more macro- and micro- prudential banking culture? It is a perplexing question-of-judgment-balancing; do people or systems, private or public interests, animal-spirits or politics, count for most in how global finance works well or badly. Whose face should be on the dollar, Lincoln or Bernanke? The G20 meeting is therefore about whether the political leaders around the negotiating table can make a difference; collectively recognise the imperatives of what to do about the world's banking systems including the culture of star-player bankers or not? The crisis has eviscerated shareholders of banks and replaced private funding sources and capital reserves with state funding. But there is a mutual dependency and stand-off between banks and governments. Banks have various means to resist government controls, not least by the political insistence on behalf of capitalism as essentially a private matter that government intervention shoiuld be as temporary as possible. Governments are trying to ensure that before they exit their centrally supportive role that the banks are at least subject to new adjusted regulatory controls to ensure that banks recognise their macro-political-economic responsibilities and not simply return to 'business-as-usual'. There is a war being waged between politicians supported by angry general public and bankers on behalf of private finance. Does money or votes count for more in our democracies? The US finance sector as the world's most powerful is the benchmark against which everyone's else's banking sectors are defined, just as the dollar and the US economy dominate world asset values, trade and ouput and therefore G20 is about accepting or modifying or adding to the US agenda, Geithner's agenda:
US TREASURY STATEMENT WITH MY COMMENTS IN BRACKETS
The global regulatory framework failed (yet again for the umpteenth time) to prevent the build-up of risk in the financial system in the years leading up to the recent crisis. (Risk build-up is always inevitable. The global financial system, mainly following a US lead in dispersing credit risk internationally, but in debt markets of structured finance the originate-to-distribute model became an originate-to arbitrage model, with the effect of prolonging the peak of the credit/economic cycle by 2years thereby creating a stronger financial impact on the inevitable Anglo-saxon recession to produce a shock that became a brief Global Recession).
Major financial institutions around the world had reserves and capital buffers that were too low; used excessive amounts of leverage to finance their operations; and relied too much on unstable, short-term funding sources. (They were too low by being predicated on the recent past, not on future unexpected worst case - macro-model failure, ignorance or resistence to? Banks/bankers were not prepared to accept that they have collectively - and individually in the case of the biggest banks - a responsibility to be prudent by caring about the wider economy and their role in it a role that is not defined anywhere within the system except by the Basel II Accord issues on 'pro-cyclicality', something not taught by accademics, accountants or in Economics 101, and something that they are not motivated to care about by shareholders, by bonus remuneration, or by government tax & penalty-setting powers.)
The resulting distress, failures, and government bailouts of these firms imposed unacceptable costs on individuals and businesses around the world. (This is an inexact statement that is only believed by populaist political opinion. Bailouts removed half the pain so that individuals and businesses are in reality only having to cope with the equivalent of a relatively normal recession. The funding of bailouts is off-balance sheet of central governments that taxpayers' money so far is very little used. Furthermore, also rarely statd, the asset balloon build-up in credit-boom economies with massive trade deficits, US especially, that preceded the crash was a bonus to emerging market poor countries by giving them 2-3 years extra foreign investment inflows and trade surpluses, which were positively transformative, transferring from rich world to poor-world in a few years the financial equivalent of decades-worth of aid!)
Going forward, global banking firms must be made subject to stronger regulatory capital and liquidity standards that are as uniform as possible across countries. (This is already happening in a process preceding the Credit Crunch by 12 years). Today the Treasury Department set forth the core principles that should guide reform of the international regulatory capital and liquidity framework to better protect the safety and soundness of individual banking firms and the stability of the global financial system and economy. (This form of words is based on a perspective of banking and even government as merely large important cogs in the engineering machinery of the world economy, like water, transport and energy. Like any cog in a machine consisting working with other cogs, no cog can be allowed to spin at its own self-determined speed; it cannot have an agenda of its own. This is not a view of finance sector necessary restraint that appeals to the imperial egos of big bonus bankers. After all, the whole ethos of 'private' capitalism is that it should not need to take account of public interest, of the wider economy. The US Treasury proposes the following:)
1. Stronger capital and liquidity standards for banking firms:
Capital requirements should be designed to protect the stability of the financial system, not just the solvency of individual banking firms, including banks, bank holding companies, financial holding companies and large, interconnected firms. (We have minimum regulatory capital to cover worst case expected losses plus economic capital buffers for unexpected losses, which has been increased, and maybe now we may see a third category of systemic risk capital buffers? These should vary according to the too-big-to-fail relative size of banks.)
2. Capital requirements for all banking firms should be increased, and capital requirements for financial firms that could pose a threat to overall financial stability should be higher than those for other banking firms. (higher capital reserves means reduced leverage and reduced speed of asset growth).
3. The regulatory capital framework should put greater emphasis on higher quality forms of capital that enable banking firms to absorb losses and continue operating as going concerns. (This is saying that too much of banks' business models shifted from traditional funding from deposits to wholesale funding by borrowing and investment trading on the banks' own accounts rather than merely charging for services delivered to customers and clients.
4. The rules used to measure risks embedded in banks' portfolios and the capital required to protect against them must be improved. Risk-based capital requirements should be a function of the relative risk, including systemic risk, of a banking firm's exposures, and risk-based capital rules should better reflect a banking firm's current financial condition. (Giving systemic risk more prominence in the Basel Accord also means more prominence for liabilities, for liquidity risk, which were relatively under-played in the Basel Accords I & II, which are the basis for global banking regulation.)
5. The procyclicality of the regulatory capital and accounting regimes should be reduced and consideration should be given to introducing countercyclical elements into the regulatory capital regime. (These considerations are already there, but not systemetised in detail. Basel II authors and regulators repeatedly expressed concerns for sensitivety to pro-cyclicality risks i.e. banks knee-jerk responses to cycle downturns thereby making recessions deeper and longer. The risks are that while Government seeks recovery by deficit-spending to pump new circulating-money into the economy banks would be cancelling loans and not making new loans thereby sucking circulating-money out of the economy.)
5. Banking firms should be subject to a simple, non-risk-based leverage constraint. (This is the Comptroller of the Currency view that capital reserves should be a ratio to gross assets, not merely to risk adjusted assets net of risk-adjusted collateral and hegding. This leverage constraint could be a major restriction on derivatives generally though aimed specifically at arbitrage in credit derivatives.)
6. Banking firms should be subject to a conservative, explicit liquidity standard. (This will force banks to seek more government treasuries as part of their reserves and less reliance on shareholder equity. In consequence, banking growth will be constrained more by government deficits - bond issurance - and more controllable by central banks money market actions in dictating banks' CB deposits and short-end treasury bills - liquidity windows.)
7. Stricter capital and liquidity requirements for the banking system should not be allowed to result in the re-emergence of an under-regulated non-bank financial sector that poses a threat to financial stability. (The short end official money markets is essentially for unsecured short term lending & borrowing and is entirely for developed economy banks and governments only. Non-banks resented this and effectively created Money Market Funds and Credit derivatives to emulate siilar liquidity leverage, but by creating longer-lasting securities built up a massive credit derivatives inventory that became the focus of much leverage arbitrage that when it unravelled could bring down the world's banking system - the so-called ' financial weapons of mass destruction'. Hedge funds deny they are responsible for the Credit Crunch. There will be a major series of battles over the next few years o see how much that is unregulated & over-the-counter - off-exchange - and how much will become regulated & on-exchange.)
7. A comprehensive agreement on new international capital and liquidity standards should be reached by December 31, 2010 and should be implemented in national jurisdictions by December 31, 2012. (We may interpret this as the dates and therefore the announcement of Basel III Accord - or Basel II+?).

FDIC Receivership Banks

There is much in the allegory of Moby Dick that smacks of our efforts to kill the great banking crisis. Those of you familiar with my Geneva bank, Banque Rupp et cie, (see blogs passim) may not know of its US subsidiary, Bank Pequod, motto: "blubber is blubber you know; tho' you might get oil out of it?"
My strategic problem is currently to decide whether my bank should become, to use old fishing terms, a whale or a whaler, to double my bets by buying other banks hopefully dirt-cheap, or sell my own bank on, either way through the FDIC FBA policy-scheme. On July 9, the FDIC sought comments on “Proposed Statement of Policy on Qualifications for Failed Bank Acquisitions.” The policy statement suggests tough terms whereby the federal agency can sell failed banks to non-traditional buyers i.e. private equity firms. 61 comments were filed during the 30-day comment period – most from private-equity firms, their lawyers, financial-services trade associations and lobbyists, plus comments from academics, 4 U.S. senators and 6 individuals. The FDIC also received 3,190 form-letter comments in support mostly saying “yeah, sell the bastards! Good riddance!” It may no longer be fashionable to own a bank, but could be fashionable to buy one and then close it to new business, strip out its blubber, the assets, to get oil, from foreclosures, take maximum income and charge 80% of any remaining losses at the end to the FDIC?
Selling off busted, near-busted, banks, or banks than look like they could go bust sometime, to vulture fund investors strikes a dissonant chord about private equity players (hedge funds, or private corporate banks like Pequod etc.) among voting taxpayers, and of course to other banks who wonder why anyone is foolhardy to want to own a discredited bank? It may inadvertently lead to another storm of political discontent and even trigger more possible bank failures some way down the river, wrecked out to sea or on a landbank? So far this year, 81 US banks have failed, costing FDIC an estimated $21.5bn. And the situation may worsen - currently 416 distressed banks - highest level in 15 years (at end-June ’09, up from 305 at the end of March), maybe 800 by next year? The FDIC had that many on its “problem list” last in June 1994, when there were 434. Assets at troubled institutions total $300bn –worst level since end of '93.
FDIC’s insurance fund (at March 31), was down to $13.5bn. Bank failures in Q2 ‘09 cost FDIC’s insurance fund $9.1bn - offset by an emergency special assessment (raisings) of $6.2bn + $2.6bn raised in the regular quarterly assessment on FDIC-insured banks. Colonial Bank cost $2.8bn and Guaranty Bank, $3bn. FDIC Chairman Sheila C. Bair is seeking from the U.S. Treasury a $500bn line of credit (by the way, equivalent to the assets of the IMF, the BIS, and ECB).
FDIC’s special assessment in Q4 ’09 and another in Q1 ‘10 may tip more banks onto the butcher's block of the credit crunch. FDIC not only covers insured deposits; if costs of a troubled bank is judged to be getting too high by the FDIC it can seek to ‘combine’ the bank with another, or sell its carcass outright, and if not that it can manage the “unwinding” of a bank’s stockpile of smelly blubber. With 100s of banks potentially in receivership trouble and few willing to acquire the hard to value assets, private equity firms have offered to buy failed banks in the asset-stripping belief these banks can be restructured, perhaps into larger groupings, and profitably turned around or sold on, though not necessarily continued to operate as banks, or not until all current assets have been sold and debt recoveries completed. In fact the whole deal may appear to be more like paying receivers to take over and make for themselves whatever they can. Let’s not forget that mortgage assets have commercial, residential and land assets as collateral that should cover at least half of the outstanding loans. An owner can cherrypick. banks can deem loan contracts any time. Many accounts may have foreclosable collateral larger than the outstanding loan. Hence, a 60% asset discount should translate into a profit over time, which may be substantial once property and business values begin to regain lost ground. The FDIC issued a new version of its plan after comments were received, this time with weaker terms & conditions. These raise questions about federal government’s respect for existing covenants and regulations if set against its perception of the broader political-economy interest, including that of the FDIC balance sheet. In one instance, instead of the initially proposed requirement that new investors maintain a 15% Tier 1 common equity capital ratio to risk-weighted assets, the new ‘hurdle rate’ is only 10% . Private equity firms are excused the requirement of other bank holding companies and will not be called upon as a “source of strength,” should their investment in a bank they have bought need shoring up. This is a cause of concern. Bank holding companies have to make their reserves available if operations need support, but private equity firms don’t want to expose their investors’ capital by dedicating reserves to any one investment. For example, Cerberus Capital refused to put any more money into Chrysler – leaving it to government to bail out. FDIC made other compromises to attract private equity such as excusing them from having to cross-guarantee their portfolio-bank investments – unless they own at least 80% of two or more banks. Private equity did not get all it wanted. The final policy prohibits “insider” and “affiliated” loan transactions and strips firms of using a controversial “silo” structure to obfuscate ownership and control. Private-equity got FDIC to agree to share losses whereby the FDIC bears the larger share.
Acquiring banks also have such loss-sharing agreements with the FDIC, but at least they are regulated entities while private equity firms are not. Nor will private equity firms become regulated in order to buy banks, though this may change if Hedge Funds etc. come under SEC oversight. Private equity firms can buy failed or failing banks by banding together and dividing the equity commitment and investment liability. If there is no recourse against other private equity firm assets or even any cross-guarantees against other acquired banks, unless 80% owned, the consortia cannot be called upon or relied upon to be a “source of strength” for their depository, taxpayer-backed portfolio banks. Regardless of any rules on self-dealing, private equity firms will most probably find legal ways to lend from their newly acquired banks to leverage their other investment portfolio and extract fees. If they don’t lend to their own portfolio companies, they will surely lend to other private equity firms’ portfolio companies in a modified version of the “club deals” that bind them together. These firms have a mutual interest in generating deal fees, cutting up the assets, re-packaging ans selling on. The problem with banks is if over-leveraged they cannot borrow to fund their funding gaps because they cannot set aside sufficient “reserves,” and must rely on “off-balance-sheet” vehicles to sell assets, or if they cannot grow assets, then to acquire leveraged pools of assets, becoming leveraged inside and out. But now the originators of the leveraged-buyout business model want to apply another round of leverage to already crippled banks in order to squeeze out all possible profits. The FDIC needs therefore to be aware of the risk that ‘saved banks’ sold to high return financial engineers may become problem banks again in the future, much as Lehman Brothers did on a large scale having been saved several times in it history. In a comment letter to the FDIC, the Private Equity Council, without recognizing the irony of its comment, suggested that higher capital ratios for private equity buyers of failed banks would increase the risk at those banks because their owners would essentially have to employ more leverage to generate sufficient returns to meet the higher capital standards – while still generating returns high enough to satisfy the investors in their private-equity funds. This is a self-made argument by hedge funds/private equity funds for why they are inappropriate buyers of banks. They clearly do not understand that capital reserves must be ‘own funds’ clear of obligations, not loans to them by investors.
Private equity should be allowed to buy banks, but should also be held to a higher standard, and no less high than for fully-regulated banks. They have a proven record of success at leveraging companies when they have access to cheap funding, and they also have a record of spectacular failures. The last thing US banks need is management that leverage them to generate rates of return at double or triple the average for traditional banking. FDIC is probably aware of this, of the need to avoid resorting to solutions to problems that will repeat past behaviour. The original herbert Melville's Pequod's quest to hunt down Moby Dick itself is allegorical. To Ahab, making a big killing, the white whale, became the ultimate and only goal in his life, and if expanded allegorically, everyone's goals. His vengeance against the whale is analogous to man's struggle against fate, or the public's against the banks. The only escape from psychosis is seen through the Pequod's encounters with other ships, whose captains warn against the folly of risking all for the sake of getting the big win. Melville implies people in general need something to reach for in life, a goal that can destroy one if allowed to overtake all other concerns, and that seems a neat version of bankers, their bonuses and hedge funds and their 50% returns - "Nothing exists in itself. If you flatter yourself that you are all over comfortable, and have been so a long time, then you cannot be said to be comfortable any more."

FDIC LLP to LLC

Should governments feel free to sell banks and their assets to non-banks or to other banks simply to cut short the period of state assistance?
As we all know, Governments around the world have in various ways provided funding support for banks in trouble, which means for banks with under-performing or non-performing loans on such a scale that if written down fully and subtracted from banks’ reserves would endanger or severely question the current (or near future) solvency of the banks. That is at least the perception. It would be more accurate to say that the above applies most especially to medium and small-sized banks while for bigger banks a major additional problem threatening their solvency and thereby the economy generally has been inability to renew medium and long term loans to cover the ‘funding gap’ they have between loans and deposits.
What is much less well understood is that funding to secure the solvency of banks has not been directly at tax-payers’ expense, but mostly off-budget by swapping treasury bills for collateral consisting of larger amounts (by market value) of banks’ loans (variously securitized as bonds), i.e. heavily discounted (so-called ‘hair-cut’) with default risk covered by guarantees and insurance plus a substantial fee that may be repeated every time the swap is ‘rolled-over’.
The classic example has to be the US Federal Deposit Insurance Corporation, created by Congress in 1933 to restore public confidence in the nation's banking system. The FDIC insures deposits at the nation's 8,305 banks and savings associations and promotes ‘safety and soundness’ of these institutions by identifying, monitoring and addressing risks to which they are exposed. The FDIC receives no federal tax dollars – insured institutions fund its operations i.e. it is like an exchange for ensuring bank solvency with funding and insurance guarantees paid for by the members, the banks & savings associations.
Not all of the thousands of small banks need help, only about 8%. Some take pride in that, while at the same time using their FDIC membership as their solvency guarantee e.g. White Hall Bank, Illinois, which on its web-site states soberly "TEMPORARY LIQUIDITY PROGRAM - White Hall Bank has chosen NOT to participate in the FDIC's Transaction Account Guarantee Program. Our customers with non-interest bearing accounts will continue to be insured through December 31, 2009 for up to $250,000.00 under the FDIC's general deposit insurance rules. On May 20, 2009, FDIC deposit insurance temporarily increased from $100,000.00 TO $250,000.00 per depositor through December 31, 2013." Politically, however, for whatever blend of ideological reasons, including sometimes laws such as in the European Union, governments are anxious that their support measures should be paid off as soon as practical, and this stance can mean selling off the aid-supported banks and/or their impaired loan-books. ‘Impaired’ means portfolios of loans where the market value of the loans has fallen below ‘book value’ (to understand the accounting parlance I suggest you look it up).
Steps to increase transparency have reduced some of the uncertainty in the markets. FDIC specified simple indicators for short-term stress tests undertaken by major banks (19 of the largest). This framed the basis for ordering 10 major banks to raise a total of $75bn capital to protect against worst-case unexpected losses - a result better than many feared, leading to financial stocks trading at higher levels over the summer. Risks to the economy and financial sector remain as a pipeline of knock-on defaults feed through, and as the housing market has yet to reach bottom in terms of actual price falls appearing on for sale offers, and as additional unwinding of complex financial instruments progress, hopefully in an orderly manner without confidence-shaking shocks. Property values underpin almost everything directly or indirectly. Commercial real estate fundamentals, and therefore also banking lending growth, typically lag the economy 6-9 months. As a result, deep job losses in recent months are forecast to translate into rising commercial property vacancy through year end after recession may have formally ended, with rollbacks in rents and slow residential property recovery likely to continue through 2010. Commercial real estate fundamentals and the investment climate ultimately will benefit from improving capital flows and the economic recovery, especially since in the US that sector was generally not overbuilt heading into the downturn. On March 29, FDIC issued proposal for comments on the Legacy Loans Program (LLP). The FDIC and the Department of the Treasury announced the LLP (like the bank of England’s APS or Germany and Ireland’s ‘bad bank’ schemes), which will remove troubled loans and other assets from FDIC-insured institutions, but with the additional idea of attracting private capital with soft-loan terms to purchase the banks’ loans. At the time some banks let it be known they would like to be able to buy their own impaired loans back on the same terms as offered to non-banks, but of course that was a dimension too far politically.
The FDIC asked for comments from interested parties on the critical aspects of the proposed LLP to boost (some would say subsidise) private demand for distressed assets that are currently held by banks and thereby facilitate market-priced sales of troubled assets (even if no-one suggests the prices discovered are true market prices except in a very convoluted sense). It semmed necessary, however, really because FDIC funds were close to becoming exhausted, and because uncertainty otherwise about the value of these assets makes it difficult for banks to secure funding to support lending to households and businesses. At bottom, the fundamental aim is to avoid bank runs. The LLP combines an FDIC guarantee of debt financing with equity from the private sector and from the US Treasury. These private-public partnerships will purchase assets from banks and place them into what will be known as Public-Private Investment Funds (PPIF). Institutions of all sizes will be eligible to participate in the LLP to sell assets. It is expected that a range of investors will participate. The program will particularly encourage the participation of individuals, mutual funds, pension plans, insurance companies and other long-term investors. Investors will be pre-qualified by the FDIC to participate in auctions. For providing a guarantee, FDIC is paid a fee, a portion of which gets allocated to FDIC’s Deposit Insurance Fund. The FDIC is protected against losses by PP equity in the pool, the newly established value of the pool's assets plus fees collected. FDIC will continue to audit progress and it also structures the debt that a selling bank will get paid for when the legacy loans are sold by the participant banks into the market. Comments were required no later than April 10. Following consideration of various comments, by June the FDIC said it will develop this program by testing the LLP's funding mechanism through a sale of receivership assets i.e. assets of bankrupt banks. The first transaction to be offered, the receivership transfered a portfolio of (serviced) residential mortgage loans to a limited liability company (LLC) in exchange for an ownership interest in the LLC i.e. rather like an SIV. The LLC sold an equity interest to an accredited investor, now responsible for managing the mortgage loans. Loan servicing conforms to either the Home Affordable Modification Program (HAMP) guidelines or FDIC's loan modification program. Accredited investors were offered equity interest in the LLC under two different options: 1. an all cash basis, equity split of 80% (FDIC) and 20% (accredited investor); 2. sale with leverage, whereby equity split is 50% (FDIC) and 50% (accredited investor). The funding mechanism is financing by the receivership to the LLC using an amortizing note guaranteed by the FDIC. Financing is offered with leverage of 4-to-1 or 6-to-1 depending on bid offers by private investors. If the bid is 6-to-1 leverage, then performance of the underlying assets are subject to performance thresholds including delinquency status, loss severities, and principal repayments. If any of the thresholds are triggered over the life of the note, all principal cash flows to equity investors are applied instead to reduction of the note until the balance is zero. Performance thresholds do not apply if the bid is based on the lower leverage option. FDIC is protected against losses on the note guarantee by limits on leverage (in terms of a maximum ratio and $ amount), with mortgage loans collateralizing the guarantee & its fee. This is not especially controversial since it is a means of an orderly sell-off of impaired assets where government via the self-financing FDIC retains a role, but there is no taxpayer exposure unlike the cartoon above of Uncle Sam requesting citizens to invest in financial toxic waste (actually not abad deal if citizens could do so). And this is so far applied to collapsed institutions. What is more problematic is where still-operating institutions are sold off (see next blog).
My own preferred solution would be to restructure and bundle up mortgagees debt so they get some discounts by matching discounted bank assets to discounted house prices and outstanding loan values thereby reducing negative equity risk (at same or lower cost to banks and insurers), but that is not yet anywhere on the table for discussion other than something like that wished by more than a few legislators in Congress.

US rating agencies in the dock?

For many people the credit crunch must feel like they were invested in Confederate bonds!
Among the worst of the blameworthy institutions responsible for the crunchiness of the credit crunch are the ratings agencies, Moodys, Fitch, and Standard & Poors. In structured finance Moody's has been the dominant player with perhaps half of the market. Why, are the ratings agencies in trouble - because their models were severely faulty, especially that of Moody's, in particular for confusion between underlying credit risk rating and credit enhancement and the macro-economy, and for having severely critical system design bugs. If you like you may buy various models from the agencies to calculate ratings including for complex instruments. The models you get appear quite comprehensive and suitably complex, but they rely for key input data on your finger-in-the-air assumptions, crude factor inputs, and abstract variables where real world data, especially economics data would be not merely wholly, but are solely, appropriate. The ratings agencies have two main strengths, 1, historical data, critical aspects of which were ignored it seems or failed to be incorporated in pre-2007 models; and 2, legal requirements that valuations throughout the financial services industry should employ ratings agency values, which enforces their market reference position as an oligopoly, collectively a near-monopoly. This does not mean, however, that the financial industry knows adequately what the agencies' strengths and weaknesses are, or necessarily believe their gradings are superior. The industry knows that everyone uses the 3 global raters and that is a power that must be supervised from a regulatory/quality assessment perspective and that their modeling approaches should be more transparent for expert review. New US moves will face the credit rating agencies with new disclosure rules and restrictions but would not be forced to overhaul their business models under proposed US legislation to be sent to Congress on Tuesday. From a European perspective the new rules fall well short of the European Commission's wishes. The main problem for the ratings agencies is whether rule changes in the US will do anything to protect them from law suits coming down the turnpike that should bust the companies if they get to court. In that context why invest in improvements, in anything other than what will defend their sorry records? The plan (of US Treasury) is aimed at managing better issues that were long known:
- conflicts of interest at rating agencies,
- providing regulatory oversight by the SEC and
- reducing the financial system’s reliance on credit ratings.
The plan is one major part of the Obama administration’s financial regulatory blueprint. The ratings agencies overlooked or under-estimated or mis-modeled or wrongly implemented software for assessing the risks of investing in securitisations, in complex, “structured” securities, especially those linked to mortgages. As all should know by now Moody's until June '07 operated a rating model that was indifferent to default rates - a glaring error that caused all securitisation issues (across what should have been 17 grades) to be all classed in one risk bucket, triple-A. The problems to be sorted out about the ratings agencies that were overlooked after LTCM, Enron and the dot com bubble burst have to be tackled this time comprehensively. The severe doubts about the companies' survivability is reflected in their share prices, though these also reflect fall-off in new structured product ratings business. Barney Frank, head of the chairman of the House financial services committee, on Tuesday endorsed the proposed measures to overturn requirements to use the credit ratings agencies. “There are a lot of statutory mandates that people have to rely on credit rating agencies. They’re going to all be repealed,” he told Reuters. This would trigger changes in Basel II statute law in Europe if the EU followed suit. The business models at Moody’s Investors Services, Standard & Poor’s and Fitch Ratings – which are paid by the companies whose debt securities they rate – remain largely intact. There has, however to be severe doubts remaining about these. We know that none of the agencies have macro-economy models that incorporate detailed financial sector statistics! It is unclear too, in the case of structured product bonds, whether credit risk enhancements were modeled when assessing the issues just because standby credit and insurance was part of the issue contracts, or whether the underlying was separately rated first? We do not know what macro-economic modeling correlations were used before the crisis and if these have since been changed? We do not know how comprehensively national credit risk ratings are determined and what the models are that determine watch-lists or if subjective judgments are part of the assessments? Defending the Treasury’s decision not to heed calls by some for a fundamental overhaul, Michael Barr, assistant Treasury secretary for financial institutions, said there were conflicts inherent in alternative models too. But, the conflicts being considered are few in number and yet little analysed. Tuesday’s proposals would bar ratings agencies from providing consulting services to any company they rated and would require them to disclose fees for a rating. It also attempts to stem “ratings shopping’’ in which a company solicits “preliminary ratings’’ from multiple agencies but only pays for and discloses the highest.
Ratings agencies will be required to use different symbols for structured finance products, which are perceived to be riskier, than for corporate bonds. What the point of this is when it merely means that financial service firms will have to construct converters or engage in major risk accounting system overhauls?
The plan is “a continuation of what the SEC has already done to a more limited extent’’, said Lawrence White, professor at New York University’s Stern School of Business, talking to Reuters. His view is that the proposal does not go far enough to reduce the ubiquity of the credit ratings in how they are hardwired into the financial markets via financial regulation (implication: Basel II) and did little to foster competition in the sector. To my knowledge it is worse than that insofar as ratings tables have in many banks been so hardwired that they have become inflexible to change in accordance for example with recent experience, experience that has bust the parameter limits of pre-credit crunch models. The SEC has appointed special auditors to oversee ratings agencies, and last year passed rules prohibiting activities such as executives providing both ratings and advice on how to structure securities, and barring those who evaluate the debt from discussing fees, as well as limiting gifts from debt underwriters to rating agency employees. S&P said it was studying the proposal. Moody’s said it supported the goals of “increased transparency and enhanced ratings quality’’. Fitch said the plans were consistent with its views on transparency. What the news comments do not broach is that there are issues here and others not addressed that go to the heart of the survivability of the credit ratings agencies, and indeed to the heart of investment banking as we have hitherto known it?