April 30, 2010

Turning the Corner in Banking – A Wall Street Tale

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Finance, Forward thinking, government, investment advisor, investment banking, investments, local banks, municipal bonds, San Francisco, Stocks, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 3:45 PM by Robert Barone

Wall Street was upbeat in mid-April because the country’s four largest banks (Bank of America (BAC), JPMorganChase (JPM), Citibank (C), and Wells Fargo (WFC)) all reported what Wall Street considered “turning the corner” earnings and all the CEO’s except BAC’s Moynihan were positive on the immediate future.  The data, however, do not lead to such conclusions.

Profits rose at two of the big four.  C’s profit rose to $4.43 billion in I/10 from $1.59 million in I/09.  Believe it or not, C’s profits were the highest reported among the group despite the fact that they have been selling off many of their most lucrative businesses, like the Smith Barney brokerage unit.  At JPM, profits rose to $3.33 billion from $2.14 billion in I/09.  At BAC and WFC, profits fell.  The $2.5 billion profit at WFC was 16% lower while BAC’s $3.2 billion profit was lower by 25%.

Sources of Profit

The basic source of profits at all four of the institutions was their proprietary trading operations (75% at JPM, more than 50% at BAC, and 40% at WFC).  No wonder there is such a furor over the proposed Volcker rule (restrictions on proprietary trading) in the financial reform legislation.

The health of the industry is often measured by top line revenue growth.  Using this measure would not lead to the conclusion that the industry is “healthy”, as at three of the four, top line revenue fell from year earlier levels.  At C, top line was down 5.8%.  It was the lowest in four quarters at WFC, and it fell 11% at BAC.  Only at JPM did top line rise (5.0%).

Asset Quality

As measured by asset quality, the basic banking function was still in the doldrums.  C said its charge-offs were higher.  At JPM, defaults were at an all time high, and mortgage defaults continued to rise.  The $131 million loss in JPM’s retail banking unit was much lower than the $474 million profit a year earlier.  Only credit card losses of $303 million showed improvement over the $547 million loss of I/09.  That’s not a lot of evidence to indicate that “this would be the makings of a good recovery” as suggested by Jamie Dimon, JPM’s CEO.

At WFC, the charge-off percentage was a high 2.71% versus 1.54% a year earlier, and equivalent to the charge-off percentage in IV/09.     This is surprising.  Normally, in a bad earnings year like 2009, a bank writes-off everything it can in the fourth quarter so that the next year looks better.  This is known as a “kitchen sink” quarter.  The fact that the charge-off percentage continued at the “kitchen sink” rate in I/10 indicates that asset quality has continued to deteriorate and has exceeded management’s expectations embedded in their fourth quarter estimates.  This should be of concern to the marketplace.

Charge-offs at BAC were quite high at 4.44% ($10.8 billion) in I/10 compared to 2.85% ($6.9 billion) a year earlier.  In addition, they rose sequentially from IV/09 (3.71%).  And 30 day delinquencies, the precursor to charge-offs, now stand at a whopping 8.5% of the loan portfolio.    Again, the market should be concerned with such deterioration.  At JPM and C, I/10 charge-offs were only slightly better than those in IV/09 (C: 1.14% vs. 1.17%; JPM: 4.83% vs. 5.27%).  How the senior executives of these institutions can be upbeat about these figures is puzzling.

Misleading Provisions

One of the ways banks manipulate their earnings is through the addition or non-addition to their loan loss reserves.  This used to be a fairly simple calculation, but over the last few years this has become a complex algorithm which, while it looks very precise and detailed, it is based on assumptions and judgments which can be manipulated to achieve desired results.  So, earnings have to be examined in light of loan quality and the provision for loan losses.  At C, while charge-offs were higher and no real improvement occurred in asset quality, the provision for future losses fell 16% from I/09 and 5% from IV/09.  At JPM, the provision fell by 30% to $7 billion from $10 billion.  Without this $3 billion reduction, the $3.33 billion of profitability would have all but disappeared!  WFC’s provision of $5.33 billion was higher than the $4.56 billion of I/09.  While it was slightly lower than the $5.91 billion of IV/09, WFC clearly sees significant loan issues ahead.  BAC’s loan loss provision fell to $9.8 billion from $13.4 billion in I/09, a $3.6 billion reduction.  With delinquencies and charge-offs at all time highs, a $3.6 billion reduction in provision casts doubt about the quality of the $3.2 billion profit.  After all, without the provision reduction, profits here, too, would be significantly lower.

Other Economic Indicators

Loan delinquencies and foreclosures are at record highs.  There are at least 18 more months of foreclosures issues as the 5/1 ARMS and Alt-A mortgages of ’05 and ’06 reset in ’10 and ’11.  Yet, despite these facts, loan loss provisions at three of the four were significantly reduced.  The rationality for such reductions would be much more compelling had loan losses and delinquencies shown marked improvement.  But they didn’t.  There may be trends in the internal data that only the banks can see.  But, not all of them see such trends.  WFC, for example, increased their loss provision.  And while BAC provided a whole lot less for future losses indicating an upbeat future, its CEO, Moynihan, indicated that BAC’s loan demand was weak and the mortgage division (which includes Angelo Mozilo’s Countrywide) continued to struggle.

Conclusion

The bottom line is that it doesn’t appear that credit strains have been resolved.  Even if the worst has passed, there still appears to be several more quarters of severe credit issues which will continue to be a huge anchor holding back basic bank profits on the micro level, and economic growth and employment on the macro level.  Only when delinquencies and foreclosures are rapidly declining will the U.S. economy take off.

Don’t be fooled by upbeat CEO statements or irrational market behavior.  The basic business of banking is still troubled.  This, of course, is obvious by the continuing record number of weekly small bank failures.  But it is also obvious in the big bank data when analyzed:

  • Most of the profitable revenue was generated from proprietary trading at the big institutions, not from basic banking; and this source is now threatened by the financial reform legislation;
  • Top line revenue is still falling;
  • Delinquencies and charge-offs remain at record levels;
  • The reduction in provision for loan losses, which enhances earnings, in the face of record delinquencies and foreclosures leaves much room for skepticism.

Robert Barone, Ph.D.

April 26, 2010

The mention of securities or types or securities in this article should not be considered as an offer to sell or a solicitation to purchase any securities mentioned.  Please consult an Ancora West Investment Professional on how the purchase or sale of securities can be implemented to meet your particular investment objectives goals.

Ancora West Advisors LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.  A more detailed description of the company, its management and practices are contained in its registration document, Form ADV, Part II.  A copy of this form may be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778

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April 22, 2010

Fool’s Gold 2: Los Angeles

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Finance, Forward thinking, government, investment advisor, investment banking, investments, local banks, municipal bonds, San Francisco, Stocks, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , at 6:42 PM by Robert Barone

In a January blog, I discussed the fact that despite the conventional wisdom about the “safety” of municipal bond investments, the immediate future could see a significant number of municipal defaults.  So, it shouldn’t have come as a shock to our readers when Los Angeles’ Controller Wendy Greuel recently warned that the city’s general fund could run out of money by May 5th.  She reported that the city’s budget gap was $222.4 million for the current fiscal year which ends June 30.  Is the current budget issue in Los Angeles a tipping point?

Recently, elected officials of the city and the Los Angeles Department of Water and Power squared off over periodic payments ($73.5 million) the utility is supposed to make to the city in lieu of taxes and franchise fees.  The utility, the nation’s largest ($4.2 billion annual budget and 8,600 employees) stopped making payments when the LA City Council voted not to allow rate increases.  Utility officials claimed such increases were necessary to cover the costs of investing in renewable energy projects mandated by the state.  On April 12th, the utility’s general manager, David Freeman, wrote to the Controller, “There is no surplus money to transfer at this time”.  Ms. Greuel ordered an immediate audit of the utility.

While the $73.5 million payment would help the city’s budget, it does not appear to be enough money to change the city’s plight.  The deficit has forced the city to dip into its reserves to cover the short fall.  The city started the fiscal year with a reserve fund of about $207 million.  With the $73.5 million from the utility, it is estimated that the reserve would end the fiscal year with $39 million, or .9% of the annual city budget, far below the targeted level of 5% of budget.  There is no doubt that something will have to be done, and soon, as budget projections show a $500 million short fall for the next fiscal year.  Given the California State budget woes, it is unlikely that help will come from that source.  Los Angeles Mayor Villaraigosa has suggested cutting the work force but has run into resistance from the City Council that must approve such cuts.

Given the city’s precarious position, it isn’t any wonder that Moody’s cut the rating on some $3.2 billion of Los Angeles’ general obligation bonds citing “continued erosion of the city’s historical better-than-average willingness and ability to quickly rebalance its budget mid-year”.  A recent quote from LA Times Reporter Tim Rutten sums up the situation.

The crux of the city’s crisis is this: Los Angeles has suffered a catastrophic decline in tax and fee revenues… the city’s public employee pension funds underwent an equally devastating collapse…  city payrolls were allowed to grow heedlessly in recent years…  The truth is that everyone knows the way out of this crisis – and that involves reopening and renegotiating all the city’s labor contracts, including those with unions representing police, firefighters, and the Department of Water and Power’s workers.

On April 13th, the City Council’s Budget and Finance Committee, by a 3-1 vote, put a freeze on the hiring of new police officers.  This is but a baby step.  It is a freeze, not an in force reduction or the opening of negotiations on wage and benefit levels.  And, already there is huge resistance.  Whether Los Angeles can avoid default remains in question.

Los Angeles is not the only city in the U.S. with budget issues.  One needs only to turn on the local news to hear about municipal budget woes, furloughs, and firings.  Municipalities get their revenues from income taxes, property taxes, and sales taxes all of which are down significantly in the current economic environment.  Detroit has had to “trim” its workforce by 300 people, move satellite offices back to City Hall, and cut budget spending significantly in all departments.  Detroit’s Mayor Bing said, “It is indeed now or never” if the city is to avoid bankruptcy.  It appears that such actions will become the norm as city and state budgets become more strained.  As Ms. Greuel put it, “the sooner you take action, the less draconian the cuts need to be and you don’t find yourself at the edge of a cliff, peeking over”.

So, it may well be that the budget battle in Los Angeles is a tipping point.  While not every municipality is in such dire straights, many are.  After one or two major municipal entities use the Chapter 9 bankruptcy, it won’t be such an “unthinkable” event, and, seeing that the world won’t end, many others will follow suit.  Municipal bond investors should take heed and review and adjust their portfolios before that first major seminal bankruptcy event occurs.

Joshua Barone, Managing Partner

April 16, 2010

The mention of securities or types or securities in this article should not be considered as an offer to sell or a solicitation to purchase any securities mentioned.  Please consult an Ancora West Investment Professional on how the purchase or sale of securities can be implemented to meet your particular investment objectives goals.

Ancora West Advisors LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.  A more detailed description of the company, its management and practices are contained in its registration document, Form ADV, Part II.  A copy of this form may be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778

April 21, 2010

Financial Reform – Still on the Hook

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Finance, Forward thinking, government, investment advisor, investment banking, investments, local banks, municipal bonds, San Francisco, Stocks, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , at 4:03 PM by Robert Barone

In the wake of the financial meltdown, Wall Street and those that are “Too Big To Fail” have returned to business as usual with leverage levels and risk taking on par or greater than in 2007, including proprietary trading and the resumption of abusive derivative trading relative to their capital capacity.  To date, there has not been meaningful reform.

Proprietary trading occurs when firm’s traders actively trade stocks, bonds, currencies, commodities, their derivatives or other financial instruments with their own capital as opposed to its customers’ money, so as to make a profit for themselves.  It is estimated that 68% of all Goldman Sachs 2009 revenues were derived from this type of trading.

The issues with proprietary trading are fundamental and ethical.   While the most visible problems are the abuse called “Front Running” (proprietary trading desks trade for their own account  ahead of large blocks from pensions or hedge funds thus guaranteeing a riskless and undeserved profit) and the sale of products to clients while the proprietary desk puts on a short position in the same issue (the current Goldman probe), the biggest problem in the proprietary trading area is the over-leverage caused by bets (yes, bets!) using over-the-counter credit derivatives.  If you remember, this was the type of behavior that forced the U.S. Taxpayer to bail out AIG.  One would think that, given the magnitude of the risks to the financial system that can be caused by a few ill conceived bets, there would, by now, be some legal and regulatory safeguards to insure that the taxpayer would not again be on the hook for another large bail out.  But, so far, there has been no such movement, and, in fact, these types of contracts are the biggest profit producers (and largest risks) for the proprietary desks.

In the insurance industry, one cannot buy a policy on someone else’s life without having and “insurable interest”, like being a family member or a business partner.  Yet, in the derivative market, anyone can buy such a policy (called a Credit Default Swap or CDS) on say, the debt of another entity.   AIG went down because they issued CDSs that were several times the amount of debt that Lehman Brothers had outstanding, and the government stepped in to prevent a domino effect on Wall Street.  If AIG couldn’t pay off the CDSs at par, then a significant portion of the assets (and capital) of the other large Wall Street firms, like Goldman and JPMorgan, would have to be written down.  You see where this could have led!

In addition, it has recently come to light that Lehman used “unorthodox” accounting at each quarter’s end to “window dress” its balance sheet to hide toxic assets. (I wonder how widespread this practice is!)  Finally, it appears that the big U.S. Wall Street firms have been able to “fluff” their capital through various other accounting gimmicks, thus publicly reporting higher capital ratios (lower leverage ratios) that actually exist.

There are a lot of rumblings regarding “financial reform” on Capitol Hill these days.  The Volcker Rule is the hot topic.  Volcker has proposed that to control their capital ratios and prevent over-leverage, banks that accept federally insured deposits be restrained from investing in hedge and private equity funds and be restricted from operating proprietary trading activities.

For the sake of looking like they are doing something, Senator Dodd of Connecticut passed a “reform” bill out of the Senate Banking Committee on a strict 13-10 party line vote.  Since that time, all focus has shifted away from substance, i.e., correcting the issues discussed above, to form.  No longer are they arguing about what is in the bill, they are now debating which of their bureaucratic cronies (Fed, Treasury, or a new and costly Federal Agency) gets to have regulatory oversight of Wall Street.

It is clear that the original risks that caused the financial meltdown still prevail at the large Wall Street institutions.  With such large profit at stake, the lobbyist are in full gear.  As a result of that economic power, those lobbyists, and their political clout via their political contributions (which the U.S Supreme Court has now made unlimited), real reform will likely not be in the legislation. Without real reform, Treasury Secretary Timothy Geithner’s mantra, “we must insure that such a financial meltdown never again occurs” are just empty words.  America is still on the hook for significant major bailouts.

Robert Barone, Ph.D.

April 15, 2010

The mention of companies and securities in this writing should not be considered as an offer to sell or a solicitation to purchase any investments, securities of the companies mentioned.  Please consult an Ancora West Investment Professional on how the purchase or sale of securities can be implemented to meet your particular investment objectives goals.

Ancora West Advisors LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.  A more detailed description of the company, its management and practices are contained in its registration document, Form ADV, Part II.  A copy of this form may be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778.

April 13, 2010

The Coming U.S. Debt Crunch

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Finance, Forward thinking, government, investment advisor, investment banking, investments, local banks, municipal bonds, San Francisco, Stocks, Uncategorized tagged , , , , , , , , , at 10:57 PM by Robert Barone

Much energy has recently been spent gaming Japan’s probability of future default, as their government debt has risen to nearly 200% of Gross Domestic Product  (GDP).  While this number is extraordinarily large, and portends future problems, Japan is not alone.  While the U.S. Federal debt is not at the lofty levels of Japan’s, there are huge issues.  When we look at any budget, we can look at how much cash comes in, and how much cash goes out.  If more cash is spent than is taken in, an entity must go into debt to continue spending at the same level.  Let’s take a look at some numbers from the United States.  Keep in mind, these numbers fluctuate every year, so the numbers used are approximations.

Over the last 50 years, the U.S. government has taken in tax revenue that has averaged 18.2% of Gross Domestic Product (GDP).  In 2008, Medicare spending equaled 3.2% of GDP, while Social Security amounted to 4.4%.  Keep in mind, both of these payments are expected to rise on a percentage basis, as the baby-boomer generation retires.  Using a GDP of $14 billion for 2009, the above percentages yield the following dollar figures:

Tax Revenue: +  $2550 Billion
Social Security: –       640 Billion
Medicare: –       450 Billion
Defense: –       794 Billion (Includes Iraq & Afghanistan)
Remaining Revenue: +      666 Billion
Welfare (2009): –       405 Billion
Pensions (2009): –       738 Billion
Remaining Revenue: –       477 Billion

It is easy to see that we have a huge budget problem.  Tax revenues are down due to the recession, but we used an average tax % gleaned from 50 years of data, likely a higher number.  And, my list of expenses is incomplete.   I haven’t included Federal help for states, NASA, subsidies, or education, or the cost of new entitlements like the new health care bill.   Of utmost importance, I haven’t even talked about the yearly cost of the federal debt.

The problem with debt is that it has to be paid back, plus interest.  The U.S. currently has over $12.5 trillion in federal debt (this does not include Social Security, Medicaid, and other off budget, but real IOUs).  The country added roughly $3 trillion in debt (around a 30% increase in 2009), and will more than likely do it again this year.   Interest has to be paid on this debt.   In 2009, interest was $383 billion.  Doing the math, it appears that the interest cost is currently about 3% per year to borrow the $12+ trillion dollars.

As we know from the current issues in Greece, the more debt a nation takes on, the higher the interest it must pay.  This is common sense.  What happens to the cost of America’s debt as it increases on a scale only approached during World War II?  Will foreigners, banks and U.S. citizens continue to buy it without a “risk” premium (i.e., a higher rate)?  And what happens to the cost of the debt if the economy improves and rates rise as a result?  If the debt cost just goes from 3% to 6%, the interest cost alone rises $400 billion.

Raising taxes to plug the deficit will add fixed costs to businesses.   Businesses are the ultimate source of all revenue, as they provide taxes and wages.  Adding taxes to businesses and consumers will surely slow economic growth, and make the debt burden more difficult to bear, let alone grow out of.  Further, since taxes are politically unpalatable, governments have historically preferred to print more money, the equivalent of an “inflation tax”.

While Ancora West can’t predict exactly how or when the country will be forced to fix the budget issues, we can do our best to protect capital against a potentially hostile climate.  Quality, cash producing assets with minimal liabilities complemented by some inflation hedges are more desirable than ever.  So is a large Margin of Safety.

Matt Marcewicz

April 12, 2010

Ancora West Advisors LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.  A more detailed description of the company, its management and practices are contained in its registration document, Form ADV, Part II.  A copy of this form may be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511 or by calling 775-284-7778.

Information has been compiled from sources and historical data provided to Ancora West Advisors LLC that is believed to be accurate and credible.  Ancora West Advisors makes no guarantee to the complete accuracy of this information.