Monday, September 21, 2009

And now the banks bail out the FDIC

How crazy is THIS ?

Apparently the FDIC which is broke is going to borrow money from ...drum roll please ... The banks.


Isn't the FDIC supposed to insure the deposits of the banks. So if bad loans make the bank fail, the FDIC is there to pay back depositors. But what if the FDIC itself makes up those loans? What if the FDIC can't pay back those loans and makes the bank fail which then needs the FDIC to bail out depositors?

Won't this mess up the whole space time continuum?

Well not really. The FDIC is not like a regular borrower. It is a borrower with an almost infinite ability to raise revenue kind of like the government itself. They can raise insurance premiums on the banks (just like a tax really) and eventually pay back whatever they borrow. Really this is all about extending the period over which the losses are taken. If they raise insurance premiums now to collect the money, this will hurt bank profitability and put more downward pressure on banks. So they just borrow the money and will raise premiums on banks in the future. More reasons why banks in the future will be less profitable. The price of not failing now is less profits over the next decade.

This all works because of the way the Federal reserve can print money out of nowhere and force interest rates to zero making banks very profitable and able to absorb losses.

Saturday, August 29, 2009

Strathmore Minerals

One of my stock holdings Strathmore Minerals (STM.V) just became somewhat more enticing. STM is a Uranium miner with properties in Wyoming and New Mexico. They have some good properties and excellent people and management.

One of my beliefs is that if you can't explain why an investment is a good idea with a simple explanation, it probably isn't such a good idea.

So here goes. STM owns land with about 150 million lbs of recoverable Uranium (hereafter U308) resources. The sales price (long term contract price, not spot price) of U308 is about $70/lb. STM's operating costs are likely to be about $20/lb since it can extract the uranium with either open pit mining or the in-situ leaching (ISL) process. No complicated underground mines required. STM purchased most of this land when U308 was only $7/lb to $15/lb and claimed that it would be profitable to extract the U308 at about $20/lb. They correctly predicted that the price would rebound.

So the operating profit might be about $50/lb.

There are about 72 million common shares. The stock price is about $0.52/share. My first purchase was at $0.20/share in March 2009. Market cap is therefore $37MM.

So a VERY rough estimate of the value (assuming all the U308 is extracted at a $50/lb profit) is 50*150 = $7500MM. Note that this is 202 times the market cap. Now, this may be an over estimate. There is no guarantee that U308 price will not fall or that operating expenses will not be higher. But even if you take $40/lb for a selling price and $30/lb for an operating cost, you get a value of $1500MM. Now, maybe discount that by a factor of three to take into account the time required for the cash flows to arrive and the risk. You still get a present value of $500MM or 14 times the market cap.

Basically the stock is priced as if the U308 will never be extracted. Actually it is priced as if it is ALMOST CERTAIN that the U308 will not be extracted. That is, even if the U308 price was so low that STM could not extract it profitably, the company should have option value just like an out of the money call option. That is, there is always a chance that the U308 price will sky rocket to say $100/lb (where it was just last year) or higher.

Another risk is that they can't raise the capital required to extract the uranium. I have never worried much about this risk. If there is money to be made, capital seems always to be available. The company already sold a 40% stake in their New Mexico, Roca Honda properties to Sumitomo, the Japanese conglomerate for $50MM. There is about 33 million lbs of U308 in Roca Honda or about 20% of their total resources. That would value that entire asset at $125MM or $3.75/lb of U308.

Remember the market cap of the whole company is only $37MM. Valuing it all at the price Sumitomo payed would be $562MM or 15 times higher.

Very recently, they sold another asset, Pine Tree & Reno Creek that holds about 20 million lbs. They sold it for $30MM in cash or $1.5/lb. Valuing all their U308 resources at this price would be $225MM or 6 times the market cap. But this is likely a very low price. They sold this land because they needed the cash to start operations on some of their core assets. The deal has not been finalized. It depends on the buyer obtaining financing. But if it goes through, they will have $30MM in cash. Cash should always be valued at full value on the companies balance sheet. So subtract $30MM from the market cap of $37MM and you have an Enterprise Value of only $7MM. It is costing you only $7MM in net cash to buy the whole company which will still have 120 million lbs of U308. Even if you only value the U308 at $1/lb, it is worth $150MM.

So there you have it. Now matter how you slice it, the company is worth many times it market cap. If you get lucky, the U308 price will remain high or go higher and the company will be worth a fortune. If the U308 price falls a lot, it still seems worth the current price even if the recent deal falls through.

Very little risk and the chance for enormous gains makes STM currently one of my favorite investments. I am glad I bought at $0.20/share but will be adding more at the current price.

Monday, July 27, 2009

The American Century? Hardly.

There is a great website that I discovered called . It has all kinds of data including economic data for lots of different countries. I was able to make the following plot of GDP per capita from 1820 to the present for a few different countries: US, Germany, France, Japan, Canada, China, India and Brazil.

The 20th century has often been called The American Century. The US did indeed do well over this century. They became the foremost economic and military power. However, when you look at GDP per capita (a measure of the wealth of a nation), you find that they don't exactly stand out. For example, France and Germany didn't grow their GDP must slower than the US over this period. In fact, they started out a few percent behind the US and ended up about 30% lower. Ok, but they were both nearly destroyed by world war. Germany lost both wars and suffered a period of hyperinflation in between. They both suffered from stagnant population growth unlike the US which grew population rapidly. In addition, the US had more abundant natural resources. Canada basically tracked the US. No one calls it the Canadian Century.

However, If GDP growth is your metric for naming centuries, you would have to choose Japan. Japan is basically equal to the US in terms of present day GDP per capita. But in 1820, GDP per capita was half that of the US. In 1900, it was 28% of the US. In 1950 (after losing WWII to the US) it was only 20% of the US. Now they are tied. So the GDP growth crown for the last century and especially the past 50 years has to go to Japan.

The darlings of today's investment crowd, China, India and Brazil have lagged miserably. In fact India has hardly grown real GDP per capita at all in almost 200 years. Brazil has done OK, since 1900 but was quite far behind.

Wednesday, July 22, 2009

Swine Flu

Lets make some numerical estimates about how severe swine flu could be for the US.

Start with the US population which is about 300 million people.

Lets discuss two scenarios. One is the mild scenario and the other is the severe one. Obviously, it could be anywhere in between and even outside of these two bounds. But I would say, to my knowledge, that these two scenarios contain about 80% of the possibilities.

Lets pick a time scale. Assume it lasts about two years with some tail before and beyond that.

Now we need to estimate the attack rate. What percentage of the population will get it? From what I have read, I think this is between 20% and 50% of the population. These are my mild and severe scenarios.

Then you can discuss things related to the severity of the illness. For example, what percent of people infected will have it severe enough to require hospitalization. What percentage of those hospitalized will require a ventilator? What percentage of those infected will die.

Lets start with the death rate since it is pretty well studied wit this current strain. Most think it is between 0.2% and 0.5%. Obviously this is dependent on the quality of health care received which will be affected by the number of people that get dangerously sick compared to the heath care resources available.

So right off, we can estimate the number of people that will die using the mild and severe scenarios. This is

MIld case: 300 million x 0.2 x 0.001 =60 thousand Americans or 30 thousand per year
Severe case: 750 thousand Americans or 375 thousand per year

Obviously that is a huge difference. Consider that this flu seems to be more severe for young people rather than the usual target for influenza which is infants and the elderly. See age distribution below from a study in Mexico.

Lets look at the three age groups, 5-14, 15-24 and 25-34 who will probably suffer about half the case of H1N1. Lets look at their morbidity statistics, that is the chance of dying in any one year. This is usually done in deaths per 100,000 people. There are some numbers here for these age groups. It has all causes and individual causes including Influenza (which is linked with Pneumonia, see below).

So lets translate our numbers above in morbidity statistics and add them to these numbers. Our death rate per 100,000 individual per year (for each of the two years) is 100,000 x 0.2 x 0.001 x 0.5 = 10 for the mild case and 100,000 x 0.5 x 0.005 x 0.5 = 125 for the severe case. Lets put these in the table with All causes and normal influenza.

Age GroupAll causesInfluenzaH1N1 mildH1N1 severe
5-1421.7 0.4 10 125
15-2489.6 0.6 10 125
25-34126.7 1.4 10 125

Even for the mild case, the number of people in these age groups that will die of influenza will be 7 to 25 times higher than usual. It will be the major cause of death next year for this age group. The mild case will increase the change of a 5-14 dying (of any cause) by 31%. The severe case would double the chance of dying for 25-34 year olds. For 5-14 year olds, the chance of dying has increases by a factor of 6.7.

People often say that the flu kills 36,000 people per year so this H1N1 is nothing to worry about. But this is wrong. First of all, as I mentioned Pneumonia is linked with Flu and "influenza-like illness". Flu by itself actually kills less than 1000 per year and less about 142 children under the age of 18. source .

Using these number above and assuming the average high school has about 1000 students, the mild case would imply that one in every five high schools will have a swine flu death (in two years). The severe case would say that every school would average 2.5.

Now on to another issue: health care and its ability to handle the situation. I will only focus on one issue, the availability of ventilators. Severe cases of swine flu require the patient to put on a ventilator in order for them to breath, sometimes for weeks. The US has about 100,000 ventilators and 80,000 are in use in normal times. During flu season, most of the others are in use as well. Lets look at how swine flu could impact this. For the mild case, we assumed that 0.1% of people who get swine flu will die. Lets assume that 10 times this amount are put on ventilators so that 90% of people that are put on ventilators will live. So this is 1% of swine flu cases requiring ventilators. If we assume that each requires it for a week, this works out to be 3,000 people needing ventilators for swine flu if you evenly distribute it over two years. However it won;t be evenly distributed. It will probably peak about three times this average so that is 9,000 ventilators. This is beginning to stress the system but is probably manageable with some rationing. For the severe case, there are five times more cases which means 14,000 ventilators are needed (evenly distributed) and maybe 42,000 in peak periods. Now we are talking major panic. There will have to be major rationing. The system is completely overwhelmed. Consider that the ventilators will not likely be in the optimal places. What if New York has too many but San Francisco has too few. Imagine the chaos and ethical dilemmas that hospital and politicians will face. Canadian hospitals have been reporting that young people suffering from swine flu have required a special kind of ventilator call an oscillatory ventilator rather than the usual kind. How many of those do we have?

Other questions to consider. How many does of Tamiflu and Relenza do we have? If we run out of that, the death rate will surely rise. There is the issue of vaccines. Hopefully these will be finished in time to slow the spread. I have my doubts.

Finally, there is the effect on the economy. With chaos ensuing and fear rising, most people will not fell like shopping. Many will stay home from work to take care of sick family members. Many will be sick themselves and some of course will die. The effect on the economy means, less spending, less consumption, less production.


The Washington Post has a story on the stress on the health care system.

Consider the following statistics which they give

The swine flu virus, also known as H1N1, could infect up to half the U.S. population, making as many as 1.8 million sick enough to need hospitalization, including as many as 300,000 who might need intensive care, according to a presidential advisory council estimate.
... "There will be millions and millions of people seeking care in a relatively short period of time," said Eric Toner of the University of Pittsburgh's Center for Biosecurity, noting that the nation has only about 85,000 critical-care beds.

What he didn't say is that most critical care beds are being used at all times. Hospitals don't plan to have many more beds than are usually needed. That would be too costly. So we might assume, optimistically, that 70% on average are being used at any given time which leaves only 26,000 free beds for possibly 300,000 critically ill people. Now, it might not be that bad. But even if it is 100,000 critically ill people with 33,000 available beds, that will be a disaster. Two-thirds of the sick people can't get an ICU bed and may die because of it. Now consider that as much as half of the healthcare workers could be out of work due to infection of themselves or their dependents. Can they even operate at 100% capacity with half the workforce and three times as many people needing emergency ICU care?

----------------- Update --------------

Looks like there is more evidence on the death rate being much, much smaller than first thought. Looks like it is more like 0.1% or maybe even 0.05%. So this would be even milder than my mild scenario. Lets hope this is correct.

Sunday, July 19, 2009

US Private Consumption

Here are the numbers for private consumption, in $ Trillion, for the US and some other areas

US 10.1
Eurozone 7.6
Japan 2.8
UK 1.6
China 1.6
India 0.6
Korea 0.5

Source: CEIC

Many economists expect the US, Europe and Japan to slow their consumption after this great loss in wealth and also due to demographics. They also expect emerging markets like China, India etc to pick up some of the slack.

Those three combined are $20.5T. Lets says, they reduce consumption by 10%. That is a loss in demand of $2T. If China, India and Korea were to pick up all of this slack, they would have to increase their private consumption by 76%. They would have to do this while their export markets (their largest employer) are undergoing this historic bust. Does that make sense to anyone? Of course not. There is no other consumer capable of replacing the US and European consumers. The conclusion is unavoidable excess capacity.

Saturday, July 18, 2009

Real Estate Declines in Chicago

My wife and I visited some friends of ours in nearby Portage Park, a neighborhood in Chicago. Portage Park has long been an immigrant community, mostly Polish in the past but now hispanics are prevalent there as well. The Park itself is rather nice and the neighborhood may be considered up-and-coming if not exactly there yet.

Our friends have had a foreclosed home right next door that had been on and off the market a few timed over the past couple of years. It has recently sold. Our friends couldn't remember exactly the sale price but they thought it was around $130K. They also told us that it once sold for $450K near the peak of the housing bubble. I thought that sounded a little far-fetched so I went to to try to find the sales records. Yup. he was right. Here it is.

4933 W. Byron
Sale History
05/04/2009: $134,000
03/21/2007: $450,000
05/15/2006: $390,000

That is a 70% decline between actual sales in two years.

Here are some more examples in that neighborhood.

For example, here is 4136 N. Monitor Ave. .
Sale History:
05/06/2009: $134,000
01/17/2007: $480,000
12/17/1998: $189,000

That is a 72% decline in actual selling price in a little over two years!

5146 W. Dakin St.
Sale History
06/23/2009: $90,000
11/03/2004: $289,000

A 69% decline between sales and that is only 2004, two years before the bubble peaked.

5706 W. Wilson Ave.
Sale History
01/22/2009: $174,000
06/29/2006: $410,000
12/08/2005: $337,000

A 57% decline in 2.5 years.

5919 W. Warwick
Sale History
09/17/2008: $5,000
06/25/2004: $340,000
08/29/2002: $240,000

This one takes the cake, a 98.5% decline! Ok, that might have had a tax lien or something but still.

6028 W. School St.
Sale History
03/23/2009: $118,000
09/11/2006: $425,000

A 72% decline in 2.5 years.

Amazing stuff. This area must have been big into the subprime lending fiasco. Most of these houses must have been foreclosures that were auctioned off or sold by the bank.

Wednesday, July 15, 2009

Long Beach Ports Traffic in June

Here is a plot of the container traffic in June at Long Beach Ports which is America's second busiest seaport. Units are Twenty Foot Equivalent Units (TEU)s.

The number of TEU loaded in, a measure of imports, has declined 28% from last June and 39% from June 2007. This is a major contraction of imports and shows how dramatically the US consumers has put an end to their 20 year shopping spree.

Monday, July 6, 2009

Earnings and PE ratios in the Great Depression

Stock prices have risen about 40% from the low a few months ago. The main reason appears to be that people think the recession will end soon and that stocks are simply pretty cheap. Though I disagree about the recession ending, I would have to agree that stock look pretty cheap with the emphasis on the look.

For example the 30 stocks in the Dow Jones Industrial average have an average PE ratio of about 13. It is about the same whether you use trailing earning or forward analyst estimates for next year. Well 13 is indeed pretty cheap compared to the long term average of about 15.

But looks can be deceiving. The question is what the earnings will be in the future. Corporate profits as percent of GDP were recently at an extreme value. The long term trend for real earnings (as compiled by Robert Shiller) puts the S&P 500 earnings at about 50. That would be the trend value not the value one might expect in a very deep recession. Typically earnings fall to about half the trend during deep recessions. So earnings for the S&P 500 might be more like 30 over the next few years. With the S&P 500 at 900 that would put the PE ratio at about 30. Not so cheap looking anymore.

Let's look at the data for the Depression years 1928-1936 as an example.

This plot shows the aggregate earnings (black), stocks prices (blue) and the (trailing) PE ratio in red. The data is from Robert Shiller's data-sets. The stock prices have been divided by 17.

In late 1929, the bubble popped and stock prices fell as market participants realized that corporate earnings would fall and that stocks were overvalued. The PE ratio fell quickly from about 20 in 1929 to about 13 by the beginning of 1930. People naturally expected a quick economic recovery and decided that stocks were cheap. After-all, a PE of 13 (just like today) is pretty enticing. So began the rally of 1930. The PE ratio jumped up to about 18 before the rally fell apart. The market then fell steadily with occasional rallies until the bottom in late 1932. The amazing thing is that the PE ratios never strayed far from 17 during the rest of the bear market except for right at the end when it fell quickly to bottom at 10. The blue line is price over 17 so the fact that the blue line traces the black line demonstrates this. It is just that earnings fell steadily until they fell to about 7 from the peak at 26, a 73% decline. The story of the great bear market was really one of corporate earnings not valuation.

The moral of the story of course is that a PE ratio is pretty meaningless by itself. What matters is where earnings will be in the future. The best guide to that is simply mean reversion. Corporate profits tend to revert to about 6% of GDP. They recently peaked at almost twice that. If they bottom at half this average that would be a 75% fall just like in the Depression. If that happens we might expect the S&P to fall to at least a PE of 15. The S&P 500 earnings peaked about about 85 so a 75% decline would be 21 and a 15 PE would bring the index to a horrifying 315 a 65% decline from here.

Of course this might be overly pessimistic or it might not. But the point is that stocks will follow future earnings and that those will likely go down from here. Stocks are not nearly as cheap as they look.

Wednesday, July 1, 2009

The savings rate

The US personal savings rate might be the key indicator to tell us when the economy is at the bottom. Basically the savings rate needs to increase from its bottom of about zero in 2006 to its historical average of around 8%. In fact it may need to stay above 10% for a few years to rebuild much of the wealth that was squandered over the past decade.

So here is the data from the government's Bureau of Economic Analysis (BEA).

The good news is that we almost half way there. The bad news is that this is probably incorrect. Trim Tabs, an independent economic research firm says that the BEA data is flawed for a few different reasons. The main reason is that the BEA uses income data that is six months old. The real time data that Trim Tabs uses shows that incomes have been falling rapidly over the past few months. So the savings rate is actually more like 0.9% and not 6.9%. In other words, we haven't made any progress on saving. This is Irving Fisher's "paradox of thrift" in action. If everyone tries to save at once, incomes fall even faster and no one makes any progress on reducing their debt burden. That is probably an over-simplification but the point is that it does not appear that American's have made much progress on repairing their balance sheets. It does not appear that spending is reaching the bottom. Keep in mind that consumer spending accounts for roughly 70% of the US economy. Another 10% decline in consumer spending would take another 7% out of GDP. This doesn't bode well for an economic recovery any time soon. In fact we may only be half way through this recession.

trimtabs BLS

Wednesday, June 24, 2009

The best articles of the year.

Here is what I think are the most important articles on the Crash of 2008 and the aftermath.

First former IMF chief Simon Johnson's critique of the Wall Street Oligarchs control over Washinton, published in the Atlantic magazine.

The crash has laid bare many unpleasant truths about the United States. One of the most alarming, says a former chief economist of the International Monetary Fund, is that the finance industry has effectively captured our government—a state of affairs that more typically describes emerging markets, and is at the center of many emerging-market crises. If the IMF’s staff could speak freely about the U.S., it would tell us what it tells all countries in this situation: recovery will fail unless we break the financial oligarchy that is blocking essential reform. And if we are to prevent a true depression, we’re running out of time.

Michael Lewis wrote a story in about the subprime fiasco and the hedge fund manager Steve Eisman who bet against it. An excerpt:

For Eisman wasn’t raising his hand to ask a question. He had his thumb and index finger in a big circle. He was using his fingers to speak on his behalf. Zero! they said. “Yes?” the C.E.O. said, obviously irritated. “Is that another question?” “No,” said Eisman. “It’s a zero. There is zero probability that your default rate will be 5 percent.” The losses on subprime loans would be much, much greater. Before the guy could reply, Eisman’s cell phone rang. Instead of shutting it off, Eisman reached into his pocket and answered it. “Excuse me,” he said, standing up. “But I need to take this call.” And with that, he walked out.

Finally, there is a new story in Rolling Stone by Matt Taibii which portrays Goldman Sachs as the parasite on the American people that they are.
It is a story about how Goldman Sachs is the cause of every major bubble in the US Economy from housing to internet stocks to oil prices to global warming.

Here is a good quote

In other words, the mortgages it was selling were for chumps. The real money was in betting against those same mortgages. "That is how audacious these assholes are", says one hedge fund manager. "At least with the other banks, you could say they were just dumb - they believed what they were selling, and it blew them up. Goldman knew what it was doing." I asked the manager how it could be that selling something to customers that you're actually betting against - particularly when you know more about the weaknesses of those products than your customers - doesn't amount to securities fraud. "It is exactly securities fraud," he says. "It is the heart of securities fraud."

and another

If America is circling the drain, Goldman Sachs has found a way to be that drain.

and another

The basic scam of the internet age is pretty easy for even the financially illiterate to grasp. Companies that weren't much more than pot-fueled ideas scrawled on napkins by up-too-late bong-smokers were taken public via IPOs, hyped in the media and sold to the public for megamillions. It was as if banks like Goldman were wrapping ribbons around watermelons, tossing them out of 50-story windows and opening the phones for bids. In this game you were the winner only if you took your money out before the melon hit the pavement.

Great stuff!

Update. Here is another very good one.

Saturday, June 13, 2009

What is really going on in China

Chinastakes is one of the best places to read about economic trends in China. The latest article is a doozy.

Basically the Chinese are following America's example and flooding their economy with stimulus spending. In fact the majority of the stimulus is just the government directing their state run banks to lend money to anyone for any reason. Where is the money going to go when demand for manufacturing is plummeting? Speculative assets obviously. Here is the money quote.

“I began to invest my money in villas when orders began to decline in the second half of last year and my factory's production was cut by 1/3. The reason is simple. Under current economic conditions, investing in houses is safer than investing in factories,” said the owner of a private firm.

“Do you really think all those stimulus bank loans have entered the real economy?” queried a real estate dealer in Shanghai. “Of course not. They are still in enterprises’ hand, or have been invested in real estate and the stock markets. Some companies took money they scored on the stock market and invested in real estate soon after.”

Anyone with thorough knowledge of financial history knows how this is going to end.


Good story with links at
Zerohedge .

Tuesday, June 9, 2009

Whiney banks

The banks are whining again. This time about buying back their TARP warrants. Remember, the tiny amount of warrants were issued to make it look like the taxpayer was going to get a little bit of the upside from their investment" in the banks. Now that they want out of TARP, they also want to renege on their contract and get those warrants back.

Listen to the whining

“We shouldn’t have had to pay a dime,” said Sun Bancorp Chief Executive Thomas Geisel...Taxpayers deserve a return for the risk they took on, but it wasn’t a risk to invest in us.”

"You shouldn't have to pay a dime, Tom?". Did you not sign a term sheet giving you tax payer financed capital in exchange for warrants? Now you want those warrants cancelled for nothing in return? Please show me in the term sheet where it says that the warrants will be cancelled.

Jamie Dimon, CEO of New York-based JPMorgan Chase, said June 1 that that the U.S. should cancel half the warrants it holds “out of fairness.”

Ok, Jamie and why don't we reduce everyone's mortgage balance by half out of fairness. Can I pay back half my credit card balance? That sounds fair to me. 50-50. Even steven. Meeting you half way. Apparently contracts are sacred to bankers except for the ones signed between the banks and the taxpayer where the banks have made concessions.

Saturday, May 23, 2009

Long Term House Prices

This is Bob Shiller's famous plot of the US housing bubble.

This is using Shiller's more accurate repeat sales method instead of median prices. You can see how house prices go up because everything goes up. This is called inflation.

Shiller made another study of repeat sales of identical properties along the canals in Amsterdam. This is also pretty fascination. There is no upward trend once corrected for inflation though there is lots of variation tracing the history of Holland. Here is a version in Dutch.

This is Bob Shiller's famous plot of the US housing bubble.

Sunday, May 10, 2009

How banks plan to survive

The banks have a survival plan and the Fed and Treasury seem to be on board. It looks like this. They are going to earn their way out of trouble. Sure, the capital they have now is probably not truly there if they really took all the marks that they should. But they will write it down slowly over the next few years and replace it with earnings.

They think they will be able to do this because of a few things

  • High interest rate spread. Their deposit cost is very low due to the Fed's zero interest rate policy.
  • They can raise interest rates on loans.
  • They can borrow cheaper in the capital markets because the government is guaranteeing their debt

Now lets look at these in detail to show how all of them are direct wealth transfers from individuals and businesses to the banks.

First, the Fed's zero interest rate policy (ZIRP), forces deposit costs down. People with money in the bank are now getting 0.25% or something instead of 3% or so that they were getting a few years ago. This punishes seniors and other savers including businesses with large cash balances. This results in about $200 Billion dollars per year of interest income getting shuffled from the savers back to the banks.

They can raise rates on loans. They are already doing this. Here are a couple links from the New York Times and ABC News talking about how they are increasing credit card rates on people with good credit. Why are they doing this? Simply because they can. The right question is why didn't they do this in the past. Well, the credit card business is very competitive and people frequently do balance transfers to get better rates. But in this deleveraging environment, no one wants new credit card customers. They would love it if their customers paid off their balance and dropped off the face of the earth. They are not growing these portfolios. They are trying to reduce them. So it is an easy problem for them. Raise rates and fees through the roof. Either you pay them and make them lots of money or you pay off your balance and they reduce their leverage and so reduce the amount of capital they need to raise.

How much does this get them? Well, there is $2.5 Trillion in US consumer debt. If they can raise interest rates (or fees) by 5%, that is $125B/year in extra income. And that is just consumer debt. Total household debt (minus consumer debt) is about $11.5 Trillion and there is another $7 Trillion of non-financial corporate debt. Banks owns about $5 Trillion of this. If they can squeeze another 2% interest rate out of that $5 Trillion, that is $100B/year. Again, if the borrowers don't like it, they can try to find a loan elsewhere. If they leave, the bank has successfully delevered. So raising interest rates on borrowers might get another $225B/year.

Finally, there is all the government guarantees on their debt and direct government lending. I won't estimate the impact on earnings other than to say that without it, they would probably cease to exists. Certainly the Wall Street "banks" would have failed just as Bear Sterns did without the access the discount window and other such programs.

So the impact of lower deposit cost and high interest rates creates a much larger spread which might be roughly $425B/year in extra income for the banks. This is money that is transfered from US individuals and businesses directly to the banks. Most estimates of US banks losses is around $1 Trillion. So the banks can replace this capital through higher interest income is roughly two years.

In summary, the Fed and the government have orchestrated a massive wealth transfer in favor of the banks. This, of course, is in addition to Federal bailout of the banks through the TARP and other such programs. The banks are able to so this because they have essential control over the US government and have power over the central bank with its ability to create money and determined interest rates that banks have to pay for deposits. The banks will probably survive and replace this $1 Trillion capital hole with our money but ownership of the banks will largely remain in the same hands.

There is perhaps a bigger point to be made here. Banks are really intermediaries between borrowers and lenders. They don't produce anything. When you deposit money in a bank, and your neighbor gets a mortgage from that banks, it is really you lending to your neighbor. The bank is a useful intermediary. It performs credit analysis and protects you (with final backstop from the FDIC) from losses. For this service, it collect a fee. But the fee that is collected is a cost to the greater society, i.e. the real economy. The economy therefore is better off with banks being less profitable. Large bank profits, result in capital piling up at the bank which leads to a need to produce more and more credit. This obviously leads to a credit bubble and a crisis when it collapses. At the top of the bubble financials produced 40% of all corporate earnings, without producing anything. This is up form the long term average of about 15%. Those bank earnings which could have been income or industrial earnings would have resulted in a stronger US economy. Instead we had a credit bubble. The lesson is that the banks should not be the dominant force in an economy. They should be the oil that greases the wheel not the wheel itself.

Thursday, May 7, 2009

More real estate madness

Jess and I used to live in a funny neighborhood of LA called Montecito Heights. It was basically Mexico hidden away in the hills above downtown LA. This is East LA where Cheech and Chong come from.

We used to go for a walk from our place and pass this boarded up place that looked like a former crack-house. It was basically a wooden box on metal stilts hanging on the side of a steep hill. I would doubt that even cock roaches would sleep inside. Very gross. These pics are not so great but, believe me, it doesn't look better from close up.

Yes, that is a chain link fence two feet from the front door. They are not much for zoning in the Montecito hills. To get in the front door, you open up the chain link fence and walk across a piece of plywood into the front door. If the plywood was not there, you would tumble down the hill rolling underneath the house. Lovely!

I looked on Zillow today to see how much it is worth. They say $300K. But funnier still is that it sold near the top of the bubble at over $700K. What utter madness, this housing bubble!

Friday, May 1, 2009

Swine Flu

I had previously read a lot about the Flu of 1918 and so when I heard about the possibility of pandemic swine flu coming out of Mexico, I immediately got very worried. I expected people to start dying in the US. After a few days, no one died. The media started saying that the symptoms were mild, about the same as normal flu. So naturally, I calmed down a bit.

But maybe that was not the right reaction. There is the curious case of Dr. Gitterles. The doctor in Texas is saying that the situation is far worse than the authorities are saying. Read the email, especially this part

Since it is such a novel (new) virus, there is no "herd immunity," so the "attack rate" is very high. This is the percentage of people who come down with a virus if exposed. Almost everyone who is exposed to this virus will become infected, though not all will be symptomatc. That is much higher than seasonal flu, which averages 10-15%. The "clinical attack rate" may be around 40-50%. This is the number of people who show symptoms. This is a huge number. It is hard to convey the seriousness of this.

Taking this as face value, it means that the flu will likely spread around the world and infect maybe 20% of the world population or 1.2 billion people (60 million Americans) If the "clinical attack rate" is 40%, that means that 480 million people (24 million Americans) will get sick. Note that the US has only a million hospital beds. It has enough antiviral medicine (Tamiflu and Relenza) to treat about 50 million people. So we likely have enough medicine. But we don't have the capacity to treat so many people. In poor countries, they lack the medical capacity and the medicine. This scenario would likely lead to total chaos if not huge numbers of deaths.

The death rate is so far unknown but probably nothing like the 1918 virus. It seems to lack the key gene that made the 1918 flu do so much damage to the lungs. But viruses can mutate and it seems new viruses like this tend to mutate more easily. Who knows where that would lead. The 1918 flu started in a milder wave and came back as a much more deadly virus the following winter. How deadly can a flu get? The H5N1 bird flu killed 60% of infected people but thankfully did not spread easily between people. The death rate for the 1918 flu was probably about 3%.

For the time being, I am not going to freak out. But keep an eye on this and think about how you will respond if the facts begin to indicate that it is worse than we now think. Even if the death rate stays low, this could cause real problems.

Wednesday, April 22, 2009 on Geithner has a cover story on Tim Geithner which is decidedly negative.

Monday, April 20, 2009

Another ray of hope

Neil Barofsky seems to be taking his job seriously as TARP watchdog.

He seems to be warning about the same kind of abuses that I am worried about. That is good news for Americans.

But it is bad news for bank stocks and probably bad news for the markets. It means that the banks are going to have a harder time swindling their way out of trouble and so the question of how to save the banks is back on the table. Sorry, it won't be by defrauding hard working Americans. On to plan B or it is M by now.

Sunday, April 19, 2009

Strange NYTimes article

This New York Times article is certainly strange. Apparently the Obama administration is floating the idea that they have more ammo for recapitalizing the banks than everyone thinks.

Oh,really? What is the latest shennanegans? Well, remember that $350B in TARP money that Paulson put into the 8 largest banks. Well, that was preferred equity shares. That is sort of like a loan that never needs to be paid back (except on liquidation) where the company must pay a fixed dividend to these shareholders before paying the dividend to common shareholders. The yield (annual dividend over the price) was a measly 5%. What a great deal for the banks! But if times gets tight, it can stop paying both dividends without there being an event of default. The shares are non-cumulative so missed dividends never need to be paid back.

Because not paying the preferred dividend is not an act of default, this is considered equity not debt. Preferred equity is not counted any differently than common equity in the three capital ratios that are used by bank regulators although there are guidelines on how high the preferred portion can be - more than half is frowned upon.

These rules are well established in banking. Until now that is. Now the Fed wants to redefine what equity means. Now they want to pretend that all that matters is tangible common equity, bank regulation tradition be damned. So now you can increase the tangible common equity by converting the preferred equity to common equity. Presto, the banks have more capital!

Huh? This does not increase the total equity by one bit. It does nothing to change ASSETS-LIABILITIES which is the definition of equity. They have just shuffled the form of the equity. Really, they have just lowered the standard of acceptable capital levels and made it so that the banks fit the lowered standard.

While they are at it, maybe they can change the definition of liabilities as well. They can redefine it as all debts except those to the federal government. There you go again, instant improvements in capitalization! Just ignore those liabilities when calculating capital ratios.

Honestly, what a joke! Do they really think the market is going to buy this nonsense. The market knows what capital means and they know these banks ain't got it.

Saturday, April 18, 2009

Monday, April 13, 2009

China's bubble economy

While many people trumpet the strength of the growing Chinese economy, there are other signs that it is on the verge of collapse. Note the following Financial Times article .

Property prices in China are likely to halve over the next two years, a top government researcher has predicted in a powerful signal that the country’s economic downturn faces further challenges despite recent positive data.

The property market, along with exports, were leading drivers of the booming Chinese economy over the past decade and the slumps in both have taken a heavy toll.

Cao Jianhai, professor at the Chinese Academy of Social Sciences, a leading government think tank, said an apparent rebound in the property market was unsustainable over the medium term and being driven by a flood of liquidity and fraudulent activity rather than real demand.

He told the Financial Times he expected average urban residential property prices to fall by 40 to 50 per cent over the next two years from their levels at the end of 2008.

"being driven by a flood of liquidity and fraudulent activity". Hmm, why does that sound familiar? Ah, that's right. It sounds like our housing market in 2006.

Real estate agents in the residential property bellwether of Shanghai said the market seemed to have bottomed out as a result of government stimulus measures, falling prices and pent-up demand from owner-occupiers.

But Mr Cao said preliminary government investigations had turned up numerous examples of real estate developers using fake mortgages to offload apartments on to the books of state-run banks facing enormous pressure from Beijing to rapidly increase lending to boost the economy.

Does that sound like the basis of a sound economy? A sound housing market is one in which houses are affordable for the majority of the population. So how is that working out in China?

At a national level, average housing prices tripled between 2003 and the peak in mid-2008 and are now 10 to 12 times average income, which means 60 per cent of homebuyers’ monthly income must go to mortgage repayments, Mr Cao said.

Ok, I am pretty sure we all know how that story ends. Good luck China in your quest to prop up the world economy.

Here is more from the Times Online.

China faces a surge of bad loans and speculative bubbles as the country’s banks open lending and flood the market with record levels of money supply, economists are warning

... The peril appears to lie in the speed and geographical spread of lending: the mostly state-owned banks, scattered throughout both economically weak and strong parts of the country, are duty-bound to follow Beijing’s orders to lend. Few analysts believe that the banks have the mechanisms or expertise to assess the quality of the borrowers.

In short, China has a command economy. It doesn't have a real banking system. The "banks" in China are just state owned entities who don't know how to say no to loans. Even if China keeps growing due to this forced lending, it will eventually end badly. It is classic boom bust ponzi lending. Since capital is being allocated by fiat rather than based on economic soundness, it will result in inefficiency and waste and ultimately economic stagnation. Another result will be excess supply which will export deflation to the rest of the world which the boom finally goes bust.

Sunday, April 12, 2009

William Black Interview

Great interview on PBS with former banking regulator William Black.

Get the word out and forward this around.

Thursday, April 9, 2009

Interesting fact about imports/exports.

China sends us manufactured goods and we send them pieces of paper. No, I am not talking about US dollars or Treasury bills. We literally send them pieces of paper. Recycled paper is the biggest US export by ocean going container.

The list of biggest exporters and importers is here . Basically China and other high-export countries send us ocean going containers full of high value goods like TVs, cars, furniture etc, the stuff that gets sold at Walmart (the biggest importer). We send these shipping containers back filled with recycled paper which basically has little value. The Chinese turn the paper into cardboard so they can send us more cardboard boxes full of high-value goods. Pretty depressing huh?

We export lots of other high-value goods such as software, financial services etc. But not much in the way of tangible goods sent by ocean going container. Paper is pretty heavy though so many containers go back empty when ships hit their weight limit. Next time you want to take a trip to China, bribe some seaman to let you bum a ride in one of their empties.

Corporate Earnings plunging

Here are the total quarterly operating earnings for the S&P 500 companies (annualized). This excludes non-operating write-downs. Actual "as-reported" GAAP earnings are worse. Quite a plunge! S&P estimates that earnings will rebound some in 2009. I have my doubts. The S&P 500 is currently (Feb 10, 2009) at 834. So if 2009 earnings come in around 55, and the S&P trades at 15 times that, we come up with 825 which is about the current price. If it comes in at 30 (basically where it is in Q4 2008), the S&P may drop to 450 using 15X earnings.

The S&P earnings for 2008 were $27.7 using the Q4 estimates with 85% of companies having reported. The S&P 500 is trading at 827 which puts the P/E ratio at 29.86 which is one of the highest ever. According to the trailing PE, stocks are not cheap. In fact, they are amazingly expensive. However, there is something wrong with that argument. It has to do with the way things are averaged. For example, if the average PE is 29, one might think that there must be roughly half of companies trading at more than 29 times trailing earnings. Well, lets look and see. In the Dow 30, there are three companies with negative earnings in 2008 (C, GM and AA). Ignoring these three, here are the five with the highest trailing PE ratio: JPM (18.1), KO (17.0), MCD (15.1), INTC (15.0), WMT (13.5). Hmm, this is a funny kind of average when the top 5 have a lower than average PE. What is going on?

Well, S&P calculates the total earnings of the 500 companies making up the average. Then it is calculates the total market value. The it divides both by the same number (about 8700, called the divisor, it doesn't matter really) to report the S&P stock market index value and also the "earnings". The idea is that people then know about what the average PE is. However, this is not the same as < P/E >. Rather it is more like < P > / < E>. The two are not equal. For example, lets suppose that one company (lets call it Citigroup) loses $1 Trillion next year and goes bankrupt but the other 499 companies make $1.2 Trillion. Together then have made a net $0.2 Trillion. Lets say the total market cap of the 500 companies is $10 trillion. That looks like a PE of 50. Wow, pretty expensive right? Well, not really. Citigroup's weighting for the S&P is currently 0.27%. So if C goes to zero it reduces the index by a 0.27%. But then it gets replaced in the index by some other company that is unlikely to lose $1 Trillion the following year. People owning the index say good riddance to Citigroup and move on. In reality, they own an index at 8.3 times earnings not 50. Stock holders have limited liability. If C goes to zero, it doesn't matter how many gazillions of dollars they lose. The stock holders are not on the hook for it. Stock's can't have negative value.

It is important to consider the earnings weighted by the same weighting used in the S&P index which is by market cap. These can be found here .
The top 45% of the index includes only two banks, JPM and WFC. If you wipe out the shareholders of JPM, C, BAC, GS and MS you have wiped out only 4.02% of the total index. That is just a bad day in the stock market these days. The S&P 500 companies have annual operating earnings of roughly $500B. These five banks could easily lose that much money in 2009 if they properly market down assets to market value.

So lets go back to the current situation and look at some numbers gathered from my Morningstar account. I screened for the largest 500 companies by market cap and trading on either the NYSE or NASDAQ which is a decent proxy for the S&P 500 companies. Then I can rank them by various quantities to get some statistics. Here are some results.

First the trailing 12 month PE ratios. The median is 10.0. The quartiles (25 and 75 percentiles) are 7.0 and 15.7. The median price-to-cash-flow is 7.3. The median forward PE is 10.3. So according to this, stocks are not particularly expensive. In fact those are below average valuations.

Of course, stocks could be expensive if earnings drop a lot and if analysts are wrong about next years earnings (almost certainly the case). For example the median price-to-book-value (P/B) is 1.9. The median return-on-equity is 18.7%. Both are pretty high still. For the major bear market bottoms of the 20th century (1920, 1932, 1949, 1974, 1982) the average P/B came down to roughly 0.5 almost four times lower than now. Profitability is still quite high. That is likely to change.

To see this, consider the ratio of corporate earnings to GDP. See chart here . This ratio should be mean reverting if capitalism is functioning properly. Excess profits should attract capital investment until the excess profits go away. This chart shows that the ratio peaked at 10% in 2007. The average value is about 6% with a low around 3%. It is probably best to assume that this ratio will drop to 3% before rebounding back to the mean of 6%. Looking at our chart above, we see that S&P 500 operating earnings peaked at about 90. So assuming constant GDP (a decent approximation), that means if the corporate earnings to GDP ratio goes to 3% before rebounding to 6%, the S&P 500 earnings will drop to 27 before rebounding to 54. The normalized earnings is probably close to this number, 54. The value of the S&P 500 is probably about 15 times this or 810 which is not far below today price of 827.

So stock are probably fairly valued. However it is still likely I think that they go lower. Usually after a period of over-valuation, there is a period of undervaluation. If earnings really hit 27 and the economy is really, really bad with unemployment over 10%, I would not be surprised for stocks to trade at 10 times normalized earnings or 540. If earnings drop to 27, that would be 20 times trailing earnings which might not appear cheap to people expecting the current conditions to continue indefinitely (which is human nature). That would still likely leave the average P/B above 1 which would well above previous bear market bottoms. Given the different nature of today's non-capital intensive, service oriented companies, that might make sense. If we have a depression, earnings could go lower still. Earnings were negative during the Great Depression. If we have something similar and earnings go negative, stocks will trade based on book value and if they fall to 0.5 book, that mean the S&P near 220. I don't see that happening but it is not outside of the realm of what has happened in the past.

####### Update ########
AIG is going to post a $60B loss for Q4 which is much worse than the $12B loss that analysts expected. This will bring done the Q4 number for the S&P by about $5.50. The trailing PE for the S&P is now about 36 which is the second highest ever. The only year that ended with a trailing PE this high was 2001 when it was 46.

######## Another update ###########
The Q4 is now done. I was right about AIG but underestimated other losses. The final tally for Q4 was -$23.25. Wow! S&P now estimates "as reported" earnings for the next three quarters. $7.32, $6.64, $7.46. Note that those three add up to only $21.42 so if they are right about these, the trailing 12-month earnings will be negative in Q3 2009.

Yes, I know, you can't make a sensible PE based on a negative number for earnings. For example the PE is predicted to be 1875 in Q2 and -450 in Q3. Ok, ok, lets look past "as reported" earnings and look at operating earnings which ignore one time losses and non-cash write-downs. We will make pretend that those things don't matter. S&P makes operating earnings predictions in two different ways: top-down estimates, looking at the macro picture and predicting total earnings and also a bottom-up picture, adding up the total earnings predicted by analysts of each company.

Using the top-down estimates, the forward operating earnings PE is 25 in Q3 and 18 thereafter. Using bottom-up estimates it is 18 in Q3 and about 12 thereafter. So there is a huge difference. I am more inclined to believe the top-down estimates especially if we are going to agree to ignore the "one-time" losses which have a habit of repeating themselves. I think analysts are making the incorrect assumption that companies can cost-cut their way back to profitability. I don't think this will work when everyone is doing the same thing. It just results in higher unemployment and less demand.

Stocks don't look so cheap to me.

Wednesday, April 8, 2009


This article really nails it. It is one of the clearest explanation of what is going on, why it can't be stopped by traditional means and what we need to do to get out of it. In short, we are in a depression not a recession. The difference is that a depression is when people's collective action are self defeating. They all try to save, cut costs and avoid taking risk and this just results in economic collapse rather than the desired outcome of improved individual balance sheets.

The only solution is truly massive government intervention because only government can organize collective action. The trouble is that the Fed, US government as well as foreign governments have not yet come to this understanding. They are still resisting nationalizing the banks and undertaking massive fiscal stimulus. Yes, the Obama administration has passed a stimulus bill but this is not nearly enough. Nor are the stimulus packages from abroad large enough. It will also be necessary for all of the governments to coordinate this action. Government as well as the market in general is still convinced this is just a deep recession not a depression. The longer they deny this, the harder it will be to fix.

Tuesday, April 7, 2009

Sheila Bair to the rescue?

The NY Times has a story in which Shelia Bair, head of the FDIC, says that the FDIC does not expect to absorb any net losses from Geithner's new PPIP idea. This restores within me a small bit of hope that the banks are not going to defraud their way out trouble at the taxpayer's expense, or rather not as much as the markets seems to be expecting.

Lets analyze this a bit at the macro level. If the FDIC does not take a net loss and the investors do not take a net loss then then the banks have to take the loss as they should. It is as simple as that... well sort of.

What the FDIC can do is raise their insurance premiums to collect back any losses in the future directly from the banks. If it has a cash flow problem, it is possible that they can borrow money directly from the capital markets with an implicit government backing.

If you trust Sheila Bair (I have a warm place in my heart for her) this cannot be good news for the banks or Wall Street. It means that the FDIC is not going to guarantee any loans in which it is likely to get screwed. That is, it is not going to guarantee any toxic asset purchases unless the price is low enough for the FDIC to come out OK in the long run. This probably means, lower prices and less leverage. Lower leverage means the investor's larger down payment will provide a larger first-loss cushion if the FDIC has to take over the assets.

Still, I think the FDIC will take some nominal losses. But I think they intend for the banks to pay for these losses through future FDIC premiums. This means that banks will be less profitable in the future even in they can survive. So really this is just a way for banks to postpone taking losses. Japanese lost decade, here we come!

Sunday, April 5, 2009

Nice plot of total US credit market debt breakdown

Some comments:

The Great Depression was partially caused by the vicious deleveraging of corporations and household. This time corporations are somewhat better off but households are worse and financials are a basket case. Remember, our money supply is determined by debt. Debt is money. If debt contracts, so will the money supply and this will lead to deflation.

Friday, April 3, 2009

Let's sum up the Geithner plan quickly

Every trade is a zero sum game. There is a winner and a loser. One bets right and the other bets wrong even if it isn't clear immediately which is which. If there are three parties involved, it doesn't make a difference. The sum is still zero.

The pimps at Pimco are calling the Geithner plan a win-win-win plan. Everybody wins. The banks will make a profit, the hedge fund investors will make a profit and so will the taxpayer! Wow, that must be quite a plan to defy even logic itself.

The fact of the matter is that the banks are not dumb enough to lose money on this plan. The hedge funds are not dumb enough to lose money either. The only one dumb enough to lose money is the hapless taxpayer whose representative Tim Geithner is actually working for the other players.

Saturday, March 28, 2009

The real American Patriot is a British guy

No one does a better job at playing American Patriot against our parasitic banking system and their captive regulator, the Federal Reserve, than Willem Buiter of the Financial Times. After reading Buiter, you realize how morally bankrupt our financial system really is. No one in the American press writes as well as Buiter about the US financial system. There is no one defending the principles of Americanism better than this British journalist. Buiter's latest piece sums up the situation perfectly. I will be Bad-Blogger and quote it in its entirely. It is a must-read.

Willem Buiter of the Financial Times takes down Geithner and the Fed.

More on robbing the US tax payer and debauching the FDIC and the Fed

March 26, 2009 5:34pm
The US authorities have no money to fulfil their ambition of stopping large US banks from failing without taking them into public ownership. The $300 bn left in the TARP kitty is all that is available for recapitalising banks, purchasing toxic assets and providing other financial support. Congress has thrown its toys out of the pram and is unwilling to appropriate more funds for the rescue of the banking sector.

As an aside: it is astonishing that Congress and much of the US populace are apoplectic about $165 mn (perhaps $182 mn) of bonuses paid to AIG executives and employees, when $170 billion or so of public money is at risk (and tens of billions probably already gone out of the window) in the rescue of this most undeserving of companies. Perhaps you can only get indignant about what you can comprehend… .

The US authorities are reduced to begging, stealing and borrowing the rest of the funds they believe they will need. The two main proximate sources of funds are the FDIC and the Fed. The ultimate sources of funds will be (1) the US tax payer and the beneficiaries of future US spending programs that will have to be cut, (2) the holders of nominally denominated liabilities of the US state, including the monetary liabilities of the Fed and US Treasury bills and bonds.

Owners of dollar-denominated debt instruments will see the real value of their claims on the government eroded by future inflation if, as I expect, the recent and prospective future increases in the US monetary base (driven by credit easing and, in the future also be quantitative easing) cannot be reversed in the future. The main obstacle to such a reversal will be the US fiscal authorities, who are unlikely to let the Fed dump large amounts of US Treasury debt, acquired by the Fed as part of its quantitative easing program, into the markets.

I believe that the raids by the US Treasury on the FDIC and on the Fed are illegitimate and, in the case of the FDIC, quite possibly illegal.


The FDIC is supposed to be an independent agency of the US federal government. Its website tells us that “The FDIC receives no Congressional appropriations - it is funded by premiums that banks and thrift institutions pay for deposit insurance coverage and from earnings on investments in U.S. Treasury securities” . The FDIC also has no borrowing capacity except that granted it by the US Treasury.

The operating budget of the FDIC for 2009 is $2.24 billion, a big increase from the $ 1 billion set in 2008, but still a tiny number. Its current Treasury borrowing limit is $30 bn, again nowhere near enough to make an impact on the black hole that is the asset side of the balance sheet of the US cross-border banking system. With an insurance fund of just over $45 billion, the FDIC insures more than $5 trillion of deposits in U.S. banks and thrifts. The insurance fund is therefore less than one percent of the amount of insured deposits.

The near-demise of the US banking system means that, should even a single large deposit-taking bank go bust, there is not enough money in the kitty to pay off all insured depositors. The FDIC would have to borrow - hence the usefulness of the increase in the borrowing limit. It is both unwise and illegitimate to use that borrowing limit instead to subsidise potentially non-viable banks (likely to still be non-viable even after the subsidy) as well as the private investors who plan to purchase these banks’ bad loans through the Legacy Loans Program.

The FDIC’s Mission Statement is clear: “The Federal Deposit Insurance Corporation (FDIC) is an independent agency created by the Congress that maintains the stability and public confidence in the nation’s financial system by insuring deposits, examining and supervising financial institutions, and managing receiverships.” I don’t see anything there about guaranteeing debt from or loans to private entities wanting to buy bad loans from bad banks. The Federal Deposit Insurance Corporation Improvement Act of 1991 also does not, as far as i can see, authorise the FDIC to engage in the kind of quasi-fiscal activities it is engaging in through the Temporary Liquidity Guarantee Program (see below) and is about to engage in under the Legacy Loans Program.

But help is on the way! Senate Banking Committee Chairman Chris Dodd of Connecticut is proposing, in a bill submitted on March 5 2009 (the Depositor Protection Act of 2009) to increase the FDIC’s Treasury borrowing limit from $30 billion to $500 billion. With the deposit insurance limit now at $250,000 at least until the end of 2009 (up from $100,000) and so many large deposit-taking banks in the US insolvent but for past, present and anticipate future hand-outs from the tax payer, the increased borrowing limit of $500 bn may come in handy to make whole the insured depositors if and when one or more large banks keel over.

But this does not appear to be the use (the proper use) that the US authorities have in mind for it. Instead the increase in the FDIC’s Treasury borrowing limit to $500 billion is likely to be diverted to the entirely improper use of providing debt guarantees for debt used to co-finance the purchase bad loans from the banks under the Legacy Loans leg of the Private-Public Investment Program (PPIP). This quasi-fiscal role of the FDIC is on top of the earlier prima-facie illegitimate use of FDIC resources under the FDIC’s Temporary Liquidity Guarantee Program (TLGP), under which the FDIC guarantees newly issued senior unsecured debt of banks, thrifts, and certain holding companies.

The FDIC, under the TLGP also provides full coverage of non-interest bearing deposit transaction accounts, regardless of dollar amount. This is a legitimate use of its resources, albeit an unwise one. As of February 28, 2009 the amount of debt insured under the TLGP was more than $268 billion. After debauching the Fed to pay for the bail-out of insolvent US banks, the US administration is now subverting the purpose of another so-called independent government agency.

The debauching of the FDIC is, however, different in one respect from that of the Fed. The Fed has an independent source of revenue - seigniorage, that is, the revenue from issuing base money, part of which is non-interest-bearing (bank notes) and part of which (commercial bank deposits with the Fed) earns an interest below what the Fed earns on its assets.

The FDIC has no independent source of revenue (ignoring the premia charged for the deposit insurance, which is chicken feed). Getting the FDIC to guarantee loans is therefore just a cute and non-transparent way of having the US Treasury guarantee those loans. But it’s off the books, off-budget and off-balance sheet as far as the US Treasury is concerned. With a bit of luck the guarantees will not be called. And if they are called - well, that will be then and this is now. If the FDIC can insure $ 5 trillion worth of deposits with a mere $45 bn fund, think of what amount of lending the FDIC can guarantee when it borrows its full allotment of $500 bn! The bill will be presented to the tax payers later.

How large could the bill be, that is, how much money could be transferred from the US tax payers to the banks or the investment funds bidding for toxic assets?

The potential for subsidies to the private parties involved in the PPIP’s Legacy Loans and Legacy Securities Programs is truly astonishing. Jeff Sachs, in a recent Financial Times column, provides a representative calculation for the Legacy Loans Program. Note that this is targeted not at toxic assets (assets whose value is unknown) but on bad loans, whose (low) fundamental value can be ascertained without too much effort.

What follows paraphrases Jeff Sach’s argument and calculation. I put all of it in quotation marks, even though a few words have been changed.

“For every $1 of bad assets that an investment fund authorised under the PPIP buys from the banks, the FDIC will lend up to 85.7 cents (six-sevenths of $1), and the Treasury and private investors will each put in 7.15 cents in equity to cover the balance. The Federal Deposit Insurance Corporation (FDIC) loans will be non-recourse, meaning that if the bad assets purchased by the investment fund fall in value below the amount of the FDIC loans, the investment funds will default on the loans, and the FDIC will end up holding the bad assets. The investment fund is not responsible for part of the FDIC loan not covered by the liquidation value of the bad assets. At most it loses the equity it put in.

Consider a portfolio of bad assets with a face value of $1 trillion. Assume that these assets have a 20 percent chance of paying out their full face value ($1 trillion) and an 80 percent chance of paying out only $200 billion. The fair value of these assets is given by their expected payout, which is 20 percent of $1 trillion plus 80 percent of $200 billion, i.e. $360 billion.

Investment funds will bid for these assets. It might seem at first that the investment funds would bid $360 billion for these toxic assets, but this is not correct. The investors will bid substantially more than $360 billion because of the massive subsidy implicit in the FDIC non-recourse loan. The FDIC makes a “heads you win, tails the taxpayer loses” offer to the private investors.

With a little arithmetic, we can calculate the size of the transfer from the tax payer to the banks and the investment funds. In this example, the private investment fund will actually be willing to bid $636 billion for the $360 billion of fair value of the bad assets, in effect transferring excess $276 billion from the FDIC (taxpayers) to the bank shareholders.

Under the rule of the Geithner-Summers Plan, private equity investors and the TARP each put in 7.15 percent of the purchase price of $636 billion, equal to $45 billion each. The FDIC will loan $546 billion. (All numbers are rounded). If the bad assets actually pay out the full $1 trillion (which happens with 20 percent probability), there will be a profit of $454 billion, equal to $1 trillion payout minus the repayment of the FDIC loan of $546 billion. The private investors and the TARP will each get half of the profit, or $227 billion.

Since this outcome occurs only 20 percent of the time, the expected profits to the private investors are 20 percent of $227 billion, or $45 billion, exactly what they invested. Similarly, the TARP’s expected profits are also equal to the TARP investment of $45 billion. Thus, both the TARP and the private investors break even. As competitive bidders, they have bid the maximum price that allows them to break even.

The bank shareholders, however, come out $276 billion ahead of the game, while the FDIC bears $276 billion in expected losses! This transfer occurs because the investment fund defaults on the FDIC loan when the bad assets in fact pay only $200 billion, an outcome that occurs 80 percent of the time. When that happens, the investment fund is “underwater” (holding more in FDIC debt than it gets in payouts on the bad assets). The investment fund then defaults on its debt to the FDIC. The FDIC gets $200 billion instead of repayment of $546 billion, for a net loss of $346 billion. Since this outcome occurs 80 percent of the time, the expected loss to the taxpayers is 80 percent of $346 billion, or $276 billion. This is exactly equal to the overpayment to the banks in the first place.”

The problem of collusive behaviour between the private investment funds and the banks for whose assets they bid will undoubtedly rear its ugly head. Indeed, the banks could set up their own investment funds (through SPVs registered in places where information is even harder to obtain than in Liechtenstein) and so make sure the underpriced put provided by the FDIC through its non-recourse loan can indeed be exercised.

This is a very bad deal for the tax payer indeed. And the Legacy Securities Program works on the same principles, although the non-recourse leverage provided by the Fed will be less than that provided by the FDIC for the Legacy Loans Program.

The Fed

I have written at length before about the ever-expanding quasi-fiscal role of the Fed. This began as soon as the Fed began to take private credit risk (default risk) onto its balance sheet by accepting private securities as collateral in repos, at the discount window and at one of the myriad facilities it has created since August 2008. It is possible - I would say likely - that the terms on which the Fed accepted this often illiquid collateral implied even an ex-ante subsidy to the borrower. But the Fed is refusing to provide the necessary information on the valuation of the illiquid collateral, interest rates, fees and other key dimensions of the terms granted those who access its facilities, for outsiders, including Congress, to find out what if any element of subsidy is involved.

Should the borrowing bank default and should the collateral offered also turn out to be impaired, the Fed will suffer an ex-post capital loss on its repos and other collateralised lending operations against private collateral. It does not have an indemnity from the Treasury for such capital losses.

The Fed also created the Maiden Lane I (for Bear Stearns toxic assets), Maiden Lane II (for AIG’s secured loans and Maiden Lane III (for AIG’s credit default swaps) special purpose vehicles in Delaware. The losses made by Maiden lane II and III when the Fed paid off the investors (counterparties) of AIG at par, were, however, not booked on the balance sheets of the two Maidens, but were booked on AIG’s balance sheet, keeping Maiden Lane I and II, and the Fed, clean for the time being. The financial shenanigans used by the Fed (in cahoots with the US Treasury) to limit accountability for these capital losses are quite unacceptable in a democratic society. Clearly, the US authorities are using the financial engineering tricks and legal constructions whose abuse by the private financial sector led to our current predicament, to engage in Congressional- and tax payer accountability avoidance/evasion. To watch the regulators engage in regulatory arbitrage is astonishing.

With the onset of credit easing, the Fed now also takes private credit risk onto its balance sheet through outright purchases of private securities (including commercial paper and possibly corporate bonds) and by making non-recourse loans through the TALF (that is, though unsecured lending). There is no full (100 percent) Treasury guarantee for this credit risk taken by the Fed. In fact, the $1 trillion TALF has at most $100 billion of Treasury funds to back it up.

I don’t envy Ben Bernanke the extremely uncomfortable position he finds himself in. He can insists on minimizing the quasi-fiscal role of the Fed by insisting on a 100% US Treasury guarantee for any credit risk, other than the credit risk of the US sovereign, that the Fed assumes. In that case the amount of financial ammunition that the US state, broadly defined to include the US Treasury, the FDIC and the Fed, have at their disposal to deal with financial sector reconstruction is inadequate. Or he can compromise the independence of the Fed and let the central bank be used as an off-balance sheet and off-budget special purpose vehicle of the US Treasury, reducing transparency and undermining democratic accountability. Talk about a rock and a hard place.

Even faced with this kind of dilemma, however, certain practices are clearly improper and unacceptable. The (ab)use of the Maiden Lane SPVs to hide some of the losses made by the Fed and the US Treasury and to channel money non-transparently to AIG counterparties (in the case of Maiden Lane II and III is just plain wrong. So is the refusal to make public the information required to judge the appropriateness of the terms and conditions attached by the Fed to the use of its facilities.

Conclusion: we need banking; we don’t need these banks

The raiding by the US Treasury of the financial resources of the FDIC and the Fed is not just unwise, illegitimate and possibly illegal, it is also unnecessary. For some reason, perhaps an example of cognitive capture of the Treasury and White House policy makers by the spin doctors and skilled persuaders of Wall Street, Tim Geithner, Larry Summers, Ben Bernanke and Sheila Bair all appear to believe that to save the banking sector you have to save the existing banks as going concerns. Indeed, in view of the astonishing survival rate of CEOs and other top managers in the zombie banks, they may even believe that to save the banking system you have to rely on the continued contribution of those whose past best efforts brought us this crisis and debacle.

All that matters is banking as a function and activity, that is, new lending and borrowing by banks. When a massive disaster strikes the existing banks, it is essential to decouple the stocks of existing assets and liabilities from the flows of new lending and borrowing. The good bank model does that.

Both Fed Chairman Bernanke and US Treasury Secretary Geithner have called for the creation of a special resolution regime (SRR) with prompt corrective action (PCA) for non-bank systemically important institutions. Bernanke clearly had AIG in mind when he told the US Congress on March 20, that there was a need for a special insolvency regime that “permits the orderly resolution of a systemically important nonbank financial firm”. With a proper federal resolution authority, AIG could have been put into conservatorship or receivership and could have been unwound slowly, with not just the shareholders but also the unsecured creditors taking the haircuts (losses) justified by the financial condition of AIG. Bernanke’s words that a proper special resolution regime for non-banks would permit the Conservator or Administrator to “unwind it slowly, protect policymakers, and impose haircuts on creditors and counterparties as appropriate,” truly are music to my ears.

I also agree with Chairman Bernanke’s statement that “given the interconnected nature of our financial system and the potentially devastating effects on confidence, financial markets and the broader economy that would likely arise from the disorderly failure of a major financial firm in the current environment, I do not think we have had a realistic alternative to preventing such failures.”

But with a proper SRR, there can be orderly failures of major financial firms, banks and well as non-banks. The US has a proper SRR for FDIC-insured banks. That now includes all Wall Street banks. The orderly failure and resolution of one of more Wall Street banks need therefore pose no threat to financial stability. Indeed, with the limited resources the US authorities have at their disposal, the failure and orderly resolution of all dodgy Wall Street banks may well be the best way to stabilise the financial sector and to get financial intermediation - new lending and borrowing between banks and the non-financial sectors - going again. With the information the authorities now are acquiring (I hope) about the soundness of the large banks (whose balance sheets and financial fitness are being scrutinised as part of the Treasury’s Capital Assistance Program), the authorities will soon know which banks should be allowed to survive and which ones should be put out of their and our misery.

Why hasn’t the FDIC’s special resolution regime been used to resolve the large Wall Street zombie banks, but just the tiddlers in the boonies (OK, add WAMU)?

Any large, deposit-taking Wall Street bank (the old bad bank or OBB) with a significant amount of non-insured deposit liabilities on its balance sheet and a survival-threatening amount of toxic assets, can be split into a new good bank and a new bad fund virtually with the stroke of a pen, using the proposal by Bulow and Klemperer and Hall and Woodward (see also Buiter (1) and (2)). The new good bank gets the insured deposits and the non-toxic assets. If liabilities net of insured deposits of the OBB exceed toxic assets, the new good bank will have positive equity. Give that equity in the new good bank to the new bad fund. The new bad fund does not have a banking license and cannot make new loans or acquire any new assets. It simply manages down its portfolio of existing assets in the interests of its owners. It gets no further government financial support of any kind. If it fails, it goes into Chapter 11 or Chapter 7. Both the shareholders and the unsecured creditors can be expected to take a hit. That is as it should be.

If the new good banks needs additional capital, it can go to the market or obtain it from the government. Government guarantees (just from the Treasury, please) are only granted to new bank borrowing or bank lending.

Save banking. Allow the zombie banks to die.

The unsustainable rally

The stock market has been in bull market mode for the past three weeks. Many are saying that we have seen the bottom are now in a bull market. I think this is all hogwash. Here are some reasons why this is not the bottom:

The economy is not improving nor is it likely to improve soon. We may be nearing the low in home sales and also auto sales. But that doesn't mean we will have a quick rebound in either. Sales of homes or autos require financing. While financing for either is available and at reasonable interest rates, it is only available for those with good credit and money for a down payment. That means that most Americans and businesses are excluded from more credit.

Nobody with good credit wants to borrow anyway. In an economy like this, there are few places to invest so why borrow money? Why would anyone borrow money to open a restaurant when so many are failing and closing down? Businesses are being penalized for having lots of debt so why would any business add more debt right now? House prices are falling so fast that it makes sense to wait to get a lower price in the future.

The key thing to note here is that you can only lever up once. Once you have turned the balance sheet of a country into a heavily indebted one, you can't add any further credit. The Fed and Treasury are desperate trying to find someone else capable of levering up and continuing the spending. Who is available? The government of course is one. The government can borrow and spend and offset the retrenchment in spending to some degree. But there are limits there. If they add much more Federal debt, the Fed will have to purchase it. This is obviously just printing money and eventually our foreign creditors will say enough is enough and stop buying dollar denominated debt.

The other party is private capital: hedge funds and private equity who will always borrow if they can be assured at getting a good return on the borrowed money. Geithner's plan is to lever up these groups in order to offload some of the toxic assets on bank balance sheets. This plan will face some obvious political problems. There is some serious danger that taxpayers will get stuck with some major losses which will make Geithner and Obama's chance of keeping their jobs quite slim. This plan can only work if private capital ends up making a profit. But if the profit is too large, this will stoke populist outrage and for good reason. It is already looking like a massive wealth transfer from the taxpayer to banks and private capital. Some have called this the biggest wealth transfer since the government gave away land to the railroads in the 19th century, the beginning of the last gilded age.

Even if this dicey plan works, they are really just ways of inflating out of the debt problem. Will the rest of the world who holds dollars as reserve currency put up with us debasing the currency to avoid paying the price of our profligacy? We will find out this week at the G-20 meeting. My guess is that this week will coincide with a loss of faith in the current rally. The market will realize that the rest of the world is not on board with the US plan of printing our way out of trouble. You just have to look ahead a little further. What is the Bernanke/Geithner plan really? What is the endgame? Is there really any reasonable way for this to turn out OK? I think not. I am using this really as a chance to sell stocks that are turning up due to the hope of economic recovery although I hold very few of them anyway. Gold is looking more and more attractive as is resource stocks like Uranium miners. Recession resistant, low debt, multinationals that have a high fraction of sales in other currencies also look good, like my long-held core position in Johnson & Johnson. Eventually I think China will get tired of buying treasuries and will start buying up our multinational companies in addition to commodities.