Are The Banks In Trouble? (ZT)

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Are The Banks In Trouble?

By Mike Whitney

“The new capitalist gods must love the poor – they are making so many more of them.” Bill Bonner, “The Daily Reckoning”

“Thehope of every central bank is that the real problem can be kept frompublic view. The truth is that the public---even professionals on WallStreet---have no clue what the real problem is. They know it hassomething to do with derivatives, but none of them realize that it'smore than a $20 trillion mountain of unfunded, unregulated paper thathas just been discovered to not have a market and, therefore, no realvalue… When the dollar realizes the seriousness of the situation---bethat now or sometime soon---the bottom will drop out.” Jim Sinclair,Investment analyst

09/07/07 "ICH"- -- -About a month ago, Iwrote an article “Stock Market Brushfire: Will there be a run on thebanks?” which showed how the collapse in the housing market and thedeterioration in mortgage-backed bonds (CDOs) in the secondary marketwas creating difficulties for the banking system. Now these problemsare becoming more apparent.

From the Wall Street Journal:

“The rising interbank lending rates are a proxy of sorts for theincreased risk that some banks, somewhere, may go belly up.”(Editorial; WSJ, 9-6-07)

Ironically, the WSJ editorialstaff—-which normally defends deregulation and laissez faireeconomics---is now calling for regulators to make sure they are “on topof the banks they are supposed to be regulating, so we don't get anysurprise bank failures that spook the markets and confirm the worstfears being whispered about.”

“Surprise bank failures?”

Credit standards have tightened and banks are increasingly reluctant toloan money to each other not knowing who may be sitting on billions ofdollars in toxic mortgage-backed debt. (Collateralized debtobligations) It makes no difference that the “underlying economy issound” as Bernanke likes to say. When banks hesitate to loan money toeach other; it shows that there is real uncertainty about the solvencyof the other banks. That slows down normal commerce and the gears onthe economic machine begin to rust in place.

The banks woeshave been exacerbated by the flight of investors from money marketfunds, many of which are backed by Mortgage-backed Securities (MBS).Wary investors are running for the safety of US Treasuries even thoughyields that have declined at a record pace. This is causing problems inthe Commercial Paper market as well as for the lesser-know SIVs and“conduits”. These abstruse-sounding investment vehicles are theessential plumbing that maintains normalcy in the markets. Commercialpaper is a $2.2 trillion market. When it shrinks by more than $200billion ---as it has in the last 3 weeks--the effects can be feltthrough the entire system.

The credit crunch has spreadacross the whole gamut of commercial paper and low-grade debt. Banksare hoarding cash and refusing loans to even credit-worthy applicants.The collapse in subprime loans is just part of the story. More than 50%of all mortgages in the last two years have been unconventionalloans—no down payment, no verification of income “no doc”,interest-only, negative amortization, piggyback, 2-28s, teaser rates,adjustable rate mortgages “ARMs”. All of these reflect the shoddylending standards of the past few years and all are contributing to theunprecedented rate of defaults. Now the banks are holding $300 billionof these "unmarketable" mortgage-backed CDOs and another $200 billionin equally-suspect CLOs. (Collateralized loan obligations; the CDOscorporate-twin).

Even more worrisome, the large investmentbanks have myriad “off-book” operations which are in distress. This hasforced the banks to circle the wagons and reduce their issuance ofloans which is accelerating the downturn in housing. Typically, housingbubbles unwind very slowly over a 5 to 10 year period. That won't bethe case this time. The surge in inventory, the financial distress ofmany homeowners and the complete breakdown in loan-origination (due tothe growing credit crunch) ensures that the housing market willcrash-land sometime in late 2008 or early 2009. The banks are expectedto write-off a considerable portion of their CDO-debt at the end of the3rd Quarter rather than keep the losses on their books. This willfurther hasten the decline in housing prices.

The banks arealso suffering from the sudden sluggishness in leveraged buyouts(LBOs). Credit problems have slowed private equity deals to a dribble.In July there were $579 billion in LBOs. In August that number shrunkto a paltry $222 billion. By September those figures will deteriorateto double-digits. The big deals aren't getting done and debt is notrolling over. More than $1 trillion in debt will have to be refinancedin the next 5 weeks. In the present climate, that doesn't look likely.Something's has got to give. The market has frozen and the Fed's $60billion repo-lifeline has done nothing to help.

In the first 7 months of 2007, LBOs accounted for “$37 of every $100 spent on deals in the US”.

37%! How will the financial giants make up for the windfall profits that these deals generated?

Answer: They won't. Just as they won't make up for the enormousorigination fees they made from “securitizing” mortgages and sellingthem off to credulous pension funds, insurance companies and foreignbanks.

As Steven Rattner of DLJ Merchant Banking said, “It'sbecome nearly impossible to finance a private equity transaction ofover $1 billion.” (WSJ) The Golden Era of Acquisitions and Mega-mergersis coming to an end. We can expect that the financial giants willprobably follow the same trajectory as the Dot.coms following the 2001NASDAQ-rout.

The investment banks are also facing enormouspotential losses from liabilities that “operate off their balancesheets” In David Reilly's article “Conduit Risks are hovering overCitigroup” (WSJ 9-5-07) Reilly points out that “banks such as CitigroupInc. could find themselves burdened by affiliated investment vehiclesthat issue tens of billions of dollars in short-term debt known ascommercial paper”… Citigroup, for example, owns about 25% of the marketfor SIVs, representing nearly $100 billion of assets under management.The largest Citigroup SIV is Centauri Corp., which had $21 billion inoutstanding debt as of February 2007, according to a Citigroup researchreport. There is NO MENTION OF CENTAURI IN ITS 2006 ANNUAL FILING withthe Securities and Exchange Commission.

Yet some investors worrythat if vehicles such as Centauri stumble, either failing to sellcommercial paper or suffering severe losses in the assets it holds,Citibank could wind up having to help by lending funds to keep thevehicle operating or even taking on some losses”.

So, manyinvestors don't know that Citigroup could be holding the bag for “$21billion in outstanding debt”? Or, perhaps, the entire $100 billion isred ink; who knows? (Citigroup's stock dropped by more than 2% afterthis report appeared in the WSJ.)

Another report which appearedin CNN Money further adds to the suspicion that the banks' “brokerageaffiliates” may be in trouble:

“The Aug. 20 letters from theFed to Citigroup and Bank of America state that the Fed, whichregulates large parts of the U.S. financial system, has agreed toexempt both banks from rules that effectively limit the amount oflending that their federally-insured banks can do with their brokerageaffiliates. The exemption, which is temporary, means, for example, thatCitigroup's Citibank entity can substantially increase funding toCitigroup Global Markets, its brokerage subsidiary. Citigroup and Bankof America requested the exemptions, according to the letters, toprovide liquidity to those holding mortgage loans, mortgage-backedsecurities, and other securities…This unusual move by the Fed showsthat the largest Wall Street firms are continuing to have problemsfunding operations during the current market difficulties.” (CNN Money)

Does this mean that the other large banks are involved in thesame type of “hide-n-seek” strategies? Sounds a lot like Enron's“off-the-books” shenanigans, doesn't it?


Wall Street Journal:

“Any off-balance-sheet issues are traditionally POORLY DISCLOSED, so tosome extent, you're dependent on the insight that management is willingto provide you and that, frankly, is very limited," says MarkFitzgibbon, director of research at Sandler O'Neill &Partners.”…..Accounting rules DON'T REQUIRE BANKS TO SEPARATELY RECORDANYTHING RELATED TO THE RISK that they will have to loan the entitiesmoney to keep them functioning during a markets crisis.”….” Thevehicles (SIVs and conduits) ARE OFTEN ESTABLISHED IN A TAX HAVEN ANDARE RUN SOLEY FOR INVESTMENT PURPOSES AS OPPOSED TO TYPICAL CORPORATEACTIVITIES.”

Still think the banks are on solid ground?

“Citigroup,the nation's largest bank as measured by market value and assets. Itslatest financial results showed that it administers off-balance-sheet,conduit vehicles used to issue commercial paper that have assets ofabout $77 BILLION.

Citigroup is also affiliated with structuredinvestment vehicles, or SIVs that have "nearly $100 billion" in assets,according to a letter Citigroup wrote to some investors in thesevehicles last month.” (IBID)

Yes; and how many of these“assets” are in fact cooperate debt, auto loans, credit card debt, andstudent loans that have been securitized and are now under extremepressure in a slumping market?

In an “up market” loans canprovide a valuable income-stream that that transforms someone else'sdebt into a valuable asset. In a down-market, however, defaults canwipe out trillions in market capitalization overnight.

How Did We Get into this Mess?

More than 20 years of dogged lobbying from the financial industry paidoff with the repeal of the Glass-Steagall Act which was passed byCongress following the 1929 stock market crash. The bill was written tolimit the conflicts of interest when commercial banks are permitted tounderwrite stocks or bonds.

The financial industry whittledaway at Glass-Steagall for years before finally breaking down itsregulatory restrictions in August 1987, Alan Greenspan -- formerly adirector of J.P. Morgan and a proponent of banking deregulation --became chairman of the Federal Reserve Board.

“In 1990, J.P.Morgan became the first bank to receive permission from the FederalReserve to underwrite securities, so long as its underwriting businessdoes not exceed the 10 percent limit. In December 1996, with thesupport of Chairman Alan Greenspan, the Federal Reserve Board issues aprecedent-shattering decision permitting bank holding companies to owninvestment bank affiliates with up to 25 percent of their business insecurities underwriting (up from 10 percent).

This expansion ofthe loophole created by the Fed's 1987 reinterpretation of Section 20of Glass-Steagall effectively rendered Glass-Steagall obsolete.” (“TheLong Demise of Glass Steagall, Frontline, PBS)

In 1999, after25 years and $300 million of lobbying efforts, Congress aided byPresident Bill Clinton, finally repealed Glass-Steagall. This paved theway for the problems we are now facing.

Another contributingfactor to the current banking-muddle is the Basel rules. According tothe BIS (Bank of International Settlements) website:

“The BaselCommittee on Banking Supervision provides a forum for regularcooperation on banking supervisory matters. Its objective is to enhanceunderstanding of key supervisory issues and improve the quality ofbanking supervision worldwide. It seeks to do so by exchanginginformation on national supervisory issues, approaches and techniques,with a view to promoting common understanding. At times, the Committeeuses this common understanding to develop guidelines and supervisorystandards in areas where they are considered desirable. In this regard,the Committee is best known for its international standards on capitaladequacy; the Core Principles for Effective Banking Supervision; andthe Concordat on cross-border banking supervision.”

The BaselCommittee on Banking (Basel 2) requires “banks to boost the capitalthey hold in reserve against the loans on their books.”

Soundslike a good thing, doesn't it? This protects the overall financialsystem as well as the individual depositor. Unfortunately, the banksfound a way to circumvent the rules for minimum reserves by“securitizing” pools of mortgages (MBS) rather than holding individualmortgages. (which called for more reserves) This provided lavishorigination and distribution fees for banks, but shifted much of therisk of default to Wall Street investors. Now, the banks are saddledwith roughly $300 billion in mortgage-backed debt (CDOs) that no onewants and it is uncertain whether they have sufficient reserves tocover their losses.

By October, we should know how this willall play out. As David Wessel points out in “New Bank Capitalrequirements helped to Spread Credit Woes”:

“Banks now behavemore like securities firms, more likely to mark down the value ofassets when market prices fall---even to distressed levels---ratherthan sitting on bad loans for a decade and pretending they'll be paidback.”

The downside of this is that once that banks write offthese toxic MBSs and CDOs; the hedge funds, insurance companies andpension funds will be forced to do the same----dumping boatloads ofthis bond-sludge on the market driving down prices and triggering apanic-sell-off. This is what the Fed is trying to prevent through its$60 billion repo-bailout.

Regrettably, the Fed cannot hope toremove half-trillion of bad debt from the balance sheets of the banksor forestall the collapse of related financial institutions and fundswhich are loaded with these “unmarketable” time-bombs. Besides, most ofthe mortgage derivatives (CDOs) have been massively enhanced with lowinterest leverage from the “carry trade”. When the value of these CDOsis finally determined---which we expect will happen sometime before theend of the 3rd Quarter—we can expect the stock market to fall sharplyand the housing recession to turn into a full-blown economic crisis.