Friday, May 29, 2009

U.S. Banks Have $168 Billion Reason to Avoid PPIP

Posted on Bloomberg by Jamie McGee and Margaret Chadbourn:

U.S. banks have a $168 billion reason to shun a government program designed to strip toxic loans from their books.

That’s how much lenders could lose if the banks sell loans into the Public-Private Investment Partnership at market prices instead of their balance-sheet valuation, based on estimates in regulatory filings. It would erase the $75 billion that banks were told to raise by the Federal Reserve to withstand a deeper recession.

The imbalance helps explain why the Legacy Loans program, the Federal Deposit Insurance Corp.’s side of PPIP, is “stuck in the rut on the side of the road,” said Walter “Bucky” Hellwig, who helps oversee $30 billion at Morgan Asset Management in Birmingham, Alabama.

FDIC Chairman Sheila Bair herself signaled this week that participation in PPIP may be low, saying lenders may be reluctant to sign up because of “discomfort” that lawmakers could change the rules. She cited legislation that imposes conflict-of-interest restrictions on buyers and sellers.

Banks say they have enough capital after the Fed’s stress tests on 19 lenders this month and will profit by holding their loans until they are repaid at full value. They have little incentive to sell loans at a discount to BlackRock Inc. and other investors that plan to participate in the $500 billion PPIP.

Only If Forced

“Banks that have gone out and raised all this money are not going to be inclined to take that hit,” said Peter Boockvar, an equity strategist at Miller Tabak & Co. in New York. “You really only want to sell a distressed security if you have to.”

Bank of America Corp., the largest U.S. bank, has a $44.5 billion gap between the carrying value of its loans and their fair value, based on data included in a regulatory filing. It’s the widest variation of the top 19 banks, according to data compiled by Bloomberg.

JPMorgan Chase & Co. followed, with a $21.7 billion difference, and Citigroup Inc. was third, at $18.2 billion. All told, the gap at the banks was $168 billion. Some banks included other commitments and receivables with loan valuations.

Scott Silvestri, a spokesman for Charlotte, North Carolina- based Bank of America, couldn’t be reached. Spokesmen for New York-based JPMorgan and Citigroup didn’t return calls for comment.

Bair on May 15 signaled regulators may pressure some banks to sell their assets under programs to cleanse balance sheets. “The troubled assets are still there and the need is still there to clean that up,” Bair said on Bloomberg Television.

Obama Effort

The Obama administration unveiled the two-part PPIP on March 23 as a centerpiece of its effort to shore up the financial system by removing illiquid assets. It would be funded by $75 billion to $100 billion from the Treasury’s Troubled Asset Relief Program.

The Legacy Loans program aims to encourage private investors to buy loans, with funding assistance from the Treasury and guarantees from the FDIC. The Legacy Securities program, run by the Treasury and the Fed, would use federal money and funds raised by companies from private investors to buy distressed mortgage-backed securities. They’re considered distressed because they’re backed by assets such as troubled commercial and residential mortgages.

Government officials are still pitching the Legacy Securities program, said Philip Feder, chairman of global real estate at law firm Paul, Hastings, Janofsky & Walker LLP.

Fed Urging

“The Fed is urging private equity players to meet with them and to think about ways to participate on the buy side,” said Feder. “Today alone, I heard about three clients that have meetings with either the Fed or the U.S. Treasury to talk about PPIP.”

Treasury Secretary Timothy Geithner originally said that the Treasury would announce the companies that had qualified to participate as funds managers for the program on May 1, and that the auctions could begin shortly afterward. It missed that deadline without comment, then said May 20 that both programs should start within six weeks.

Since PPIP was announced, U.S. banks raised $67.9 billion, Bloomberg data show. The 19 largest lenders sold stock and converted preferred shares to add capital.

“Many banks do not feel the same amount of pressure to get involved because of their ability to raise capital right now,” said James Reichbach, leader of Deloitte LLP’s U.S. banking and securities group. “The program has always been questioned by the market.”

Loan Pools

The FDIC intends to target pools of real-estate loans. Mutual funds, pension plans, hedge funds and private investors will be encouraged to bid on the soured assets. Banks would be barred from purchasing their own assets.

“Banks have been able to raise a lot of new capital even before taking more aggressive steps to cleanse their balance sheets, so the incentives to sell may be less,” Bair said on May 27.

President Barack Obama signed a mortgage bill May 20 that included a measure heightening scrutiny for managers of the public-private investment funds and set rules for more disclosure of the debt sales.

Bair said the law may pose a conflict of interest on managers of PPIP funds to ensure securities purchases are “arm’s-length” transactions. She said there “are a couple of factors that remain in play” as the FDIC and Treasury are coordinating how to get the program operational.

Talf takes plaudits but much to be done

Posted in the Financial Times by Aline van Duyn:

Securities backed by credit cards and auto loans have rallied sharply in recent months and values are now close to levels not seen since before the sector’s breakdown last September.

Following the panic that seized financial markets across the globe after the bankruptcy of Lehman Brothers, the value of even relatively low-risk securities backed by loans plunged as selling hit all credit markets. The turmoil made it impossible for new financing to be raised through the sale of asset-backed bonds, for years one of the biggest sources of financing for the credit market.

But, like most other parts of the financial markets, consumer asset-backed securities are now in better shape, largely thanks to government intervention. Much of the credit for the improved sentiment and renewed functioning of this part of the asset-backed securities market has been given to the Federal Reserve and its loan financing plan, the term asset-backed securities lending facility (Talf).

The original $200bn portion of that plan – later expanded to provide financing of up to $1,000bn with the planned inclusion of mortgage loans – has restored confidence among investors that there is a buyer of last resort, and the existence of such a “backstop” has helped normalise the market and encouraged investors to return.

Talf works like this: the Fed lends money to investors, on favourable terms, which they can use to buy certain types of triple A-rated securities.

“The fact that we have seen secondary [market] spreads come in nicely is a good sign,” said Katie Reeves, director of asset-backed research at Deutsche Bank, at a recent conference. She said the most important part of the Talf was that it showed the government was serious about fixing the securitisation markets. In addition, the Fed’s willingness to revise terms until they worked “was critically important to confidence of the securitisation market”, she said.

Next week, the fourth leg of the Talf will begin. Already, close to $6bn of deals have been announced, and the final amount of money borrowed could be at least double that.

In spite of the success, however, the programme has not played out precisely as expected.

Even as the consumer loans part of the market has rallied, the much larger mortgage-backed securities sectors have not done as well.

On the residential mortgage-securities side, for example, confusion remains about how various government programmes to modify mortgages and reduce foreclosures will affect investors owning securities backed by these mortgages.

On the commercial mortgage-backed securities front, renewed uncertainty about whether many of the triple A-rated securities will retain those ratings has pushed spreads wider again.

Indeed, tackling these more troubled parts of the asset-backed markets presents a much bigger challenge to the Fed.

Although the Fed is widely expected to try to readjust its programme following the potential for downgrades by Standard & Poor’s of triple A-rated commercial mortgage-backed securities, such rating uncertainty at the very least delays any stabilisation of this sector.

The political spotlight will be especially fixed on these riskier securities, on which taxpayers stand to make losses, and balancing the needs of investors and taxpayers could be a far bigger challenge than the ones tackled so far.

More broadly, the concerns about the Talf fall into two areas.

First, the economic slowdown means there is likely to be less of a need for financing than anticipated. The loans used to back the securities are new loans and the financing method allows banks and financial institutions to take them off their balance sheets and make room for fresh loans. But credit is slowing, and not just because of the state of the credit markets.

Chris Flanagan, analyst at JPMorgan, says he expects the consumer loans part of the Talf – such as credit cards and auto loans – to contribute to volumes of $100bn this year, not the original $200bn anticipated by the Fed.

Second, the original idea was to bring in a wave of new investors, to take the place of the special investment vehicles that were big buyers of structured and securitised debt. Hedge funds, not usually buyers of triple A-rated securities, were particularly targeted by the Fed, as these investors often borrow money to pump up the returns on investments.

However, the political tensions that have surrounded this and other government plans that involve taxpayers subsidies to allow large returns for private investors, have kept hedge funds and others on the sidelines.

Ish McLaughlin, managing director for investment grade syndicates at Citigroup, said hedge funds were among those most nervous about political fallout.

“It still is a market that is resting on too narrow a base of investor support,” Mr McLaughlin said at a recent conference. “We have not seen the dozens and dozens of investors who asked all these questions show up yet.”

He said many of the new deals were still being supported by half a dozen big investors.

Hayley Boesky, director of market analysis at the Federal Reserve Bank of New York, which is responsible for handling the Talf, says that although the political temperature has dropped, concerns about executive compensation restrictions, whether or not profits would be clawed back and other issues such as visa restrictions that come with some government plans remained factors for some investors.

“The temperature seems to have been lowered but these concerns continue as they are extraordinarily sensitive issues among the investor community,” she said at a securitisaton conference.

Wednesday, May 27, 2009

FDIC Won’t Rule Out Banks as Buyers of Toxic Assets

Posted on Option ARMageddon by Rolfe Winkler:

During a press conference today, FDIC Chairwoman Sheila Bair was asked about this morning’s WSJ report that banks are lobbying to buy assets under Geithner’s toxic asset plan, the PPIP.

She says banks will not be able to bid on their own assets, but clearly leaves open the possibility that they’d be allowed to buy the assets of other banks.

This is highly problematic. If banks can act as buyers in any capacity, what’s to prevent collusion? With just a sliver of equity and a pile of non-recourse federal loans, Citigroup could fund a special purpose vehicle to overpay for BofA’s bad assets. In exchange BofA would overpay for Citi’s assets. The beauty of using non-recourse debt is that you can walk away from it. The lender, in this case the taxpayer, is stuck eating the loss on the bombed-out asset.

All banks stand to lose is their small equity investment.

The ranking Republican member of the House Financial Services Committee, Spencer Bachus, previously expressed outrage that such collusion might be possible. He promised to introduce legislation to prevent it from happening. I’m not aware that he has and have a call in to the Financial Services Committee for comment.

Below, I’ve transcribed Bair’s full response to the question she was asked about PPIP….

No [banks] will not be able to bid on their own assets. I think there has been some confusion about that….There will be no structure where we would allow banks to bid on their own assets. I think there have been separate issues about whether banks can be buyers on other bank assets and I think that’s an issue that we continue to look at. There’s also a question of whether banks who come to the PPIP to sell assets, while they would not be involved in the bidding process—private investors would set the prices—whether part of the consideration they would take back once the price has been set by the private sector, would be in an equity piece in the PPIP. Those are things we’re actively discussing….

I think there are a couple of factors that are still at play here as we try to devlop this structure and look toward the launch of PPIP. One is we’re finding on both the buyer and the seller side there continues to be discomfort about Congress’s view of this program, whether the rules could potentially change. The Boxer/Ensign amendment I think is a good amendment…it addresses conflict of interest issues and we want that too. Nonetheless I think this has created some uncertainty about certain aspects of the Boxer/Ensign amendment and the Treasury will need to issue regulations I think to clarify those issues before we will have comfort by market participants.

Bair’s sentence beginning “nonetheless” was not clear. What I transcribed is what she said. It sounds as if she’s uncomfortable about the amendment (more below)…..she quickly changes the subject…

Also the good news is banks have been able to raise a lot of new capital before taking more aggressive steps to cleanse their balance sheets. The incentives to sell [assets to the PPIP] may be less for good reasons because they’ve been able to raise new capital.

So there are still some issues we are working through…

She knows taxpayers are getting a raw deal, which is why it would be “good news” that banks’ have less incentive to sell assets to these vehicles. She also knows that banks are still swimming in so much toxic junk, it has to be flushed away somehow. But she’s apprehensive that the public might have a transparent view of the cleansing process.

Enter the Boxer/Ensign amendment, which is attached to S. 896. It reads:

To provide for oversight of a Public-Private Investment Program, and to authorize monies for the Special Inspector General for the Troubled Asset Relief Program to audit and investigate recipients of non-recourse Federal loans under the Public Private Investment Program and the Term Asset Loan Facility.

In other words, Senators Boxer and Ensign want to give Neil Barofsky oversight over PPIP in addition to TARP. Is Bair uncomfortable with this because she knows Barofsky would publicize some of the very abuses the administration is counting on to help banks push their losses onto taxpayers?

Banks Aiming to Play Both Sides of Coin

Posted in the Wall Street Journal by DAVID ENRICH, LIZ RAPPAPORT and JENNY STRASBURG:

Some banks are prodding the government to let them use public money to help buy troubled assets from the banks themselves.

Banking trade groups are lobbying the Federal Deposit Insurance Corp. for permission to bid on the same assets that the banks would put up for sale as part of the government's Public Private Investment Program.

PPIP was hatched by the Obama administration as a way for banks to sell hard-to-value loans and securities to private investors, who would get financial aid as an enticement to help them unclog bank balance sheets. The program, expected to start this summer, will get as much as $100 billion in taxpayer-funded capital. That could increase to more than $500 billion in purchasing power with participation from private investors and FDIC financing.

The lobbying push is aimed at the Legacy Loans Program, which will use about half of the government's overall PPIP infusion to facilitate the sale of whole loans such as residential and commercial mortgages.

Federal officials haven't specified whether banks will be allowed to both buy and sell loans, but a list released by the FDIC and Treasury Department of the types of financial firms likely to be buyers made no mention of banks.

Allowing banks to have it both ways would give them added incentive to sell assets at low prices, even at a loss, the banks contend. They claim it also would free up capital by moving the assets off balance sheets, spurring more lending.

"Banks may be more willing to accept a lower initial price if they and their shareholders have a meaningful opportunity to share in the upside," Norman R. Nelson, general counsel of the Clearing House Association LLC, wrote in a letter to the FDIC last month.

The New York trade group represents 10 of the world's largest banks, including Bank of America Corp., Citigroup Inc. and Wells Fargo & Co. Those banks are seen as likely sellers of assets using PPIP. Officials at the banks declined to comment.

"It's an issue that's been raised and an issue we're aware will need specific guidelines," said an FDIC spokesman, adding that the agency still is working on the final structure of its program and plans to launch a $1 billion pilot program this summer, which likely won't include an infusion from the Treasury.

Some critics see the proposal as an example of banks trying to profit through financial engineering at taxpayer expense, because the government would subsidize the asset purchases.

"To allow the government to finance an off-balance-sheet maneuver that claims to shift risk off the parent firm's books but really doesn't offload it is highly problematic," said Arthur Levitt, a former Securities and Exchange Commission chairman who is an adviser to private-equity firm Carlyle Group LLC.

"The notion of banks doing this is incongruent with the original purpose of the PPIP and wrought with major conflicts," said Thomas Priore, president of ICP Capital, a New York fixed-income investment firm overseeing about $16 billion in assets.

One risk is that certain hard-to-value assets mightn't be fairly priced if banks are essentially negotiating with themselves. Inflated prices could result in the government overpaying. Recipients of taxpayer-funded capital infusions under the Troubled Asset Relief Program also could use those funds to buy their own loans.

"Sensible restrictions should be placed on banks, especially those that have received government capital, from investing their own balance sheets in a backdoor effort to reacquire what could be their own assets with an enormous amount of federally guaranteed leverage," said Daniel Alpert, managing director at Westwood Capital LLC, an investment bank.

Even supporters of letting banks buy their own loans said it could be a tough sell.

"A bank bidding on its own assets really has the potential to look awful in the public's mind," said Mark J. Tenhundfeld, an American Bankers Association lobbyist. Some bankers said the concerns can be addressed through strong oversight by the government and outsiders.

The banking industry's lobbying is meant to overcome a hurdle facing PPIP: unwillingness by banks to sell assets at steep discounts.

Banks generally would rather hold on to assets they believe have more inherent value, avoiding selling them at a low point in the market. Many mortgage securities are valued at less than half their original price.

"Bankers see it as a win-win," said Tanya Wheeless, chief executive of the Arizona Bankers Association, which has urged the FDIC to let banks buy their own assets through PPIP.

U.S. banks held about $4.7 trillion in commercial and residential mortgages of the type that banks are lobbying to buy as of the end of the third quarter of 2008, according to Federal Reserve data. PPIP is designed in part to mitigate $600 billion of potential losses through the end of 2010 tied to toxic assets at the nation's 19 largest banks, according to the Fed's stress tests.

Mr. Nelson proposed to the FDIC that banks be allowed to control as much as half the capital in a buyers' group. In some cases, he wrote, "the selling bank should be able to participate as the only private-sector equity investor."

The California Bankers Association said in a letter that the FDIC's supervision of the asset-pricing process "should alleviate concerns about the inability to effect arm's length transactions between a bank and its affiliate that purchases through a public-private investment fund."

Irene Esteves, the chief financial officer at Regions Financial Corp., which has been lobbying to buy assets through PPIP, included a reference to gobbling up loans under the heading "Conflict of Interest" in a letter to the FDIC. A spokesman for the Birmingham, Ala., bank declined to comment.

Towne Bank of Arizona plans to sell some of its soured real-estate loans into PPIP and wants to profit from the program. "We think it would be attractive to our shareholders to be able to share in whatever profits there are from the venture," said CEO Patrick Patrick.

Tuesday, May 26, 2009

Puff Piece on OSFI

Posted on Prefblog:

OSFI has republished a puff-piece written for Central Banking magazine, titled Lessons for Banking Reform: A Canadian Perspective, by Carol Ann Northcott & Graydon Paulin of the Bank of Canada and Mark White of … OSFI.

Credit for Canada’s performance throughout the crisis is given to:

  • High levels of capital
  • A rational mortgage market
    • relatively low Loan-to-Value
    • Recourse to borrower
    • Non-deductability of interest
  • Assets-to-Capital (ACM) multiple control
  • lack of competition from shadow banks
  • The wise and beneficient supervision of those sadly underpaid geniuses (genii?) at OSFI

Not much meat on these bones, frankly. I would have been much more interested in a solid analysis of just WHY we were so lucky. Why weren’t the banks up to their necks in sub-prime paper, like everybody else? Was it the ACM? Was it because Canadian banking is such a profitable rent-extraction machine that banks didn’t need to lever up on Sub-prime at LIBOR+50? I find the idea that “Canadian Bankers are Smart” rather difficult to swallow. We nearly went bust in the MBA crisis of the 1980’s … we’ll find something else soon, don’t fret.

And why are we so highly capitalized, anyway? It has been very useful in the downturn, there’s no denying that … but what are the net, through-the-cycle cost/benefits of tying up a lot of capital in the banking system?

Lowest Libor Hides ‘Exceptionally Wide’ Bank Spreads

Posted on Bloomberg by Gavin Finch and Anna Rascouet:

The drop in the London interbank offered rate, the benchmark for $360 trillion of financial products, to a record low masks a growing gap between the rates that the biggest banks charge each other for credit.

The difference between the highest and lowest interest rates banks say they pay for three-month dollar-denominated loans is near the widest this year, according to data compiled by the British Bankers’ Association. The spread signals that lenders still lack confidence in each other, even though measures ranging from the so-called Libor-OIS spread to corporate bond sales show credit markets have recovered from the freeze caused by the Sept. 15 collapse of Lehman Brothers Holdings Inc.

“It’s premature to judge that the credit meltdown is fully over,” said Kazuto Uchida, chief economist in Tokyo at Bank of Tokyo Mitsubishi UFJ Ltd., a unit of Japan’s largest bank. “Banks remain wary of extending credit to each other due to strenuous concerns about counterparty risk.”....

“The dispersion of Libor submissions seems to be exceptionally wide,” said Marc Chandler, the global head of currency strategy at Brown Brothers Harriman & Co. in New York. “There is potential for bifurcation of the financial system between banks perceived to be healthier than others.”...

Libor-OIS, which indicates banks’ reluctance to lend, fell to 0.45 percentage point last week, the lowest level since February 2008. Still, futures indicate the measure is about two years away from shrinking to 0.25 percentage point. That’s the level former Fed Chairman Alan Greenspan has said would be considered “normal.”....

“The disparity and the difference is really a signal to the market of who really wants to make some loans and who’s got the ability to make those loans,” said Mark MacQueen, partner and money manager at Austin, Texas-based Sage Advisory Services Ltd., which oversees $7.5 billion. “A lot of banks are just trying to hold on to what they have and not really make loans.”

Rather than signaling that the world’s banks are more willing to lend to each other, some investors and strategists say the decline in Libor has more to do with deposits reducing demand for funds in the interbank market. Deposits at U.S. banks jumped by almost $400 billion in the past six months, according to Jim Vogel, head of bond research at Memphis, Tennessee-based FTN Financial.

“Libor’s decline is not necessarily a sign of improving bank credit or the willingness of banks to lend to each other,” said Vogel, whose firm is one of the 10 biggest underwriters of Fannie Mae, Freddie Mac and other U.S. government agency debt. “It’s a sign of improving bank liquidity as customer deposit growth replaces borrowing in the short-term money markets.”

Friday, May 22, 2009

The next asset classes to default

Posted on Reuters by Felix Salmon:

I had an interesting lunch with Vipal Monga of The Deal this afternoon, and he came out with a rather startling datapoint: apparently there’s roughly $500 billion of leveraged loans out there which mature between 2012 and 2014. Is there any conceivable way those loans will be able to be refinanced?

But now go back and read your Lucian Bebchuk: he says that under the stress tests, Treasury didn’t even try to guess the value of assets on banks’ books which mature after 2011. Let’s say I’m a bank with a $10 billion portfolio of leveraged loans maturing in 2012. Under Treasury’s adverse scenario, that portfolio will be worth a lot less than $10 billion in 2010 — and if they’d run a solvency calculation using a reasonable value for that portfolio, the results might well have been very ugly. But under the stress tests, Treasury just ignored any drop in value of those assets. Yikes.

Is this the mechanism behind a coming W-shaped recession? Just as today’s fabled green shoots start growing into something viable, we’ll be hit by a massive new spike in defaults in newly-toxic asset classes: not just leveraged loans but also munis, sovereigns, and other things which have yet to blow up enormously. And of course the banks will be hit all over again, and will require yet another round of monster bailouts. If the crisis in structured finance grew to become a broader economic crisis, then the economic crisis might well yet swing around to bring down asset classes on the finance side which have been largely default-free to date, if only because they’re long-term loans which got locked in at low interest rates at the height of the credit bubble.

Why Britain has to curb finance

Posted in the Financial Times by Martin Wolf:

The UK has a strategic nightmare: it has a strong comparative advantage in the world’s most irresponsible industry. So now, in the wake of the biggest financial crisis since the 1930s, the UK must ask itself a painful question: how should the country manage the cuckoo sitting in its nest?

The question is inescapable. London is one of the world’s two most important centres of global finance. Its regulators have, as a result, an influence on the world economy out of proportion to the country’s size. In the years leading up to the crisis, that influence was surely malign: the “light touch” approach led the way in a regulatory race to the bottom.

The fiscal costs of this crisis will be comparable to those of a big war. Thursday’s threatened downgrade by Standard & Poor’s is a reminder of those costs. Loss of jobs and incomes will also scar the lives of hundreds of millions of people around the world.

All this occurred, in part, because institutions replete with highly qualified and highly rewarded people were unable or unwilling to manage risk responsibly. The UK, as a country, the City of London and the broader financial industry bear much responsibility for this calamity. This is a time for self-examination.

A recent report on the future of UK international financial services, produced by a group co-chaired by Sir Win Bischoff, former chairman of Citigroup, and Alistair Darling, chancellor of the exchequer, fails to provide such self-examination. This is partly because the committee consisted of the industry’s “great and good”. It is far more because Mr Darling had already decided that “financial services are critical to the UK’s future”. Thus, the report’s remit was “to examine the competitiveness of financial services globally and to develop a framework on which to base policy and initiatives to keep UK financial services competitive”.

If you ask the wrong question, you will get the wrong answer. The right question is, instead, this: what framework is needed to ensure that the operation of the financial sector is compatible with the long-run health of the UK and world economies?

Quite simply, the sector imposes massive negative externalities (or costs) on bystanders. Thus, the recommendation “that the financial sector be allowed to recalibrate its activities according to the sentiments and demands of the market” is wrong. A market works well if, and only if, decision-makers confront the consequences of their decisions. This is not – and probably cannot be – the case in finance: certainly, people now sit on fortunes earned in activities that have led to unprecedented rescues and the worst recession since the 1930s. Given this, the industry has become too big. If implicit and explicit guarantees and externalities, including volatility, were fully charged, the sector would surely shrink.

So how should one manage a sector that produces such “bads”? The answer is: in the same way as any polluting activity. One taxes it. At this point, the authors of the report will surely ask: “How can you suggest taxing a sector so vital to the UK economy?” The answer is: easily. Financial services generate only 8 per cent of gross domestic product. They are more important for taxation and the balance of payments. But this tax revenue turns out to be perilously volatile. True, in 2007, the last year before the crisis, the UK ran a trade surplus of £37bn in financial services, partially offsetting an £89bn deficit in goods. But smaller net earnings from financial services would have generated a lower real exchange rate and more earnings elsewhere. Given the costs imposed by the financial sector, a more diversified economy would have been healthier. Such sacrilegious ideas are, of course, not to be found in the Bischoff report.

How then should the UK approach policy towards the sector? I would suggest the following guiding ideas.

First, the UK needs to make global regulation work. It should discourage regulatory arbitrage even if it expects to gain in the short run.

Second, it must, in particular, help ensure that owners and managers of financial institutions internalise most of the costs of their actions.

Third, it must reject egregious special pleading from the industry. The sector argues that moving derivatives trading on to exchangesmight damage innovation. So what? Maximising innovation is a crazy objective. As in pharmaceuticals, a trade-off exists between innovation and safety. If institutions threaten to take trading activities offshore, banking licences should be revoked.

Fourth, while trying to create a stable and favourable environment for business activities, the UK should try to diversify the economy away from finance, not reinforce its overly strong comparative advantage within it.

Fifth, UK authorities need to ensure that the risks run by institutions they guarantee fall within the financial and regulatory capacity of the British state. They should not let the country be exposed to the risks created by inadequately supported and under-regulated foreign institutions. At the very least, they should not undermine other governments’ efforts to regulate their own institutions.

The “old normal” was simply unsustainable. The “new normal” must be very different. It is far from clear that the industry and government recognise this grim truth.

Why public private plan has bankers squirming

Posted in the Financial Times by Gillian Tett:

Cometh the hour, cometh the acronym. Thus might run the unspoken motto of American financial policy these days.

As the banking saga has unfolded in the past two years, a string of US initiatives have tumbled out, with titles so lengthy I will not attempt to list them in full. Remember the M-LEC programme that was launched to reorganise the shadow banks (but quickly died)? Then came Talf, TSLF and Tarp, which aim to provide liquidity, restart the securitisation machine and recapitalise the banks.

Now a new focus is emerging. This week Tim Geithner, US Treasury secretary, said that a PPIP – or public-private investment plan – would start in early July to use $75bn-$100bn of state funds to encourage the sale of up to $1,000bn of toxic assets by banks. Part of the programme will cover loan sales and be run by the Federal Deposit Insurance Corporation; the other half, relating to securities, will be organised by the Treasury. In both schemes, asset managers will be given state finance to encourage bids. So will this latest acronym-filled endeavour work? (Or, at least, avoid the fate of the ill-starred M-LEC?) If you listen to some senior US bankers, it is easy to feel pretty doubtful that the PPIP can really fly. The key sticking point is price. The PPIP plan will work if banks take part to sell assets. But right now, no banker wants to participate in an auction that produces asset prices lower than those on bank books. After all, if that were to happen, banks would face pressure to make more writedowns – which they can ill afford.

The Treasury and FDIC hope to avoid this scenario by encouraging asset managers to place high bids for the bank assets, by offering non-recourse leverage of up to five times (or far higher than non-recourse leverage available in the market). Some politicians hate that, since the details of the deals mooted so far appear to leave taxpayers with little embedded upside.

That political scrutiny, in turn, makes asset managers nervous. As a result, it is still unclear whether enough asset managers will produce bids that are high enough to make the banks happy with an auction price.

So some large banks are – unsurprisingly – adopting a policy of quiet footdragging. A senior official at one large bank observed this week that his group would participate in a pilot scheme, as a gesture of goodwill. But after that token gesture, this bank will probably stop.

And while the government wants to set a minimum lot size of $1bn, this bank is lobbying for a figure nearer $250m to limit the auction to a few choice (token) assets. Unsurprisingly, this banker – like others – concludes that he is “not optimistic” about PPIP, not least because the urgent pressure to sell assets is receding as banks raise capital.

That view may not be entirely representative: another bank tells me it is preparing to get properly involved (not least because it has the financial strength to have written many assets down). Government officials running the PPIP scheme insist there is strong overall interest from potential buyers and sellers. They also point out that it need not matter if the scheme ends up being limited in size. After all, what PPIP is trying to do (like Talf and much else) is reignite market activity, not replace it. Think of it as a chunk of firelighter on a pile of wet wood. Thus, the sheer act of talking about PPIP – and then staging a few sales – may be enough to kickstart a private sector trading toxic assets again. Or so the hope in Washington goes. “Success is what happens to the market overall,” says one.

They have a point, given that there is some evidence that schemes such as Talf are contributing to a market thaw. But, almost irrespective of whether PPIP “succeeds” in delivering many deals (and personally I have doubts that it will), there may be another reason to welcome it.

Most notably, irrespective of the complexities of arranging deals, the PPIP has already served one extremely valuable function by highlighting the sheer insanity that has bedevilled the financial world in relation to asset prices.

Most notably, if large American banks had previously marked their assets at a realistic market-based price, they would not be so scared of engaging in auctions with PPIP now. Better still, they might have spotted earlier the degree to which their assets were deteriorating – and taken action to address it.

But precisely because the supposedly “free market” western financial system has become stuffed with complex assets that were rarely traded – even during the credit boom – banks have been able to use fantasy prices for their assets for years. Hence their continued horror at the idea of open trading.

That is the real scandal that bedevils the PPIP idea. That in turn points to a wider lesson for the future: namely that to avoid a similar credit disaster, it is crucial that financiers are forced to place as much financial activity as possible on transparent trading arenas. Better still, they need to do that well before a bubble bursts – or there is any need to start fighting over whether a PPIP can truly fly.

Thursday, May 21, 2009

How Healthy Is Your Bank?

Posted on by Edward Teach:

On March 27, Omni National Bank of Atlanta was closed by federal regulators. The Office of the Comptroller of the Currency put the $956 million (in assets) bank in receivership because losses had depleted most of Omni National's capital, and there was "no reasonable prospect that the bank [would] become adequately capitalized without federal assistance," according to the Comptroller's office.

Omni National became the 21st U.S. bank to fail during the first three months of 2009. That number approaches the 25 bank failures for all of 2008 and is seven times 2007's total. More are sure to fail. In December, the Federal Deposit Insurance Corp. disclosed that its list of problem banks numbered 252, the most since the middle of 1995, with combined assets of $159 billion. The FDIC won't name the banks, for fear of triggering panics, but it's probable that the list is not comprehensive. Analysts point out that giant Washington Mutual ($307 billion in assets) wasn't on the problem list prior to its demise.

CFOs can take comfort that analysts expect relatively few of the nation's more than 8,200 FDIC-insured banks to go bust. "The vast majority of banks will be OK," says Scott Valentin, a managing director at FBR Capital Markets. Historically, only about 13% of the banks on the FDIC's problem list have failed. FDIC chairman Sheila Bair said in March that 98% of banks were well capitalized by regulatory standards.

Capital seems steady but asset quality is deteriorating.

Still, loan portfolios are deteriorating rapidly in the downturn, and some banks are going to become just another statistic. The FDIC forecasts that bank failures over the next five years will cost the agency $65 billion, on top of last year's $18 billion tab. Christopher Whalen, managing director and senior vice president of Institutional Risk Analytics (IRA), a bank-rating firm, predicts that some 100 U.S. banks with assets totaling more than $800 billion will fail in 2009. Other observers have been even more pessimistic.

CFOs appear braced for some bad news. According to CFO's Q4 2008 Business Outlook Survey, 72% of finance chiefs said they had "moderate" or "significant" concerns about the condition of the financial institutions they deal with.

Federal regulators are expected to announce some results of their stress tests for the nation's 19 largest banks in May. But companies can perform their own check of a bank's health the same way that analysts do, by reviewing the bank's key capital ratios and loan-performance trends. That information is easily accessible on the Internet, via Securities and Exchange Commission filings and the quarterly call reports that every FDIC-insured bank is required to file (see

Evaluating a bank's health falls into two parts, says Mark J. Flannery, a finance professor at the University of Florida's Warrington College of Business Administration. One, how well capitalized is the bank — how much loss can it stand without failing? Two, what is the quality of its assets — how much loss risk is the bank exposed to?

In the FDIC's eyes, a well-capitalized bank has a ratio of Tier 1 capital to total risk-weighted assets of at least 6% (analysts prefer to see 8%); a ratio of total capital to total risk-weighted assets of at least 10%; and a Tier 1 leverage ratio of at least 5%. (Tier 1 capital includes common stock, some preferred stock, and retained earnings, among other things. The leverage ratio is Tier 1 capital divided by average total consolidated assets.) All three ratios can be found in Schedule RC-R (Regulatory Capital) of a bank's call report.

The trouble is, the risk-based capital ratios "don't work very well," says Frederick Cannon, chief equity strategist at Keefe Bruyette Woods, specialists in financial services. That's because the risk weightings that the government uses are out of date. For example, a mortgage-backed security is weighted at 20%, meaning that it requires one-fifth the capital of whole loans. "But some of those securities have declined in value a lot more than the values of whole loans," says Cannon. The option ARM, which "proved to be an absolutely horrible product in terms of performance," is weighted at 50%; "in hindsight it probably should have been weighted at 200%," he says. As for the leverage ratio, "it doesn't pay any attention to the composition of assets and their risk," says Flannery.

Many investors no longer trust the regulatory ratios. Shareholders, conscious that they will be the first to lose if a bank fails, are turning to the tangible common equity (TCE) ratio as a better measure of solvency. The TCE ratio, which isn't a GAAP metric, is tangible common equity divided by tangible assets; hybrid equity instruments and all intangibles are excluded. "It's a harsh measure," notes Whalen. There's no general rule of thumb for an adequate level of TCE, but many analysts like to see a ratio of at least 4% for large banks and 5% or 6% for regional banks.

An officially well-capitalized bank may have a dangerously thin TCE ratio. Take Citigroup. At the end of December, the $1.9 trillion (in assets) bank holding company had a Tier 1 ratio of 11.9%, a total capital ratio of 15.7%, and a leverage ratio of 6.1%. (Capital ratios for bank holding companies can be found at the National Information Center's Website, But its TCE ratio was just 1.5%. Acknowledging the importance of TCE to investors, this past February Citigroup announced that it would offer to exchange up to $52.5 billion of its existing preferred stock for common stock, thus raising its TCE ratio to about 4%. "This securities exchange has one goal — to increase our tangible common equity," said CEO Vikram Pandit.

All About the "A"
But the TCE ratio is not infallible. Right before Washington Mutual failed, its TCE ratio was 7.8%. For regulators and analysts, TCE is one more metric in the tool kit. That tool kit is typically based on CAMELS, the supervisory rating system that looks at a bank's capital, asset quality, management, earnings, liquidity, and sensitivity to market risk (hence the acronym). Earnings are always important, but "these days it's more about the 'C' and the 'A,'" says Valentin.

The "A" is a growing source of discomfort as the recession drags on. With growth slowing and unemployment rising, a broad swath of consumer and business loans is beginning to sour. "Most of the banks that have failed to date have had significant early credit-cycle exposure — subprime, option-ARM, residential construction loans," says Cannon. "We're starting to see significant deterioration in midcycle credit: prime mortgages, home-equity loans, some nonresidential construction. And there's increasing concern about late-cycle credit instruments such as commercial real-estate mortgages and commercial loans."

It's prudent, therefore, to keep an eye on a bank's loan-loss reserves and nonperforming assets. "If you put a couple of quarters together and you see a trend increase in the loan-loss reserve and an increase in the amount of delinquencies, you start to get a picture of what is likely to happen to these assets in the near future," says the University of Florida's Flannery. "There are two categories [of delinquent loans] reported. One is 30 to 89 days late, and that's kind of noisy; it includes all the people who mailed their checks late. Ninety days–plus is a problem; you know you're going to have some sort of loss on that."

Banks are taking a beating on write-offs of delinquent loans. In February, credit-card defaults rose to their highest level in 20 years. IRA predicts that net charge-offs will peak in 2009. Total net charge-offs for the industry reached 2% of assets in 1990–91, the tail-end of the savings-and-loan crisis; this time around they will reach 3% or 4%, IRA predicts. "These charge-offs are already baked in," says Whalen. "They are the result of portfolio decisions made during the last three or four years."

How many banks will be done in by the deterioration of their loan books? Whalen agrees that most banks, particularly smaller ones, are sound. Still, while most community banks (typically banks with assets under $1 billion) weren't affected by subprime or Alt-A loans, they don't have a diversified geographic footprint and are "very exposed" to the local economy, points out Valentin. "Banks that have large construction portfolios are probably at risk," he says, particularly in states like California and Florida. Layoffs and unemployment will mean higher vacancy rates in commercial buildings, which will result in more defaults.

When All Else Fails
Despite all of the attention on banks' earnings the past year and a half, a flawless diagnostic tool for bank soundness has yet to be invented. "There's no single perfect measure of solvency," says Cannon. "Accounting statements are not a perfect measure of value. They are all shorthand for solvency. We spend a lot of time looking at balance sheets and we still haven't got it right on some banks, given how quickly things have deteriorated."

Scott Bugie, a managing director at Standard & Poor's, thinks capital ratios are unreliable. "Unfortunately, and much to the consternation of the global regulatory authorities, the correlation between creditworthiness and capital ratios is weak," he says. Regulatory capital ratios and the capital measures used by S&P "have by themselves been mediocre indicators of relative strength of credit," says Bugie. "If one institution has a 12% capital ratio and another has a 6% ratio, that doesn't necessarily mean that the latter is more likely to encounter problems or to default." Bugie says S&P is working on a new measure of bank capital, called the risk-adjusted capital framework, that it believes will correlate with a bank's creditworthiness better than its current ratios do.

Of course, there's another, forward-looking indicator of a bank's strength: what the market is willing to pay for a share of stock. As of April 1, the KBW Bank Index had fallen more than 60% in the past year, while the KBW Regional Banking Index had dropped more than 40%. Shares in Citigroup traded at just $2.68. While that is a big improvement over the stock's all-time low of 97 cents in March, it's a long way from a price that would indicate the hard times are over. For many banks, unfortunately, the worst may lie ahead.

U.S. Rescue Aid Entrenches Itself

Posted in the Wall Street Journal by DAMIAN PALETTA, DAVID ENRICH and DEBORAH SOLOMON:

Within a few weeks, some of the nation's biggest banks will start disentangling themselves from the government's grip by repaying billions in federal bailout dollars.

But the moment, a symbolic bookend to a turbulent period, will likely be overshadowed by a parallel phenomenon: Many of the other emergency measures created to prop up the financial system are developing an air of permanence.

As such, the move to repay funds from the Troubled Asset Relief Program might represent not the beginning of the end, but rather the end of the beginning.

"There will be a time when we will be able to come to you and say 'This is how the unwinding process will work,' " Treasury Secretary Timothy Geithner told a Senate hearing Wednesday. "But it is too early to do that now."

On Wednesday, President Obama signed a law extending higher deposit-insurance limits through 2013. The Federal Deposit Insurance Corp. and the Treasury are developing public-private partnerships to help banks purge bad assets and the Fed on Tuesday agreed to expand a liquidity facility to accept high-quality commercial-mortgage backed securities.

Government officials remain concerned about the fragility of the financial sector. Their hesitance to fold these programs, and the financial industry's willingness to keep using them, has made it harder for regulators to re-establish a sense of market discipline, government officials say.

"The longer they exist, the more markets will depend on them," Sen. Richard Shelby (R., Ala.) said at the hearing. "As a result, it is very likely that the greatest challenge posed by this financial crisis still lies ahead."

Goldman Sachs Group Inc., J.P. Morgan Chase & Co., Capital One Financial Corp., U.S. Bancorp and Morgan Stanley are among those in discussions with regulators about repaying the government's TARP investment. Treasury officials could allow a batch of banks to begin repaying the money around the week of June 8.

Banks will have to prove to regulators they are on solid footing and can issue debt without government assistance. After the first group, the Fed is expected to recommend to Treasury on a monthly basis that another batch of banks be permitted to repay TARP money.

There mightn't be a rush for the exits. Just five of the roughly 45 federal thrifts that received money under TARP have asked to repay the money, a spokesman for the Office of Thrift Supervision said.

Edward J. Wehmer, chief executive of Wintrust Financial Corp., a $10.8 billion bank holding company that has received $250 million in aid, views the funds as "cheap capital."

He doesn't like rules imposed by Washington after the program began, particularly executive-compensation limits, but Mr. Wehmer does like how the government capital is helping his Lake Forest, Ill., company expand in a tough operating environment. He doesn't expect to repay the funds until late this year.

"Until the economy is back and banks stop closing, they're going to need to provide the support to make people feel good" about the system's stability, Mr. Wehmer said. But, he added, "it's hard to believe it could be a permanent situation."

The Treasury plans to use the repaid funds to pump money into other institutions, including smaller banks and insurance companies.

Banks with assets under $500 million, including ones that already have received government aid, will be able to get a larger chunk of government money. Firms can now apply for funds equaling 5% of risk-weighted assets, instead of the 3% allowed previously.

Mr. Geithner also said the government would extend for six months the deadline for small banks to form a holding company in order to qualify for government aid.

The Treasury's capital injections into hundreds of banks have assumed immense symbolic importance. In dollar terms, though, they represent a sliver of the U.S.'s intervention in the financial system.

Washington is on track to pump up to $14.9 trillion into the financial system through more than two-dozen federal initiatives, according to a Deutsche Bank report last month.

Of that, only $250 billion, less than 2% of the total, is slated for the Treasury's Capital Purchase Program. The rest is designated for propping up areas including money-market mutual funds and commercial-paper markets, and for purchases of asset-backed securities.

"In some parts of the financial community it's going to take a longer period than that, probably with AIG, too," Mr. Geithner said. "Realistically, this is going to take time."

U.K. May Lose AAA Rating at S&P as Finances Weaken

Posted on Bloomberg by Lukanyo Mnyanda:

Britain may lose its AAA credit rating for the first time as government finances deteriorate in the worst recession since World War II.

Standard & Poor’s lowered its outlook on Britain to “negative” from “stable” and said the nation faces a one in three chance of a ratings cut as debt approaches 100 percent of gross domestic product. The pound fell the most in four weeks against the dollar, the FTSE 100 Index slid as much as 2.8 percent and the cost of insuring U.K. debt against default rose.

Britain needs to sell a record 220 billion pounds ($344 billion) of bonds in the fiscal year through March 2010 as the economy contracts and Chancellor of the Exchequer Alistair Darling predicts that the budget deficit will reach 175 billion pounds, or 12.4 percent of GDP. The U.K.’s worsening Gordon Brown finances parallel the public perception of Prime Minister, whose Labour government has trailed the Conservative opposition for more than a year in polls.

“The downgrade highlights the precarious fiscal outlook the U.K. economy faces,” said Nick Stamenkovic, a strategist in Edinburgh at RIA Capital Markets, a securities broker for banks and institutional investors. “The huge amount of issuance to face the gilt market in the coming months will push yields to the upside. We’re bearish.”

Gilts Drop

Gilts fell, pushing the yield on the 4.5 percent note due March 2019 up as much as 13 basis points to 3.71 percent, before rebounding to 3.62 percent at 12:14 p.m. in London. The budget deficit increased to 8.5 billion pounds last month, the most for April since records began in 1993, the Office for National Statistics said in London today.

Britain would become the fifth western European Union nation to lose its rating because of the economic slump, following Ireland, Greece, Portugal and Spain. The U.K.’s debt load next year will be 66.9 percent of GDP, exceeding Canada’s 29.1 percent and Germany’s 58.1 percent, according to April 22 forecasts by the International Monetary Fund. The U.S. will be at 70.4 percent, and the 16-nation euro area at 69 percent, according to the IMF.

“The key from a market perspective is whether this is a stand-alone U.K. problem or whether it is the start of a trend where the agencies start to review the ratings of various sovereigns across the developed world,” said Gary Jenkins, head of credit research at Evolution Securities Ltd. in London. “If this is really just a case of the U.K. deteriorating as a credit then it could have a significant impact going forward.”

Unemployment Jumps

Brown’s efforts to patch up the nation’s finances are being hobbled by an economy mired in its first recession since 1991. Unemployment surged to 2.2 million in March, the highest since 1996, and tax income has dropped 10 percent in the past year. The IMF expects gross domestic product to contract 4.1 percent this year, the most since World War II.

British Land Co., the largest office developer in London, reported a record annual loss of 3.9 billion pounds today as property values slumped across the nation’s capital.

There are no U.K. companies with AAA ratings by S&P or Moody’s Investors Service. British Land is rated BBB by Fitch Ratings, its second-lowest investment-grade ranking.

The difference in yield, or spread, between U.K. 10-year bonds and equivalent German securities widened six basis points to 21 basis points following the S&P statement. As recently as March 19, gilts yielded less than bunds.

Stocks, Pound Drop

The FTSE index declined the most since March 30. The pound dropped 0.7 percent to $1.5639 and weakened 0.7 percent against the euro to 88.07 pence. Credit-default swaps on U.K. debt rose 5.5 basis points to 78, according to CMA DataVision prices.

European governments are increasing borrowing to bolster ailing economies and bail out banks reeling amid the fallout from the global credit crisis. Ireland had its AAA credit rating removed by S&P on March 30. S&P lowered the ratings of Spain, Portugal and Greece in January.

“We have revised the outlook on the U.K. to negative due to our view that, even assuming additional fiscal tightening, the net general government debt burden could approach 100 percent of gross domestic product and remain near that level in the medium term,” S&P analysts led by David Beers in London, said in the report today.

The British economy, the second largest in Europe, shrank 1.9 percent in the first quarter, the biggest contraction since 1979, when Margaret Thatcher became Prime Minister, the Office for National Statistics said on April 24. Darling said in his budget the economy will slump about 3.5 percent this year, before expanding in 2010.

Government Support Slumps

Brown needs to increase borrowing to pay for rescuing banks that have reported $121 billion in credit-related losses and writedowns since the start of 2007. The government pledged 40 billion pounds to bail out lenders and hundreds of billions of pounds in loan guarantees.

Labour trailed the Conservatives by as much as 22 points this month, according to a BPIX Ltd. survey completed on May 16. Conservatives had the support of 42 percent of voters, compared with 20 percent for Labour, according to the poll, which didn’t provide a margin of error.

Support for Brown is tumbling in the run-up to European elections on June 4 as a scandal about lawmakers’ expenses engulfs British politicians. House of Commons Speaker Michael Martin resigned two days ago, the first time that has happened since 1695.

Bank of England

The government gave the Bank of England authority to purchase as much as 150 billion pounds of assets with newly printed money in an attempt to lower borrowing costs.

Britain’s “balance sheet is deteriorating rapidly,” Moody’s analysts led by Arnaud Mares in London wrote in a report on April 23. “The government is taking risks with public finances.”

Some reports indicated the economic decline is slowing. Nationwide Building Society said April 30 house prices fell less than forecast in the month, after posting a surprise increase in March. Consumer confidence climbed to the highest level in a year during April, GfK NOP said in a report the same day.

Reasons why bear market rally will stall and reverse

Posted in the Financial Times by George Magnus:

The rally in equity markets has spread a little optimism around a global economy that is still in deep funk. Some argue this is precisely how new bull markets begin. Others, including your scribe, assert it is an impressive bear market rally. The latter case has been made consistently since it began, and maybe that is a reason why it may continue for a while. It is certainly the pain trade par excellence, that is, the risk of not being involved is becoming increasingly painful. However, this rally will stall eventually and then reverse for three important reasons.

First, the structural credit system dysfunction in advanced economies hasn’t been fixed yet. Some previously blocked credit arteries have been opened up a little, and credit risk in the banking system has receded thankfully, but we are still a long way from a viable, solvent banking system that intermediates credit independently. Surveys suggest banks have become a little more willing to make loans, but they lack creditworthy borrowers. The biggest hurdle of all, as David Roche highlighted in this column yesterday, is that the great debt restructuring, especially of mortgages, has barely begun. The collapse in asset values has left household and aggregate economy debt ratios (in relation to GDP, net worth, income and cash flows) at record highs as of March 2009. These ratios will all decline markedly over the next 2-3 years as debt restructuring occurs.

In the meantime, markets will face two strong balance sheet headwinds. The increases in household savings and unemployment will be outside our ‘normal’ experience, accentuating the household sector’s balance sheet repairs. And banks’ assets will continue to shrink as they too deleverage. In fact, we should continue to see financial institutions lining up to sell assets and issue equity into a rising equity market, and looking to dispose of non-core businesses. In the US, the rush to issue equity to pay off Tarp funding and meet stress test capital requirements has raised about $40bn in the last two weeks, though this is just 13 per cent of what would be needed. These observations underscore the essential truth about a deleveraging crisis, namely that it is a multi-year work in progress. Banks have been at it for less than a year, and households have barely begun.

Second, the rise in equity markets has occurred hand-in-glove with the improvement in sentiment about the global economy. However, investors should heed the complex strands of this argument. The good news is that the recovery in China and some other emerging nations, which experienced a steep but quite familiar downturn, looks genuine. And it is surely of consequence that oil and some other commodity prices, especially softs, have risen in spite of the aggregate demand weakness in richer nations. However, even in emerging markets, growth optimism has to be tempered to the extent that they rely on exports to western consumers, whose spending and borrowing will remain subdued.

It is, however, in the west that economic recovery prospects carry the loudest health warning. We are currently experiencing some cyclical noise related to the inventory cycle and to fiscal and monetary initiatives, but these are unlikely to evolve into a sustainable expansion. For that, we need to see higher spending on capital formation and consumer durables. With debt financing put out to grass, the financing can only come from a durable improvement in employment, incomes and profits, and a normalisation of credit flows. This may not happen until 2011 at the earliest.

Third, regardless of the pattern of GDP in 2009-10, how can markets realistically price the large uncertainties surrounding the global economy in the medium term? We can assess probabilities about the avoidance of more drastic protectionism, the return of global imbalances, the exit strategies from quantitative easing and asset purchases, and a fiscal credibility crisis. But probabilities are as far as we can go, for we have no reliable templates, and that alone argues for sustainably higher risk premiums.

We do know, though, that a higher cost of capital and weaker trend growth, not least because of demographic change, are baked in the cake. We also know that the reflation trade will probably endure for as long as rising unemployment, bankruptcies, defaults and debt restructuring continue. The stall in nominal GDP growth can and will be reversed by central banks, but neither they nor we can be sure how the split between real GDP and inflation will be distributed. In that vein, investors may continue to be attracted to the gold, energy and other commodity sectors. Reflation may also finally claim the US dollar as a victim, but while the world is awash with US dollar debt that it is seeking to reduce, the dollar should be stable or even stronger. Anyway, the big currency move should be against China and others in Asia, and they aren’t ready to acquiesce yet.

Wednesday, May 20, 2009

Pension Benefit Guaranty Corporation Deficit Increases

Posted on Calculated Risk:

From Eric Lipton at the NY Times: Bankruptcies Swell Deficit at Pension Agency to $33.5 Billion

The deficit at the federal agency that guarantees pensions for 44 million Americans more than doubled in the last six months to a record high, reaching $33.5 billion ...

The Pension Benefit Guaranty Corporation, as of October, had faced a shortfall of $11 billion. But the combined effect of lower interest rates, losses on its investment portfolio and the increase in the number of companies filing for bankruptcy protection resulted in a deepening of its estimated deficit, officials said Wednesday.
With the bankruptcy of Chrysler and a possible similar move by General Motors, the agency is facing a record surge in demand. The new deficit estimate takes into account both pensions it has taken over in the last six months, and others it believes it will have to assume control of soon.
Here is the PBGC statement: PBGC Deficit Climbs to $33.5 Billion at Mid-Year, Snowbarger to Tell Senate Panel
The $22.5 billion deficit increase was due primarily to about $11 billion in completed and probable pension plan terminations; about $7 billion resulting from a decrease in the interest factor used to value liabilities; about $3 billion in investment losses; and about $2 billion in actuarial charges.

Snowbarger notes that as of April 30, the PBGC’s investment portfolio consisted of 30 percent equities, 68 percent bonds, and less than 2 percent alternatives, such as private equity and real estate. All the agency’s alternative investments have been inherited from failed pension plans.
Last year the PBGC voted to allow equity investments, but luckily the entire portfolio wasn't moved into equities - and they only lost $3 billion on their $56 billion asset portfolio.

Unfortunately there is much more to come:
The PBGC is closely monitoring companies in the auto manufacturing and auto supply industries. According to PBGC estimates, auto sector pensions are underfunded by about $77 billion, of which $42 billion would be guaranteed in the event of plan termination. The pension insurer also faces increased exposure from weak companies across all sectors of the economy, including retail, financial services and health care.
With companies moving away from defined benefit plans, there will be fewer companies paying for insurance in the future - so the PBGC will probably have to be bailed out.

Do Jim Cramer Stock Picks Beat the Market?

Posted on the Wall Street Journal MarketBeat by Matt Phillips:

The hooting and hollering that accompanies Jim Cramer’s nightly stock picks on CNBC’s “Mad Money,” have drawn disapproval from a broad range of critics, from dour financial types to spoof-news anchor Jon Stewart, who famously dressed down Cramer back in March.

But beyond matters of style, many have wondered whether Cramer’s stock picks actually pan out. A newly published study by two Northeastern University finance professors set out to find an answer by looking at a dollar-weighted portfolio of recommended stocks. The professors — Paul J. Bolster and Emery A. Trahan — spell out the bottom line:

The cumulative return for this portfolio for the entire period is 31.75%, or an annualized return of 12.09%. The progression of returns for the portfolio and the S&P 500 index is shown in Figure 2. The S&P 500 earned 18.72%, or 7.35% annualized over the same period. The Russell 1000 Growth and Value indexes earned 24.54% (9.51% annualized) and 24.77% (9.59% annualized), respectively. The Russell 2000 Growth and Value indexes earned 22.51% (8.76% annualized) and 9.39% (3.78% annualized), respectively. Thus, the Cramer portfolio outperformed all of these benchmarks.

Even so, the academics explain that their analysis “suggests that Cramer’s portfolio returns are driven by beta exposure, smaller stocks, value-oriented stocks, and momentum effects.” Huh?

In a quick chat with MarketBeat one of the paper’s authors, Paul Bolster, was kind enough to translate, explaining that Cramer beats the market in part because of the excess risk in his picks. “If we adjust for his market risk, we come up with an excess return that is essentially zero,” Bolster said, adding that “zero,” in this case, means his returns are roughly in line with the risk he’s taking on. “He’s pulling his own weight with respect to the risks that his picks represent,” Bolster said. In the paper, Bolster and fellow finance professor Trahan conclude that “we find inconsistent evidence of Cramer’s ability to add value through security selection.”

There has been a lot of interest over the last few years in trying to figure out exactly how much stock-picking skill Cramer actually has. For his part he noted in a 2007 article in New York magazine that “my most recent internal performance review found that the stocks I pick for the show beat the S&P 500 63 percent of the time.”

In August of that year, Barron’s published a piece that attempted to get a fix on exactly how the Cramer’s picks fare. (It turns out that there seemed to be some debate over exactly what qualifies as one of his picks, centering on whether to include calls from the “Lightning Round” segment of the show where he fields questions about company shares on the fly.)

Numbers wonk Patrick Burns served as the key stat cruncher for the Barron’s story, and here’s his paper explaining his approach. Conclusion: “In my opinion, Jim Cramer’s stock-picking superiority is at best unproved.”

Not So Fast: Indiana State Pension Fund Seeks To Block Chrysler 363 Sale,

Posted on Naked Capitalism by Tyler Durden:

White & Case, made famous by its irreverent lawyer Tom Lauria, who led a valiant fight for the non-TARP lender committee until its disbandment after holdout after holdout decided fighting against the US government was not reasonable, has been retained again, this time by Indiana Pension Funds, holders of Chrysler first-lien claims, who are continuing where the non-TARP lenders dropped off.

In several motions with the Chrysler docket earlier, the Indiana State Teachers Retirement Fund, Indiana State Police Pension Trust, and Indiana Major Movers Construction Fund, fiduciaries for "approximately 100,000 civil servants, including police officers, school teachers and their families" have objected to the 363 sale, and demand Judge Gonzalez should block the sale, claiming "the plan is illegal and tramples their rights."

Among other things, the Indiana Pensioners seek to appoint both a trustee and an examiner in the case (an examiner was eventually retained in the Lehman bankruptcy), claiming that the company "has ceded control over their business and their restructuring efforts to the United States Treasury Department" which is using the Chapter 11 process to reward creditors that the "government deems politically important."

Not only that, but lawyers added that "the Treasury Department has taken constructive possession of Chrysler and is requiring it to adopt a sale plan in bankruptcy that violates the most fundamental principles of credit rights."

Whereas before it was easier to scapegoat certain evil, vicious hedge fund managers who could much easier be stripped of their fiduciary obligations and painted for the greedy, disgusting animals they are, Obama and Rattner will have a much more difficult time playing the blame game on this occasion, where the actual impaired party is so much closer to the people for whom it is a fiduciary, in this case, as the filing notes, roughly 100,000 ordinary men, women and children in the state of Indiana.

Lastly, this could significantly derail any plans for a fast and streamlined 363 sale: hopes were high that with the dissolution of the non-TARP committee it would be smooth sailing for Fiat and for the administration to get everything they wanted. With this last minute objection coming completely out of left field, Chrysler and its advisors will be stumped which lever in the media blame game to use now.

Geithner Says Toxic-Asset Plan to Start in Six Weeks

Posted on Bloomberg by Rebecca Christie and Robert Schmidt:

Treasury Secretary Timothy Geithner said policy makers plan by early July to begin helping banks sell distressed assets, in the U.S. government’s next step to end the worst credit crisis in decades. (The prepared statement can be downloaded here.)

“Working with the Federal Reserve and the FDIC, we expect these programs to begin operating over the next six weeks,” Geithner said in testimony to the Senate Banking Committee today in Washington.

The Treasury’s Public-Private Investment Program will use $75 billion to $100 billion of government funds to finance sales of as much as $1 trillion in distressed mortgage-backed securities and other assets. The effort has two components, which the Treasury will manage in conjunction with the Fed and the Federal Deposit Insurance Corp.

“A variety of troubled legacy assets are congesting the U.S. financial system,” he said. “This constraint on capital reduces the ability of financial institutions to provide new credit and uncertainty about the value of legacy assets is constraining the ability of financial institutions to raise private capital.”

Geithner also said that the Treasury has about $124 billion left in the $700 billion Troubled Asset Relief Program, including $25 billion in expected repayments over the next year. This compares with the department’s previous estimate of about $135 billion remaining as of late March.

He told the panel the Obama administration has no plans to ask Congress to approve more money for the rescue.

Commercial Real Estate

Geithner said the Treasury and the Fed also expect to expand programs, such as the Fed’s Term Asset-Backed Securities Loan Facility, designed to help asset-backed securities markets. The central bank yesterday announced it would add older commercial real estate securities to the TALF by July, marking the first time the program has included legacy assets as well as newly issued securities.

“The Treasury and the Federal Reserve will continue to monitor and enhance the ABS programs to bring in new, more niche asset classes and make sure that the number of eligible borrowers and issuers continues to increase,” Geithner said.

The Treasury chief reiterated his view that “there are important indications that our financial system is starting to heal,” highlighting diminished premiums in corporate, municipal and interbank lending markets.

Less Leverage

“Leverage has declined, the most vulnerable parts of the non-bank financial system no longer pose the same risk and banks are funding themselves more conservatively,” Geithner said.

The department is investigating “metrics” to use in judging the health of markets and the economy to determine “whether additional or different steps are needed,” he said. The “process of financial recovery and repair will take time.”

Banks have taken steps to strengthen their capital reserves since the conclusion of regulators’ stress tests on the biggest 19 lenders, he noted. Geithner repeated that “the vast majority of banks have more capital than they need to be considered well capitalized by their regulators.”

Geithner said the Obama administration is still working with General Motors Corp. as that company seeks to meet a government-imposed deadline for restructuring. The company has until the end of this month to come up with a new plan or enter bankruptcy, as Chrysler LLC did.

‘Significant Efforts’

“We will continue to work with GM and its stakeholders in the lead-up to the June 1 deadline,” Geithner said. “We will also continue our significant efforts to ensure that financing is available to creditworthy dealers and to pursue efforts to help boost domestic demand for cars.”

He told senators that “we do not want to have the government involved in day-to-day management decisions” at bailed out companies such as the automakers. If board members are installed by the administration, they would have a duty to maximize shareholder value over time, he added.

On China, Geithner said the U.S. is encouraged by recent gains in its currency, the renminbi or yuan.

“There’s been very substantial change over the last two years; they’re committed to further evolution,” Geithner said. “We’re going to continue to encourage it.”

China is playing “a very constructive, stabilizing role as the world goes through the worst recession in decades,” he said.

The Treasury “shortly” will finish details of a plan aimed at helping small businesses by making as much as $15 billion of TARP funds available to unlock the secondary market for the government-guaranteed part of Small Business Administration Loans, Geithner said.

Tuesday, May 19, 2009

Fed expands TALF to include legacy CMBS

The Federal Reserve Board on Tuesday announced that, starting in July, certain high-quality commercial mortgage-backed securities issued before January 1, 2009 (legacy CMBS) will become eligible collateral under the Term Asset-Backed Securities Loan Facility (TALF).

The TALF is designed to increase credit availability and support economic activity in part by facilitating renewed issuance of consumer and business asset-backed securities (ABS) and CMBS. The Board authorized the TALF on November 24, 2008, under section 13(3) of the Federal Reserve Act. Under the TALF, the Federal Reserve Bank of New York (FRBNY) has extended loans secured by triple-A-rated newly issued ABS backed by certain consumer and business loans and leases. On May 1, 2009, the Board announced it would expand the range of acceptable TALF collateral to include newly issued CMBS starting with the June subscription.

On March 23, 2009, the Federal Reserve announced that it would evaluate extending the list of eligible collateral for TALF loans to include certain legacy securities. The objective of the expansion is to restart the market for legacy securities and, by doing so, stimulate the extension of new credit by helping to ease balance sheet pressures on banks and other financial institutions. Tuesday’s announcement marks the first addition of a legacy asset class to the list of eligible TALF collateral.

The CMBS market, which has financed approximately 20 percent of outstanding commercial mortgages, including mortgages on offices and multi-family residential, retail and industrial properties, came to a standstill in mid-2008. The extension of eligible TALF collateral to include legacy CMBS is intended to promote price discovery and liquidity for legacy CMBS. The resulting improvement in legacy CMBS markets should facilitate the issuance of newly issued CMBS, thereby helping borrowers finance new purchases of commercial properties or refinance existing commercial mortgages on better terms.

To be eligible as collateral for TALF loans, legacy CMBS must be senior in payment priority to all other interests in the underlying pool of commercial mortgages and, as detailed in the attached term sheet, meet certain other criteria designed to protect the Federal Reserve and the Treasury from credit risk. The FRBNY will review and reject as collateral any CMBS that does not meet the published terms or otherwise poses unacceptable risk.

Eligible newly issued and legacy CMBS must have at least two triple-A ratings from DBRS, Fitch Ratings, Moody’s Investors Service, Realpoint, or Standard Poor’s and must not have a rating below triple-A from any of these rating agencies. More broadly, the Federal Reserve is formalizing procedures for determining the set of rating agencies whose ratings will be accepted for various types of eligible collateral in the Federal Reserve’s credit programs.

The initial subscription date for TALF loans collateralized by newly issued CMBS will be June 16, 2009. The subsequent subscription dates for TALF loans collateralized by newly issued and legacy CMBS will be announced in advance. The subscription date for loans collateralized by all other ABS will remain toward the beginning of the month.

A new term sheet and a frequently-asked-questions document, specific to legacy CMBS, are attached. Also attached are a revised term sheet and frequently-asked-questions document for newly issued asset-backed securities and CMBS.

Term Asset-Backed Securities Loan Facility (Legacy CMBS): Terms and Conditions

Term Asset-Backed Securities Loan Facility (Legacy CMBS): Frequently Asked Questions


TALF Terms and Conditions