Credit Crunch, Bank Failures, Moral Hazard and Adverse Selection

The selective enforcement of ‘no naked shorts’ shorts rule on 19 financial stocks expires today…

FDIC Fund Strained by Bank Failures May Lift Premiums (Update2): “The failure of IndyMac Bancorp Inc. and seven other banks this year may erase as much as 17 percent of a government insurance fund and raise premiums for all banks, from Franklin National of Minneapolis to Bank of America Corp.

The closing of IndyMac in July, the third-biggest U.S. bank failure, may cost the Federal Deposit Insurance Corp.'s fund $4 billion to $8 billion, in addition to an estimated $1.16 billion for seven closures through Aug. 1. Premiums for insuring deposits will likely rise, FDIC Chairman Sheila Bair said in a July 30 interview. A decision is due by the fourth quarter.”

Idiots.

“Premiums for deposits will likely rise.” I understand that. Imploding banks are costing so much money so quickly that the FDIC Fund is being depleted and needs to be replenished. Sheila Bair, lacking all kinds of understanding and creativity, will simply raise premiums to increase revenues. Great. Just great. Dead banks won’t be able to pay any of the premiums. Weak banks really don’t need the extra costs right now. That leaves the more prudent, conservative banks that did not go ‘balls out’ in this credit bubble to bear the full burden. So as irresponsible financial institutions fail, a shrinking circle of responsible financial institutions get to pay an ever increasing amount.

Can you say Moral Hazard: “The prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk. Moral hazard arises because an individual or institution does not bear the full consequences of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to bear some responsibility for the consequences of those actions. For example, an individual with insurance against automobile theft may be less vigilant about locking his car, because the negative consequences of automobile theft are (partially) borne by the insurance company.”

Can you say Adverse Selection: “Anti-selection, or negative selection is a term used in economics, insurance, statistics, and risk management. On the most abstract level, it refers to a market process in which "bad" results occur due to information asymmetries between buyers and sellers: the "bad" products or customers are more likely to be selected. A bank that sets one price for all its checking account customers runs the risk of being adversely selected against by its high-balance, low-activity (and hence most profitable) customers.”

Fed Says Banks Toughen Lending Standards Amid Slump (Update3): “The Federal Reserve said more banks made it harder to borrow money as defaults and delinquencies on home loans soared and the economy faltered.

Most “domestic institutions reported having tightened their lending standards and terms on all major loan categories over the previous three months,” the Fed said today in its quarterly Senior Loan Officer Survey.

Funds were scarcer for homebuyers and small businesses, credit card loans became tougher to get, and even banks' best customers were subject to greater scrutiny. Tighter credit may delay any recovery in economic growth, which economists forecast will slow well into next year.”

Credit continues to tighten. SIGNIFICANTLY.

“The survey, conducted last month, covers 52 domestic banks with combined assets of $6.1 trillion, along with 21 foreign institutions. About 75 percent of U.S. banks indicated they tightened standards on prime mortgage loans, up from 60 percent in the previous survey, the central bank said.”

The only possible outcome is a MASSIVE, PROLONGED RECESSION. (Hehe, and to think, the Bulltards are buying equities in general and financials in particular as oil comes off with the naïve belief that some decrease in oil will more than offset a GLOBAL CREDIT CONTRACTION.)

“The economy is also faltering. The unemployment rate has moved up 1 percentage point during the past 12 months to 5.7 percent, while delinquencies on home loans to borrowers with weak or limited credit histories rose to 18.8 percent in the first quarter from 13.8 percent a year earlier.”

“The credit crunch is intensifying. It reinforces the view that the economy will be weak in the next several months and there will be renewed pressure on the Fed to start easing again.” -James O'Sullivan, UBS

Morgan Stanley Rating Cut by Moody's on Risk Controls (Update2): “Morgan Stanley had its long-term credit rating lowered by Moody's Investors Service, which cited the second-biggest U.S. securities firm's failed risk-management practices.

Morgan Stanley's debt was downgraded one level to A1 from Aa3, Moody's said in a statement today. Both firms are based in New York. A1 is the fifth-highest investment-grade rating.”

The long run consequences are serious. Morgan Stanley (MS) and the rest of Wall Street needs to go on another massive capital raising binge and lower credit ratings will translate into a higher cost of capital.

The short covering bounce in financials should be just about over. It’s Time To Go Ultrashort, Again.

Wachovia's Second-Quarter Loss Widens on Legal Costs (Update2): “Wachovia Corp., the fourth-largest U.S. bank, said its second-quarter loss was bigger than reported in July because of costs to settle a probe of auction-rate securities sales. It also increased planned job cuts.

The bank revised the loss to $9.11 billion, or $4.31 a share, from $8.86 billion, or $4.20 a share, according to a regulatory filing today. The Charlotte, North Carolina-based bank now plans to dismiss 6,950 employees later this year, 600 more than previously disclosed. The new job cuts will come from Wachovia's mortgage operations, spokeswoman Christy Phillips Brown said.”

Expect more of this as the legal “bubble” is just getting started…

Argentina's Debt Rating Cut to B by Standard & Poor's (Update2): “Argentina's foreign debt rating was cut by Standard & Poor's on concern slowing economic growth will crimp tax revenue while mounting investor mistrust in inflation data erodes confidence in the government.

S&P lowered Argentina's rating to B, five levels below investment grade and in line with countries including Jamaica and Paraguay, from B+.”

Argentina has been faking it’s inflation statistics like you wouldn’t believe. The world ignored this when credit was cheap and plentiful, buying into the emerging market miracle story. Now that credit is neither cheap nor plentiful, the market has taken notice. Argentina will find it very very difficult to raise funds from abroad going forward.

I bring this up because the U.S. too has been faking it’s inflation statistics. Nobody is fooled by ‘core’ and ‘headline’ CPI numbers that bear no relation to reality. Should the budget deficits get large enough, and I believe they will, then the world’s Bond Vigilantes will wake up and lay down the law.