Is the U.S. Banking System Safe?

by Jim Quinn
by Jim Quinn

Treasury Secretary Henry Paulson delivered an upbeat assessment of the economy, saying growth was healthy and the housing market was nearing a turnaround. "All the signs I look at" show "the housing market is at or near the bottom," Paulson said in a speech to a business group in New York. The U.S. economy is "very healthy" and "robust," Paulson said.

~ CBS Marketwatch 4/20/07

"At this juncture, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained."

~ Ben Bernanke during Congressional Testimony 3/2007

"We will follow developments in the subprime market closely.  However, fundamental factors - including solid growth in incomes and relatively low mortgage rates - should ultimately support the demand for housing, and at this point, the troubles in the subprime sector seem unlikely to seriously spill over to the broader economy or the financial system."

~ Ben Bernanke 6/5/07

"It is not the responsibility of the Federal Reserve - nor would it be appropriate - to protect lenders and investors from the consequences of their financial decisions. But developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy."

~ Ben Bernanke 10/15/07

"We've got strong financial institutions.Our markets are the envy of the world. They're resilient, they're.innovative, they're flexible. I think we move very quickly to address situations in this country, and, as I said, our financial institutions are strong."

~ Henry Paulson 3/16/08

Deception

After reading the above quotes, it should be clear to you that these gentlemen do not have a clue. Our economy and banking system is so complex and intertwined that no one knows where the next shoe will drop. Politicians and government bureaucrats are lying to the public when they say that everything is alright. They do not know. Therefore, it is in our best interest to cut through all the crap and examine the facts with a skeptical eye.

Last week, bank stocks, which had been falling faster than President Bush's approval rating, soared higher based on earnings reports that were horrific, but not catastrophic. Again, the talking heads, like Larry Kudlow, were calling a bottom in the financial crisis. The bank with the largest increase in share price was Wells Fargo. Their earnings exceeded analyst expectations and the stock went up 22% in one day. Wells Fargo has $84 billion of home equity loans, with half of those in California and Florida. Coincidently, Wells Fargo decided to extend its charge-off policy in the 2^nd quarter from 120 days to 180 days, in an effort to give troubled borrowers more time to reach a loan workout. A skeptical person might think that they did not change this policy out of the goodness of their hearts. Maybe, just maybe, they changed this policy to reduce their write-offs for the 2^nd quarter, to beat analyst expectations.

There are many stories of people who are still living in houses, twelve months after making their last mortgage payment. Their banks have not started foreclosure proceedings. Is this due to incompetence by the banks, or is this a way to avoid writing off the loss? The FASB has joined the cover-up gang by delaying the implementation of new rules that would have made banks stop hiding toxic waste off-balance sheet. The new rule would have made banks put these questionable assets on their balance sheet and would have required a bigger capital cushion. What a surprise that bank regulators, the Treasury and Federal Reserve urged a delay in implementation. How very Enron like.

The Future FDIC Bailout

During the S&L crisis in the early 1990's, 1,500 banks failed. So far, seven banks have failed in 2008, the largest being IndyMac. The FDIC has about $53 billion in funds to handle future bank failures. The IndyMac failure is expected to use $4 to $8 billion of those funds. Average Americans will lose $500 million in uninsured deposits in this failure. The FDIC says that they have 90 banks on their "watch list." They do not reveal the banks on the list, so little old ladies with their life savings in the local bank will be surprised when they go belly up. Based on the fact that IndyMac was not on their "watch list," I wouldn't put too much faith in their analysis.

There are 8,500 banks in the U.S. Based on an independent analysis by Chris Whalen from Institutional Risk Analytics, they have identified 8% of all banks, or around 700 banks as troubled. This is quite a divergence from the FDIC estimate. Should you believe a governmental agency that wants the public to remain in the dark to avoid bank runs, or an independent analysis based upon balance sheet analysis? The implications of 700 institutions failing are huge. There is roughly $6.84 trillion in bank deposits. It is almost beyond belief that $2.6 trillion of these deposits are uninsured. There is only $274 billion of the $6.84 trillion as cash on hand at banks. This means that $6.5 trillion has been loaned to consumers, businesses, developers, etc. The FDIC has $53 billion to cover $6.84 trillion of deposits. Does that give you a warm feeling?

Based on the analysis done by Reggie Middleton, I would estimate that we are only in the early innings of bank write-offs. The write-offs will at least equal the previous peaks reached in the early 1990's. If a large bank such as Washington Mutual or Wachovia were to fail, it would wipe out the FDIC fund. If the FDIC fund is depleted, guess who will pay? Right again, another taxpayer bailout. What's another $100 or $200 billion among friends.

What Is a Level 3 Asset?

Other banks have been moving assets to Level 2 and Level 3 in order to put off the inevitable losses. The definition of these levels according to FAS 157 are as follows:

• Level 1 Assets that have observable market prices.
• Level 2 Assets that don't have an observable prices, but they have inputs that are based upon them.
• Level 3 Assets where one or more of the inputs don't have observable prices. Reliant on management estimates. Also known as mark to model.

This is Warren Buffett's view on the financial institution practice of valuing subprime assets on the basis of a computer model rather than the free market price.

"In one way, I'm sympathetic to the institutional reluctance to face the music. I'd give a lot to mark my weight to 'model' rather than to market."

So, the managements of the banks that loaned money to people who could never pay them back are now responsible for estimating what these assets are worth. According to Bill Fleckenstein, "Recently, the portfolio of Cheyne Finance, one of the more infamous structured-investment vehicles, or SIVs, was sold at 44 cents on the dollar. I suspect that similar assets are not marked anywhere near that valuation on financial institutions' balance sheets. So, the game of "everything's contained" continues, albeit in a different form."

Merrill Lynch - Poster Child for Lack of Bank Credibility

John Thain is the Chairman and CEO of Merrill Lynch. He makes in excess of $50 million per year in compensation. He previously held positions as President, COO and CFO at Goldman Sachs. He is a good buddy of Hank Paulson. Here are a few recent quotes from Mr. Thain:

"...These transactions make certain that Merrill is well-capitalized." (January 15, 2008 - Thain in a statement after selling $6.6 billion of preferred shares to a group that included Japanese and Kuwaiti investors)

"...Today I can say that we will not need additional funds. These problems are behind us. We will not return to the market." (March 8, 2008 - Thain in an interview with France's Le Figaro newspaper)

"We deliberately raised more capital than we lost last year ... we believe that will allow us to not have to go back to the equity market in the foreseeable future." (April 8, 2008 - Thain to reporters in Tokyo, as reported by Reuters)

"Right now we believe that we are in a very comfortable spot in terms of our capital." (July 17, 2008 - Thain on a conference call after posting Merrill's second-quarter results)

Merrill Lynch reported a loss of $4.7 billion for the 2^nd quarter on July 17. On July 28, eleven days after this earnings report they announce a $5.7 billion write-down and the issuance of $8.5 billion of stock. Thain, the $50 million man, is either lying or completely clueless regarding the company he runs. The SEC needs to investigate him, rather than short-sellers. Their books are a fraud and anything their CEO says cannot be trusted.

Below is Barry Ritholtz' assessment of the Merrill Lynch deal:

• Merrill appears to be moving $30.6 billion dollars of bad paper off of their books.
• This paper was carried at a value of $11.1, meaning there was almost $20B in prior related write-downs.
• After this transaction, Merrill's ABS CDO exposure in theory drops from $19.9 billion to $8.8 billion (hence, the $11.1B number).
• The $6.7B purchase price relative to the $30.6B notational value is 21.8% on the dollar.
• Merrill is providing 75% of the financing - and MER's only recourse in the event of default is to retake the CDO paper back from the buyer.
• While Merrill hopes to be made whole, the reality is they still have potential exposure to these ABS CDOs via the financing;
• Actual sale price = 5.47% on the dollar

"Less than five and half cents on the dollar? That's an even cheaper sale than originally advertised. What this transaction actually accomplishes is getting the paper - but not the full liability - off of Merrill's books. How very Enron-like!"

Merrill Lynch has a market cap of $24 billion and has raised $30 billion since December just to keep making their payroll. How long will investors be duped into supporting this disaster? You can be sure that the other suspects (Citicorp, Lehman Brothers, Washington Mutual) will be announcing more write-downs and capital dilution in the coming weeks.

Is Housing Near the Bottom?

The one person who has been consistently right regarding the housing market is Yale Professor Robert Shiller. (He also called the top in the stock market in 2000). The chart in Mr. Shiller's book Irrational Exuberance clearly shows that home prices are so far out of line with historical averages that there is no doubt that further decreases are in store.

Home prices have historically tracked inflation and are likely to revert to the mean. The latest data from Case-Shiller does not paint a pretty picture. Sale prices of existing single family homes declined by 15.8% in the past year, with markets in California declining by 22% to 28%. Over 10% of the U.S. population lives in California. Bank of America, Wells Fargo, Washington Mutual, and Wachovia have a large exposure to California. The link below gives a U.S. and market by market analysis of how bad things are.

Many pundits have been downplaying the resetting of adjustable rate mortgages, saying that the worst is over. I don't think so. There are $440 billion of adjustable mortgages resetting this year. That means that the majority of foreclosures will not occur until 2009. This means that the banks will still be writing off billions of mortgage debt in 2009. The reversion to the mean for housing prices and the continued avalanche of foreclosures is not a recipe for a banking recovery. Home prices have another 15% to go on the downside. An article by John Mauldin proves that there is much further to go on the downside for housing.

Fannie & Freddie Fiasco

President Bush signed the Housing Recovery bill this week. We are now on the hook for all of their bad decisions. We believe in capitalism when there are obscene profits, but we prefer socialism when it comes to losses. The CBO estimates that we will pay $25 billion for their mistakes, with a 5% chance that it reaches $100 billion. The only problem is that they have been given an open-ended guarantee. According to former Fed governor William Poole, Fannie Mae is technically insolvent. Their shareholder equity was $35.8 billion at the end of 2007. It plunged by $23.6 billion to $12.2 billion as of March 31, 2008. Does anyone think that as of June 30, they have any equity left? We'll know shortly. Fannie Mae has guaranteed $2.4 trillion of mortgages. According to the Mortgage Bankers Association, as of June, 2.5% of U.S. mortgages were in foreclosure and 6.4% of mortgages are delinquent. Fannie and Freddie are on the hook for $5.2 trillion in mortgages. It doesn't take a rocket scientist to figure out that about 4% of the $5.2 trillion of guaranteed mortgages will default. This would be $208 billion in defaults. If they are able to recover 50% (current recovery rate) from foreclosure sales, their losses would be $108 billion. Oh yeah, that would be our losses. This is assuming things don't get worse.

Next Shoes to Drop - How High Will the Losses Go

Banks and security firms have reported $468 billion of losses thus far. Bridgewater Associates, a well-respected analytical firm, thinks things will get much worse.

According to Bridgewater, the models used have grossly underestimated the actual losses. They doubt the financial institutions will be able to generate enough capital to cover the losses. According to the report, "Lenders would have to curtail loans by roughly 10-to-one to preserve their capital ratios. This would imply a further contraction of credit by up to $12 trillion worldwide unless banks could raise fresh capital."

Not all of these losses are in the sub-prime market. According to the report, more than 90% of the losses from sub-prime loans have already been written off. Unfortunately, the losses from the prime and Alt-A loans could be much larger than we have already seen. The sizes of these loan portfolios are much larger than the sub-prime portfolios. Further, Bridgewater expects about $500 billion in corporate losses that must be written off. This leads to the current estimate of more than $1 trillion in losses yet to be written off. The link below shows that the consumer is stressed to the maximum.

Bill Gross, the well-respected manager of the world's largest bond fund, expects financial firms to write down $1 trillion. "About 25 million U.S. homes are at risk of negative equity, which could lead to more foreclosures and a further drop in prices. The problem with writing off $1 trillion from the finance industry's cumulative balance sheet is that if not matched by capital raising, it necessitates a sale of assets, a reduction in lending or both that in turn begins to affect economic growth.'' Nouriel Roubini, economist at NYU, believes that losses could reach $2 trillion.

The other shoes have begun to drop. Last week Amex reported a 40% decline in earnings as their wealthy super-prime customers are not paying their bills. So, even the well-off are struggling. This week, CB Richard Ellis, the largest commercial real estate broker in the country reported an 88% decline in earnings. So, commercial real estate is imploding. Bennigans's and Mervyn's filed for bankruptcy this week. The consumer is being forced to cut back on eating out and shopping. The marginal players will fall by the wayside. Big-box retailers, restaurants, and mall developers are about to find out that their massive expansion was built upon false assumptions, driven by debt.

The U.S. banking system is essentially insolvent. The Treasury, Federal Reserve, FASB, and Congress are colluding to keep the American public in the dark for as long as possible. They are trying to buy time and prop up these banks so they can convince enough fools to give them more capital. They will continue to write off debt for many quarters to come. We are in danger of duplicating the mistakes of Japan in the 1990's by allowing them to pretend to be sound. We could have a zombie banking system for a decade.

My advice is:

1. Absolutely do not have more than $100,000 on deposit with any single institution.
2. Do not buy financial stocks. There are years of write-offs to go.
3. When you see a bank CEO or a top government official tell you that everything is alright, run for the hills. They are lying. They didn't see this coming and they have no idea how it will end.
4. Educate yourself by reading the writings of Ron Paul, John Mauldin, Barry Ritholtz, Mike Shedlock, Bill Bonner, Paul Kasriel, John Hussman, Bill Fleckenstein and Jeremy Grantham. They will tell you the truth. Truth is in short supply today.

August 5, 2008

Jim Quinn is Senior Director of Strategic Planning, The Wharton School, University of Pennsylvania. This article reflects the personal views of Jim Quinn. It does not necessarily represent the views of his employer, and is not sponsored or endorsed by them.