Fin/Inv

“Lehman was forced into bankruptcy not because it neglected to act responsibly or seek solutions to the crisis, but because of a decision, based on flawed information, not to provide Lehman with the support given to each of its competitors and other nonfinancial firms in the ensuing days.”

-Richard S. Fuld Jr., Lehman Brothers former chief executive (NYT)

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The fantasy world inhabited by Lehman Brothers CEO Richard Fuld was given a surprisingly sympathetic ear from an unexpected forum yesterday: The Financial Crisis Inquiry Commission.

This is a deeply disturbing development, as it leads to the unfortunate suspicion that the FCIC does not have the slightest clue as to the causes of the housing collapse, recession and and market crash.

There are two issues here: The first is “why did Lehman collapse?” The second is “Why didn’t the Fed rescue them?” Let’s look at both.

I’ve spilled far too many pixels explaining why Lehman crashed and burned, but for those of you who may have forgotten:

1. Under-capitalized, over-leveraged: Lehman Brothers was the biggest bankruptcy in US history. To avoid that fate, LEH mneeded to be sufficiently capitalized, and use only moderate leverage (LEH embraced 40 to 1 leverage). Rather than have a sufficient capital base, the bank chose instead to chase profits: A greater capital cushion meant less underwriting activity, smaller gains, greater risk. The downside of having a de minimus capital structure is when bad investments are made, there is no room for error.

2. Bad Modeling Assumptions: LEH made numerous false assumptions in their econometric models: a) Residential RE never goes down; b) The derivatives market is always liquid, with ready buyers available; c). We can always borrow short and lend long with no liquidity concerns;  There was substantial evidence and warnings that ALL of these assumptions were false, but they were ignored by management as a risk to profits.

3. Excess RE Exposure: Lehman was the biggest securitizer of mortgages on Wall Street. They underwrote more mortgages than any other bank on Wall Street. By 2004, LEH was originating $40B per year in mortgages to feed their own CDO machine (which as Roger Lowenstein has pointed out, was more lucrative than the stock and bond business).

4. Reliance on Ratings: Lehman’s entire business model was predicated on the ratings of Moody’s and S&P being reliable. However, LEHMAN was one of the prime purveyors of credit rating payola — they were paying the NRSROs a fee to slap a Triple AAA rating on junk paper. If they did not know the credit ratings were utterly worthless, they sure should have.

5. CDO Ownership: Lehman kept the senior-most layers of CDOs they created for themselves, but bought credit default swaps on them “for safety.” Consider that they were not confident enough of the models which forecast the solvency of those tranches, yet they used the same models to determine AIG was a credit worthy counter party to insure them.

That’s why LEH collapsed, and it was apparent (at least to us) back in June 2008 they were in trouble.

Why did the Fed not save them? There were several reasons:

1. One off: The Bear Stearns bailout was supposed to be a “one of a kind,” not the start of a series of rescues. The Fed hoped to hold the line at only one such taxpayer backed rescue. The fear was if they did a 2nd, they could not say no to the rest of the Street. Lehman was in effect the Fed’s Maginot Line (it also was out flanked and rendered strategically useless).

2. Fed Overreach:  Bernanke was widely criticized for the Bear rescue as a huge overstep of authority. Even former Fed Chair Paul Volcker overcame the inherent reluctance of formerFOMC chairs to to criticize sitting Fed heads to express his concern about the over reach and power grab.

3. No to Private Rescue: Dick Fuld turned down a private rescue just months earlier. Warren Buffett offered Fuld billions, plus the equivalent of the Berkshire Hathaway Good corporate Housekeeping seal of approval. FULD TURNED BUFFET DOWN. How could the Fed, in good conscience, bail out a firm that refused to accept a Buffett rescue? Indeed, his terms for LEH were far more generous than what BRK ultimately offered Goldman Sachs and GE.

4. Insolvent: Lehman books are why a loan never happened. LEH was essentially insolvent, with liabilities that vastly outweighed what few assets there were. This insufficiency is why a loan was simply not possible — it was  considered a guaranteed loss.

5. Moral Hazard: How much of a clusterfuck must any financial firm be before a rescue is deemed an outrageous moral hazard? For the 3rd and 4th reasons above, Lehman was believed to be “Beyond rescuing.” And it was due to the specific choices Lehman’s management made.

To think that Fuld’s brand of psychopathic revisionism was given a sympathetic hearing is deeply disturbing.

I haven’t written this before, but now I am compelled to: I now fear the FCIC report is going to be an ideological farce. The nightmare report scenario is a collection of false statements, half truths, misunderstandings, confirmation biases, and rhetorical nonsense.

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Previously:
Financial Sector: Beware LEH, CIT (June 3rd, 2008)

Understanding Lehman & AIG (March 22nd, 2009)

Bear Stearns, Lehman Execs Kept Billions . . . (November 23rd, 2009)

Grading Financial Regulatory Reform (June 25th, 2010)

The Bloomberg/BusinessWeek headline was enough to ruin your evening: SEC Declines to Sue Moody’s Over Inflated Ratings.

The facts were even worse: Moody’s, the bond rating company, chose not to downgrade inflated ratings on almost $1 billion of debt in 2007. The reason? Concern for their own reputation. The decision came out of Moody’s Investors Service committee in Europe, raising jurisdictional issues.

Our CrowdQuery for this evening:

1. Will the Rating Agencies ever be forced to pay for the massive damage they have inflicted?

2. Is the current system of NRSRO going to change?

3. What is structured finance and bond ratings likely to look like in the future? What should it look like?

What say ye?

The most recent quarterly Bailout Tally, via Nomi Prins:

Bailout and Subsidization Type Report

Bailout and Subsidization Type Report (July 2010)

Bailout Tally

Bailout Tally July 2010

I wanted to draw your attention to a great read by Michael Hirsh in Newsweek titled How Obama Got Rolled by Wall Street.

“The fundamental structure of Wall Street had hardly changed. On the contrary, the new law effectively anointed the existing banking elite, possibly making them even more powerful. The major firms got to keep the biggest part of their derivatives business in interest-rate and foreign-exchange swaps. (JPMorgan, Goldman Sachs, Citigroup, Bank of America, and Morgan Stanley control more than 95 percent, or about $200 trillion worth, of that market.

The same banks may end up controlling or at least dominating the clearinghouses they are being pressed to trade on as well. New capital charges, meanwhile, have created barriers to entry for new firms. This consolidation of the elites has in turn kept alive the “too big to fail” problem. “It makes it way tougher now to kiss somebody off when they get in trouble,” says the former Fed official. Eugene Ludwig, a former comptroller of the currency, believes the new law’s impact will be “profound” in changing the way banks do business. But he worries about a “skewing of the playing field” in favor of the big banks, putting community banks at a disadvantage.

…after a two-year fight over financial reform, one other question still lingers: has Wall Street come out the big winner yet again?”

Read How Obama Got Rolled by Wall Street.

“Now I’m looking at the political system turning itself into a paralyzed beast. A lost decade now looms as a much bigger risk. The Fed’s running out of powder; Its really powerful ammunition has been expended.”

-Alan Blinder, former vice chairman Federal Reserve, on whether the US could sink into a Japan-style quagmire

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Peter Goodman has a longish article in the NYT Week in Review, What Can Be Done to Cure the Ailing Economy?.

It is notable for a few reasons: Great chart porn (see right), a few good quotes (see above), and a bombshell from Bruce Barlett, the Treasury economist in the first Bush administration.

Bartlett has become a pariah to the Republican party, saying out loud what few people dare to even think. He notes that we are already in gridlock, with the GOP deploying a blocking strategy. He thinks nothing substantive is going to change for a simple reason:

“Clearly, a weak economy in 2012 will be very good for whoever the Republican presidential candidate is. It’s hard to see how the Republicans lose by blocking stimulus.”

That is a pretty damning accusation. Bartlett is essentially arguing that the anti-stimulus crowd is doing so not for ideological beliefs, but for political advantage. He is implying their goal is to keep the economy weak in order to prevail politically.

That is quite an accusation . . . Do any of you buy it?

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UPDATE: August 29, 2010 6:00PM

Bruce Bartlett writes in to clarify my interpretation:

I don’t actually believe that there are any Republicans intentionally blocking policies that they know would help the economy just so that their party would benefit.

But on the other hand, there is no denying that a bad economy is good for the out-party, especially in presidential elections. So what we have is a situation in which Republicans can’t lose. Insofar as they actually believe that their policies would be better for the economy than Obama’s, and insofar as Obama’s policies are in fact bad for the economy, Republicans benefit politically from gridlock either way.

The only way Republicans can lose is if Obama suddenly gives them carte blanche to enact whatever policies they want and we get a 1937-type double-dip from inappropriate fiscal tightening. But then it would still be Obama’s fault for listening to them. As Otter explained to Flounder in Animal House, “You f&%ed up. You trusted us.”

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Source:
What Can Be Done to Cure the Ailing Economy?
Peter S. Goodman
NYT, August 28, 2010
http://www.nytimes.com/2010/08/29/weekinreview/29goodman.html

Your weekend home work assignment is Chris Whalen’s invective, I am Superman: The Federal Reserve Board and the Neverending Crisis:

This article asserts that, in dealing with the 2007-2009 financial crisis, the Federal Reserve Bank (Fed) has placed its role as monetary agency and de facto steward of the market for U.S. Treasury debt ahead of its statutory responsibility for ensuring the soundness of the private banks.  This is not to say that the Fed supplies whatever credit the government wants — at least not yet — but in terms of both the provision of credit to the private financial system and the price of this credit, the growing fiscal imbalances of the U.S. government seem to be playing an increasing role in Fed policy decisions.  This paper explores some of the issues involved in recent Fed policy decisions and draws some preliminary conclusions as to the conflicts between the Fed’s role as central bank and also as prudential supervisor.

Its must reading . . .

ProPublica has a devastating take down of some of the self-inflicted wounds the big bailed out banks caused, all in the pursuit of bigger bonuses. Merrill lynch, CitiGroup, UBS, Goldmasn Sachs all come in for scathing criticism for their circular CDO sales to themselves:

“Over the last two years of the housing bubble, Wall Street bankers perpetrated one of the greatest episodes of self-dealing in financial history.

Faced with increasing difficulty in selling the mortgage-backed securities that had been among their most lucrative products, the banks hit on a solution that preserved their quarterly earnings and huge bonuses: They created fake demand.

A ProPublica analysis shows for the first time the extent to which banks — primarily Merrill Lynch, but also Citigroup, UBS and others — bought their own products and cranked up an assembly line that otherwise should have flagged. The products they were buying and selling were at the heart of the 2008 meltdown — collections of mortgage bonds known as collateralized debt obligations, or CDOs. “

This is a very clear (written  for a non-technical audience) and focused article. Pro Publica doesn’t claim they are the first to report this (“Individual instances of these questionable trades have been reported before”). But ProPublica’s investigation (in partnership with NPR’s Planet Money), is comprehensive and written for the layperson. And, there is lovely chart porn (below) and a cartoon graphic.

Kudos to Jesse Eisinger and Jake Bernstein.

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click for larger graphics

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Sources:
Banks’ Self-Dealing Super-Charged Financial Crisis
Jake Bernstein and Jesse Eisinger
ProPublica, August 26, 2010
http://www.propublica.org/article/banks-self-dealing-super-charged-financial-crisis

Via Pro Publica comes the latest tale of theft and woe of the big banks derivatives scams: Selling products to themselves, artificially creating fraudulent profits (capturing big bonuses). Whent he underlying assets drop, the derivatives become worthless — but the bonuses are already spent!

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Sources:
Welcome to CDO World!
Al Granberg, Special to ProPublica
ProPublica, August 26, 2010

http://www.propublica.org/special/cdo-world

Banks’ Self-Dealing Super-Charged Financial Crisis
Jake Bernstein and Jesse Eisinger
ProPublica, August 26, 2010

http://www.propublica.org/article/banks-self-dealing-super-charged-financial-crisis

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Kotlikoff.net
http://www.kotlikoff.net/-laurence-j-kotlikoff

Source:
U.S. Financial System Still “Fundamentally Corrupt,” Kotlikoff Says: Here’s How to Fix It
Aaron Task
Yahoo Tech TIcker, Aug 24, 2010 10:37am EDT
http://finance.yahoo.com/tech-ticker/u.s.-financial-system-still-”fundamentally-corrupt”-kotlikoff-says-here’s-how-to-fix-it-535361.html

From Academy Award® nominated filmmaker, Charles Ferguson (“No End In Sight”), comes INSIDE JOB, the first film to expose the shocking truth behind the economic crisis of 2008. The global financial meltdown, at a cost of over $20 trillion, resulted in millions of people losing their homes and jobs. Through extensive research and interviews with major financial insiders, politicians and journalists, INSIDE JOB traces the rise of a rogue industry and unveils the corrosive relationships which have corrupted politics, regulation and academia. Narrated by Academy Award® winner Matt Damon, INSIDE JOB was made on location in the United States, Iceland, England, France, Singapore, and China.

http://www.insidejobfilm.com

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*Genre: Documentary
*Director: Charles Ferguson
*Cast: Matt Damon

Hat tip Infectious Greed

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Stephen J. Dubner, NYT journalist and co-author of the book Freakonomics, asks the following question at the Freakonomics/Times blog:

“How Would You Simplify the Financial-Reform Bill?

The rules were simple: 5 suggestions, 500 words.

The other participants are Nassim Taleb, Justin Wolfers (Professor of Business and Public Policy at the University of Pennsylvania), and Raghuram Rajan (Professor of Finance at the University of Chicago, former Chief Economist at the IMF).

My answer began as follows:

“The lessons of this crisis are manifestly obvious: Three decades of “Radical Deregulation” freed banks to engage in all manner of reckless behavior. Leaving the status quo in place guarantees another crisis in the future. Historical patterns suggest the next calamity will dwarf the collapse of 2007-09.

How to fix it? Here are the first 5 ideas out of a longer list in Bailout Nation that not only would have prevented this past crisis, but would also prevent the next one:″

The rest of my answer — and Taleb, Wolfers and Rajan’s — are here . . .

Government Motors, more commonly known as General Motors has filed its prospectus for listings on both the Toronto and New York Stock exchanges.  Effectively, what they did, with the help of both the Canadian and U.S. Governments, (read: TAXPAYER) is use taxpayer money to bail themselves out of one huge financial mess.  Effectively, the scheme has now come full circle as they look to come back to market to raise more funds while they undoubtedly will continue to be muscled by the unions while at the same time build crappy vehicles.  Both these factors were significantly contributed to their demise.

This is a company remember that earned $2.2 billion in the first half of this year on revenue of $64.7 billion.  A measly profit margin of 3.4%.  You soon begin to see that it won’t take much to derail this company yet again.

Marketwatch.com dug deeper into the prospectus and revealed some additional information that should raise some red flags.  (full article).  Marketwatch reported:

But look at all the balls GM is going to juggle. It's getting rid of 700 U.S. dealers and has axed four brands -- which, given other companies' experiences has led GM to conclude that "our market share could decline because of these reductions" from its current top position of 19% in North America.  [emphasis mine]

GM is also worried that four years down the road, it may have to make "significant contributions" to its U.S. defined pension plan that was underfunded by $17 billion at the end of 2009 -- when the interest rates of corporate bonds were higher. [emphasis mine]

The old GMAC, now called Ally Financial, doesn't have the financing power of old; the vaunted Chevy Volt relies on battery power "that has not yet proven to be commercially viable"; the top two executives don't have previous automotive experience; and, not to be ignored, its controls over financial reporting "are currently not effective."  [my emphasis]

Just as with Ford, there are no dividends on offer, and while it's dumped previous healthcare obligations, new ones are coming on stream.

A pig is a pig no matter what colour you paint it or what badge you place on it.  Why do I get the feeling that, just like all other bailout recipients, the can is simply being kicked down the road without the real underlying fundamentals really changing one bit.  The way I read it, taxpayers bailed out General Motors so it could continue breathing while it figured out a way to keep the lights on for a few more years.   In my view, those lights will burn out again at some point and this whole song and dance will continue.

This is a company that is drowning in bailout debt and who continues to pump out low quality vehicles.  It has seen its market share dwindle and it may never be profitable, long term, again.  I ponder the thought…..is the offering simply a ploy to raise funds to pay back the Government so this entire “Ponzi Scheme” will run its course?   I sincerely apologize if my initial reactions come across as sounding far-fetched or outrageous.  However,    given all that I have seen over the last two years, I don’t think my initial pessimism is really as outrageous as might first seem.  It’s easy really, get bailout funds from taxpayers, re-structure, show a profit with a measly 3.4% gross margins, go to the public to raise funds, pay back the Government and sucker new investors into a stock that will probably sell-off the moment it starts to trade again.  Given the problems it faces “down the road”, at some point, this whole song and dance will be forced to continue. 

I ask, would it not have been simpler to close the 700 dealerships and axe the 4 brands before going to the taxpayer?  In their infinite wisdom they would rather kill GM stock and bondholders once and position themselves to do the same to new investors.   I’m curious….is there anything in the prospectus that discusses union concessions? 

Earlier this month, I discussed a NYT OpEd by Treasury Secretary Tim Geithner (Welcome to My Job Security). Geithner pointed approvingly to the report released by Alan Blinder and Mark Zandi, advisers to President Bill Clinton and Senator John McCain, respectively:

“The combined actions since the fall of 2007 of the Federal Reserve, the White House and Congress helped save 8.5 million jobs and increased gross domestic product by 6.5 percent relative to what would have happened had we done nothing.” (emphasis added).

I did not have cause to disagree with the Blinder/Zandi numbers; they are best guesses using Moody’s econometric modeling. However, I did criticize their overall approach, saying: “That is now our standard — what was done versus doing nothing? That is truly the wrong counter-factual…”

David Weidner took issue with that assessment. In his column A Nation That Won’t Be Fooled Again, he noted:

“The financial crisis and stagnant economy have made us bitter. We’ve become a nation of complainers and critics. Nothing is ever good enough for us. The bailouts are misguided. The stimulus didn’t work or wasn’t enough. Reform is too weak or makes matters worse. It’s one thing to call the glass half empty, but these days we deny the existence of tableware.”

I don’t disagree with Weidner’s perspective. Many people have gone off the deep end, obsessing with “recession porn,” seemingly addicted to negative commentary and wild conspiracy theories.

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My disagreement with the Zandi-Blinder report is not its theoretical underpinnings — it is by definition a hypothetical counter-factual. Rather, it is the counter-factual Blinder/Zandi chose to use: “What would the economy look like now if we had done nothing?”

Instead, I propose a better counter-factual: “What if we had done the right thing, instead of nothing — or the wrong thing?”

A quick definition first: The term “counter-factual” is a term of art often misunderstood. The definition of counter-factual is a “what-if” — counter-factuals explore historical incidents by extrapolating an alternative time line:

-What-if Chrysler was not bailed out in 1980?
-What-if JPM was not guaranteed $29B of Bear’s liabilities?
-What if Citi and BofA were put into reorg/receivership?
-What if AIG’s counter-parties were not made whole 100 cents on the dollar?

We don’t have alternative universe laboratories to run control bailout experiments, but we can imagine the alternative outcomes if different actions were taken.

So let’s do just that. Imagine a nation in the midst of an economic crisis, circa September-December 2008. Only this time, there are key differences: 1) A President who understood Capitalism requires insolvent firms to suffer failure (as opposed to a lame duck running out the clock); 2) A Treasury Secretary who was not a former Goldman Sachs CEO, with a misguided sympathy for Wall Street firms at risk of failure (as opposed to overseeing the greatest wealth transfer in human history);  3) A Federal Reserve Chairman who understood the limits of the Federal Reserve (versus a massive expansion of its power and balance sheet).

In my counter factual, the bailouts did not occur. Instead of the Japanese model, the US government went the Swedish route of banking crises: They stepped in with temporary nationalizations, prepackaged bankruptcies, and financial reorganizations; banks write down all of their bad debt, they sell off the paper. Int he end, the goal is to spin out clean, well financed, toxic-asset-free banks into the public markets.

Thus, Bear Stearns is not bailed out by the Fed. Instead, the FOMC chair tells JP Morgan’s CEO “You have 9 trillion dollars in exposure to Bear derivatives. Instead of guaranteeing you $29 billion for a risk free takeover, we will start preparing a liquidation plan for Bear. And given your exposure to them, we best plan one for JPM too. (and if you don’t like that, you can kiss our ass).”

Tough talk, but the outcome would have been much better: JPM would likely have bought Bear anyway, if for no other reason than to prevent someone else from buying them, and forcing JPM into bankruptcy, to pick up their assets for pennies on the dollar. That would have set a much better tone for future bailout expectations, versus the massive moral hazard the Fed created with the Bear bailout.

Lehman? Prepackaged bankruptcy, less disruptive.

AIG ? There never was an implicit government guarantee that all counter-parties dealing with AIG-Financial Products — a giant leveraged structured finance hedge fund hiding under the skirt of the regulated insurer — would be made whole. But the Bush/Paulson/Bernanke bailout created one. Instead, AIG-FP should have been carved out for dissolution/wind down, while the insurer could have continued to exist on its own. AIG would have had the liability for the government’s costs, but the counter parties? They would have gotten zero. If you go to Vegas and shoot craps in the alley way behind the casino, don’t expect the gaming commission to collect your winnings. But that is what we did with AIG.

Fannie & Freddie: Two more crappy banks that should have been wound down. These were publicly traded companies that were guaranteed lower interest rates — not an infinite backing from taxpayers. They should have been wound down like all any insolvent bank. Today, they serve as the mechanism for backdoor bailouts of the rest of the wounded banking sector.

The same approach should have occurred with the rest of the crowd of irresponsible banks, investment houses, monoline insurers, etc. One by one, we should have put each insolvent bank into receivership, cleaned up the balance sheer, sold off the bad debts for 15-50 cents on the dollar, fired the management, wiped out the shareholders, and spun out the proceeds, with the bondholders taking the haircut, and the taxpayers on the hook for precisely zero dollars. Citi, Bank of America, Wamu, Wachovia,  Countrywide, Lehman, Merrill, Morgan, etc. all of them should have been handled this way.

The net result of this would have been more turmoil, lower stock prices, and a sharper, but much shorter economic contraction. It would have been painful and disruptive — like emergency surgery is — but its better than an exploded appendix.

And today, we would have a much healthier economy:

• Functioning Banking System: Clean banks not laden with bad paper would be actually making loans to qualified borrowers;

• Healthier Housing Sector: An unsubsidized real estate sector — no tax credits to first time buyers, no ultra low interest rates — would have had much lower prices, with far less bad mortgages floating around. We would be much further along in the foreclosure process. More of the folks who bought more house than they could afford would have moved into homes they can afford;

• Much Smaller Federal Deficits: The trillions of dollars of bailout costs on the books of Uncle Sam would not exist. Not he Tarp, not the government guarantees, not the GSEs, none of it.

• Right-sized Finance Sector: Instead of an outsized banking sector, finance in the US would be more proportional relative to the overall economy. Resources and assets (including programmers, quants, and engineers) would go to more appropriate firms.

• Bond holders Lose: Here is an insane idea: If you lend money to a firm that goes out of business, you lose most of that money (You do get a high priority in the liquidation). The US Taxpayer does not step in to guarantee the loss. Crazy, I know, but it is crazy enough that it just might work!

• Counter-parties Lose: See above

• Managements Lose: It seems that for the most part, most of the upper level bankers who helped bring about the crisis are still working for the same banks. A study found that “92% of the management and directors of the top 17 recipients of TARP funds” are still working for the same banks. Reorg would have caused these people to be fired; perhaps the bankruptcy judges would have clawed back some of the execs ill gotten gains.

• Moral Hazard: Bankers expectations that they can behave recklessly because Uncle Sam will bail them out, is dramatically reduced.

While we certainly can compare what was done with doing nothing, the proper counter-factual is to compare what was done with what should have been done.

Throwing trillions of dollars at the crisis, and hoping for the best will provide a short term improvement over doing nothing; trillions of dollars have that sort of power.

The proper comparison, however, should be versus what should have been done. Performing that analysis leads one to a very different set of conclusions . . .

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Sources:
Perhaps, It’s Time to Play Offense
DAVID LEONHARDT
NYT: September 16, 2008
http://www.nytimes.com/2008/09/17/business/17leonhardt.html

A Nation That Won’t Be Fooled Again
David Weidner
WSJ, AUGUST 12, 2010
http://online.wsj.com/article/SB10001424052748704901104575424332141218568.html

Previously:
Banking Sector Remains (literally) Unchanged (January 4th, 2010, 10)

Welcome to My Job Security (August 3rd, 2010)

Krugman’s Crisis Responsibility: Reagan or Bush ? (June 12th, 2009)

Grading Financial Regulatory Reform (June 25th, 2010)

Bear Stearns, Lehman Execs Kept Billions . . . (November 23rd, 2009)

Just in case you missed this article in The Hill, the headline will save you from any suspense: Banks to benefit most from White House program to help fight foreclosures.

Here’s the bad news:

“Banks will get the biggest benefit from an Obama administration housing program designed to help unemployed homeowners escape foreclosure.

Housing experts expressed concern that banks, not homeowners, will be helped by the White House’s $3 billion funding infusion — $2 billion from the Treasury Department and another $1 billion from the Housing and Urban Development Department — going to those states hit hardest by the housing market crash and unemployment.”

This is no surprise, as we have mentioned repeatedly (here, here, here and here), the so-called mods and abatement programs are thinly disguised back door bailouts for banks.

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Previously:
More Foreclosures, Please . . . (March 25th, 2010)

Treasury Looks to Mandate Foreclosure Abatements, Mortgage Mods (February 23rd, 2010)

Fannie And Freddie And the Backdoor Bank Bailout (May 12th, 2010)

GSEs: $1 Trillion Dumping Ground for Bad Bank Loans (June 14th, 2010)

Source:
Banks to benefit most from White House program to help fight foreclosures
Vicki Needham
The Hill 08/15/10 
http://thehill.com/blogs/on-the-money/banking-financial-institutions/114349-banks-to-benefit-most-from-white-house-program-to-stave-off-foreclo

Did you know that the London School of Economics has a “Paul Woolley Centre for the Study of Capital Market Dysfunctionality?”

Me neither!

But I found out about them a few weeks ago via MIT’s Simon Johnson, writing in the NYT’s  Economix blog about the LSE’s publication of The Future of Finance, and The Theory That Underpins It (London School of Economics Press).

The report has its own website: The Future of Finance: The LSE Report.

Here is an excerpt from the intro:

The financial crash of 2008-9 has been the most damaging economic event since the Great Depression – affecting the lives of hundreds of millions of people. The most immediate problem now is to prevent a repeat performance.

Much has been written about reforming the world financial system. But it is rarely based on a searching in-depth analysis of the underlying weaknesses within the system. Nor does it usually tackle the key question of what a financial system is for.

To correct this omission, we invited eighteen leading British thinkers on these issues to form a Future of Finance Group. They included journalists, academics, financiers and officials from the Financial Services Authority, the Bank of England and the Treasury. We have met twelve times, for what many of those present described as the best and most searching discussions they had ever participated in. The result is this book.

The issues at stake are extraordinarily difficult and profound. The central question is what the financial system is for? Standard texts list five main functions – channelling savings into real investment, transferring risk, maturity transformation (including smoothing of life-cycle consumption), effecting payments and making markets. But if we study how financial companies make their money, it is extraordinarily difficult to see how closely this corresponds to the stated functions, and it is often difficult to explain why the rewards are often so high. Any explanation must also explain why the system is so prone to boom and bust.

This is your weekend reading . . .

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Bloomberg’s Chart of the Day shows the growth in federal payouts to state and local governments, also known as grants-in-aid, in the past half century:

They have increased almost three times as fast as overall spending during the period, according to data compiled by the Commerce Department. Funds were provided at a $525 billion annual rate in the second quarter, a 33 percent jump from two years ago. Most of the money went to pay health-care expenses under the Medicaid insurance program and to cover educational costs. . . .

The federal government provided $131.25 of state and local aid last quarter for every dollar spent 50 years ago. For total expenditures, the second-quarter figure was only $45.75, as the chart illustrates.”

That’s just great . . . Now I have another book to write.

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Source:
Soaring Federal Aid Bails Out U.S. States, Cities: Chart of Day
David Wilson
Bloomberg, 2010-08-11 14:36:57.821 GMT

I love this paragraph from Bloomberg’s Caroline Baum:

“What we had was a government-prescribed course of amphetamines (to keep it up), antibiotics (to prevent infection) and antidepressants (to make it feel better). It endured regular steroid injections from both monetary and fiscal authorities. And it still has no real muscle.”

Awesome . . .

Speaking of untidy accounting issues:

The American Banker reports today that “Bank of America, in a new public filing, said it had $11.2 billion of “unresolved” mortgage buyback requests at June, a 50% spike since the beginning of the year.”

These buyback disputes are with Fannie Mae and Freddie Mac ($5.6 billion), although AB reported BofA “is having trouble with claims made to mortgage insurance firms” — in particular, the monoline insurers, for another $4 billion.

AB quoted the bank’s 10-Q SEC filing as acknowledging that “disputes have increased with buyers and insurers regarding representations and warranties.”

BofA is the second largest residential funder in the US

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Source:
Bank of America FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
Quarterly Period Ended June 30, 2010
Commission file number: 1-6523
SECURITIES AND EXCHANGE COMMISSION, August 6, 2010
http://www.sec.gov/Archives/edgar/data/70858/000095012310074181/g24023e10vq.htm

Bank of America Buyback Disputes Top $11.2B
American Banker | Wednesday, August 11, 2010
http://www.americanbanker.com/issues/175_153/bank_america_buyback_disputes_11.2b-1023892-1.html

Over the past few months, we have learned about extraordinary levels of excessively bad corporate behavior.

As bad as the Bailouts were from an economic, wealth transfer, and moral hazard perspectives, it turns out that the grim reality was an order of magnitude worse than previously believed.

We have since learned that many TARP recipients, bailed out banks and other ne’er-do-wells were actively engaged in cooking their books. I don’t mean various FASB 157 permission to lie, and other legal but nefarious activities. I am referring to the 2002-2007 era of scams, frauds, and outright theft.

The public’s righteous indignation over the lack of just desserts for the perpetrators of these frauds has morphed since September 2008 into an unresolved, unfocused anger. When this all plays out, we might very well see bonus clawbacks, fines and penalties, disgorgement of ill gotten gains, and criminal arrests for some of the major names at the biggest brokerage houses.

Why do I think that 2 years later, some justice might be done? The truth is slowly coming out, as insiders provide testimony, release papers, and even offer up recordings of conversations to various investigators and prosecutors.

• Lehman Brothers: used “Repo 105 transactions” to remove $50 billion of liquid assets from the balance sheet at quarter-end in 2008 in order to mislead investors as to Lehman’s net leverage. It also hid from view billions of dollars worth of troubled assets. The latest reveal is that Lehman CEO Dick Fuld was aware of this accounting technique. Do not be surprised to see some form of indictment of Dick Fuld over the next 12 months;

• Merrill Lynch: Engaged in a different but just as nefarious technique to hide leverage and losses , thereby to misleading public investors, the NYT reported yesterday:

“Pyxis was created at the height of the mortgage mania as a sink for subprime securities. Intended for one purpose and operated off the books, this entity and others like it at Merrill helped the bank obscure the outsize risks it was taking.”

This took place during the riegn of Stan O’Neal, who left Mother Merrill with an egregious $161.5 million in severance.

• Citigroup: Similarly shifted CDO risks and leverage off its books, failing to disclose them to investors and regulators during the era of Citi with Chuck Prince as CEO (who walked away with over $40 million in severance).

• Morgan Stanley, Bear Stearns, Wells Fargo, Wachovia, Wamu, B of A: What of the rest of the major banks and investment houses? I recently asked a very savvy credit analyst about who else engaged in these SIVs, swaps, off balance transactions, and other fraud with the intent to deceive investors and regulators.

His answer?

“Pretty much all of them. The only exceptions are probably Goldman Sachs and JP Morgan (I have no evidence they did this). The rest of the Street either are known to, or are unknown but likely to have engaged in the same behavior. Morgan Stanley, Bear Stearns, Wells Fargo, Wachovia, Wamu, B of A, all of them.”

Lacking evidentiary proof, I was not permitted to quote him by name.

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I have long believed that the general anger of the public about the bailouts were about the inherent injustice in bailing out incompetent bankers who made tidy profits and huge bonuses through their own incompetence.

It turns out that this was more than mere incompetence, this was a malicious fraud, a full on intent to deceive the investing public in order to grab huge bonuses, economic consequences tot he nation be damned.

But the noose is slowly tightening. The FCIC has undercovered documented illegal behavior, while a newly revitalized SEC opens more cases.

In the post Sarbanes-Oxeley era, where CEOs signed off on their accounting statements and quarter earnings release, that calls for investigation, prosecution, confiscation — and jail time. As much as the public has been frustrated, they may very well see some justice soon . . .

Here is the key portions of the FOMC statement:

“Information received since the Federal Open Market Committee met in June indicates that the pace of recovery in output and employment has slowed in recent months.”

“The pace of economic recovery is likely to be more modest in the near term than had been anticipated.”

“Inflation is likely to be subdued for some time.”

“Exceptionally low levels of the federal funds rate for an extended period.”

“To help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve’s holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities.”¹

Note that this is not quite QE2, so lets call it QE 1.5.

Also of interest: Hoenig voted against . . .

Nice interactive graphic from the FT on reforming the financial system

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The financial centers covered in the graphic are: US, European Union, UK, Germany, Singapore, Hong Kong, Japan.

Over the past few years, I have increasingly taken to referring us humans as “Slightly smarter, pants wearing primates.” (here, here and here). When I discussed it in an Forbes interview (Ritholtz’s Monkey Theory)  it generated a ton of email:

What is the greatest financial lesson you’ve ever learned?

You’re a monkey. It all comes down to that. You are a slightly clever, pants-wearing primate. If you forget that you’re nothing more than a monkey who has been fashioned by eons on the plains, being chased by tigers, you shouldn’t invest. You have to be aware of how your own psychology effects what you do. This is why we as investors sell at the bottom, get panicked. All the other lessons I’ve learned have come out of that. As has the field of behavioral economics.

Wall Street clichés, like “cut your losses and let your winners run” come back to prevent the monkey part of your brain from doing what it does. There’s a banana–I want it. That’s how chimps behave. Us humans react to greed and fear in predictable ways. We are predictably irrational. If you understand that you can take steps to prevent that–we don’t own anything in the office that doesn’t have a stop-loss on it. In 2008, we watched the market go down 40%. We figured out we’re chimps, and don’t let the chimp inside us make those chimp-like decisions.

Every good financial decision I’ve made comes from, “Wait a second, monkey boy, step back, don’t do that.” Once you realize how your own brain chemistry works against you, it gives you a chance to not panic at the bottom.

It was (mostly) a glib comment to show how irrational and biased us monkeys can be. (I even made reference to it in Bailout Nation.)

It turns out that joke was closer to the truth than anyone believed. Laurie Santos gives a talk at TED that looks at how shockingly similar our biases are to those of monkeys when it comes to hardwired foolishness.

The good news, for investors as well as monkeys, is that recognizing our limitations — acknowledging, learning the details of, and contextualizing them — allows us to rise above them . . .

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Previously:
Festival of Links (May 21st, 2006)

How Rational Are Markets? (January 16th, 2008)

How Overrated is Sentiment in Economics? (November 22nd, 2009)

Sources:
Ritholtz’s Monkey Theory
David Serchuk
Forbes 03.13.09
http://www.forbes.com/2009/03/12/barry-ritholtz-interview-intelligent-investing-ritholtz.html

Laurie Santos: A monkey economy as irrational as ours
TED, July 2010
http://www.ted.com/talks/laurie_santos.html

Hank Paulson, the criminally inept Treasury Secretary who shoveled trillions of taxpayer dollars to insolvent banks, facilitated the grand theft of some near $20 billion dollars from AIG by Goldman Sachs (where he was previously CEO), is attempting to change the narrative of the credit crisis and collapse.

In today’s Washington Post piece, Paulson ignores facts, rewrites history, and fabricates causes of the economic collapse:

“A significant root cause of the crisis was the combined weight of government policies promoting homeownership; these are apparent in the housing GSEs, the Federal Housing Administration (FHA), the Federal Home Loan Banks, the federal tax deduction for mortgage interest and various state programs. Homeownership was overstimulated to the point that it was unsustainable and dangerous to the broader economy.”

Let us point out a small problem with Paulson’s rewrite: Throughout the 20th century, interest rates were kept in a realistic range, at least relative to economic growth, by bond traders and the Fed.

At the same time, bank lending standards were based upon historically well founded measures: The borrowers ability to service the debt. Factors that impacted this involved such quaint notions as income, employment history, credit score, other debt obligations, and assets. Further, home loans were based on specific Loan to Value — LTV — meaning that a substantial down payment was actually required. And last, legitimate appraisals were performed at the behest of banks that actually kept these loans on their books for 10 or 20 years — not 30 days.

None of this finds its way into Paulson’s assessment of the causal factors.

How about Alan Greenspan? That is a major systemic risk at the root of the crisis. Greenpan’s tenure as Fed chair was one of irresponsibility and recklessness. His Federal Reserve’s generational low rates set the housing spiral into motion originally. Somehow, Paulson did not see fit to so much as mention Greenspan or the Federal Reserve at all.

Despite repeated warnings by some Fed members, Greenspan directed the Fed to commit nonfeasance — to fail to fulfill its obligation as regulator of lenders. They allowed a proliferation of irresponsible, non-bank subprime mortgage underwriters, who abdicated any and all lending standards. If you really want to find the root causes of the crisis, you begin there. Just don’t look for any mention of subprime lending in Paulson’s commentary. Just as astonishingly, Paulson fails to so much as mention the Federal Reserve’s ultra low rates.

Other things somehow missing from the Paulson commentary? How about the word “derivatives?” Perhaps that might have been a factor? Misaligned Wall Street compensation? Excess Leverage of investment houses? The Repeal of Glass Steagall? The Federal Pre-emption of state lending rules? 

Don’t bother looking for any of these either . . . they were not deigned worthy by the former Gioldman Sachs CEO, and are thus omitted from his discussion as well.

Perhaps the former US Treasury Secretary can explain how the world had a global housing boom and bust — countries not covered by the FHA or GSEs. How did THAT happen? Indeed, the boom and bust in the US was smaller than that of many other nations. And the FHA/GSE role in that? Perhaps the former Treasury Secretary can explain the root causes of that.

Paulson oversaw the greatest transfer of wealth in the history of mankind — from taxpayers to insolvent banks and their bondholders. His commentary is thinly veiled attempt to rewrite what actually occurred, and to shift his own sad role from conductor of the theft, to hapless victim of long standing government policy.

If this exercise wasn’t such a transparent attempt at self-exoneration, it would be amusing, Instead, it is merely pathetic.

Paulson’s book on the crisis is “On the Brink.” It should be titled “Too Much to Drink.”

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Source:
Housing policy must be set on sustainable basis
Hank Paulson
Washington Post, July 30, 2010
http://www.washingtonpost.com/wp-dyn/content/article/2010/07/29/AR2010072905007.html

Yet another economist who dines at the restaurant of the free lunch: David Greenlaw of the US Economics Team at Morgan introduces what he calls a “Slam Dunk Stimulus” of sorts:

“If it were possible to inject a significant amount of stimulus into the US household sector, and this stimulus had zero impact on the budget deficit, did not require an exit strategy, did not distort the markets, and took effect almost immediately, wouldn’t it seem like a slam dunk? Such an option actually exists in the form of a change to mortgage refinancing requirements.”

His proposal? Change the Loan-to-Value requirements of homeowners applying for a refinancing.

In other words: The solution to poor lending standards and ultra low rates is to reduce the lending standards further to take advantage of even lower rates.

WTF? If that sounds absurd, it probably is because it is.

The best rationale that Greenlaw musters for doing this is that Uncle Sam is already on the hook for the existing debt, so why the hell not do the refis: “The Federal government stands alone as the guarantor of the principal value of agency-backed mortgages.”

But that leads to such absurd conclusions as Greenlaw’s argument for a streamlined refi process for agency mortgages. In his final sentence, he states: “Quite simply, there is no need for a case-by-case credit analysis when the principal value of the mortgage is already backed by the government.”

I’m sure that will work out just fine . . .

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Source:
Slam Dunk Stimulus
David Greenlaw
Morgan Stanley, July 27, 2010
US Economics
http://www.morganstanley.com/views/gef/team/index.html

Back in 2008, I ran this updated chart of the Case Shiller Housing Price Index by BP reader Steve Barry.   It was widely reproduced around the web. (Unfortunately, some unscrupulous folks striped Steve’s authorship off of it, and passed it off as their own).

I asked Steve to update Shiller’s NYT chart, now that much of the government intervention has run its course. There is still massive Federal Reserve subsidies in the form of record low rates. But the short term bounce caused by HAMP, Foreclosure abatements and first time home buyers tax credits are mostly over.

Here is Steve’s chart:
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click for ginormous graphic

Chart courtesy of the NYT, as modified by Steve Barry

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Previously:

Classic Case Shiller Housing Price Chart, Updated (December 30th, 2008)

A Closer Look at the Second Leg Down in Housing (June 24th, 2010)

“The answer is yes, it does. If it didn’t, I wouldn’t be able to justify getting out of bed in the morning and charging the outrageous fees that we charge our clients, which they willingly pay.”

-A former regulator, now corporate lobbyist, as to whether he had an inside edge in lobbying his ex-colleagues

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Well, don’t let it be said that this Congress isn’t creating jobs: The 2,300 page financial reform bill seems to be generating demand for more of what we surely don’t need: Corporate Lobbyists.

150 lobbyists that used to work in the executive branch — lawyers for the Securities and Exchange Commission, Commodity Futures Trading Commission, Federal Reserve bankers, and other regulatory agencies — have registered as lobbyists. Add to that 100s of attorneys “scouring the financial regulations” on behalf of corporate clients, and you have the makings of a small army of former Federal employees. They are now working for the firms they used to regulate.

The lobbyist’s goal? Now that finreg legislation has passed, they seek to influence the future rule making that has been written into the new law. According to a NYT:

• The law firm of Davis Polk determined that 243 new financial rules and 67 new studies are required by the legislation.

• The S.E.C. must developing 95 rules (derivative trading, credit rating agencies standards, executive bonus disclosure).

• The Commodity Futures Trading Commission must develop 61 rules.

• Federal Reserve is required to develop 54 specific rules.

• The 2 new agencies created by Congress — Consumer Financial Protection Bureau and the Financial Stability Oversight Council — will create 80 new financial oversight and disclosure rules.

The firms that will be covered by these rules are seeking to influence them before they are even written: Water them down, reduce disclosure requirements, soften oversight, neuter penalties.

As we previously discussed, the bang these firms get for their bucks is extraordinary.

The battle continues . . .

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Previously:
Government for Sale: 2009 Lobbying $3.49 Billion (July 14th, 2010)

Source:
Ex-Regulators Get Set to Lobby on New Financial Rules
ERIC LICHTBLAU
NYT, July 27, 2010   
http://www.nytimes.com/2010/07/28/business/28lobby.html

Terrific visualization from Information is Beautiful showing a treemap of different government spending that helps contextualize what $1B large is.

Please note how the size of the Bailouts overwhelm everything else — Defense, education, wars, entitlements, etc:

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Spreadsheet here

NYT headline:

G.M. Spends $3.5 Billion for Lender to Subprime.

The purchase of Americredit is the last step GM needs before it can take itself public again. With that piece of the puzzle in place, “Government Motors” can now accelerate its bid to return to the NYSE.

Look for GM to file its SEC registration statement as soon as next month. Their IPO should raise $10-20 billion dollars.

If the filing takes place later this summer — before Labor Day — then the initial public offering itself will occur in the Fall. I would expect that GM will be public prior to the 2010 November Congressional elections.

No word on who the underwriters will be — but post SEC settlement, it would be surprising if Goldman Sachs was not prominently on the book, along with fellow bail-outtees Morgan, BA/MER and Citi. If had to guess, it would be that the lead banker will be JPMorgan, led by wonder-boy/WH fave Jamie Dimon.

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UPDATE: July 23, 2010 9:25am

Time magazine says “GM IPO? Don’t Hold Your Breath,” but Reuters claims the IPO registration statement will be filed after Q2 earnings are reported . . .
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Previously:
When Does GM Get Kicked Out of the DJIA? (November 7th, 2007)

When Does GM Get Kicked Out of the Dow, part II (June 26th, 2008)

GM: Out of the Dow (May 7th, 2009)

Top 10 Things the Letters “GM” Stands For (April 2nd, 2009)

“Whoever is in command will determine the agency’s path. When you have a lot of power vested in an agency, everything depends on how effectively they carry out their rulemaking authority.”

-Kathleen Engel, a Suffolk University law professor who sits on the Federal Reserve’s Consumer Advisory Council (WSJ).

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The real question is, who will be the first chairperson of this agency ?

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Source:
Consumer Agency’s Path Will Be Set by First Chief
SUDEEP REDDY
WSJ, JULY 6, 2010
http://online.wsj.com/article/SB10001424052748704699604575342992848011622.html

UPS lobbyists have buried a short 230-word legislative bailout deep inside the FAA Reauthorization Act of 2009 currently before Congress. It’s worth billions to “Big Brown” at the expense of today’s American economy that thrives on next-day commerce, competitive shipping options and ready access to markets around the world.

I believe the site Brown Bailout is Fedex related.

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