May 31, 2011

Greek EMU Exit: More Pain than Gain

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, taxes, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 11:43 PM by Robert Barone

In a recent blog post, we argued that, despite her credentials, Ms. Lagarde may not be the best choice for heading the International Monetary Fund (IMF) because of her bias to protect the French, German and European banks from the losses they will have to take in a Greek default, and that she will pursue the same “extend and pretend” policies that were put in place a year ago rather than face up to the fact that we are dealing with insolvency, not temporary illiquidity.

The Moral Hazard Expectation

It is clear that Greece will never be able to repay its debt in today’s Euros, and European banks are clearly in jeopardy.  Yet the market has yawned, and European bank equity values have been untouched.    A comment received from a colleague regarding that blog post read, in part:

If she [Lagarde] gets into position and kicks the ball down the road a ways, it will only be to give these big banks a chance to off-load and write-off Greek credit over a few years which will make it more palatable when the time comes to restructure.

The market appears to have much the same attitude expecting the governmental institutions to save the “systemically” important financial institutions.  Moral Hazard is now the expectation.  Not only are all depositors implicitly protected, but so are the shareholders, bondholders and the managements.  We always thought that investing was a risk-reward business.  Investments that fail are supposed to penalize the investor through a monetary loss.  There isn’t supposed to be a floor of book or par value supported by public funds.

The Implications of Additional Austerity

We suspect the reason for the kid gloves treatment is that the alternatives inflict too much short-term pain.  As mentioned above, a Greek default significantly impacts most large European banks.  Rather than recognize the impairment of the investments in Greek debt, in exchange for additional monetary support, the European Central Bank (ECB) and IMF will likely impose even more stringent austerity measures on Greece than the ones that currently exist and cannot be met.  What isn’t factored in is the impact this will continue to have on the Greek economy and its population.

It was only 10 years ago (2001) that the government of Argentina was compelled by the IMF and other large institutional debt holders to apply more and more austere measures on their economy in order to pay back debt.  In the month of December, 2001, the austerity imposed was met by protests which quickly erupted into revolution, governmental overthrow, and eventually a tacit default.  Is this where we are heading again?

Given the resistance of the Greek populous to the existing imposed austerity, additional austerity could trigger a popular uprising and result in a Greek exit from the European Monetary Union (EMU), i.e., the Euro, or from the European Union (EU) itself.  The founding Maastricht Treaty (1992) and original amendments didn’t discuss provisions for a member’s exit from either the EMU or the EU.  The Treaty of Lisbon (2009) does allow for an exit from the EMU, but that appears to be predicated on a negotiated rather than unilateral withdrawal.  It is clear, however, that the EMU was meant to be an irreversible arrangement. (For a detailed discussion, see P. Athanassiou’s ECB working paper entitled “Withdrawal and Expulsion from the EU and EMU” at http://www.ecb.int/pub/pdf/scplps/ecblwp10.pdf)

The “New Drachma”

Putting aside the legal questions, an exit from the EMU and formation of a new Greek currency (call it the “New Drachma”) has its own set of troubling issues.  Once again, a look at the recent Argentine experience is enlightening.  A decision to leave the EMU would need to be done quietly, as public knowledge would cause a run on the banks to acquire Euros causing nearly instant failures in the banking system.  So, severe restrictions on Euro withdrawals would have to be imposed, like the much hated “corralito” that was imposed in Argentina in ’01. That government imposed policy restricted withdrawals to a nominal amount per week.  This was a key repression that led to the social unrest, riots, and the eventual toppling of the government.

Next, Greece would need to decide what to do with its debt.  Hard choices would have to be made on externally held debt. Any attempt on the part of the Greek government to convert externally held debt to the new currency on a 1:1 basis would be met with massive resistance.  Keeping external debt denominated in Euros would become crippling as the value of the “New Drachma” would immediately devalue in the forex markets.  And, all of the “extend and pretend” would be for naught, as the Greek sovereign assets on the balance sheets of the banks would be repaid in a devalued currency.

Impairment is Inevitable

Thus, the results of an imposed austerity likely leading to a Greek exit from the EMU are the same as a simple recognition on the part of those banks that hold Greek sovereign debt that those assets are impaired.  Facing up to this basic problem would seem to be a better than the current “extend and pretend” approach in which we ultimately end up in the same place, but without the social unrest and bloody carnage that accompanies it.

Recognizing today’s value of the Greek debt on financial institution balance sheets is called “transparency”.  Accounting standards, both in the U.S. and internationally, have been pushing for transparency for two decades.  Yet, now, governments are madly scrambling to cover up the true values of such assets on the books of their “systemically” important institutions.

There are also tens of billions of dollars of Credit Default Swaps (CDS) outstanding on Greek sovereign debt.  Regulators failed to deal with the capital issue in the CDS marketplace in the aftermath of the ’08-‘09 AIG meltdown, so it is impossible to predict the effects of a Greek default on this marketplace because there is no information on CDS counterparties and their capital positions. But we suspect these markets, being unregulated, continue to be over-levered.

“Extend and Pretend” Causes Stagnation

The interconnected nature of today’s global financial system implies that many other banks around the world face asset impairments and a need for more capital. Many banks could fail.  The stockholders and bondholders of these institutions should suffer losses, and not be recipients of the “moral hazard” of government protection.  There will be terrible short-term pain.  But, history shows that the pain of balance sheet depressions, while severe, is short-lived.  The system returns to health with huge lessons learned about risk.  “Extend and pretend” only imposes a long-term period of economic stagnation as the cancers on bank balance sheets fester.  Japan’s is a 20 year example of the impact of unrecognized bank losses on the economy.  In an interview given to Investors Business Daily (“Slow Growth Normal For Post-Fin’l Crisis Recoveries”, Norm Alster, 5/23/10) by Vincent Reinhart regarding the paper he recently wrote with his wife, Carmen, concerning the aftermath of 18 financial crises (see After the Fall, 8/17/10), in Japan, “the banks were allowed to carry bad assets on their books at inflated values.”  As a result, “property prices have declined for 20 year”.  As an overview, Reinhart concluded that “the government’s willingness to let banks carry bad debt rather than force them to take losses tends to stretch out the process of deleveraging.  When you let banks carry their assets at high values relative to their market values, it freezes that market”.  His prescription: “Recognize the losses … Take the hit”.  Since it appears that the inability to restart America’s economic engine is partly due to bank balance sheet impairment, why is Europe about to go down the same road?

Robert Barone, Ph.D.

Matt Marcewicz

May 31, 2011

Statistics and other information have been compiled from various sources.  Ancora West Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.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 “Firm Brochure”, (Form ADV, Part 2A).  A copy of this Brochure may be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778.
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May 20, 2011

Commentary- Citi & Pandit

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, taxes, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 4:43 PM by Robert Barone

Vikrim Pandit was named CEO of Citigroup in December, 2007.  Most people have forgotten that he pocketed at least $165 million when he sold his hedge fund, Old Lane Partners, to Citi.  His hedge fund was shut down in the middle of 2008 due to investor redemptions, forcing Citi to write down the value of the poor investment.

As per the Wall Street Journal, by February 2009, taxpayers gave Citi $50 billion dollars in capital, and guaranteed $301 billion of bad debt.  The excuse given for taxpayers bailouts of the mega banks is that “credit is the life blood of the economy.  If the credit system isn’t working then firms cannot finance themselves, people cannot borrow to buy a car, to send a student to college, to buy a house.”
 (Bernanke 9/25/08).  So, let’s take a look at the “credit flow” Citi has done since its taxpayer bailout and since Mr. Pandit gained control.

From Citi Quarterly Statements : Numbers in Millions of Dollars
 

12/31/2007

3/31/2011

% Change

Consumer Loans

592,307

441,213

-25.5%

Corporate Loans

185,686

195,923

5.5%

Total Lending

777,993

637,136

-18.1%

It doesn’t appear that Citi, under Pandit, has lived up to the lending mandate that was accepted along with TARP funding.

It is also important to remember what Citi’s achievements have been during a period when rates paid on deposits and other borrowings have been essentially zero.  It is easy to make money when you borrow for next to zero, and buy treasury bonds.  This subsidy has come directly out of the incomes of retirees, savers, pension funds, and municipal cash accounts.  Yet, for its size, Citi has barely been profitable.  Imagine what its performance would have been if the Fed hadn’t repressed interest rates for the past 3 years.

At the end of 2007, Citi had 4,905.8 million fully diluted shares outstanding (10Q). By March 31st 2011, there were 29,965.8 million shares, a dilution greater than 6 fold.  Since the dilution, Citi has done a 1-10 reverse split.  Usually, reverse splits occur because a company’s stock price is languishing.  Citi’s split is no exception.  Since that split, the stock has fallen an additional 10%.

So, why reward a manager, who has already been paid hundreds of millions of dollars by the company for a fund that had to be shut down at a huge loss to the shareholders, with a four year no cut contract worth many more millions with the only criterion being that the company simply survives. We don’t think that diluting shareholders and shrinking business all while being coddled with Federal Reserve subsidies deserves a massive pay raise.

“This time, CEOs won’t be able to use taxpayer money to pad their paychecks or buy fancy drapes or disappear on a private jet,” Obama said. “Those days are over.” (2/24/09)  Apparently, those days have now returned.

Robert Barone, Ph.D.

Matt Marcewicz

The mention of companies in this article should not be considered as an offer to sell or a solicitation to purchase any security and or investments of the companies mentioned.  Please consult an investment professional on how the purchase or sale of such investments can be implemented to meet your particular investment objectives and goals.Statistics and other information have been compiled from various sources.  Ancora West Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.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 “Firm Brochure”, (Form ADV, Part 2A).  A copy of this Brochure may be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778.

May 19, 2011

Commentary- The IMF

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, taxes, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 4:40 PM by Robert Barone

The IMF  is the key organization in the world’s complex currency system.  It was founded in the immediate post World War II period (Bretton Woods) and is an important regulator of the currency system now that the world’s major currencies are all fiat (no real asset backing or restraints).

To date, the IMF has played a key role in dealing with the debt issues surrounding the EU’s weak sisters.  If Greece is allowed to default, the Greek banks will all become insolvent, virtually guaranteeing a long-term depression in that country.  The European banks, which hold $72 billion of Greek debt and $165 billion of loans to Greece’s private sector, could muddle through a Greek default, but most would be severely wounded – with significant consequences for European growth in the near term.

Now, here is the crux of the issue.  If Greece is allowed to restructure, what is to prevent Ireland from following suit?  Look at the exposure of the European banks to Ireland:  Germany: $215 billion; France: $82 billion; Great Britain: $237 billion; the ECB $244 billion.  If Greece were allowed to default, the European banks could not handle an Irish, Portuguese, or Spanish default.  So, now the importance of the IMF should be perfectly clear.  Dominique Strauss-Kahn has been an important player for the IMF in dealing with all of these debt issues, and, it remains to be seen if his absence will have an impact.

My own personal view is that default and a restructuring of the debt of these weak nations is inevitable.  The solutions offered, so far, have treated these debt issues as if they were only liquidity problems instead of what they really are – solvency issues.  Eventually, the insolvencies need to be addressed, and with it the very survival of the EU itself.

Robert Barone, Ph.D.

May 18, 2011

Statistics and other information have been compiled from various sources.  Ancora West Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.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 “Firm Brochure”, (Form ADV, Part 2A).  A copy of this Brochure may be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778.

May 5, 2011

Community Banks

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, taxes, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 4:37 PM by Robert Barone

Jobs are the number one economic and political issue of today despite the better than expected April employment data.  Try as they might, no amount of fiscal stimulus and excess reserve creation appears to be working.  And most politicians are baffled as to why.

The monetary and fiscal medicine administered may have worked within the institutional structures of the past, but those structures have radically changed.  Part of the jobs issue is right in front of our noses.  Simply put, the rapid changes in U.S. financial institutions over the past 25 years have been detrimental to job creation in the U.S. because capital is no longer readily available to the entrepreneurial small business sector, widely acknowledged as America’s engine of job creation.

The Changing Financial Landscape

From 1983 to 1989, the number of new community bank charters averaged 297/year.  In the 90s and throughout much of the last decade, the average was more than 130/year.  But, since the financial meltdown, new charters have all but disappeared; there were 29 in ’09, and only 1 last year.  Meanwhile, community banks have been disappearing over the past 25 years through consolidation, driven partly by overregulation, and, lately, by outright failures.  In 1984, there were 14,507 commercial banks; nearly all were community banks.  At the end of ’09, that number had fallen to 6,840.

At the same time, the big have become gigantic.  The table below shows the percentage of U.S. deposits of the largest banks in 1994, and then for 2009.

Percentage of Total Bank Deposits

1994

2009

Bank of America

4%

Bank of America

12%

Nationsbank

3%

Wells Fargo

10%

Chemical Bank

2%

JPMorganChase

9%

Bank One

2%

Citigroup

4%

Citicorp

2%

PNC

3%

   Total

13%

   Total

38%

The 1994 Reigle-Neal law allowed banks to cross state lines to branch or purchase other institutions without restrictions, but put a 10% cap on deposits for any single institution.  There were loopholes, one of which allowed banks to exceed the 10% limit if it were caused by the assumption of a failing institution.  So, the last few years have seen a feeding frenzy for the megabanks.  For example, Bank of America absorbed Merrill Lynch soon after they purchased Countrywide, JPMorganChase acquired Washington Mutual, and Wells Fargo took on Wachovia.  Clearly, what was considered “large” in the 90s is now dwarfed by these whales.

In 1999, with the repeal of the Glass-Steagall Act, the megabanks were able to cross the investment banking line, which had been forbidden to them since the 1930s.  And, from that time forward, their capital ratios fell as the natural inclination of an investment banker is to use leverage.

Shadow Banks

These megabanks, even when they were merely “large”, were never community and small business lenders.  Instead, in the 80s and 90s, and up to the financial meltdown of ’08, these institutions set up lines of credit lending to the “shadow” banking system.  By doing so, they were able to avoid the overhead and expense of managing large portfolios of small loans.  The “shadow” banks were largely unregulated and they became the lenders to consumers and small businesses, and consisted mainly of mortgage companies and consumer lenders.  Many of these “shadow” banks got crushed in the financial meltdown and no longer exist.

TARP

Besides the “shadow” banks, community banks have traditionally been community and small business lenders.  And, in contrast to the megabanks, community banks have historically had higher capital ratios.  But, like the megabanks, community institutions were hard hit by the financial meltdown.  In ’08 and ’09, the TARP program was rolled out.  It was supposed to save the financial system, but what it saved was the Wall Street megabanks, as the lion’s share of TARP funds went to America’s 19 largest institutions.  In an academic paper entitled TARP Investments: Financials and Politics (June 27, 2010), authors Duchin and Sosyura (University of Michigan) found that of the 714 TARP investments made, larger banks were favored, and that political activism was a large contributing factor in determining if a small bank would receive TARP funding.

Access to Capital

By the end of the financial crisis, the megabanks were able to access the capital markets to pay back their TARP loans and to beef up their capital bases to be able to weather the coming onslaught of souring loans.  They were able to access the capital markets because the market participants knew that these banks were “Too Big To Fail”.

The Fed has extended huge volumes of liquidity and created unprecedented levels of excess reserves through their QE1 and QE2 programs.  Most of this excess had ended up on the balance sheets of the megabanks.  But until this past March, commercial and industrial loans continued to shrink.  From their peak in October ’08 to their trough in October ’10, such loans contracted by 24.75%.  From last October through March, they have turned up slightly, and I note that the unemployment rate began responding in December.   Rather than lend, the megabanks used their reserves to purchase new debt issued by the Treasury.  For the three years ending in February, government securities on bank balance sheets have risen 50% or by $545 billion.

Unlike the megabanks, community banks have no such access to capital.  Like the megabanks, community banks suffered loan quality issues, and many of these institutions now have “impaired” capital.  That means that their capital levels are below regulatory standards.  Many community institutions are under regulatory orders, and, in almost every case, those orders require additional capital.  Until they raise such capital, their capital ratios do not permit them to lend new funds.  Furthermore, the regulators are generally heavy handed, and, the capital that may be available is hesitant to enter for fear (borne out by many anecdotal stories) that the regulators will not quickly release the institution from its regulatory shackles. (Ask any community bank CEO with a regulatory order “who runs the bank”: it’s not management; it’s not the board, the answer is “the regulators”. )

Conclusion:  No Lending – No Jobs

In the end, the capital markets are largely unavailable to community banks, and the regulatory process has displayed a complete lack of sensitivity to which institutions actually lend to small businesses, America’s job creators.  What is said in Washington and what is practiced in the field are two completely different things.  As a result, the Wall Street megabanks get bigger and fatter, and have used the reserves created by the Fed, not for new loans, but to purchase newly created government debt.  The community banks, the only remaining lenders to America’s small businesses, without access to capital, and under the thumbs of their regulators, continue to disappear, and those that have survived are generally not able to lend or simply are too small to make a material difference.  The end result: Washington is happy (someone is buying their debt); Wall Street is happy (free money and wide spreads); but America still has no jobs.

Robert Barone, Ph.D.

May 5, 2011

Statistics and other information have been compiled from various sources.  Ancora West Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.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 “Firm Brochure”, (Form ADV, Part 2A).  A copy of this Brochure may be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778.