Accountability to the shareholder - the failure of corporate governance

Wall Street 1987, Gordon Gekko Teldar Speech:

"The new law of evolution in corporate America seems to be survival of the unfittest. Well, in my book you either do it right or you get eliminated."
...
"America, America has become a second-rate power. Its trade deficit and its fiscal deficit are at nightmare proportions. Now, in the days of the free market when our country was a top industrial power, there was accountability to the stockholder. The Carnegies, the Mellons, the men that built this great industrial empire, made sure of it because it was their money at stake."

The former Chairman of the FSA made an interesting speech in 2003, in relation to Corporate Governance in Financial Intitutions. What is interesting is the content of his speech. I have pulled some extracts below. It is very interesting to look at the failure of corporate governance in the light of the recent financial crisis we have witnessed. Have we really learnt from it?

Corporate Governance in Financial Institutions:
Speech made by Howard Davies, former Chairman of the UK Financial Services Authority , 3rd of June 2003.

http://www.fsa.gov.uk/Pages/Library/Communication/Speeches/2003/sp132.shtml



"There is not as much systematic and useable analysis of the reasons for failure in financial institutions as one would like. But there are some helpful sources.

European banking supervisors studied a number of banking problems across the continent between 1988 and 1998. Their overall conclusion was that management and control weaknesses were underlying, fundamental and contributory in almost all of the cases they considered.

A very similar conclusion was reached by a group of European insurance supervisors who looked at 21 cases of failure or near failure in European insurance companies between 1996 and 2001. (One astonishing feature of the work was that there were, during that 5-year period, a total population of 270 cases to consider, from which that selection of 21 were made.)

That report shows that there were usually a number of contributory causes to the collapse of an insurer. Poor underwriting practice, or inadequate reserving, was often the proximate cause of failure. But in all the case studies underlying management or governance causes were identified, in many cases relating to significant systems and controls issues. The widespread underwriting or asset problems were able to arise because of these fundamental weaknesses, and the combination of poorly managed risks made firms particularly vulnerable to adverse external events.

•When the group compared problem cases with other firms who weathered similar circumstances better, a pattern emerged of the following four forms of management malfunction:
•Incompetence, with firms straying outside their field of expertise or uncritically following the herd instinct.
•Excessive risk appetite, or objectives that were at odds with the prudent management of the business;
•Lack of integrity, or
•Lack of autonomy and inappropriate pressure for short-term results from, perhaps, the parent company.

Following my distinction between management and governance problems, I see governance issues in at least 3 of these 4 cases. Certainly a Board should identify the risks involved in companies straying outside their field of expertise, should ensure that there are no incentive structures in place which promote excessive risk-taking, and should ensure that the business does not come under inappropriate pressure to maintain earnings or market share."

All the above points raised by Howard Davies seems to indicate what went wrong with regulators in trying to mitigate the risk appetites of some of the financial players they were supposed to regulate. The regulators failed.

Howard Davies also added the following:

"A third interesting source can be found in the New York Fed’s most recent economic policy review, published in April of this year. It was a special issue entitled "Corporate governance: what do we know and what is different about banks?"

The volume includes a series of interesting analytical pieces, by different hands. They all, from different perspectives, try to assess just how much relationship there is between good governance and corporate success. As that, after all, is what ought to interest shareholders, not elegant governance per se.

One of the papers concludes that Board composition does not seem to be a useful predictor of firm performance. That is an interesting conclusion given the focus on Board composition in some of the codes. On the other hand, they found that in the US, at least, Board size does have a negative relationship to performance. In other words, the bigger the Board, the poorer the results."

Howard Davies goes on:

"Some of the bankers among you might welcome this conclusion. But I ought to add that one of the pieces in the Fed’s report argues that "a clear case can be made for bank directors being held to a broader, if not higher standard of care than other directors". Essentially, their point is that there are important stakeholders in banks other than shareholders – including major creditors and other institutions, given the safety net. The same authors go on to argue that, as a result, they support "a hybrid approach to corporate governance in which most firms are governed according to the US model, while banks are governed according to a variant of the Franco-German paradigm"."

Howard Davies also make an interesting point in his speech:

"Our experience shows, for example, that a dominant chief executive, or indeed business head, who is not effectively challenged by the Board or his colleagues, is a danger sign. Similarly, a Board lacking in relevant experience is unlikely to act effectively as a constraint on excessive risk taking."

His final conclusions in his speech made in 2003, indicates how corporate governance failed in financial institutions. Most of Howard Davies recommendations were not followed.

The failure of appropriate corporate governance is leading to a sigificant welcomed shareholder activism:

http://www.investmentweek.co.uk/investment-week/news/1360340/f-c-highlights-corporate-governance-failures

From this article:
Karina Litvack, head of governance and sustainable investment at F&C, says: "We believe that a failure in governance lies at the heart of the banking crisis. The events of the last few months have confirmed that the soaring pay packages for top bank executives were driven by extraordinary risk-taking rather than real, sustainable profits. Investors can be part of the solution, by spotting red flags and using their influence as shareholders to press for better governance practices."

Corporate Governance failed mostly because regulators failed to do what they are paid for: regulate. In May 2009, Stephen Friedman resigned as Chairman of the New York Fed’s Board of Directors.
The reason of his resignation was the following:

http://inthesenewtimes.com/2009/05/04/new-york-fed-chairmans-ties-to-goldman-raise-questions/


"The Federal Reserve Bank of New York shaped Washington’s response to the financial crisis late last year, which buoyed Goldman Sachs Group Inc. and other Wall Street firms. Goldman received speedy approval to become a bank holding company in September and a $10 billion capital injection soon after.

During that time, the New York Fed’s chairman, Stephen Friedman, sat on Goldman’s board and had a large holding in Goldman stock, which because of Goldman’s new status as a bank holding company was a violation of Federal Reserve policy.

The New York Fed asked for a waiver, which, after about 2½ months, the Fed granted. While it was weighing the request, Mr. Friedman bought 37,300 more Goldman shares in December. They’ve since risen $1.7 million in value."

If the regulators cannot even regulate themselves and avoid conflict of interests, how are they supposed to do their job properly?

http://mostlyeconomics.wordpress.com/2009/05/08/new-york-fed-corporate-governance-failure/


The author of this blog raise an important point? How can an entity like the New-York Fed can properly regulate financial institutions when 6 of the members supposed to represent the public representatives are from the very same financial institutions?

In addition to corporate governance, disclosure of information, adds transparency and would alleviate concerns and restore trust in the system.
There is an ongoing legal battle of great interest currently happening in the US relating to the access of the financial institutions to the Fed Discount Window during the Financial crisis:

http://noir.bloomberg.com/apps/news?pid=newsarchive&sid=aUQp2owUUueA


"The Federal Reserve won’t join a group of the largest commercial banks in asking the U.S. Supreme Court to let the government withhold details of emergency loans made to financial firms in 2008."
...

"The bank group is appealing a federal judge’s August 2009 ruling requiring the Fed to disclose records of its emergency lending. Bloomberg LP, the parent company of Bloomberg News, sued for the release of the documents under the Freedom of Information Act.

The central bank has never disclosed the identities of borrowers since the creation in 1914 of its Discount Window lending program, which provides short-term funding to financial institutions, the Clearing House said in its petition."

Would transparency do more harm than good? This is what the bank group thinks according to this Bloomberg article.

“Greater transparency results in more accountability, and the banks’ resistance continues to engender suspicion among taxpayers about the bailouts,” said Matthew Winkler, Bloomberg News editor-in-chief.

It is very important to track the results of this appeal. If it leads to full disclosure, it will give a great insight into the difficulties faced by many insititutions during the crisis.

It is indeed a very sensitive issue.

The Great Pretender - the Bluff Call of 1971 - the Nixon shock.

In 1971, one of the greatest poker game ever played came to halt. It marked the end of the Gold Standard and the convertibility of the US dollar in Gold.

In this post I will revisit this great moment and highlight some of the contributions of one of the great adversary of Keynes to this moment, Jacques Rueff.

The context of the Nixon Shock of 1971:

http://en.wikipedia.org/wiki/Nixon_shock

"By the early 1970s, as the costs of the Vietnam War and increased domestic spending accelerated inflation, the U.S. was running a balance of payments deficit and a trade deficit, the first in the 20th century. The year 1970 was the crucial turning point, which, because of foreign arbitrage of the U.S. dollar, caused governmental gold coverage of the paper dollar to decline from 55% to 22%. That, in the view of Neoclassical Economists and the Austrian School, represented the point where holders of the U.S. dollar lost faith in the U.S. government’s ability to cut its budget and trade deficits.

In 1971, the U.S. government again printed more dollars (a 10% increase) and then sent them overseas, to pay for the nation's military spending and private investments. In the first six months of 1971, $22 billion dollars in assets left the U.S.[citation needed] In May 1971, inflation-wary West Germany was the first member country to leave the Bretton Woods system — unwilling to deflate the Deutsche Mark to prop up the dollar. In order to prevent the dumping of the Deutsche Mark on the open market, West Germany did not consult with the international monetary community before making the change. In the next three months, West Germany’s move strengthened their economy; simultaneously, the dollar dropped 7.5% against the Deutsche Mark.

Because of the excess printed dollars, and the negative U.S. trade balance, other nations began demanding fulfillment of America’s “promise to pay” - that is, the redemption of their dollars for gold. Switzerland redeemed $50 million of paper for gold in July. France, in particular, repeatedly made aggressive demands, and acquired $191 million in gold, further depleting the gold reserves of the U.S. On 5 August 1971, Congress released a report recommending devaluation of the dollar, in an effort to protect the dollar against foreign price-gougers. Still, on 9 August 1971, as the dollar dropped in value against European currencies, Switzerland withdrew the Swiss franc from the Bretton Woods system."

The great imbalances we have witnessed in the last couple of decades come from this defining moment of the summer of 1971, when the great poker game played by the US came to halt as more and more countries called their bluff, worried by the US deficits. The agressive demands coming from France had been initiated by the advisor of General de Gaulle, Jacques Rueff, Keynes greatest opponent.

"The conditions which formerly were able to give rise to the ‘gold exchange standard’ have changed. The currencies of the Western European States are restored, to the extent that gold reserves of the Six today equal those of the Americans … This means that the custom of ascribing a superior value to the dollar as an international currency no longer rests on its initial foundation – I mean America’s possession of the largest share of the world's gold. This unilateral facility which is granted to America is serving to cloud the idea that the dollar is an impartial and international medium of exchange, when it is a means of credit belonging to one State … Gold has real value."

- Charles de Gaulle, February 4, 1965.

With great power comes great responsibility.
Stan Lee - Spiderman

The abuses of Bretton Woods.

The US have behaved irresponsibly for too long, putting us all at risk.

The privileged status of the US which was granted under the Bretton Woods arrangements, made it possible for the US to run a deficit that would never disappear while the dollar standard prevailed. Jacques Rueff concluded that this privileged status would inevitably lead(dollar standard and associated deficits) to a global economic crisis that would end in tears, an event akin with the Great depression. This is the situation we are currently going through.

Jacques Rueff has proven to be right and the Keynesians dangerously wrong.

A recently published biography on Jacques Rueff by Christopher Chivvis, The Monetary Conservative, is reviewed using the below link. It gives you a brief insight on Rueff's belief and contributions to economic policies:

http://www.realclearmarkets.com/articles/2010/09/14/book_review_the_monetary_conservative_by_christopher_s_chivvis_98667.html
http://74.217.243.103/publications/pubID.2261/pub_detail.asp

The clear abuse from the Dollar domination was very clear with the 1985 Plaza Accord of the 22nd of September 1985. I went through the consequences for Japan in a recent post relating to the bogus currency wars and the attitude of the USA towards China. Japan's never fully recovered from the economic suicide they committed by allowing the Yen to rise very fast again the US dollar.

The US survived the Saving and Loans Crisis by pushing Japan to the floor, and ruining in the process their largest creditor at the time. The US are attempting the same game with China today, this time around let's all hope they will fail. China is trying to curb hot money pouring in as well as taming inflation. They recently raised one year lending rate to 2.5%. It is becoming extremely difficult for China to slow hot money flows. Some countries have already implemented capital controls.

For Jacques Rueff, the only solution to remove the great current imbalances, would have been to reform the system and avoid a currency like the US Dollar to play the role of the world's leading currency or any other currency. Would a return to a Gold Standard work? Or a Bancor currency as advocated by Keynes? Bancor was indeed proposed before Bretton Woods led to the US Dollar assuming the role of the World's currency. Both Rueff and Keynes did not want the US Dollar to be the prevailing currency. They both understood the risks.

Tim Geithner's latest proposal targeting trade deficits and surpluses is basically an attempt to go back to Keynes Bancor proposal.

Felix Salmon recently wrote a post on Geithner's proposal in Seeking Alpha:

http://seekingalpha.com/article/231671-tim-geithner-s-poor-imitation-of-john-maynard-keynes

"Tim Geithner has proposed to his fellow G-20 finance ministers that trade surpluses and deficits be capped at 4% of GDP. The idea is already running into criticism from countries that run big trade surpluses."

QE2 is the nuclear option the US are currently playing with. They are willing to export inflation to the emerging markets to force their hands.

Ambrose Evans Pritchard in an article published in the Telegraph on the 10th of October discuss what is currently happening, paving a road to a potential new Bretton Woods, and the removal of the US Dollar as world reserve currency.

http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/8054066/Currency-wars-are-necessary-if-all-else-fails.html

"The atomic bomb, of course, is quantitative easing by the Federal Reserve. America has in effect issued an ultimatum to China and G20: either you stop this predatory behaviour and agree to some formula for global rebalancing, or we will deploy QE2 `a l’outrance’ to flood your economies with excess liquidity. We will cause you to overheat and drive up your wage costs. We will impose a de facto currency revaluation by more brutal and disruptive means, and there is little you can do to stop it. Pick your poison."

The US are playing the Great Pretender game.

The United States has had the luxury of being in a position to avoid economic adjustment in spite of its deficits for too long. It is time to adjust to the reality and stop pretending.

The Great Pretender
The Platters/Freddie Mercury:

Oh yes I'm the great pretender (ooh ooh)
Pretending I'm doing well (ooh ooh)
My need is such I pretend too much
I'm lonely but no one can tell

Oh yes I'm the great pretender (ooh ooh)
Adrift in a world of my own (ooh ooh)
I play the game but to my real shame
You've left me to dream all alone
...

Another farewell to a great mind - Benoit Mandelbrot

Benoit Mandelbrot: 24th November 1924 - 14th of October 2010.


One week on and another loss of one of the greatest minds. It is a very sad October.

He was the inventor of Fractal Geometry.

Mandelbrot was Nassim Taleb's mentor.

http://www.youtube.com/watch?v=DLFkQdiXPbo

http://www.fooledbyrandomness.com/

"A Greek among Romans".

One of the greatest book written about Markets is the below:

The (Mis)Behavior of Markets: A Fractal View of Risk, Ruin, and Reward, by Benoît Mandelbrot and Richard L. Hudson; Basic Books, 2004; ISBN 0-465-04355-0

It was published before the Black Swan and Fooled by Randomness.

Benoit Mandelbrot was one the greatest.

Thank you for opening up my mind to the perception of risk.

The Empire strikes back - Currency Wars

This in an update in relation to the previous post relating to the current debasing game played by the US.

It is turning more and more nasty by the day, the beggar-thy-neighbor policy induced by the US is raging havoc around the world. It is savaging exports for Japan and exporting inflation to the Brics which force them to raise interest rates to slow hot money pouring in, as well as introducing capital control measures.

And yes, the game being played by the US is to put the blame on China and its yuan policy. The Chinese have learned from the Plaza Athena agreement of 1985 which sealed the fate of the Japanese economy 5 years later, as the Nikkei crumbled down to earth with its real estate market at the same time. The Nikkei stock index hit its all-time high on December 29, 1989 when it reached an intra-day high of 38,957.44 before closing at 38,915.87. On March 10, 2009 the Nikkei 225 stock index reached a 27-year low of 7054.98.

http://www.telegraph.co.uk/finance/currency/8065529/China-warns-US-against-making-yuan-dispute-a-scapegoat-for-a-flagging-economy.html

However Yao Jian, a Chinese Ministry of Commerce spokesman, rejected US complaints as unfair. “It's totally wrong to blame the yuan for the Sino-U.S. trade imbalance,” he said, “The Chinese yuan shouldn't be a scapegoat for the U.S.' domestic economic problems.”

I could not agree more with Chinese Ministry of Commerce. As I stated before, should all the countries with big trade balances surplus be targeted eve more by the US? Germany? Japan? Etc.

Where are we in this deflation crisis?



Staring at the Abyss:
We are at the stage of Competitive Devaluation. These currency wars are taking us closer to protectionism and tariffs. Given we have a major US election coming, the protectionism risk is alive and real. This what moved us in the 30s to the Great Depression. Have the lessons of history been learnt by our politicians? Let's all hope so.

In the same article from the Telegraph, Mr Yao has clearly learned from the Japan collapse following the Plaza Accord of 1985:

“Job losses would hurt the Chinese economy and domestic consumption. A relatively large yuan appreciation would definitely hurt Chinese exports, so a stable yuan exchange rate is needed for domestic consumption and the stability of the world economy," Mr Yao added.

"China has also said that legislation currently being formulated in the US to impose trade tariffs as a result of the yuan’s under-valuation would be in breach of World Trade Organisation regulations."

It could get very ugly and we need to watch very closely what can happen in term of trade tariffs. Last month the House of Representatives passed a law allowing firms to seek tariff protection against countries with undervalued currencies, with a huge bipartisan majority. The US fired the warning shots first. This could have unintended consequences should politicians decide to escalate with China into a full blown trade war.

South Korea is hosting the G20 summit next month:



For the US and Europe, it is clearly looking like the above cartoon. We don't need another 1985 Plaza Accord. The truth is, given the G7 is now wider to G20, it will be more difficult for some countries, like the US, to impose (bully?) their views on the rest of the world. Quantitative Easing 2 is the issue. You cannot ask China to increase more its currency while at the same time you are willing to debase the USD even more. A compromise has to be find for the sake of the world economy. Given the fragility of the current recovery, there is this time around too much at stake.



For those who would like to extend on a possible risk, I recommend reading this report from the IMF research website from Laurence J. Kotlikoff, Professor of Economics at Boston University.


http://www.imf.org/external/pubs/ft/fandd/2010/09/kotlikoff.htm

"A minor trade dispute between the United States and China could make some people think that other people are going to sell U.S. treasury bonds. That belief, coupled with major concern about inflation, could lead to a sell-off of government bonds that causes the public to withdraw their bank deposits and buy durable goods (which will retain their value). The run on the banks could trigger a run on money market funds and insurance company reserves (as policy holders cash in the surrender value of their policies). In a short period of time, the Federal Reserve would have to print trillions of dollars to cover its explicit and implicit guarantees. All that new money could produce strong inflation, perhaps hyperinflation. Even though at the outset there might have been no serious inflation problem, the self-fulfilling aspects of multiple equilibria can take over and cause this outcome. Deposit insurance would be little help in preventing bank runs because it covers the nominal value of deposits and does not guarantee the purchasing power of those funds—which would be sharply eroded by heavy inflation.

There are other less apocalyptic, perhaps more plausible, but still quite unpleasant, scenarios that could result from multiple equilibria."

Avoiding protectionism:

http://www.imf.org/external/pubs/ft/fandd/2010/03/henn.htm#author

Christian Henn, Economist and Brad McDonald, Deputy Division Chief in the IMF’s Strategy, Policy, and Review Department wrote a long article on the subject in March this year warning of the risk posed by protectionism.

The folly of protectionism

"Further restricting trade would be a poor policy response to the situation the world faces. Moreover, the difficulty in removing measures once they are imposed means protectionist actions taken now could retard economic growth for years. Fortunately, policymakers have recognized the potential for trade measures to interfere with the economic recovery. Too many restrictions may have been imposed, but their application has been relatively narrow. Still, protectionist pressures may intensify in 2010 because unemployment is likely to remain high and imports will bounce back."

A stark reminder of the Great Depression:

Experience of the 1930s

"Policymakers have done well to recall the experience of the Great Depression. In 1929, the U.S. Congress had begun work on a substantial tariff increase even before the stock market crash. The enactment of the Smoot-Hawley Tariff Act in June 1930—despite strong objections from many economists—provoked deep resentment and some retaliation globally. A League of Nations conference convened in 1930 to avert a cycle of protectionism broke down. In 1931 there was an accelerated deterioration in global trade and a “chaotic scramble to protect domestic markets and safeguard the balance of payments” (Eichengreen and Irwin, 2009). Major countries undertook substantial currency devaluations, imposed exchange restrictions, or sharply tightened import tariffs and introduced import quotas. Lacking an independent monetary policy, countries that kept their currencies fixed against gold were more likely to restrict trade, particularly once partner countries devalued their own currencies."

China and other members of the G20 understand what the US game being played is: by reducing the value of the Dollar, the US is trying to reduce the value of US debt owned by other countries. The big mistake the US is making is that the US is a net importer of oil, and depends highly on foreigners purchasing US Treasuries.

Farewell Monsieur Allais

"In essence, the present creation of money, out of nothing by the banking system, is similar - I do not hesitate to say it in order to make people clearly realize what is at stake here - to the creation of money by counterfeiters, so rightly condemned by law." Maurice Allais - Nobel Prize in Economics - 1911-2010.

"In fact, without any exaggeration, the current mechanism of money creation through credit is certainly the "cancer" that's irretrievably eroding market economies of private property."

"La Crise mondiale aujourd'hui" (Éd. Clément Juglar, 1999).

also author of the "Allais paradox".

A great loss for France. A great economist and a great mind.

Resolution Trust Corporation II - the unavoidable Sequel

How to fix the US Commercial Real Estate Mess:

The US need a Resolution Trust Corporation similar to the one put in place during the Saving and Loans Crisis. The RTC was established in 1989 until mid 1995 and closed or otherwise resolved 747 thrifts with total assets of 394 billion USD.

http://en.wikipedia.org/wiki/Resolution_Trust_Corporation

"The Resolution Trust Corporation pioneered the use of so-called “equity partnerships” to help liquidate real estate and financial assets which it inherited from insolvent thrift institutions. While a number of different structures were used, all of the equity partnerships involved a private sector partner acquiring a partial interest in a pool of assets, controlling the management and sale of the assets in the pool, and making distributions to the RTC reflective of the RTC’s retained interest."

Between 1986 and 1991, the number of new homes constructed per year dropped from 1.8 million to 1 million, which was at the time the lowest rate since World War II.

Where are we now? In a worse situation than anytime between 1986 and 1991.



The hole is much deeper. We have beaten the record since the Saving and Loans crisis. Desperate times need decisive action and setting up a new RTC would definitely be the right move in the right direction.

We have a lot to learn from the Saving and Loans crisis:

http://en.wikipedia.org/wiki/Savings_and_Loan_Crisis#Imprudent_real_estate_lending

"Between 1980 and 1994 more than 1,600 banks insured by the Federal Deposit Insurance Corporation (FDIC) were closed or received FDIC financial assistance."

How many banks failure have we had so far this year? 129 banks went under and the year is not over yet.

In 2009, 140 banks failed.

Because the situation is worse than during the Savings and Loan Crisis, where 1600 closed down or received help, you can expect more bank failures in this ongoing crisis.

http://bankpred.blogspot.com/

"If you look at the most recent FDIC statistics on problem banks, you would see that there were 829 problem banks at the end of the last quarter."



Don't believe the situation is improving in the CMBS space:



This is what the banks are in fact doing with their damaged Commercial Real Estate Exposure:



B notes are comparable to Sub debt where the coupon payment is deferred (similar to Upper Tier 2 financial paper).

But it isn't only happening in the Commercial Real Estate space. Many large banks have recently suspended foreclosures, kicking the can down the road:

http://online.wsj.com/article/SB10001424052748704657304575539963605720860.html

"As of August, there were more than 4.4 million home loans that were either in the foreclosure process or 90 days past due, according to mortgage research firm LPS Analytics. Since 2006, about 6.4 million homes have been lost through the foreclosure process."

According to the article, it is due to documentation issues...I don't believe it is the real reason.

"Bank of America services 14 million mortgages, or one out of every five in the U.S., and its loan-servicing portfolio exceeds $2.1 trillion in size. Of its mortgages, 10 million came from its 2008 acquisition of troubled California lender Countrywide Financial Corp. More than 80% of its delinquent loans were acquired through Countrywide."

Given that 1 out of 4 US Household is already in negative equity, you can do the math.

The Mortgage mess:



In addition to the rising delinquencies in Mortgages, the Unsecured Home Equity Loans exposures of large US banks have not been resolved (the HELOC time bomb).



http://www.housingwatch.com/2010/04/13/the-heloc-bust-next-problem-for-big-banks/

"In an interview with Bloomberg, CreditSights' senior bank analyst Baylor Lancaster said: "While a lot of people are looking for dramatic improvement in the short term, one area that still has to be worked through in a material way is home equity." The writedowns from HELOCs are not likely to show up in earnings reports until later this year, Lancaster said."

"Together with Citigroup the banks hold about 42 percent of the $1.1 trillion in second-home liens. Unlike first mortgages, they are typically not bundled and sold off to investors but kept on the banks' books. The biggest home-equity lender in the U.S. is Bank of America, holding some $138 billion in such loans. Wells Fargo has about $123.8 billion of home-equity loans."

In addition to these unresolved issues:

"Fannie and Freddie are "actively exercising their right to put back to the original lenders a considerable amount of the troubled mortgages in their portfolios," write analysts Tom Abruzzo and Christopher Wolfe. The agencies have a right to require lenders to buyback delinquent mortgages, if it is determined the mortgage loan did not meet GSE investor underwriting or eligibility standards."

http://www.housingwire.com/2010/08/19/fitch-big-four-banks-face-180bn-in-buybacks-from-fannie-and-freddie?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed:+housingwire/uOVI+(HousingWire)

"Under a moderate loss scenario, in which the banks buyback 35% of delinquent loans and recover 55% of the money, Fitch expects losses around $27bn."

http://www.benzinga.com/10/09/485561/%E2%80%9Cthe-giant-elephant-in-the-room%E2%80%9D

"“Home equity is the giant elephant in the room and everybody knows it,” said Anthony Sanders, a finance professor and director of the Center for Real Estate Entrepreneurship at George Mason University."

"“If 25% of mortgages are underwater, [the second liens on those homes] should be classified as nonperforming loans, which would require a 50% reserve,” said Rebel Cole, a finance and real estate professor at DePaul University in Chicago and a former Federal Reserve Board economist."

"The four institutions now hold at least $423 billion of home equity loans, including $151 billion of loans to borrowers who are either underwater or close to it, according to data provided to the House Financial Services Committee in April."

You need to watch very closely the delinquency rate for second liens loans.

"Banks are required by regulators to charge off loans after 180 days of nonperformance, according to the Fed and the Office of the Comptroller of the Currency, which supervises large banks that service 65% of all mortgages.

A bank does not have to classify a home equity loan if the value of the property has dropped, said Bryan Hubbard, an OCC spokesman.

But Cole and others argue that banks ought to reassess the underlying credit quality of loans and account for problem credits if the collateral has changed. “Regulators have the power to force the banks to reserve against these loans, but choose not to do so,” he said."

"Gerald Hanweck Sr., a finance professor at George Mason and a former visiting scholar at the Federal Deposit Insurance Corp., agreed that banks are loath to take losses on performing loans even if the value of the home has dropped 30% or more and a default is likely."

"“The banks have been accounting for [home equity loans] at par and the reason is that supervisors won't force the writedowns,” Hanweck said. “If the loan is performing, that's their fallback, but the underlying value of the property is still less and is insufficient to support the valuation.”

But forcing writedowns would have negative consequences for capital positions, which banks have spent the last few years rebuilding and will have to further buttress in coming years under the new Basel III standards."

Allowing banks to repay TARP money early was not a smart move:

"Lenders Balk at Buying Back $11 Billion in Bad Loans from Fannie Mae and Freddie Mac"

http://www.realestatechannel.com/us-markets/residential-real-estate-1/real-estate-news-fannie-mae-freddie-mac-edward-j-demarco-federal-housing-finance-agency-bad-home-loans-loan-default-rates-home-foreclosures-fhfa-3266.php

"Banks that sold bad mortgages to Fannie Mae and Freddie Mac promised to buy the loans back, according to their regulator. But many of the nation's largest institutions aren't living up to their end of that commitment, reports DSNews.com."

http://www.thestreet.com/story/10865656/1/mortgage-buybacks-hit-profit-not-capital.html

"Miller's assumptions for a "base case" scenario show that Bank of America stands to lose $9.1 billion, or 34 cents per share, on both Fannie-Freddie and private-label buyback demands. JPMorgan Chase stands to lose $8.7 billion, or 27 cents per share; Citigroup stands to lose $3 billion, or 5 cents per share; Wells Fargo $2 billion, with no per-share loss estimate provided; SunTrust $1.05 billion, or 31 cents per share; Morgan Stanley $948 million, or 44 cents per share; and other lenders less than $500 million."

Setting up a new RTC would alleviate the burden face by banks. Until all the toxic assests have been dealt with, the crippled financial sector will not function properly. The banks are hoarding cash due to these issues and cannot participate in a sustained recovery through lending and enabling investment. It will take a very long time to clean up all the mess. By not appropriately dealing with these toxic assets issues today via a new RTC means it will take a much longer period for the economy to heal. We will see more bank failures in the process.

Hemingway: Kicking a can down the road illustrated...

Analyze this

Allied Irish CDS Sub, you know the score from the previous post (Source CMA DataVision):



Anglo Irish CDS Sub on the 6th of October, can you spell default? (Source CMA DataVision):



and on the 7th of October, this is how it looks like for Anglo Irish Sub...2743.85 bps on the 5 year CDS...300 bps wider!



Debase this! Check out the evolution of the USD since 1971 against:

Japanese Yen:



Have a look at 1985 on the Graph and the huge rise in the Japanese yen following the 1985 Plaza Agreements which spelt economic disaster for Japan and the crash of the Japanese economy and the Nikkei index at the same time. 1985 to 1990, 240 to 120, bring it!

At around 82 JPY per USD I don't expect the BOJ to stay idle...

Swiss Franc:



and the evolution of the US dollar versus the Euro since 1999:



An interesting view of the evolution of Fed Funds Rate since 1950:



And the evolution of Oil prices since 1940:



Gold is continuing its steady rise:



At the same time we have Secretary of Treasury Timothy F. Geithner still gesticulating around China and the ongoing Debasing game taking place. Pathetic...

http://www.treasury.gov/press/releases/tg894.htm

"The Framework, called the "Framework for Strong, Sustainable and Balanced Growth," was designed to create stronger incentives for rebalancing growth, as the world recovered from the crisis, with higher savings in countries like the United States, complemented by reforms to strengthen domestic demand in surplus countries like China, other emerging economies, Germany, and Japan.

Alongside this "Framework" we agreed to give emerging economies a greater stake in the most important institutions for economic and financial cooperation, to increase the resources available to the international financial institutions, and to make the G-20 the centerpiece of cooperation, replacing the role traditionally played by the G-7."

Dear Tim, I don't think you have a choice in relation "to give emerging economies a greater stake in the most important institutions for economic and financial cooperation." Guess it is a done deal with China, India and Brasil...

"We have moved aggressively to do our part to help bring the world out of crisis. We are working very hard to repair our financial system, to fix what was broken, and to reduce the future risk of financial crises here at home. We have seen a very significant increase in private savings by households. Our external deficit has fallen sharply, and we are financing at home a much larger share of the fiscal deficits we inherited."

Wow!
Who in the first place put us ALL in this mess? Was letting Lehman Brothers going down a wise decision? I don't think so. In relation to reducing the future risk of financial crisis, I disagree, banks are still too big to fail. Fannie Mae and Freddie Mac are a joke and should be gradually winded down. The commercial real estate disaster is still an ongoing concern: 129 banks down this year so far and counting.

Hey Tim, where were you working before taking up the role of Secretary of the Treasury? Weren't you president of the New-York Fed from 2003? Were you not in charge of supervising and regulating financial institutions? Great work!
In May 2007, did you not work on reducing the capital needed to run a bank? Great timing! Was the "excellent" Lawrence Summers your mentor previously? It would explain a lot...

Nice one Tim, just like you tried to talk to the Chinese about how safe it was to invest in the US...
"On June 1, 2009, during a question-and-answer session following a speech at Peking University, Geithner was asked by a student whether Chinese investments in U.S. Treasury debt were safe. His reply that they were "very safe" drew laughter from the audience."



Tim, you can always send your CV to your buddy Hank Paulson, I am sure he can help you land a good job at Goldman Sachs...

Tim also added in the same speech:
"That brings me to the second policy challenge: we believe it is very important to see more progress by the major emerging economies to more flexible, more market-oriented exchange rate systems. This is particularly important for those countries whose currencies are significantly undervalued.

This is a problem because when large economies with undervalued exchange rates act to keep the currency from appreciating, that encourages other countries to do the same.

This sets off a damaging dynamic, described first by my former colleague Ted Truman, as "competitive non appreciation." Over time, more and more countries face stronger pressure to lean against the market forces pushing up the value of their currencies. The collective impact of this behavior risks either causing inflation and asset bubbles in emerging economies, or else depressing consumption growth and intensifying short-term distortions in favor of exports.

This is a multilateral problem. It is unfair to countries that were already running more flexible regimes and let their currencies appreciate. And it requires a cooperative approach to solve, because emerging economies individually will be less likely to move, unless they are confident other countries would move with them.

This problem exposes once again the need for an effective multilateral mechanism to encourage economies running current account surpluses to abandon export-oriented policies, let their currencies appreciate, and strengthen domestic demand."

The message is that the US is concerned that everyone is devaluating at the same time and they would like to be the only one playing this game to restore competitiveness. Tim would also love China to explode like Japan did after the 1985 Plaza Agreement. Unfortunately, dear Tim, Chinese are not stupid and are well aware of the risks. If the US hadn't based 70% of its GDP on Consumption and was actually producing more and exporting more, they would not be in such a difficult situation.