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Monday, May 19, 2008

From Bubble To Bubble, More Hidden Losses

This shouldn’t come as a surprise…

Banks Hide $35 Billion in Writedowns From Income, Filings Show: “Banks and securities firms, reeling from record losses resulting from the collapse of the mortgage securities market, are failing to acknowledge in their income statements at least $35 billion of additional writedowns included in their balance sheets, regulatory filings show.

Citigroup Inc. subtracted $2 billion from equity for the declining value of home-loan bonds in its quarterly report to the Securities and Exchange Commission on May 2 without mentioning the deduction in the earnings statement or conference call with investors that followed. ING Groep NV placed 3.6 billion euros ($5.6 billion) of negative valuations in its capital account, while disclosing only an 80 million-euro depletion to income.

The balance-sheet adjustments are in addition to $344 billion of writedowns and credit losses already reported on the income statements of more than 100 banks. These companies have raised $263 billion from sovereign wealth funds, their own governments and public investors to shore up capital. The balance-sheet writedowns also reduce equity, which needs to be replenished. Adding the $35 billion leaves the banks with a $116 billion mountain of losses to climb.”

It’s those damn account rules.

“Taking losses on a balance sheet instead of an income statement is acceptable under accounting rules, which make a distinction between so-called trading books and long-term investments. Changes in value on the trading side go straight to revenue. Changes in the value of bonds held for the long haul can be marked down on the equity line of a balance sheet, as long as the declines aren't considered permanent.

Banks that are more willing to acknowledge their balance- sheet writedowns, such as Amsterdam-based ING, say the valuations of assets will be reversed when markets recover. ING, the biggest Dutch financial-services company, said in its first-quarter earnings report last week that the drop in the value of bonds tied to home loans that are held to maturity is irrelevant as long as the underlying mortgages don't default.

With that logic, most of the writedowns on the income statements could be reversed if asset prices recover. While some declines in valuations may reverse, most of the losses are permanent impairments caused by surging defaults on U.S. mortgages, said Janet Tavakoli, author of ``Collateralized Debt Obligations & Structured Finance,'' published in 2004 by John Wiley & Sons Inc.”

Worse still, the writedowns are overly conservative. The best evidence of just how inadequate these writedowns really are can be found in the continued explosion of Level 2 and Level 3 asset values. These values are growing rapidly and in many cases now the entire fate of a company rests on these arbitrary values.

For example, just recently Freddie Mac (FRE) moved $156.7 billion, or 23% of its assets, to Level 3. In so doing, FRE was able to report losses of “just” $151 million. By moving $156.7 billion into the Level 3 asset bucket, FRE now has the ability to come up with its own valuation. This was all perfectly acceptable under FAS 157. Despite these desperate measures FRE reported that the “fair value,” or estimated market value of its net assets, was a negative $5.2 billion as of March 31. I can’t imagine that FRE is valuing its Level 3 assets at anything but reckless, fantasy levels. Therefore, I have to assume that the fair value of FRE assets is actually worse than the negative $5.2 billion reported.

I think Janet Tavakoli has it just about right:

“Of course we can't tell how much of a bank's portfolio may actually be good stuff that will pay back at maturity. But there's tremendous value loss that's fundamental, not just due to credit market gyrations.” –Jane Tavakoli, author of “Collateralized Debt Obligations & Structured Finance

That means those asset prices won’t come back… EVER.

“Ignoring bad debt and postponing inevitable losses was one of the main reasons behind Japan's decade-long economic slump that began in the 1990s, said Boston University law professor Charles Whitehead.

Faced with new capital requirements and a weakened ability to meet them, Japanese banks deferred the recognition of their losses, aided by regulators who refrained from implementing the rules, Whitehead wrote in a 2006 paper published in the Michigan Journal of International Law.

The new bank-capital regime, known as Basel II, has gone into effect in some European countries and is being implemented in the U.S. and others starting this year. It allows financial institutions to use in-house risk models instead of just relying on external credit-worthiness ratings in calculating their risk- weighted capital requirements.

The largest U.S. securities firms have been under capital requirements shaped by Basel II since 2004.”

So, despite Bernanke having specialized in the great Depression and having written papers criticizing how Japanese authorities handled their own real estate and credit crisis, Bernanke looks set to repeat exactly those same mistakes.

“U.S. regulators may be tempted to go soft on banks too. The new capital rules already rely significantly on self-modeling by the banks. So if anything, the risks may be greater in the U.S. today than they were in Japan in the 1990s.” –Charles Whitehead, Boston University law professor

“A review of the balance sheets and regulatory filings of more than 50 banks showed that 20 of them chose to keep some subprime- related losses off their income statements. The marks were recorded instead on balance-sheet items labeled “other comprehensive income” or “revaluation reserves.”

This is exactly what the Japanese did. They ended up with a Zombified financial system for the next 15 years. Despite the fancy accounting footwork there are more losses yet to come.

“Declines in asset prices have spread beyond subprime though, affecting other mortgage bonds, securitized car and student loans, leveraged lending that backs private equity buyouts and credit derivatives. When all that is included, the IMF estimates that total losses from the U.S. subprime debacle will reach $1 trillion, of which $510 billion will be born by banks. That means some $130 billion in losses remains to be taken.”

The S&P 500 bounced significantly of the panic lows around 1255, but the banking and mortgage indices have not. With more writedowns pending, that makes sense. What does not make sense is the assumption that crippled banks won’t seriously negatively affect the broader economy. When that finally becomes obvious it will unleash a real vicious Bear market…

Related Posts:
Bulltrap: ABCP, and Level 3 Bombs (A list of Level 3 assets by firm and by amount)
Something To Think About: Goldman Sachs, Level 3
Level 3 Rules

Oil Producers Mask Decade's Worst S&P 500 Profit Drop (Update1): “Take away Exxon Mobil Corp., Chevron Corp. and ConocoPhillips and profits at U.S. companies are the worst in at least a decade.

Without the $70 billion that oil producers earned in the last two quarters, profits at companies in the Standard & Poor's 500 Index tumbled 26 percent and 30.2 percent, the biggest decreases for any quarter since Bloomberg started compiling data in 1998. Energy companies made up almost half the income growth reported by S&P 500 companies in the first three months of 2008 as oil prices surged past $100 per barrel, the data show.

The results leave the benchmark for American equities vulnerable to declines as oil companies' costs balloon and production slips. The industry is getting less profit from a barrel of oil than at any time since 2005, just as the rest of the U.S. economy is sputtering. Still, energy shares posted the S&P 500's steepest gains in the past year, bloating their representation to 15 percent of the index.”

The better energy does, the weaker the rest of the S&P. The effects of energy temporarily mask some of the weakness in the rest of the S&P. Furthermore, the better energy does, the more pressure it puts the rest of the economy. High energy prices are adding stress to an already stressed financial system. Consumers have clearly started to buckle. When they finally start defaulting on revolving credit with any significant scale, it will come at a time when banks are particularly vulnerable.

Pre-market oil is again at new record highs.. again. Oil has hit the runaway, parabolic, super spike phase of its speculative cycle that can only end in a massive blowout top. Unfortunately this means prices will probably carry to some ridiculous level that effectively sucks all the oxygen from the global economy before marking a top. This will cripple and even collapse most other asset classes unleashing slective asset price deflation. Then as oil collapses itself, true GLOBAL deflation will set in as credit is destroyed the world over and all asset classes get sucked down until they are valued at low or no leverage prices.

TIPS Show Bonds See Bubble Burst for Commodity Prices (Update2): “Treasury bond traders are telling Americans to stop fretting about inflation.

Consumers expect prices to rise 5.2 percent in the next 12 months, according to a monthly survey by the University of Michigan in Ann Arbor, the most pessimistic they've been since 1982. Treasury Inflation Protected Securities, or TIPS, show traders anticipate inflation of about 2.9 percent by January, in line with its average of 3.1 percent the last 20 years.

The disparity has never been wider. While consumers grapple with gasoline above $3.70 a gallon, record rice prices and the escalating cost of wheat, TIPS say the commodities market is a bubble about to burst. A commodity slump would worsen losses in the $500 billion TIPS market, where investors lost 2.35 percent in April, the most since December 2006.”

“There's a lot of people who just don't believe the economy's going to stay strong enough to keep prices of things where they are. Part of what's going on here is a lot of people view this price rise in oil, a lot of commodities, as being somewhat bubbleish and that they'll come off again very quickly.” -Chris McReynolds, who trades TIPS in New York at Barclays Plc, the largest dealer of the securities

From one bubble to the next… Long live cheap and easy money! Long live the age of Fiat Currency!

Related Topics:

A speech by Bernanke in May 31, 2003: Some Thought on Monetary Policy in Japan: “Rather, I think the BOJ should consider a policy of reflation before re-stabilizing at a low inflation rate primarily because of the economic benefits of such a policy. One benefit of reflation would be to ease some of the intense pressure on debtors and on the financial system more generally. Since the early 1990s, borrowers in Japan have repeatedly found themselves squeezed by disinflation or deflation, which has required them to pay their debts in yen of greater value than they had expected. Borrower distress has affected the functioning of the whole economy, for example by weakening the banking system and depressing investment spending. Of course, declining asset values and the structural problems of Japanese firms have contributed greatly to debtors' problems as well, but reflation would, nevertheless, provide some relief. A period of reflation would also likely provide a boost to profits and help to break the deflationary psychology among the public, which would be positive factors for asset prices as well. Reflation--that is, a period of inflation above the long-run preferred rate in order to restore the earlier price level--proved highly beneficial following the deflations of the 1930s in both Japan and the United States. Finance Minister Korekiyo Takahashi brilliantly rescued Japan from the Great Depression through reflationary policies in the early 1930s, while President Franklin D. Roosevelt's reflationary monetary and banking policies did the same for the United States in 1933 and subsequent years. In both cases, the turnaround was amazingly rapid. In the United States, for example, prices fell at a 10.3 percent rate in 1932 but rose 0.8 percent in 1933 and more briskly thereafter. Moreover, during the year that followed Roosevelt's inauguration in March 1933, the U.S. stock market rallied by 77 percent.”

Related Blog Posts:
Misconceptions About Gold
Why Does Fait Money Seemingly Work?

Related Posts:
Fannie Mae and UBS Miss, Bankruptcy Filings Up Big Time
Sarcastic Rant on Fannie and Freddie.
Fannie Mae, Freddie Mac: The Dumbest Idea Ever
Fannie Mae: Another Shoe Drops


James said...

Bernake makes it sound like this is a sunday walk in the park. We can just do this this and this and poof everything is fine! He is a complete moron.

I dont think he lives in the real world. Trying to pull this stuff off has very serious ramifications with results that are very unpredictable.

Unknown said...

I believe the credit crunch or credit bubble is far from over given those hidden needed write-downs not being written down and but if the Fed continues to offer loans in terms of treasury securities thru TAF or the discount windows 'indiscriminately'( Yes, it must be indiscriminately ), it could surely soothe the credit crunch if not solving it immediately. Besides, if Hank Paulson's proposal is approved by the Congress, the investment banks and brokerages would be under the supervision of the Fed just like all other commercial banks. Under such a circumstance, there is high chance the credit bubble would be resolved in the medium term except that it violates the duties of the Fed as the Central Bank and inflation is another worry.

Besides, there would be no more big M&A, Buyouts at least in the near future which may be good news or bad news for the market.