Starr CEO Greenberg Wins Against the Lawless and Discriminating Feds

The Federal Claims Court today ruled in favor of Starr International Company, the largest shareholder of AIG, against the Federal government's treatment of AIG during the "Lehman Weekend" and its unprecedented, claimed illegal extraction of equity in exchange for an $85 billion rescue loan.  No damages were awarded, and though that outcome seems inconceivable, Judge Wheeler's logic had some very weak merit.

 It is a clean, well written opinion, in which the text's many pithy sentences speak for themselves:

• "This sizable loan would keep AIG afloat and avoid bankruptcy, but the punitive terms of the loan were unprecedented and triggered this lawsuit." 
• "Operating as a monopolistic lender of last resort, the Board of Governors imposed a 12 percent interest rate on AIG, much higher than the 3.25 to 3.5 percent interest rates offered to other troubled financial institutions such as Citibank and Morgan Stanley. Moreover, the Board of Governors imposed a draconian requirement to take 79.9 percent equity ownership in AIG as a condition of the loan. Although it is common in corporate lending for a borrower to post its assets as collateral for a loan, here, the 79.9 percent equity taking of AIG ownership was much different. More than just collateral, the Government would retain its ownership interest in AIG even after AIG had repaid the loan. 
• The weight of the evidence demonstrates that the Government treated AIG much more harshly than other institutions in need of financial assistance. In September 2008, AIG’s international insurance subsidiaries were thriving and profitable, but its Financial Products Division experienced a severe liquidity shortage due to the collapse of the housing market. Other major institutions, such as Morgan Stanley, Goldman Sachs, and Bank of America, encountered similar liquidity shortages. Thus, while the Government publicly singled out AIG as the poster child for causing the September 2008 economic crisis (Paulson, Tr. 1254-55), the evidence supports a conclusion that AIG actually was less responsible for the crisis than other major institutions.

Though the opinion doesn't recount the discussion, the mere association of an $85 billion loan facility to fund a relatively small Financial Products Division with an 80% stake in a holding company with extremely profitable insurance businesses defies logic; surely other arrangements for collateral pledges could have been made had the Feds decided not to put the gun to AIG's head.  

• The Government did not demand shareholder equity, high interest rates, or voting control of any entity except AIG. Indeed, with the exception of AIG, the Government has never demanded equity ownership from a borrower in the 75-year history of Section 13(3) of the Federal Reserve Act. 

The government is cited by Judge Wheeler as carefully orchestrating the taking of equity, installation of management, and overrunning of the company by its favored consultants without requiring a shareholder vote, and to maximize the benefit to AIG Financial Products Division counterparties, the taxpaying public and to the U.S. Treasury.  

On the fundamental issue of illegal extraction of value from AIG shareholders, the court found,

• "Having considered the entire record, the Court finds in Starr’s favor on the illegal exaction claim. With the approval of the Board of Governors, the Federal Reserve Bank of New York had the authority to serve as a lender of last resort under Section 13(3) of the Federal Reserve Act in a time of “unusual and exigent circumstances,” 12 U.S.C. § 343 (2006), and to establish an interest rate “fixed with a view of accommodating commerce and business,” 12 U.S.C. § 357. However, Section 13(3) did not authorize the Federal Reserve Bank to acquire a borrower’s equity as consideration for the loan. Although the Bank may exercise “all powers specifically granted by the provisions of this chapter and such incidental powers as shall be necessary to carry on the business of banking within the limitations prescribed by this chapter,” 12 U.S.C. § 341, this language does not authorize the taking of equity."

Oops.  While the smart folks at the Fed and the Treasury were working hard to save us from a thirties style depression (a red herring), they did manage to violate a fundamental statute of the Federal Reserve Act in the process.  However, when an enemy with unlimited time, funds and access to the court of public opinion comes gunning for you, surrender might be the lesser of two bad alternatives, and so the AIG board capitulated based on that logic. 

• In the end, the Achilles’ heel of Starr’s case is that, if not for the Government’s intervention, AIG would have filed for bankruptcy. In a bankruptcy proceeding, AIG’s shareholders would most likely have lost 100 percent of their stock value.

The last sentence threw me because I thought surely that the extremely profitable insurance businesses would have provided some real residual value to shareholders. However, state regulators which are charged with protecting policy holders at all costs, would have brought assets which supported those policies into their ambit through existing state insurance regulations, as well as through other protections.  

In some ways, Starr and Mr. Greenberg are to be congratulated for using their slingshot against our own rapacious, selective prosecuting, and plundering financial regulatory Goliath.  Goliath has almost finished plundering the financial services sector for cash, and as it continues to selectively apply its novel legal theories to its enemies, perhaps other victims may stop and say "Basta!"  Let's see how Met Life does.  

Checking in on Intermediate-Term Bond Funds

Year-to-date, according to Alliance Bernstein, U.S. stocks are up 14%, compared to a gain of 4.2% for bonds.  From the local market peak on 9/18 to the trough on 10/15, bonds showed their shock absorbing qualities as they declined by only (-1.4%) versus equities at (-7.4%).

It's unclear what fund managers at intermediate-term bond funds are thinking, as the most recent published disclosures are from 9/30, but much has been made of higher cash levels at many funds. Morningstar data shows overall bond fund cash at over 8% of assets, which is alternatively attributed to bond sales, cash inflows, or raising cash for expected redemptions as equity markets continue to rise.

We lean towards the importance of the last factor, especially in light of the growing uncertainty about when and how the Fed plans to raise interest rates.

If bond funds behaved like equity funds, there's no doubt that they would be taking some money off the table because their winners have had long runs and the relative rewards going forward look less inviting.

Investment Grade Corporates issued by financial institutions had a total return of 2.5% in 2006, 11% in 2012, and 8% in 2013, according to Dodge and Cox portfolio managers whose allocations to IGCs is twice as high as their benchmark index.

If there were to be a flight away from bond funds to equity mutual funds ( a sure sign of a market top looking at retail funds), portfolio managers would be challenged because bond markets are relatively thin and inefficient, something we have noted before.

Financial regulation post-crisis has made the dealer market more risky and less profitable.

The favorite financial company issuers in the IGC sector include: Bank of America, JP Morgan Chase, Goldman Sachs, Morgan Stanley and Wells Fargo.  Bank of America, according to Bloomberg data from April 2014, had 1,295 bonds outstanding, but only 53 of these were liquid enough to included in the Barclays US Corporate Index, a popular benchmark.  But, these 53 issues, 4% of total bonds issued, amount for 46% of the dollar amount of Bank of America's debt outstanding. These bonds are over-owned because of their inclusion in the index, and because of their liquidity; investors who chose from the other 1,242 Bank of America issues will be in real trouble if there is a market traffic jam in a bond exodus.

According to BlackRock, market reform in bonds is long overdue, and aside from proposed regulation on mutual fund bond sales our regulators have not seen the improvement in bond markets themselves as something worthy of their serious interest.

QE: We Don't Know How It Works

We've never been a fan of the new Fed monetary policy, and here's an excerpt from a 2012 post on the subject:

"First things first.  No QE3.  No Operation Twist and Shout. No more monetary "Shock and Awe."  Lowering rates further or keeping them low indefinitely will NOT raise the "animal spirits" of entrepreneurs and megacap corporate CEOs.  Why?  If there's no reasonable prospect for increased final demand in the foreseeable future, businesses will sit on their cash because the capacity increasing projects still won't be worthwhile even if rates decline by a further 30 bp.  They will instead pursue mega mergers and short-term measures to raise their share prices. Larry Summers makes this point in more colorful language than I can conjure up.
Fiscal policy should be aimed at nudging, cajoling, and jawboning industry to build more pipelines to move North America's increasing energy resources to where consumers need products, building LNG terminals for export, building more refineries, switching coal plants to gas, and building out the power grid and telecom infrastructure, to name a few.  We have to get rid of the budget-busting social initiatives currently in place in order to accommodate a change in the expenditure mix.
Investing in what we need to become productive in the future would be a desirable by-product of this persistent low-rate environment.  Its blind perpetuation would be a continuing transfer of wealth to financiers and speculators."

 Well, it seems that even the architects of quantitative easing don't really know how or why it works.  New York Fed President William Dudley, himself an alumnus of Goldman Sachs, should certainly be among the most qualified to understand the effects of QE on investors and on market behavior.  Instead, we read in the Wall Street Journal that,

• Mr. Dudley and Fed Chairman Bernanke see "clear benefits" from QE
• Mr. Dudley acknowledged that a lot is still unknown about how the bond buying works
• "we don’t understand fully how large-scale asset-purchase programs work to ease financial market conditions—is it the effect of the purchases on the portfolios of private investors, or alternatively is the major channel one of signaling?”

One would have thought this statement would have generated some market consternation, but with the continuing euphoria the markets remain strong.  

Unwinding the Fed balance sheet, or removing $2 trillion in deadwood from commercial bank assets at the Fed, will not be simple.  The proposed reverse repo mechanism is fraught with risk and unintended consequences.  I hope to return to this in a future post.

Fed President's Plosser's consistent concerns about the Fed balance sheet have characterized him as a 'hawk,' whatever that is, but now his concerns have been echoed, in different language by a 'dove.'

QE A Feast for Wall Street

"Unless you're Wall Street. Having racked up hundreds of billions of dollars in opaque Fed subsidies, U.S. banks have seen their collective stock price triple since March 2009. The biggest ones have only become more of a cartel: 0.2% of them now control more than 70% of the U.S. bank assets.

As for the rest of America, good luck. Because QE was relentlessly pumping money into the financial markets during the past five years, it killed the urgency for Washington to confront a real crisis: that of a structurally unsound U.S. economy. Yes, those financial markets have rallied spectacularly, breathing much-needed life back into 401(k)s, but for how long? Experts like Larry Fink at the BlackRock investment firm are suggesting that conditions are again "bubble-like." Meanwhile, the country remains overly dependent on Wall Street to drive economic growth."

Andrew Huszar in the Wall Street Journal

What Kind of A Recovery Is This?

I've spent some time thinking through a typically informative presentation by my former colleague, Dr. Ward McCarthy and his partner Tom Simons, CFA of Jefferies, Inc, "U.S. Economy and Inflation: Economic Recovery in the Era of Conflicting Monetary and Fiscal Policy."

I want to pick out some points the authors make and then express a different set of questions and concerns.

• "The U.S. economy entered the 5th consecutive year of growth in Q3 of 2013."

The authors note that the recovery and expansion phases of the current business cycle "have been slow to date."  Not only is this true, but the nature of the recovery and expansion has been singular among recent cycles in that it hasn't featured an early-cycle housing recovery.  Instead, it has featured a "late-cycle housing recovery," which along with a recent pickup in CAPEX spending are both "important for the continuation of the economic expansion."

The consumer sector has usually been one of the engines of recovery in prior business cycles, but not in this one.  How could it be otherwise?  The authors note,

• "The unemployment rate has declined from 10% in October 2010 to as low as 7.2%, but remains high by historical standards."
• "Real Personal Consumption Expenditures has been remarkably steady and sluggish for an extended period." 

What of the miraculous, unconventional monetary policy of the Bernanke Fed?  It appears to be the only thing propping up the stock market, because even the faintest whisper of a taper sends the market into atrial fibrillation. The authors note, "Consumer spending behavior provides evidence that the Fed's QE has not had a widespread impact on the consumer sector outside of housing activity."  

On a broad macroeconomic front, productivity growth in the U.S. economy has been one of the biggest contributors to economic growth and wealth creation for decades.  But, a secular shift in the composition of output may not bode well for this in the future. The authors put the problem in simple terms, "It takes 85% of the U.S. labor force to generate a monthly trade sector surplus of less than $20 bn."  

So, ironically in this recovery, "The decline in goods-producing activities has been fundamental to the sizable monthly trade deficits in goods that have been a drag on the economy and growth."  

In secular terms, this could change, were higher value-added manufacturing to be "right shored" to the U.S. The biggest barrier to this happening is our own fiscal, political and regulatory irresponsibility.  

During this recovery, the Federal government has run annual deficits of over one trillion dollars.  While an observer could point to a short-term decline in the ratio of the deficit to GDP ratio, the total stock of Federal debt stands at an astounding $16.7 trillion, according to the St. Louis Fed.  

The Congressional Budget Office forecasts of tax revenue, spending and deficits are inherently untrustworthy. The authors note that the most recent CBO forecast has discretionary spending "rising for the remaining 8 years in the forecast horizon" beyond FY14.  

This is before yesterday's announcement that Medicare spending shall treat mental health expenditures equally to medical expenditures. The impacts of the 39 million or so additional consumers coming into the plans before this expansion have been dramatically understated, but out politicians are looking no further than the 2014 election campaigns. 

Finally, our banking system is holding excess reserves of over $1.9 trillion, and the Fed's balance sheet may not normalize until 2019 or beyond.  Meanwhile, studies from the New York Fed show that unwinding the Fed's balance sheet will remove the patent medicine of Fed remittances to the Treasury which have been widely hailed as demonstrating the 'success' of the bailout and unconventional monetary policy.  We'll look at these issues in some later posts.

So we have a five year old recovery that is built on pretty sandy soils.  

A Preview from Jackson Hole

The Kansas City Fed's Jackson Hole Conference kicks off its working sessions tomorrow with this item,

 “The Natural Rate of Interest, Financial Crises and the Zero Lower Bound,” presented by Robert E. Hall, Stanford University
Discussant: Hyun Song Shin, professor, Princeton University (my economist Doppelgänger?)

Professor Hall has presented on these issues before.  Here's a link to a 2011 paper, "The Long Slump," in which he starts thinking about the interest rate as a key mediating factor. Professor Hall has extended this framework to the ZLB in some recent slide presentations.

Do Regulators Want To Run Their Supervised Banks?

A big story this week has been the Fed's current hobby horse, "Comprehensive Capital Analysis and Review ("CCAR") for the 18 largest Bank Holding Companies ("BHC") with assets of over $50 billion.  The Fed's March 2013 publication set the stage by redoing the stress tests done by each of the BHCs with an "interdisciplinary team" of Fed staffers who sound just like most corporate staffs, with the exception of not having bank auditors on the corporate teams.

In August, the Fed published "Capital Planning at Large Bank Holding Companies: Supervisory Expectations and Range of Current Practice."  The large bank holding companies, as we've said before, have become too complex to manage, especially if we are looking to eliminate any possibility of a failure like the system wide crises of confidence and then liquidity which brought the global system into paralysis.

This document reads like a rehash of many reports on risk management, internal control, and corporate governance.  Have a look at the Report of the Committee of Sponsoring Organizations of the Treadway Commission from 2009, and the reader will see language, themes and recommendations which are reprised in the Fed's August volume.

Basically, the agenda seems to come down to this: the Fed doesn't want banks to consider returning capital to shareholders through dividends and buybacks without redoing their stress tests and then changing their return of capital plans to add a second significant digit (after the decimal) improvement to some capital ratios.

Here's a stirring sentence from the report's conclusion,

"The fundamental insight governing the Federal Reserve’s
expectations about capital planning is the importance
of having a forward-looking perspective on the risks
to a BHC’s capital resources under severely stressful
conditions."

We also learn, "These elements represent substantial conceptual and operational improvements in capital planning that go well beyond simple consideration of current and expected future capital ratios."  It's never clear at all what lies at the end of having gone "beyond."  A new set of indicators?  A digital dashboard of minute-by-minute risk indicators for every business, financial product, trading desk, currency, and country?  What would it all mean anyway?

We've often made reference to Andy Haldane's speech at the Kansas City Fed's Jackson Hole Meeting, "The Dog and The Frisbee."  In it he notes,

"It is close to impossible to determine with complete precision the size of the parameter space for a large  international bank’s banking book. That, by itself, is revealing. But a rough guess would put it at thousands, perhaps tens of thousands, of estimated and calibrated parameters. That is three, perhaps four, orders of magnitude greater than Basel I.   

If that sounds large, the parameter set for the trading book is almost certainly larger still. To give some  sense of scale, consider model-based estimates of portfolio Value at Risk (VaR), a commonly-used  technique for measuring risk and regulatory capital in the trading book. A large firm would typically have  several thousand risk factors in its VaR model. Estimating the covariance matrix for all of the risk factors means estimating several million individual risk parameters. Multiple pricing models are then typically used to map from these risk factors to the valuation of individual instruments, each with several estimated pricing parameters."

We haven't yet implemented Basel III, and now we are layering Dodd-Frank's evolving regulatory creosote on top of other complex, costly and ineffective frameworks.

The stories about traders dealing with marks on their trading books should tell a dispassionate observer the reality about how global international banks work, as opposed to the bureaucratic schema envisioned in the schemes of European, American, and other regulators. There is no single, infallible, scientifically correct number for the marked to market value of a trading book full of instruments with few buyers and sellers that trade by appointment.

So, some traders walked away from the midpoint of a spread convention.  A regulator would have acted differently.  So what?

Let's also not forget about the boards of directors of the largest bank holding companies. With all due respect, the membership of these corporate boards would never be willing or able to, for example, challenge management on the specifics of their scenario designs or on their methodologies for estimating credit loan losses.  Yet, the Fed report talks about these issues in bureaucratic abstraction as if their schemes can be actually implemented. They can't and they won't.  And, even if it were possible, there would probably be no net marginal benefit to shareholders.

By quoting Haldane's example, I am certainly not advocating the continuing or exclusive use of VaR models, but at least everyone has had some experience with these, for good and ill.

People who are really fluent with complex financial modelling, like Emanuel Derman know their limitations too. He writes,

"Derman, a professor at Columbia University and former head quant for Goldman Sachs, is outspoken on the limitations of modeling and the need for risk managers, along with CEOs, CFOs, financial engineers and traders, to keep their enthusiasm for modeling in check. “There isn’t a short cut or mechanical formula that will help you figure out the right price for a financial product,” said Derman in an interview, adding that, “these financial models are only trying to capture human emotions and instinctual feelings that we use to help us determine prices in financial markets. They are not absolute things like the distance from here to there or here to the sun, where everyone agrees on the distance.”

The managements of many of the largest bank holding companies have failed to exercise a degree of care, diligence and commitment over their sprawling organizations, and JP Morgan has been one recent example, among many.  Their businesses, which each have distinct portfolios with different risk profiles, have been stitched together by acquisition and by evolution.  Trading desks have cowboy cultures that are polar opposite to consistently profitable, high net worth wealth management businesses. Their compensation metrics, conventions and attitudes towards regulation and oversight are polar opposites: yet, they exist under one corporate roof, as in JP Morgan, Bank of America and Wells Fargo, for example.

When things have gone wrong, they have gone wrong in trading businesses, often by the action of rogue individuals who are allowed to buck the oversight.  These are not complex, multidisciplinary, quant issues.  The heads of profit centers, their supervisors, everybody in the C-suites, the board, internal and external auditors, analysts, shareholders, creditors, rating agencies, bank regulators, securities regulators and the courts all have responsibility for making sure that the inevitable issues that arise in complex businesses don't become systemic issues.  We already have plenty of infrastructure aimed at the problems, and we don't need more regulatory complexity.

Ed Yardeni Sheds Light on the Labor Markets

We recently wrote about the Fed going radio silent on the employment part of the dual mandate.

"In fact, the labor market has been said to hold the key to downshifting on QE3 or ending it.  If that is so, why not stop all the patter about monetary policy communications and put the cards on the table.  The June FOMC forecast suggests that the unemployment rate won't hit the top end of the central tendency target range until 2015.  

We need a more content-driven discussion of labor markets by the Fed as opposed to political apologists.  Americans beyond Wall Street trading desks would surely like to know what our sharpest economic minds think about our working futures. "

The Wall Street Journal pointed to Ed Yardeni's blog entry on this very subject.  

"In his prepared testimony, Bernanke said that “if a substantial part of the reductions in measured unemployment were judged to reflect cyclical declines in labor force participation rather than gains in employment, the Committee would be unlikely to view a decline in unemployment to 6-1/2 percent as a sufficient reason to raise its target for the federal funds rate.” 

"Wow, that’s an important statement! It’s not hard to see that all of the drop in the unemployment rate so far can be attributed to the decline in the participation rate. I constructed three hypothetical time series showing the total number of unemployed workers by subtracting actual employment from the civilian working-age population multiplied by labor force participation rates of 63%, 65%, and 67%. This analysis shows that nearly all of the 3.6 million drop in unemployment from the peak at 15.4 million during October 2009 through June of this year can be explained by the drop in the participation rate from 65.0% to 63.5%. The same can be said for the drop in the unemployment rate from its most recent cyclical peak. Currently at 7.6%, it would be at 9.7% if the participation rate were 65%. "

So, do you think that all the monetary policy sleight of hand has been good medicine for the labor market?  

NY Fed Symposium on Distressed Residential Real Estate

It looks like the NY Fed held a high level symposium on the distressed real estate and real estate owned markets, and they have made available the papers and discussions of the meeting in a handy compendium.  I have to put this on my reading stand, because surely determining the size of the backlog and its composition is the key to the market normalizing itself.

The Fed Should Stop Talking to Wall Street Traders

The Fed has the famous "dual mandate."

"The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates."

Every time the markets swoon, all of the attention is focused on how, when, or if QE3 will be tapered, unwound, or continue into the indefinite future.

The important question is , "What's wrong with the labor markets?"  The Wall Street Journal recently pointed out,

"The latest unemployment report was as underwhelming as the Household Survey. The biggest gains in June came from leisure and hospitality industries, including hotels and fast-food restaurants. Of the 195,000 new payroll jobs, 75,000 were in restaurants and bars, where the average weekly paycheck is about $351, less than half the average for all other private industries. Not to mention that these positions offer fewer hours, especially in the restaurant world, which has averaged 26.1 hours per week versus 34.5 hours for all private employers.s

What's going on? The fundamentals surely reflect the feebleness of the macroeconomic recovery that began roughly four years ago, as seen in an average gross domestic product growth rate annualized over the past 15 quarters at a miserable 2%. That's the weakest GDP growth since World War II. Over a similar period in previous recessions, growth averaged 4.1%. During the fourth quarter of 2012 and the first quarter of 2013, the GDP growth rate dropped below 2%. This anemic growth is all we have to show for the greatest fiscal and monetary stimuli in 75 years, with fiscal deficits of over 10% of GDP for four consecutive years. The misery is not going to end soon."

The Fed Chairman has made passing references to the labor market and to the Fed's work.  Why not publish the Fed's research as addenda to his testimony?  Surely, their best economists have looked at the labor market and its true underlying health, as opposed to the headline numbers.  This is where the nothing has been done, because monetary policy's power is very limited, as opposed to asset markets where it can create bubbles at will.  

In fact, the labor market has been said to hold the key to downshifting on QE3 or ending it.  If that is so, why not stop all the patter about monetary policy communications and put the cards on the table.  The June FOMC forecast suggests that the unemployment rate won't hit the top end of the central tendency target range until 2015.  

We need a more content-driven discussion of labor markets by the Fed as opposed to political apologists.  Americans beyond Wall Street trading desks would surely like to know what our sharpest economic minds think about our working futures. 

Fed President Bill Dudley Says Markets Misinterpret Fed

When the market began its summer swoon, we posted about the disconnect between what the Fed Chairman said and the market reaction. Today, the Wall Street Journal reports a statement by NY Fed President Bill Dudley saying,

"A top U.S. central bank official warned financial markets Thursday they’re reading the Federal Reserve wrong if they think a tightening in monetary policy has gotten closer.  “A rise in short-term rates is very likely to be a long way off” even as it’s possible that the central bank may slow the pace of its bond-buying program later this year, Federal Reserve Bank of New York President William Dudley said in a press briefing."

There you have it: official confirmation of our thesis.  Speaking about communications, it is clear that this press briefing and comments by other Fed Presidents are part of the Fed's communications strategy to undo the panic caused by the market's knee-jerk reactions earlier.  Nicely done. 

What makes Mr. Dudley's comments doubly interesting is that he was for many years a Managing Director and Chief U.S. Economist for Goldman Sachs.  He certainly understands how Wall Street works and how delicate and volatile market psyches can be. 

More on Tapering

From widely read blogger Bill McBride, 27 minutes ago:

"My view is the Fed will be data driven - as opposed to calendar driven - and will only taper in December if there is a clear pickup in the economy during the 2nd half."
Before coming to this conclusion, which we posted earlier, he raises a notion put forward by others that Chairman Bernanke might have been suggesting that he just wants out of QE altogether, data be damned.  This would really be a big, fat ugly black swan!

Politicians think about their legacy in their final term. Chairman Bernanke's last term will see the December meeting as the last he chairs.  To do an about face like this as his term ends would call his legacy and that of his entire board into question, as their conviction and motives for QE would be suspect for being perhaps politically motivated.  It is also highly unlikely that he would do this as his hand picked successor waits in the wings.  This would place his successor in a very untenable position coming into a situation in which the world will be looking for continuity and stability, not fire fighting. 

So, if the conclusion is as we wrote about before, and the global economic issues are the real problem, where do the markets go from here?  Stay tuned over the next weeks for a barrage of damage control from euro politicians, think tanks and others.  

Unwinding Fed Balance Sheet: Another Leap into the Unknown

Today, Goldman Sachs economists projected a lengthy time period for unwinding the Fed's balance sheet.  Here's what they had to say,

"It may take the Federal Reserve nearly a decade to bring its massive balance sheet back toward a more historically normal size, Goldman Sachs economists argue in new research.Forecasters at the firm say that if the Fed presses forward with its expected path of stimulus and continues to buy Treasury and mortgage bonds through the third quarter of 2014, it is unlikely that its balance sheet will get back toward a historical norm of around 6% of GDP until 2022.The Goldman note argues the most likely path for the Fed is that what is now a balance sheet of just over $3 trillion will top out at around $4 trillion when the Fed feels confident enough about the outlook to end its ongoing and currently opened ended campaign of bond buying. The bank expects the Fed to contract its balance sheet by allow its holdings to mature instead of actively shrinking its holding via sales."

We've talked about this being a Great Unknown for a couple of years.  Ironically, Minneapolis Fed President Kocherlakota, who has undergone several chameleon-like changes in his evaluation of QEs, wrote back in 2011,

"In the Stern book, the authors quote Minneapolis Fed President Narayana Kocherlakota as saying that the Federal Reserve's balance sheet in twenty years will likely still have $250 billion of mortgage backed securities on the books.  Unwinding the Fed's $2 trillion balance sheet will not be easy, as we've written about before."

Note that Kocherlakota was talking about unwinding a balance sheet half the size of the peak balance sheet postulated by Goldman Sachs. The GS comments about the Fed letting MBS and CMBS securities mature versus selling deserves some explanation.  Clearly, all the experts in this field are peering into the unknown, as the markets move blithely forward.  Does this remind you of another period running up to 2006?

Fed Governor Stein on Credit Market Overheating

Jeremy Stein, a member of the Board of Governors of the Federal Reserve System, made some remarks at the St. Louis Fed Research Symposium.  His talk was titled,  "Overheating in Credit Markets." 

One of the subsidiary themes in Stein's paper was hedge fund performance.  As of June 2010, the Ivy League university endowments had forty percent of combined assets in non-traditional ("alternative") investments, versus about two percent in the global investment industry portfolio.

A raw performance comparison between hedge fund indexes and the Standard and Poors 500 equity index over 59 quarters ending Q3:2010, shows hedge funds returning 9.2 percent per annum versus 7.5 percent per annum for the 500 index, with hedge funds having lower volatility and higher Sharpe ratios.

Ivy League university endowment funds, led by Harvard and Yale, pioneered large portfolio allocations to alternative investments (hedge funds, private equity, and real estate).  Dave Swensen of Yale became the public face for popularizing the use of alternative investments.

As of June 2010, Ivy endowment funds had 40 % of their combines assets allocated to alternative investments, whereas global institutional portfolios has only about 2% allocated to these investments.

According to a March 2011, Prequin survey cited by PwC, public pension plans had increased their allocations to hedge funds from 3.6% at the end of 2007 to 6.6% at the beginning of 2011.

So, what's not to like about hedge funds?  The current consensus among financial planners is that every investor needs to have exposure to alternative investments, particularly hedge funds, in their portfolio.  Morningstar even rates long/short equity funds among their mutual fund universe, although this category had a tough 2012.  Unfortunately, hedge funds are truly "black boxes," which should always be viewed with skepticism.

A 2007 paper by John Griffin (University of Texas at Austin) and Jin Xu ( Zebra Capital Management) looked at whether or not hedge fund managers were smarter equity managers than their traditional portfolio manager counterparts.  Hedge funds, they found, tended to deal in smaller, more opaque equities.  According to the multifactor APT models, small caps are an equity sector that has historically provided excess return.  Hedge fund managers also had higher turnover than mutual fund managers.  Because these smaller cap, more opaque equities often trade by appointment, this had to mean the hedge fund managers made extensive use of derivatives.  Their key finding was rather surprising.

"Decomposing returns into three components, we find that hedge funds are better than mutual funds at stock picking by only 1.32 percent per year on a value-weighted basis, and this result is insignificant on an equal-weighted basis or with price-to-sales benchmarks. Hedge funds exhibit no ability to time sectors or pick better stock styles. Surprisingly, we find no evidence of consistent differential ability between hedge funds. Overall, our study raises serious questions about the perceived superior skill of hedge fund managers."

So, why would investor agree to pay a 2/20 (2% per annum management fees; and 20% of portfolio profits) for an investment strategy which, when measured appropriately, may not add value?

According to the New York Times,

"In September 2012, the average hedge fund still charged 1.6 percent annually in management fees and collected 18.7 percent of any gains, according to data provider Preqin. Through November of that year, the average global hedge fund investor earned just 2.6 percent, according to the HFRX global index maintained by Hedge Fund Research. In 2011, investors lost nearly 9 percent. The average annual return from 2009 to 2012, supposedly recovery years following the losses of more than 20 percent in 2008, was a measly 3 percent."

Behavioral economists would say (1) investors are greedy; (2) individual investors, and even public pension funds, are forced to reach for returns in a low return environment precipitated by Fed policy; (3) investors are easily seduced by the black box, APT argument that free lunches of excess returns available to smart managers, and (4) since the fee and trading cost structures are opaque, it is nigh impossible to get an estimate of the true value added by hedge fund managers above their risk-adjusted cost of capital.

Now, in 2012 Governor Stein references papers by Jurek and Stafford who present some interesting data that seeks to decompose hedge fund outperformance.  Overall, they find that hedge funds as a category are not market neutral, which is one of the features their brokers and sales people trumpet when funds are sold to institutions.

Jurek and Stafford find that they can mimic hedge fund performance with a replicating portfolio of cash and a short position in single equity index put options.  In a recovering market uptrend, a manager could easily outperform the SandP by inexpensively replicating the index and by selling out-of-the-money put options on the index; these would expire out-of-the money and the manager would earn the option writing premia, assuring outperformance.

In both severe and mild market declines, the authors show that their replicating portfolio generates the same non-market neutral performance displayed by hedge funds over their research period.

The authors results appear in Table V in the appendix to the 2012 SSRN paper linked here.  The sample period is 1996-2010, and the gross return to hedge funds is the Hedge Fund Research Institute Composite Index plus an estimated average annual fee of 350 basis points, equating to a gross return of 13.1% per annum.  The risk-free rate is 3.14%, and the required risk premium is the mean, annualized excess return attributable to the put writing strategy, which is 9.79%.  The total hedge fund alpha in this model, accounting for a required return/cost of capital is 17 basis points.

Remember that we have progressed from the 2007 paper which showed that hedge fund managers don't have any demonstrable advantage in stock picking or market timing acumen compared to their mutual fund peers.  Yet they appeared  to outperform traditional equity or balanced fund investment strategies.  Now, when the sources of their excess return are decomposed and an attribution is made for their "cost of capital" then their alpha is essentially zero, according to the 2012 research cited by Fed Governor Stein.

So, of course, investors are now rushing like lemmings into hedge funds.

Governor Stein notes that the 2012 historic new high inflows into high yield mutual funds and new issue spread compression suggest an overheating in the high yield market. He, however, stops short of calling it a bubble, because of some historical precedents for the spread behavior.

I thought that the hedge fund material, buried in some references was at least as interesting as the discussion of high yield and leveraged loans. As opposed to financial industry economists, academia and the Fed seem to be producing the most interesting, and disinterested, research.  A reader has to dig for it, though.

Megabanks and Our Failing Banking System

Readers of this blog have seen many references to the work of President Richard Fisher and his research staff at the Dallas Fed.  The New York Times columnist Gretchen Morgenson cited a recent speech by Fisher, which reiterates themes expressed in the Dallas Fed's 2011 Annual Report.

Our last post on J.P. Morgan Chase concluded, based on the contents of JPM's own internal report, that the organization had become too risky to the financial system, and too complex to manage.

The work of the Dallas Fed comes at the megabank issue from the truly fundamental level: what are they doing with their privileged position in our financial system, to really help the economy?  The megabanks, according to the Dallas Fed research, are impeding both the transmission of monetary policy and the traditional path to additional lending and recovery.

Our banking industry post-crisis is more concentrated than ever, as shown by this chart from the Dallas Fed.


So, 0.2% of U.S. banks hold 69% of the industry assets.  This isn't good for systemic risk management, enterprise risk management, or for job creation and economic recovery.

The next point about this kind of system is that the resolution process for the 5,500 community banks can be completed in a weekend, and we've seen that happen in my home state, Minnesota.  The resolution process for banks with moderate asset size may take weeks or months, but we have a lot of experience with these too.  There is no workable resolution process for megabanks, and so they are guaranteed perpetual life support by the U.S. Federal Reserve Bank and the U.S. Treasury.  Their shareholders and creditors know this too.  There can be no "creative destruction" for JPM.

This "implicit subsidy" is extremely valuable to the managements, shareholders and creditors of the megabanks.  As a result,

"unsecured depositors and creditors offer their funds at a lower cost to TBTF banks than to mid-sized and regional banks that face the risk of failure. This TBTF subsidy is quite large and has risen following the financial crisis. Recent estimates by the Bank for International Settlements, for example, suggest that the implicit government guarantee provides the largest U.S. BHCs with an average credit rating uplift of more than two notches, thereby lowering average funding costs a full percentage point relative to their smaller competitors.[8] Our aforementioned friend from the Bank of England, Andrew Haldane, estimates the current implicit TBTF global subsidy to be roughly $300 billion per year for the 29 global institutions identified by the Financial Stability Board (2011) as “systemically important.”[9] To put that $300 billion estimated annual subsidy in perspective, all the U.S. BHCs summed together reported 2011 earnings of $108 billion.

The rating uplift, the significantly lower cost of funding, and the ability to leverage back office expenses on a huge asset base puts the other 99.2% of U.S. banks at a huge disadvantage in offering competitive products and services to their customers.   Paradoxically, the megabanks get this free ride despite the fact that they are inherently more complex to manage and to regulate.  They also pose the systemic risk.

Dodd-Frank, as we have said until we're blue in the face, adds nothing but complexity to what the British call "macroprudential regulation."  Here are some interesting charts, again from the fuller Dallas Fed study.

These are the deadweight economic losses from regulations like Dodd Frank, which are blunt instruments that weigh most heavily on those organizations for which existing regulatory and resolution mechanisms are both adequate and proven.

Finally, businesses need loans most urgently when times are tough.


This chart shows that the community banks, and the moderately sized banks are the ones which have maintained or expanded their business lending through and after the financial crisis.  Ultimately, this is why our nation needs a banking system, for maturity transformation and intermediation.  We don't need banks for proprietary trading.

Also, anyone who deals with one of the big twelve banks knows a few things about their business models:

• Over a long period of time, most of their income has become fee income as opposed to net interest income from traditional lending.
• Fees on traditional small checking and deposits have climbed into the stratosphere when measured against the risks and cost of funds.  
• Seniors, students, new entrants to the work force, and new immigrants can't get a low cost, plain vanilla banking product without arbitrary limits and high fees.  Credit unions can't compete with limited locations and few ATM's.  
• Megabanks are inexorably milking their former best customers with higher fees in the hope that they leave. The megabanks want to get into upmarket services like asset management accounts combining brokerage and banking with significant minimums.
• The investment banks in these holding companies can take as much risk as they like to show attractive returns on equity.  
• Traditional commercial and industrial loans are not attractive products for megabanks to offer, and their best customers, awash in liquidity themselves, have already floated large issues of fixed-rate term paper at historically low spreads for investment grade. 

Fisher's paper ends with the following quote,

"To us, the remedy is obvious: end TBTF now. End TBTF by reintroducing market forces instead of complex rules, and in so doing, level the playing field for all banking institutions."

Have a read through these materials linked above which are clear, well researched, and fundamentally sound.

Note: all charts and graphs above are from the hyperlinked Dallas Fed publications.

Labor Day Idylls and Europhoria

Think back to the dreaded global financial meltdown of 2008.  Monetary policy spigots wide open.  U.S. and then global real estate prices escalating. The 'originate and distibute' model in full swing at specialty finance companies.  Underwriting standards out the window.  Real estate price increases self-fulfilling.  Investors move to riskier and riskier trades to amp up their returns. 

Charles Prince makes the penetrating observation,

"When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing."

According to Deloitte's Shadow Banking Index research, assets in the shadow system peaked in the first quarter of 2008 at $21 trillion, compared to $15 trillion in the regulated banking sector.  The Reserve Primary Fund breaks the buck in 2008, beginning a run on more than $300 billion in assets in prime money market funds.  You know the rest of the story.

Here we are in the summer of 2012.  Monetary policy no longer operates through spigots but through a fire hose.  The Fed Chairman says he has a study showing easy money has produced 2 million more jobs than would otherwise have been possible, and nobody laughs or asks him to explain who created these jobs and why.  It is utter nonsense, but markets turn upward. 

Looking at a beautiful day on the Midwestern prairie, Walt Whitman's lines seem to summarize the views of our manic/depressive markets,

"O CAPTAIN! my Captain! our fearful trip is done;
The ship has weather’d every rack, the prize we sought is won;
The port is near, the bells I hear, the people all exulting.."

 Let's think about our more sophisticated neighbors in the European Union.  Global stock and bond markets have been buoyed by a Eurobanking bureaucrat stamping his feet and saying something like, "Dadgummit, I guarantee that the euro will survive.  You can bet the Sardinian villa on it."  The people exulted.  One thing he didn't say: what will that currency look like, and which nations will be in the currency union?  I don't think that Greece will be on the list.

Spain has had Valencia, Catalonia and Andalusia ask for central government help.  The Spanish government cannot cope with their requests, plain and simple.  Now, the Spanish PM talks about a EU-wide banking resolution system that will take care of Spanish banks and some 6,000 EU-wide institutions in total. Note to file: the EU does not have and is unlikely to create a workable mechanism for achieving these ends before the Spanish situation worsens with 20 billion in euro debt coming due in October. 

Yet, "currency markets are calm," and "European stocks finish higher."  The prospect for a Thursday EU meeting will keep the music box cranking and the weasel will stay contained until then. 

Recent earnings announcements from technology bellwethers like HP, Cisco and Dell have all been characterized by anemic top line revenue growth, and cuts in 2013 revenue estimates.  Asian manufacturing is slowing down dramatically, and some of its tech leaders like Acer are on life support. Cost cutting, staff reductions and restructuring are already factored into valuations. This isn't a great scenario for multiple expansion or for earnings growth looking forward.

The recent failure of SEC Chair Mary Schapiro to bring about reform of money market funds is important when looking back to the 2008 crisis.  The SEC has been "engaging for two and a half years on structural reform of money market funds."  Commissioner Luis Aguilar's two page, volte-face on reform seemed hollow and out of character.  Even with the 2010 reforms to the repo market, this market, particularly the roles of the two clearing banks, JP Morgan Chase and Bank of New York Mellon, still poses significant risks to the global system in 2012.  We haven't dealt with these issues either.

Again, U.S. equity market are near their highs, and U.S. fixed income managers now talk about looking at selected European credits as very attractive.  Aside from assurances of central bank backstopping, how can these notes issued by deadbeats be a compelling, risk-adjusted value?   World financial markets see the world as the poet Whitman did in his verse.

Going back to the 2006-2008 analogy, the music today is being played by central bankers.  Bernanke, Draghi and others have promised unlimited, interminable liquidity support to asset markets. 

Chicago Booth Professor John Cochrane puts it best in describing how the Fed has gone off the rails with respect to its fundamental mission as a central bank,

"Since the 2008 financial crisis, however, the Federal Reserve has intervened in a wide variety of markets, including commercial paper, mortgages and long-term Treasury debt. At the height of the crisis, the Fed lent directly to teetering nonbank institutions, such as insurance giant AIG, and participated in several shotgun marriages, most notably between Bank of America and Merrill Lynch.


These "nontraditional" interventions are not going away anytime soon. Many Fed officials, including Fed Chairman Ben Bernanke, see "credit constraints" and "segmented markets" throughout the economy, which the Fed's standard tools don't address. Moreover, interest rates near zero have rendered those tools nearly powerless, so the Fed will naturally search for bigger guns. In his speech Friday in Jackson Hole, Wyo., Mr. Bernanke made it clear that "we should not rule out the further use of such [nontraditional] policies if economic conditions warrant."

When the markets no longer listen to the central bankers' music, the current, long running game of musical chairs will also be over.

Waiting For Jackson Hole: More Life at the Zero Bound

It's testimony to the lack of a fundamental underpinning for our Smiley Face financial markets when the only big news is an upcoming Friday speech from Fed Chairman Ben Bernanke.  Instead of the Oracle from Omaha, we have the Oracle of Jackson Hole. 

We've posted before on Philadelphia Fed President Plosser's concerns about ongoing quantitative easing.  Professor Jonathan Wright's work, cited by Plosser, suggests that early, announcement effects of the QEs are significant, but they seem to taper off and fade quickly.  We've also talked about distortions in resource allocation caused by financial rates and asset prices being so heavily influenced by this unprecedented monetary intervention of the Bernanke Fed.

Dallas Fed President Richard Fisher has commissioned a paper by William R. White, former Head of the Monetary and Economic Department of the Bank for International Settlements. It is a useful and thorough survey paper about the evidence and theoretical underpinnings for and against quantitative easing.  It also makes a strong case for how the backwash from the unintended consequences of the QEs may exacerbate any future downturn.  It is very useful reading, and it is accessible to non-economists. 

White notes that the policy rates and longer-term interest rates we've experienced are even lower than those experienced in the aftermath of the Great Depression. Macroeconomics is a shaky science in the best of cases, but when we can't look at historical antecedents for guidance, we need to be afraid.  The prevailing orthodoxy, including a 2002 paper by Fed Chair Bernanke, suggests that monetary policy going in the aftermath of the Great Depression had not been easy enough.  Intellectually, Bernanke feels the weight of history telling him that the Fed must not be reticent as central banks were after the Great Depression. 

In addition, from 2003-2006, a number of papers were written purporting to demonstrate that a central bank could perform maturity swaps that would have the effect of lowering ten-year rates just as if the central bank had used fresh reserves to buy paper.  From this was born the mania for QEs. 

White's paper notes the work of Professor Axel Leijonhufvud, a distinguished Keynesian economist who has some interesting things to say about Keynesian policies in the aftermath of the financial crisis.  In the world of the Keynesian model, there is no explicit sub-model of the financial sector and no explicit regard for the balance sheets, either of firms or the government.  This, he says, has led to a "fiasco" when Keynesian stimulation has been applied post-crisis. 

If there is a balance sheet meltdown in the shadow banking sector, driven by counterparty performance failures, collateral fire sales, and liquidity issues, then the world will move down a deflationary path. If, on the other hand, the balance sheet issues occur on the sovereign government side, particularly in the United States, then we will have an inflationary surge. The global system could go either way.  Reinhart and Rogoff also document historical precedents for both of these scenarios.

Our current shadow banking credit system was procyclical in the credit upswing.  White makes a convincing case that the same, unreformed system will be procyclical in the inevitable credit downswing.

The paper also brings in Knut Wicksell's concepts of the natural rate of interest versus the financial rate of interest set by markets.  We have been in an environment were the financial rates are well below the natural rate, driven by trend growth rates of GDP.  In Wicksell's model, this disequilibrium creates "malinvestments." 

The paper concludes by saying that central bank actions in the current crisis have served to "buy time" for governments to get their houses in order, by balancing their budgets and by putting in place policies and regulations that provide an environment for sustainable, economic growth.  If governments here and in Europe don't make use of this breathing space, then this crisis will end in "lost decades" for the developed market economies. 

Don't expect much of substance from Jackson Hole.  Do expect the markets to get what they want.  They will party hard going into Labor Day.

Charles Plosser and the Monetary Hawks

Charles Plosser, President of the Philadelphia Fed, is routinely described as a monetary policy "hawk."  I guess that I don't understand what this means.  I do know where he stands by his writing and speeches.

A very clear and readable expression of Dr. Plosser's approach to monetary policy can be found in a paper given to the Inaugural Meeting of the Global Society of Fellows of the Global Interdependence Center, hosted in Paris by the Banque de France, in March 2012. 

He points out the inherent tension between an independent central bank and fiscal authorities.  He notes, "History teaches us that...they (governments) often resort to the printing press to try to escape what appear to be intractable budget problems."  Independence is especially tricky given that monetary policy and fiscal policy are "intertwined through the government budget constraint." 

Everyone agrees that our politicians on both sides of the aisle have been kicking the deficit can down the road for decades.  The severity of the last financial crisis, and cries about "saving the system," led the current Federal Reserve Chairman to cross the boundary into what Professor Jonathan Wright of Johns Hopkins University describes as "unorthodox monetary policies." 

Plosser's paper talks about pressures for the central bank to be "lender of last resort," something which is a hot topic in Europe.  He also cites Federal Reserve establishment of credit facilities to support specific markets for private instruments like commercial paper and mortgage-backed securities.  Support for the latter has turned into massive purchases of MBS, which he says have blurred "the traditional boundaries between fiscal and monetary policy."

Like an overweaning parent kowtowing to a spoiled child, both parties are negatively impacted by the recurring pattern of manipulation by the child and indulgence by the parent.  The current monetary policy environment at the zero bound has, in my opinion, taken a lot of the information content out of market interest rates.  Markets are now driven almost solely by what participants believe the Fed will do in response to perceived macroeconomic risks.  Thus, global markets switch "risk on/risk off" based on the statement of the ECB President.  When the market cries, the Fed comes with some candy and the child feels better.  This is not a good environment in which to allocate capital for long-term projects, which should be the real forte of the financial markets.

Plosser's fundamental objections to the Fed enabling irresponsible behavior by the government fiscal authorities are supported by some innovative econometric work by Professor Wright.  Wright comes to the conclusion that since November 2008, QE1, QE2 and QE3 (maturity extension program) have had "a significant effect on ten-year yields and long-maturity corporate bond yields that wear off over the next few months."

The quantitative easing programs, Professor Wright concludes, "were all characterized by declines in interest rates that were reversed over the subsequent months."  The market behavior seems to have been to move on the announcement effect, overreact on the upside in anticipation of future announcements, and then to correct the overshoot.  

This Federal Reserve, having gone down a political road to underwrite unprecedented fiscal profligacy and excessive financial market risk-taking, may not be able to show the courage to reclaim its independence.  Let's hope that it finds a way to go back to just being the guardian of our currency's value and long-term price stability.    That's a plenty big enough charter.

Too Big To Fail Still Too Big

It's not often that a reader sees clear, unambiguous prose in economic writing from the Federal Reserve System, but the Federal Reserve Bank of Dallas has some plain speakers, including President Richard W. Fisher and Director of Research Harvey Rosenblum.  Let's start with Rosenblum's essay in the 2011 Annual Report of the Dallas Fed.

The basic economic argument is that our regulatory framework didn't allow Schumpeter's "creative destruction," the capitalist mechanism of failure and renewal to operate in our financial institutions sector during the global meltdown.  This despite the fact that we have always had in place battle-tested means of managing failure and resource reallocation, such as Chapter 7 and Chapter 11 bankruptcies, as well as buyouts of troubled financial insitutions.  Instead, the system turned to bailouts, which they point out "is a failure, just with a different label."  Most importantly, though, a bailout fosters no renewal, but rather a reduction in competition.

In 1970, the top five banks held 17% of the industry's assets, and in 2010, the top five held 52% of industry assets.  In 2008, "commercial banks holding roughly one-third of the assets in the banking system did essentially fail, surviving only with extraordinary government assistance."  Between 2008-2011, more than 400 U.S. financial institutions failed, the most since the 1960's.  Among these were the absolutely extraordinary failures of IndyMac Bank (7/08) and Washington Mutual (9/08), which had been a darling stock recommendation of bank analysts for many years leading up to 2008.

"All booms end up busts.  Then comes the sad refrain of regret: How could we have been so foolish?"   Concentration of assets amplified the pressures in the system and the transmission to the real economy.  Within individual firms, such as IndyMac, the concentration of an "originate and distribute" model in one type of asset, namely the Alt-A mortgage--a pig with lipstick--should have set off alarms throughout the system.  In fact the regulatory failure at IndyMac was the final straw that saw the demise of the Office of Thrift Supervision. 

Concentration, complacency, and then complexity led to balance sheets that were fraught with risk, which even public company boards and managements could not understand.  Auditors certainly failed to flash caution.  "..accounting expedients (mark to market and use of proprietary corporate models for asset valuation) allowed them (banks) to claim they were healthy--until they weren't."  Subsequent write-downs were later revised by "several orders of magnitude."  Listening to recent first quarter conference calls of Citi, Wells Fargo and JP MorganChase, the balance sheets are still opaque and painted with assets of questionable value. 

In the end, what's important is the transmission of fundamental, systemic banking issues to the real economy.  December 2007 began an 18 month recession, the longest in the postwar period, in which real output dropped 5.1 percent, resulting in the loss of nearly 9 million jobs.  Over the past 22 months of expansion to December 2011, Rosemblum's research shows that only 3.2 million jobs have been recovered.

In fact, in the same presentation linked above, in the Dallas Fed's 2012 outlook, they have a "worst case" scenario of zero GDP growth or worse, in which as many as 20 TBTF global banks "require assistance (i.e.--failure)"  Even if the global economy does muddle through, the fact that this kind of TBTF risk is still present is a deplorable failure of our regulatory system.  One of Dodd-Frank's worst features is a mechanism for again sidestepping the orderly resolution process for bank failure.  "In the future, the ultimate decision won't rest with the Fed, but with the Treasury secretary and, therefore, the president."  Not comforting.

Fed Goes Oops on Stress Tests

The New York Times reports this morning that the Fed's stress test contained errors in the classification of losses in  Table 4, on page 32  of the report.  This is the table that I discussed in the previous post, and it's certainly disappointing that a high-powered organization like the Fed can't get these calculations right the first time.

It's also interesting to note that JP Morgan jumped on its positive stress tests to front-run the Fed by issuing its own press release.  This made sense, since JPM looked proactive and focused in defending its reputation.  By contrast, I looked around on the Citi website a few minutes ago, expecting to find prominent, flashing red lights pointing to a press release.  This release would have affirmed management's view that the initial test results were below expectations of the management and those of it its expert consultants.  It turns out Citi  had a point, but I couldn't find a press release. Disappointing.

There's another interesting line in  the table which purports to quantify the "Trading and Counterparty Losses" to the 19 bank holding companies from the use of derivatives for hedging risks.  In the original bailout, one of the justifications was that total global losses from a cascade of counterparty claims were incalculable and would bring the system down.  Now, in the case of a somewhat drastic economic scenario, these losses seem to be quite measurable, and they definitely do not bring down a system driven by these 19 systemically important financial institutions.  The Trading and Counterparty Losses shown range from $21 billion to $27 billion, affecting Bank of America, JP Morgan Chase, Goldman Sachs, and to a lesser extent Morgan Stanley.  I wonder what has changed in the world of derivatives that the formerly unknown has become known and manageable.