May 24, 2012

Too Big to Fail: Four Years Later, Things Are Riskier Than Ever

Posted in Banking, Ben Bernanke, Big Banks, Europe, Federal Reserve, Finance, greece, investment banking, investments tagged , , , , , , , , , , , , , , , , , , , , , , at 7:58 PM by Robert Barone

The turmoil in Europe, trading losses at JPMorgan (JPM), and recent revelations about naked short-selling by Goldman Sachs (GS) and Bank of America-Merrill Lynch (BAC) should be giving every American and every policy maker heartburn because each and every one of these issues has potential to cause systemic financial shocks. It all ultimately comes down to the continuing saga of “Too Big to Fail,” or TBTF. TBTF nearly brought the financial system down in ’08 and ’09. It was supposed to be fixed by the Dodd-Frank legislation. But today, the TBTF institutions are even bigger than they were in ’08.

European Worries

On a daily basis, reports indicate that instability is growing in the European Monetary Union’s (or EMU) banking system. There have been outright runs on Greek institutions and rumored runs on Spanish banks. In Greece, it’s been reported that some businesses will not accept euro notes (i.e., the paper currency) issued by the Greek central bank for fear that if Greece leaves the EMU, those notes will be turned into new drachmas, which will be worth only a fraction of what real euros are worth.

In the US, the paper currency is issued by a Federal Reserve Bank. There is a number on each bill (1 to 12) that shows which Federal Reserve Bank was the issuer. Like the US, each participating central bank in the EMU can issue currency; the first letter of the serial number is coded to indicate which bank issued it. Currency issued by the Greek central bank is coded with a “Y.” Some Greeks are demanding currency coded with an “X” ( i.e., Germany).

There are growing worries about European bank solvency, and Moody’s recently downgraded a significant number of the larger Spanish and Italian banks. If Greece leaves the EMU, contagion could result. If funding markets for European banks freeze (causing one or several institutions to be unable to meet their daily liquidity requirements), there is a high probability that any contagion would spread to US financial institutions.

At the very least, the interrelationships between large US and European institutions will cause significant issues if a fat tail event occurs on the continent.

In fact, on March 21, Fed Chairman Bernanke warned Congress that the risks of impacts from such events on US banks and money market funds appeared to be significant.

Lack of Internal Controls at TBTF Institutions

On May 11, Jamie Dimon announced that JPMorgan had lost $2 billion or more in a failed “hedge” trade. Since then, the estimates of the loss have escalated; some think it could be as much as $5 billion – $7 billion. This shows that even the best-of-breed bankers, like Mr. Dimon, are unable to place sufficient internal controls over the riskiest of operations.

Over the past several years, we’ve seen such trading blow-ups at several of the TBTF institutions. The so-called “Volcker Rule,” a portion of the Dodd-Frank legislation that is supposedly effective this fall, should prevent “proprietary trading” at the TBTF institutions. But many think that such rules will be easy to get around; Mr. Dimon has indicated that this huge loss was due to a failed “hedge,” and not proprietary trading. JPMorgan had $182 billion in capital according to their March 31 filings, so the loss of a few billion isn’t going to put this institution in any danger or require any taxpayer assistance.

However, on the Monday after the JPMorgan announcement (May 14), President Obama appeared on ABC’s The View and commented that it was a good thing that JPMorgan had plenty of capital, noting that had this happened at a weaker bank, “[W]e could have had to step in.”

Think about this statement. The first reaction to stress in the financial system is for the government to step in! Compare that to the first Chrysler bailout in 1979. At that time, Lee Iacocca, Chrysler’s Chairman and CEO, had to beg Congress for nearly four months for a loan guarantee (not a direct loan) of $1.5 billion.

In fact, the day before Mr. Dimon announced JPMorgan’s large loss problem, the FDIC’s acting Chairman, Martin Gruenberg, announced plans and procedures for the FDIC to seize large financial institutions “when the next crisis brings a major financial firm to its knees.” Instead of getting rid of TBTF, it is now institutionalized. The FDIC’s announced plans are simply in accordance with Dodd-Frank.

During the week of May 14, the lawyers representing Goldman Sachs and Bank of America-Merrill Lynch in a lawsuit filed by Overstock.com filed an unredacted set of documents with the court (i.e., the whole document was submitted instead of only certain parts), thus putting them into the public domain.

Those documents revealed that these TBTF institutions knowingly ignored the laws and regulations against “naked” short-selling. When one sells “short,” one must first borrow the stock, or else there is nothing to prevent someone shorting (i.e., selling) so many shares as to significantly and negatively impact the market price for the stock (which is what a short-seller hopes for). “Naked” short-selling occurs when the stock is sold without borrowing it from another owner, and three business days later, the seller “fails” to deliver the stock.

Because of their size and power, the TBTF banks could depress the stock price of any company they choose. If one of their units puts a “sell” recommendation out and the trading department “naked” short-sells, then the “sell” recommendation becomes a self-fulfilling prophecy. This, in fact, is what Overstock.com’s lawsuit has been about.

So let’s review:

1. Bernanke worries that European bank insolvencies or liquidity issues may have significant systemic impacts on US financial institutions – if anyone knows, he should know.2. JPMorgan’s losses elicited a response from the US president about the immediate active role of government with regard to issues at the TBTF banks.3. The FDIC announced its policies, plans, and procedures to seize TBTF institutions when the next financial crisis occurs.

4. It has come to light that some TBTF institutions have skirted laws and regulations.

If there were no TBTF institutions in the US, then little of the above would be of concern. Instead:

1. While the European contagion would still be a worry, it wouldn’t be as much of a worry regarding its risk to our entire financial system because no one institution alone would be a systemic risk.2. The government shouldn’t ever have to “step in” if a bank failed. Sure, there would be market reaction and shareholders and bondholders would have consequences, but as long as the failed institution couldn’t cause systemic issues, there would be no need for government (taxpayer) involvement.3. The expensive and extensive policies and processes now being set up at FDIC would be unnecessary.

4. Without the power that comes with being TBTF, the “naked” short-selling and other abuses would be much less effective or profitable.

5. The TBTF institutions are so complex that even the likes of a Jamie Dimon can’t provide effective internal controls and risk management. Smaller institutions that have such issues won’t cause systemic risk.

The lessons of the ’08-’09 near systemic meltdown were clear: TBTF is a huge policy issue. Unfortunately, after Dodd-Frank, not only are TBTF institutions bigger and systemically more risky, but we now have a government all too willing, and maybe even eager, to “step in.”

 

Robert Barone and Joshua Barone are Principals and Investment Advisor Representatives of Universal Value Advisors, LLC, Reno, NV, an SEC Registered Investment Advisor.  Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.
 
Universal Value 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: 9222 Prototype Drive, Reno, NV 89521, Phone (775) 284-7778.

Robert Barone (Ph.D., Economics, Georgetown University) is a Principal of Universal Value Advisors (UVA), Reno, NV, an SEC Registered Investment Advisor. Dr. Barone is a former Director of the Federal Home Loan Bank of San Francisco, and is currently a Director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Company where he chairs the
Investment Committee.

Information cited has been compiled from various sources which UVA believes to be accurate and credible but makes no guarantee as to its accuracy. A more detailed description of the company, its management and practices is contained in its “Firm Brochure” (Form ADV, Part 2A) which may be obtained by contacting UVA at: 9222 Prototype Dr., Reno, NV 89521. Ph: (775) 284-7778.
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February 23, 2010

The Creation of Jobs – A Systemic Failure

Posted in Banking, Finance, investments, Uncategorized tagged , , , , , , , , , , , , , , , , , , at 4:38 AM by Robert Barone

Jobs are the number one economic and political issue of the day.  The loss of more than 8 million jobs since the recession began, and the failure of the economy to produce new jobs after more than two years appears to be a systemic issue.  It is widely recognized that the majority of jobs in America are created by small business.  So, it would behoove policymakers to examine how to incent small business to expand and create jobs.  While economists believe this can be done with tax policy, there is a necessary condition that must also be present for small business, the availability of credit and liquidity.

By now, every reader is familiar with the term “Too Big to Fail” (TBTF).  Those not in this club, and especially small community based institutions, can be considered “Too Small to Save” (TSTS).  If we accept the premise that small business in America is the engine of job creation, then, we must conclude that financial institutions that support small business are also a vital part of the economy (the TSTS institutions) and their inability to properly function is a systemic issue.

Since the onset of the recession, aggregate loans outstanding at financial institutions have fallen in every single month.  They have fallen at both TBTF and TSTS institutions, but for very different reasons:

  • The TBTF institutions, those that were essentially saved by TARP, have been content to use arbitrage on their balance sheets rather than increase loans.  In the arbitrage process, they leverage their balance sheets with very low cost funds (near zero deposit and borrowing costs engineered by the Fed) using those funds to purchase “riskless” U.S. Treasury securities which are seemingly in nearly infinite  supply.  Because Treasury securities have a zero risk weight in bank risk based capital computations, there is no need for additional capital.  In effect, these TBTF institutions can expand their deposit and borrowing bases to buy the Treasury securities without the need for additional capital.  Thus, since the onset of the financial crisis, the TBTF institutions have garnered a much larger market share of deposits in the U.S.  Yet, while total assets have thus grown, we have seen a significant and rapid fall in their loan portfolio assets.  Last November and December, when it appeared that TARP holders were going to have their bonus payments capped, these TBTF institutions were easily able to raise capital to pay back TARP.  They were able to do this because the public knows that it is highly unlikely that the government will let them fail.  Note that TBTF institutions are apparently willing to raise capital to pay their bonuses, but they won’t raise it with the purpose of expanding their loan portfolios! The more cynical among us believe that the government saved the TBTF (mainly Wall Street) institutions precisely because these institutions provide the government with two necessary items: 1) the machinery to place a seemingly infinite stream of Treasury debt, and 2) someone more reliable than the Chinese to buy it.
  • Loans at the TSTS institutions have also been contracting, but for very different reasons.  They have been unable to make loans to small business because their capital has been depleted by souring loans due to deteriorated economic conditions.  Many of these small financial institutions held Fannie Mae and Freddie Mac preferred stock which initially depleted their capital when Fannie and Freddie were placed into conservatorship.  At the time of the announcement of the Fannie and Freddie failures, then Secretary of the Treasury Paulson indicated that the regulators of small financial firms would “understand” and that “help” (i.e., TARP) was on the way.  There has been neither regulator “understanding” nor “help” (few small institutions without a powerful Congressional champion received TARP).  As the recession progressed and the credit markets collapsed, private capital was simply not available to TSTS institutions because, unlike the TBTF, TSTS institutions can fail.  As loans and capital have deteriorated on TSTS balance sheets, the capacity to make loans (to small business) has disappeared.

So large banks, with the capacity to raise capital and make loans, don’t want to as the arbitrage game is too lucrative and looks to be “risk” free.  On the other hand, small banks, which would make small business loans, simply don’t have sufficient capital to expand their balance sheets and can’t tap the credit markets for additional capital because of the public’s perception of the high risk of failure.

The inability of the economy to create jobs appears to be an ongoing systemic issue that the politicians in Washington can’t seem to figure out how to address.  Reducing taxes on small business appears to be the favored solution of economists quoted in the media.  But, helping small financial institutions raise capital would allow the flow of funds to small business to return and appears to be a necessary (but perhaps not a sufficient) condition for job growth.  Unfortunately, the TARP and other related policy fiascos have so soured the public on any further taxpayer aid to the private sector that it is unlikely that the capital issues in the TSTS financial institutions can be addressed through the political process.  Thus, the creation of jobs via small business, the main engine, will have to wait for the very long economic cycle associated with credit collapses to play out.

Robert Barone,  Ph.D

February 23, 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, Phone (775) 284-7778