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What’s a few billion dollars?

October 26, 2011

Must read

Perspective;  A billion dollars effectively represents about $3.20 for every adult and child in the U.S.  A trillion dollars represents about $3,200 dollars pehe person. The National Institutes of Health (NIH), which funds basic medical research in cancer, diabetes, multiple sclerosis, Alzheimer’s, autism, and other conditions, and where the total annual budget is about $31 billion annually (roughly $100 per American). Add in just over $7 billion in research through the National Science Foundation, and about $120 per citizen a year is spent by the government on essential medical and non-military scientific research through these agencies. These figures pale in comparison to the amounts that are increasingly demanded in order to make bondholders whole on their voluntary, bad investments. 

The Federal Reserve provided an amount equal to the entire NIH budget simply to backstop the rescue of Bear Stearns, which allowed those bondholders who voluntarily lent to Bear Sterns to receive 100 cents on the dollar, plus interest. 

The federal Govt provided $185 billion to bail out AIG

The most troubling revelation in this story is the astonishing weakness of the Federal Reserve and its incompetence as a faithful defender of the public interest.
“A five-member COP, chaired by Harvard professor Elizabeth Warren, has produced the most devastating and comprehensive account of the AIG ordeal. Unanimously adopted by its bipartisan members, it provides alarming insights that should be fodder for the larger debate many citizens long to hear—why Washington rushed to forgive the very interests that produced this mess, while innocent others were made to suffer the consequences. The Congressional panel’s critique helps explain why bankers and their Washington allies do not want Elizabeth Warren to chair the new Consumer Financial Protection Bureau.”

Incomprehensibly large bailout figures now get tossed around unexamined in the wake of the 2008-2009 crisis (blessed, of course, by Wall Street), while funding toward NIH, NSF and other essential purposes has been increasingly squeezed. At the urging of Treasury Secretary Timothy Geithner, Europe has been encouraged to follow the “big bazooka” approach to the banking system. That global fiscal policy is forced into austere spending cuts for research, education, and social services as a result of financial recklessness, but we’ve become conditioned not to blink, much less wince, at gargantuan bailout figures to defend the bloated financial institutions that made bad investments at 20- 30- and 40-to-1 leverage, is Timothy Geithner’s triumph and humanity’s collective loss.

The most depressing display of math-illiteracy by investors last week was the excitement over a report suggesting that France and Germany had agreed to a 2 trillion euro bailout package for Europe. It was almost beyond belief that investors took that report seriously, but people have become so tolerant of unbelievably large figures that virtually any bailout number can now be tossed out without triggering the least bit of scrutiny. Notably, 2 trillion euros is more than the GDP of France, and is half the GDP of Germany and France combined.

The way that Europe can be expected to deal with this is as follows. First, European banks will not have their losses limited to the optimistic but unrealistic 21% haircut that they were hoping to sustain. In order to avoid the European Financial Stability Fund from being swallowed whole by a Greek default, leaving next-to-nothing to prevent broader contagion, the probable Greek default will be around 50%-60%. Note that Greek obligations of all maturities, including 1-year notes, are trading at prices about 40 or below, so a 50% haircut would actually be an upgrade. Given the likely time needed to sustainably narrow Greek deficits, a default of that size is also the only way that another later crisis would be prevented (at least for a decade, and hopefully much longer).

Gradually, but eventually, European leaders are beginning to recognize that you can’t solve a sovereign debt crisis by expanding the quantity of sovereign debt, when even the strongest countries are already bloated with it. You can’t get “Out” by walking through yet another door marked “In.” 

Of course, Europe wouldn’t need to blow all of these public resources or impose depression on Greek citizens if bank stockholders and bondholders were required to absorb the losses that result from the mind-boggling leverage taken by European banks. It’s that leverage (born of inadequate capital requirements and regulation), not simply bad investments or even Greek default per se, that is at the core of the crisis.


On the subject of bank capital, I can’t stress enough that the proper approach is for government to restrict even temporary, fully-collateralized assistance only to those institutions that are clearly solvent, and to promptly restructure the other institutions. What the global economy needs most is not bank bailouts, but to establish and enforce a legal and regulatory structure that allows the streamlined bankruptcy of insolvent institutions(Title II of Dodd-Frank addresses this with a more comprehensive policy than existed in 2008, but it doesn’t read as a “clean” solution in my view – putting too many cooks in the kitchen – particularly the Fed and the Treasury).

Again, again, again, the “failure” of a financial institution only means that the institution fails to pay off its own bondholders. Depositors typically lose nothing. For example, “saving” Bear Stearns meant primarily that Bear Stearns’ bondholders would be made whole. Saving Dexia a few weeks ago meant the same thing for Dexia’s bondholders. The key is not to prevent “failure,” but to prevent disorderly failure and piecemeal liquidation. Washington Mutual was a seamless, and therefore nearly unmemorable “failure.” Lehman was disorderly and jarring. The difference was that there was a legal and regulatory structure to quickly cut away stockholder and bondholder liabilities in the Washington Mutual instance (which was handled by the FDIC), while there was no similar way to restructure non-bank financials like Lehman in 2008.

From my perspective, weak regulation of bank leverage, inadequate capital requirements, and the need for prompt, streamlined restructuring for insolvent banks are among the most urgent problems that the global economy faces. Consider this. The Financial Times reported on Friday that in 2008, Dexia lent 1.5 billion euros of its capital to two institutional investors, who used the cash to buy newly issued shares in … wait for it … Dexia. Remember that as a bank, Dexia operated at leverage of about 50 times its tangible shareholder equity (see last week’s comment ). So Dexia’s maneuver made it possible to meet regulatory capital standards and take on a huge amount of additional leverage, without actually raising any bona-fide capital. As FT noted, “The unorthodox funding move, which roused Belgian regulators’ concern at the time, amounted to Dexia borrowing money from itself to finance a capital increase. This is illegal in most jurisdictions and is now banned in the European Union, but did not break Belgium’s existing laws.”

On a similarly outrageous note, Bloomberg reported last week that ” Bank of America , hit by a credit downgrade last month, has moved derivatives from its Merrill Lynch unit to a subsidiary flush with insured deposits… The Federal Reserve and the Federal Deposit Insurance Corp. disagree over the transfers, which are being requested by the counterparties. The Fed has signaled that it favors moving the derivatives to give relief to the bank holding company, while the FDIC is objecting. The bank doesn’t believe regulatory approval is needed.” Well, other than that it goes against Section 23A of the Federal Reserve Act , but then, the Fed can make an exemption whether the FDIC likes it or not . And that’s what we’ve come to – government of the banks, by the banks, and for the banks (because banks are people too) . 

The Bloomberg report continued, “B ank of America’s holding company — the parent of both the retail bank and the Merrill Lynch securities unit — held almost $75 trillion of derivatives at the end of June, according to data compiled by the OCC. About $53 trillion, or 71 percent, were within Bank of America NA [the FDIC insured entity], according to the data, which represent the notional values of the trades. That compares with JPMorgan’s deposit-taking entity, JPMorgan Chase Bank NA, which contained 99 percent of the New York-based firm’s $79 trillion of notional derivatives.”

Note that the figures are in trillions, not billions (U.S. GDP is $15 trillion). That said, the vast majority of the “notional value” of derivatives in the financial system represents multiple fully-hedged links in a long chain between final users who actually take the risk, so Bank of America’s true risk is most probably a tiny fraction of that notional amount. Unless those derivatives include unhedged short positions in credit default swaps on Greek debt (which we can’t really rule out), it’s not clear that the derivatives themselves are underwater. The real problem, in my view, is that the transfer is clearly driven by the intent to get around capital adequacy regulations, and runs precisely opposite to the right way to create a good bank and a bad bank . It saddles the good bank – the taxpayer insured one – with the questionable liabilities, while “giving relief” to the holding company. This is really preposterous.

As a final note, it’s worth observing that a number of banks reported positive “earnings surprises” last week. If you look at those results for any of the major banks, it is immediately clear that the bulk of the earnings were of two sources: further reductions in reserves against potential loan losses, and an accounting gain known as a “Credit Valuation Adjustment.” Those two items, for example, were responsible for nearly 90% of Citigroup’s reported “earnings.” The Credit Valuation Adjustment (CVA) works like this: as the bond market has become more concerned about new financial strains, the bonds of U.S. banks have sold off significantly in order to reflect higher default probabilities.   The decline in the market value of their bond liabilities means that the banks could technically “buy their bonds back cheaper.”  Under U.S. accounting rules, banks no longer mark their bonds to market, but happily take the accounting gain.

So the decline in the bonds, despite being due to an increase in investor concerns about bank default, actually gets reported as an addition to earnings! Surprise, surprise.

2 Comments leave one →
  1. Ktown Posse Pal permalink
    October 27, 2011 9:16 pm

    This financial mess reminds me of that Eddie Izzard routine where he’s talking about genocide, specifically Pol Pot and the Khmer Rouge. To paraphrase Izzard, we can readily get outraged and upset at the murder of one, two or even a family of four (“In Cold Blood” or serial killers galore), but when the numbers reach unfathomable limits, we glaze over, our sensitivities go numb at the … inconceivable, literally, nature of what has happened. Same with these astronomical figures (and thanks for simplifying matters with that per-person accounting). We can get outraged at the Boy Scout troop’s treasurer embezzling a couple of grand, or at some devious bank clerk (“Psycho”) making off with a thou here and a thou there, or an unscrupulous bank that charges extraordinarily high fees with little or no warning or recourse.
    But when we (most of us, that is) try to sort out What the Hell Has Happened, it is confounding.
    I think a person could make a very decent living giving weekend seminars on international economics. There must be a way to spell it out for us: Economics for Dummies? “It’s the economy, stupid!” indeed. I AM stupid. I would need LOTS of charts and graphs, and lots of repeating and metaphors and similes! One thing I know: It is NOT the same as trying to manage my own household finances; far more complex than some simplistic thinkers (you know what I’m talkin’ about) would have us accept/believe/sign on for.
    I am mathematically challenged, and although I am a lifelong investor, I am a dinosaur in my methodology.
    It’s discouraging how uninformed the electorate is … especially if I am among the group that has even a clue, which (oh, please) I think I do.
    Thanks for the ongoing tutorial, the outrage, the passion.

  2. debaseface permalink
    October 27, 2011 10:22 pm

    If it was not clear, I did not pen that blog but rather a fund manager. Must read

    But I agree with your analogy. We are all shocked to hear the donation box at the church was robbed of $15.76 cents, but are happy to hear the Govt risked trillions to save save some rich fucks from losing money on their bank debt and equity investments.

    Everbody is so happy that Greece was saved via a $1.5 trillion bail out fund, but watch people start lining up to tap that free money…
    “There’s a political problem for the government,” said Gavin Blessing, a bond analyst at Collins Stewart Plc in Dublin. “The Greeks, who are seen to be behaving badly, get rewarded, whereas the Irish, the top boys in the class, get nothing.”
    “Why is it acceptable to write down Greek debt, when the Irish pay private bankers’ debts?” Gerry Adams, leader of Sinn Fein, said in parliament.
    We all need a god damn bail out.

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