Stress-Test Ambiguity

We are told by the Government that federal Regulators are in the midst of applying a series of "stress-tests" to major US financial institutions. These tests will purportedly measure a Bank's ability to withstand a continued deterioration of economic conditions. On a positive note, it appears that the Government has come to understand the concept that not all capital is created equal, and will be focusing on Tangible Common Equity as a determinant of overall health. Unfortunately, the Government has neglected another more important concept, one that the Market has demanded continually since the onset of the Crisis. The concept we refer to is transparency, specifically with respect to the Rules of the game.

The Government has failed to provide any guidance as to what will constitute a passing grade under the parameters of the "stress test". Clearly, this ambiguity is by design. Were the Government to release a comprehensive set of parameters for Bank health assessment, the Market would very quickly be able to distinguish between the winners and the losers. However, this outcome is highly unacceptable to the Government for a very simple reason: Control. The Government, emboldened by its new found clout over corporate America, will accept nothing other than full Control over the situation.

Now, we would like to point out that no sooner had the Government dispersed the first tranche of TARP money than reports emerged that cronyism and favoritism had influenced the selection of particular Bank's for receipt of TARP funding. This, we believe, will continue to be the name of the game, a requirement for continuance of said game being a lack of transparency regarding the true financial health of institutions. We may, however, be incorrect. Sphere: Related Content

The Coming Bank Dichotomy

We recall from the Panic of last fall, and subsequent imposition of TARP funds upon US banks, that there was at least some degree of clamor from institutions who felt that they did not "need" any TARP money. That resistance movement turned out to be a short lived one indeed, as Paulson and Company did not want to expose an institution as "sick" for visiting the Government trough. The ensuing weeks saw the Government spread TARP funds across the nation, often in a politically selective fashion, to institutions large and small.

Interestingly, today has brought the first announcement of an insitution that has decided to return its TARP money to the Government. Apparently, Iberiabank Corporation of Lafayette, LA has decided that paying 8% for Government money is too expensive. Now, this decision makes complete logical sense. As the populist roar has been amplified, and the punitive Administration rhetoric has revved up, one would only expect that any TARP recipient able to do so would return the money(perhaps the executives are planning to make a deposit on a new Gulf Stream jet this weekend). 

We feel certain that many others will follow suit in the coming weeks and months, and choose to settle up with the Government. Of course, only the strong institutions will be in a position to do so. Once this process has had some time to unfold, there should emerge a clear dichotomy between those insitutions who have freed themselves from the shackles of the TARP money, and those who are too feeble to be taken off of life support. The irony is that, in the end, the Government will be unable to prevent the very circumstances it sought to avoid at the onset of the TARP program. The Government's bumbling, onerous oversight will cause the willing and able to flee, while pulling those sick insitutions further into the abyss. This is at least how we see it. 

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The Fed's Maginot Line

In 1939, the French completed construction of the Maginot Line, a truly massive undertaking that sought to fortify the border between France and Germany. The Maginot Line was built in response to the traumatic events of WW1, as well as the looming threat of Germany. In theory, the Line would serve as an impregnable wall of defense, negating any possibility of a German invasion. The finished product did not disappoint, and succeeded in providing the French with a certain peace-of-mind regarding their national security.

Unfortunately, in1940 the Germans launched an offensive codenamed "cut-of-the-sickle", in which they invaded Belgium at the weakest available point, circumvented the entire Maginot Line, and invaded France via the Belgian border. German troops quickly advanced upon Paris, and the city fell with minimal real resistance.

We would submit to our readers that the Fed has constructed its own figurative Maginot Line for the equity markets at the approximate lows of the bear market that ended in 2003. This level marks an extreme support for the markets, a powerful breaching of which could ultimately send the equity markets to multi-decade lows. With the abolition of defined pension plans, the retirement savings of millions of Americans are tied up in 401k's that primarily invest with a long strategy. A continued deflation of equity prices would force millions of Americans to put retirement on hold. We see the same panicked behavior in the Government's response to declining housing values. These too are a necessary part of the equation.

Aside from the issue of delayed retirement would be the widespread recognition that the decades-long trend of ever increasing wealth and prosperity has largely been an illusion. The opiate of continued asset inflation has made the average American numb to the crumbling fundamentals of the economy. We hold that the Government/Fed have a vested interest in the doling of that opiate to the masses, as it keeps the citizenry happy and preoccupied with the  accumulation of material objects, all the while oblivious to reality.

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"Expert" Quote of the Day

We would like to direct our reader's attention to the following quote from Steven Wood, an analyst at Insight Economics. When asked to provide his assessment of the US housing market, Mr. Wood chose to grace us all with this insightful and prescient analysis:

"A sustained recovery in the housing market is unlikely until home prices stabilize"

The fact that a majority of middle school students would have been capable of producing the previous statement aside, we feel that this comment is indicative of the "experts" utter cluelessness within the current economic environment. 

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Japan's Put Option

For the first time since the developed world began its painful deleveraging process, a nation has openely entertained the idea of direct intervention into the equity markets by way of outright purchases of stock. The Japanese certainly can not be faulted for feeling a bit dissatisfied with the way things have turned out over the past two decades. During this time frame, the Nikkei has fallen from 40,000 to a mere 8000, and real estate prices have remained consistently negative. With the importance of the equity markets insofar as bank capital requirements and a littany of insurance company obligations, we are not surprised that the Japanese have apparently reached a breaking point. The question is, however, at what point will other nations follow the lead of the Japanese and institute radical policies of stock market interventionism. When, we ask, will the Great Bernanke himself begin "pulling the lever" in a desperate act aimed at bolstering the equity markets? Nothing would surprise us at this point, however, allow us to emphasize the reality that to date, every Government action has been anticipated and met with a more resilient and powerful Market action. Caveat Emptor. Sphere: Related Content

(Under)Capitalized?

The recent announcement from the powers above, that the nation's financial institutions would soon be subjected to a series of "stress tests" has prompted much discussion concerning the proper methods of measuring capital adequacy. We have of course been bombarded by statements from bank executives throughout the course of the Crisis, who have assured us that, according to Tier 1 Capital Ratio's, their banks are well-capitalized. Although these statements are true, the CEO's were unable to convince the Market, which deemed Tier 1 to be an irrelevant measure at this point in time. Under the TARP program capital injections, the government received preferred equity stakes in the receiving institutions. The Tier 1 ratio treats these preferred stakes as capital, however the Market came to interpret this new money as simply a form of long term financing. 

Alas, the measure of Tangible Common Equity has emerged from exile, and claimed the senior most role in determinations of banking system capital adequacy. Immediately following loan loss reserves, Tangible Common Equity is the first part of the capital structure to withstand losses. Unfortunately, the Crisis has intensified by orders of magnitude, the bank's losses have blown through all loss reserves, and Tangible Common Capital has been decimated. To put the matter in perspective, the eight largest US Financial Institutions have combined assets of $12.17T(GAAP reported) and only $405B in Tangible Common Equity. 

We have assessed scenarios of de facto nationalization whereby the Government converts its preferred TARP stakes into Tangible Common Equity, and submit that at this point, there is little else to do. However, in the end we see this as measure that does little more than reduce the severity and speed of the decline, while ultimately prolonging the pain.

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The Credibility of Bernanke

The equity markets, behaving in typical fashion, have staged a brief rally in response to testimony by the Great Bernanke. Today's speech is no different than the multitude of Fed pronouncements that have preceded it, with talk of a recovery on the horizon, and anti-nationalization rhetoric. To be clear, we do not proclaim to possess a crystal ball capable of short term market prognostications. However, we do feel that there is at least some value in conducting the following exercise. The quotes below are from none other than Bernanke himself, taken from speeches/testimony/pronouncements made during the previous twelve months.

February 14th, 2008 " At present, my baseline outlook involves a period of sluggish growth, followed by a somewhat stronger pace of growth starting later this year as the effects of monetary and fiscal stimulus begin to be felt"

April 2nd, 2008  "monetary and fiscal policies are in train that should support a return to growthin the second half of this year and next year.''

July 15th, 2008, "Our banking system is well-capitalized"

October 15th, 2008, "Fortunately, the Congress and the Administration have acted at a time when the great majority of financial institutions, though stressed by highly volatile and difficult market conditions, remain strong and capable of fulfilling their critical function of providing new credit for our economy."

November 18th, 2008 "There are some signs that credit markets, while still quite strained, are improving"

February 24th, 2009 “If actions taken by the administration, the Congress, and the Federal Reserve are successful in restoring some measure of financial stability -- and only if that is the case, in my view - - there is a reasonable prospect that the current recession will end in 2009 and that 2010 will be a year of recovery,”

We would submit that the quotes above are worth a thousand words/data/charts with respect to the credibility of the Federal Reserve.

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The Polarization of Discourse

Without discussing the merits of bank nationalization (we have already made our views quite clear), we would like to focus on the increasingly ideological nature of the public debate. The modern political reality in the United States, especially with regard to the debate of recent economic developments, is the formation of two diametrically opposite schools of thought. This sort of behavior was quite evident during recent "bailouts" of the financial and auto industries, as well as the crafting of numerous "economic stimulus" measures. The two sides, of course, are those who would prefer to strictly adhere to a market based capitalism to solve our problems, and those who believe that firm Government intervention is the only way to escape financial ruin. Pragmatism, it seems, is often ommitted from the discussion.

Insofar as the debate over bank nationalization has proceeded, we would submit that a classic "false choice" argument is being furthered by both sides. The free market folks prefer to conjure imagery of a nationalized bank being run by inept politicians and red-tape bureaucrats running wild. Conversely, the proponents of Government intervention have adeptly tapped into a vein of populist rage, arguing that these insitutions must be fully nationalized in order to get credit "flowing"again.

We would like to make the point that a pragmatic and effective strategy of nationalization has occurred before-in Sweden. As any student of politics is aware, ideologies are not true, and are simply a tool in the political bag. Although we prefer optimism, we are at heart realists who doubt that this debate will be settled in pragmatic fashion.

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Potential Government Missteps

As we progress through the various stages of financial deterioration, the Government is left with an increasingly weaker hand. An appropriate analogy may be that of a chess game, with the Government on one side of the table, and the Market on the other. As any chess player knows, the key to victory is the ability to see several moves ahead, and to assess your opponent's most likely reactions. We liken the Government's varied reactions to our current predicament to the actions of a novice chess player. A beginner tends to deploy his crucial pieces for attack, despite having only planned the assault one or two moves in advance. In addition, a novice chess player will generally fail to recognize a threat until it is too late. This current match against the Market has not gone favorably for the Government. Each attack has led to a more sophisticated counter-attack. Repeatedly, the Government has claimed victory over the capture of a pawn, only to realize that it has lost a rook in the process. We now stand in the latter stages of the game, and the Government's pieces are few.

It has become painstakingly clear that the end game will involve some form of nationalization of a number of major financial institutions. We feel that nationalization is, and has been, a necessary evil given the current predicament. However, we remain skeptical as to whether the Government is capable of crafting a strategy that will save the banks without triggering profound global repercussions. We focus specifically on Citigroup, as it is both the weakest and the most systemically significant institution. Citigroup operates in over 100 countries worldwide, and does so under numerous ownership structures. For example, Citi "controls" the second largest bank in Mexico by assets.

Obviously, the global reach of Citi obfuscates any Government nationalization scenario. We are concerned primarily due to the Government's inability to think or act with any degree of nuance. If the Government did not anticipate the consequences of the decision to allow Lehman Brothers to fail, we are gravely concerned about its ability to effectively nationalize an insitution such as Citi, whose tentacles reach to every corner of the globe.
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A Noteworthy Statistic

In 1980, sixty non-financial U.S companies boasted a triple-A credit rating, according to Standard & Poors. Today, only six bear this distinction.
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The Growing Din of Protectionism

We feel it necessary to address the increased frequency of protectionist rhetoric, particularly in the United States. This sort of behavior is to be expected during a recessionary environment, at least to some degree. However, there is clearly a "tipping point" insofar as protectionist trade measures are concerned that once reached, will result in a cascade of consequences that will push the global economy deeper into Recession. The aformentioned "tipping point" is obviously an intuitive, subjective judgment. That being said, we feel that the following series of events  have set the stage for a potentially destructive trade dispute.

1) The CEO of Nucor goes on 60 Minutes and accuses the Chinese of "dumping" steel onto the market, i.e selling at a loss in order to gain market share.

2) A stimulus package which included a "Buy American" provision was signed by President Obama

3) Reports surface that attorneys have become involved in the steel dispute, and plan to file an official complaint.

4) The Minister of Commerce of the People's Republic of China writes an editorial in the Wall Street Journal entitled "Protectionism Doesn't Pay".

Now, we would not submit to our readers that a hostile trade conflict is inevitable. However, we would hold that for clues as to the length and severity of this global Recession, one needs only to monitor this situation.

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More Money?

The bailout procession continued yesterday, with an announcement from the Obama administration regarding a new "housing bailout" to the tune of $275 Billion. We note with some amusements that the Administration has attempted to characterize this as a $75 Billion measure. The $200 Billion for Fannie/Freddie is being treated (in mainstream media outlets) similar to a (illegitimate) child support payment that is too embarrassing to be discussed at the company Christmas party. Without debating the efficacy of the measures outlined by this specific plan, we would like to make two observations.

1) When crafting the "original" stimulus package, lawmakers were careful to keep the final price tag well under the psychologically incendiary amount of One Trillion Dollars. Congress apparently went with Plan B, which was to craft two smaller bills, and hope that nobody pointed out how quickly they had managed to spend an entire Trillion Dollars.

2) Why do Fannie/Freddie still exist in their present form? These bloated monsters make Citigroup look like a healthy institution. The Administration would be well served to design a "Fannie Mae exit strategy", less these two Frankensteins of Government creation continue to hemorrhage billions of dollars.

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Of Nationalization

Our interest was piqued by reports from Berlin that the German cabinet had approved a bill that would seem to allow for the "forced" nationalization of financial institutions. This action is the beginning of what we see as the eventual framework for government intervention during the subsequent stages of this economic fallout. Granted, public statements made by Bernanke/ Geithner/Congress would seem to indicate that nationalization is off the table. However, please allow us to share with the readers a selected quote from the great Dr. Bernanke himself, taken from comments he made while speaking at a conference in Chicago, on May 18th, 2007.

"We believe the effect of the troubles in the sub-prime sector on the broader housing market will likely be limited, and we do not expect significant spillovers to the rest of the economy or the financial system"

This comment tells us one of two things, that those in charge are either hopelessly incompetent forecasters, or have purposely misinformed the public throughout this entire debacle. Regardless of which assumption you make, one can conclude that any official pronouncements from the Governments as to its future course of action can safely be disregarded. Any assessment of potential investment within the financial sector must be viewed through the lens of nationalization. How long the US Government allows its largest financial institutions to remain insolvent is unknown. However, we can say with some conviction that the balance sheets of the major US banks are impaired beyond the point of repair via private capital raising, accounting trickery, and even Government capital "injections". That being said, our stance should be clear in terms of whether common equity even exists for this country's largest banks.

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Regarding Gold

This post will begin with a preface, that being that we are by no means "gold bugs". Gold should not be viewed through the same lens that one uses to evaluate traditional asset classes i.e. stocks, bonds, commodities, etc. The yellow metal does not pay a dividend, you can not rent it out to others, and it serves no fundamental human need. Warren Buffett once commented on the probable confusion that would be felt by aliens from Mars, if they were able to look down and observe our actions with regards to gold. The observation being that we expend great effort to dig gold out of a hole in the ground, only to sell it to someone else who promptly places it in a separate hole in the ground. Nonetheless, our confidence in gold is based primarily upon the following factual observation: The Government completely and utterly lacks the ability to print, debase, devalue or desecrate gold in any way. Governments/Central Banks/Monetary Institutions do have the ability to sell their holdings of physical gold, however, widescale conversion to the fiat currency system has largely reduced the influence that these entities may wield over the gold markets. Going forward, there appears no end in sight to the amount of money that the governments of the developed world will spend to support their economies. These "bailouts" will, of course, be financed by borrowing from the developing world, furthering the status of the United States et.al. as debtor nations. Once the appetite for Western Government debt has receded, the printing press will remain the only viable source of financing for subsequent Government rescue efforts. Additionally, the dilution of the dollar will allow the US Government to satisfy its geometrically increasing obligations with greater ease. Given this scenario, gold should remain a bastion of safety and a store of wealth. Of course, you may believe that this Recession is nearing an end. Officially, we would beg to differ.
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Stimulus: Where's the Construction?

When the idea of a massive stimulus package was first pitched to the American people, the basic premise was that the government would fund a massive overhaul of this country's aging infrastructure in New Deal like fashion. Unfortunately, the final bill is an agglomeration of tax cuts, aid to various states and agencies, and numerous other goodies designed to increase the influence and importance of the federal government. Actual construction of roads and bridges represents only the sixth largest line item in the current plan, or 3.6% of the entire plan. The two charts below should place the spending priorities of Congress in proper perspective.

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China's Deterioration Continues

Notably absent from the major headlines of today was the report from China that total exports had declined 18%, and that imports had plummeted by 43%. The reason offered for the disparity between the two declines is the fact that a majority of China's imports can be characterized as partially assembled items that eventually show up as exports 3 months down the road. Hence, the import decline is indicative of a massive decline of orders "in the pipeline" These latest numbers come in complete contradistinction to the Chinese Government's projections of at least 6% growth in GDP this year. Arguments concerning the legitimacy of "The Party's" official statistics aside, we fully expect Chinese GDP projections to be revised downwards from here. The story of spectacular Chinese growth has been a popular one indeed. In reality, the country has made significant strides over the past 20 years, and has emerged as an economic power to be reckoned with. However, any suggestion that they are somehow immune to the entrenchment of the American consumer is a suggestion dislocated from reality. Sphere: Related Content

The Preamble

This blog will highlight events in the financial markets that have gone under-reported by the traditional media, attempt to interpret the increasingly circus-like behavior of Washington, and discuss the implications for society as a whole. The analysis will be of an impartial nature, free of the bias that runs rampant in the "professional" investment world. While no specific investment advice will be provided, this author's views should be apparent to the critical thinker.

The recession that began in December of 2007 has thus far proved to be one of the most destructive economic periods in this country's post-war history. We now stand at a crossroads, where Fed/Treasury/Congressional actions from here forward will have a profound effect on our future economic prosperity. Historians will use many words to describe the current time period; boring will certainly not be one of them.

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