Today's Market Observation  01.19.2010  Mon  Tue  Wed  Thu  Fri  Fleckenstein Archive

In Banksters We Trust

by bill fleckenstein | january 19, 2010

Last night the People's Bank of China rattled cages once again as they allowed 1-year T-bill rates to rise 8 basis points for the second time in a couple weeks (that, in addition to announcing an increase in reserve requirements last week). So, at the margin, China's central bank is leaning into the speculative wind.

As for theirs and other equity markets, they were none too perturbed, and the early going here saw the indices higher by about 0.5% in the first 30 minutes. The market kept climbing and by midday the indices had gained better than 1%. From there the market ground sideways into the close.

Away from stocks, the dollar was quite a bit stronger and Treasurys heavier. Precious metals were higher overnight, as silver gained 2% to gold's 0.75 (with copper, platinum and palladium even stronger). The early going in New York saw those large gains evaporate before the metals rallied again with all but gold closing near their overnight highs. Today's stock and commodities markets seemed to break the silly linkage that suggested a strong dollar vs. the euro means stocks and commodities should decline.

It's worth noting, thanks to Jason Goepfert and his always-useful Web site, sentimentrader.com, that the position of large speculators in oil-futures contracts has never been bigger. Not that that means anything will happen from a timing standpoint, but it is a factoid that folks who have oil interests ought to keep in mind.

Now I'd like to touch on the subject of "banksters," a name coined by Dylan Rattigan for the employees in command of financial institutions who've marched off with massive bonuses. One aspect of this current controversy that no one has really discussed is the fact that these profits are a function of managements' judgment -- essentially the honor system (the very same honor system that led the banks to leverage themselves up 40 or 50:1 on worthless/illiquid assets and let them grade themselves on their Level II and III assets).

Now they would have us believe that all their assets are correctly and prudently marked; that their leverage also is not excessive; and that given their "rock-solid" balance sheets, they now intend to bonus out massive amounts of money that these organizations will not need for their businesses. Color me skeptical.

However, if these financial institutions had reduced their leverage to a saner manageable level (a number to be determined by future debates -- see below), and if they'd marked to market all of their assets (especially real-estate-related ones of all stripes) and associated securitized products that flowed from those asset classes, then perhaps we could say, well, you know, these institutions have healed themselves and they're not going to be a problem for us down the road, so they should feel free to distribute the profits as they see fit.

But as it is, we do know that these financial institutions are practicing forbearance (i.e., letting folks stay in their homes despite being unable to make payments); and that these financial institutions are loathe (in most cases) to make modifications or recognize losses in general.

Meanwhile, even more people will be walking away. That's the conclusion reached by Waterfall Asset Management's Tom Capasse, who (in a Wall Street Journal article headlined "Is Slashing Mortgage Principal the Answer?") said: "There used to be a scarlet D on your forehead if you defaulted... Now it's a badge of honor." And, that follows on a January 7 New York Times Magazine, "Will Walking Away from a Mortgage Go Mainstream?", in which Roger Lowenstein suggested that maybe skipping out on a negative-equity position is the right thing to do. Clearly, defaulting in the wake of the real estate bubble does not carry the stigma that it once might have.

Thus, we know that there are markdowns yet to come. And, depending on how many people decide to walk away from their negative-equity positions, there will likely be further pressure on loan valuations and the real-estate market prospectively. In other words, a whole new wave of write-downs may have its sights set on these financial institutions.

If these institutions were forced to aggressively mark their positions to where the real-estate market quite likely is (or may be) in the not-too-distant future, there'd probably be nowhere near the size of profits to disperse.

If the banks were forced to set aside capital to reduce their leverage and make their balance sheets more realistic, we could all then breathe a sigh of relief that down the road we wouldn't be going through some facet of the problems we've already had to deal with. More importantly, these so-called profits wouldn't be, in essence, a variation of fraudulent conveyance. But given how flexible the accounting is, and given the forbearance that's practiced, I for one do not believe that these huge profits pass the smell tests. All of which leaves me to believe that there are more problems yet to be faced in 2010.

Back to the issue of how levered banks should be, there's obviously no right number, i.e., whether that be 6:1, 8:1, or 12:1. But common sense suggests that the more leverage they're allowed to utilize, the more dangerous they are. That is something that needs to be discussed. Perhaps rather than mandate a number, a suggestion along the lines of last weekend's FT might be the right approach:

"For cases when regulators fear a bank may be too big to fail, the authorities should work out a model for ex ante insurance premiums payable to states. Such a structure, combined with extra-high capital requirements for these overgrown institutions, should create strong incentives for these companies to slim down. It should, in addition, make sure that they cannot profit from the public guarantees that their bloatedness brings them. States must not continue acting as omniline insurers, guaranteeing everything for free."

Which of course is the "system" that allowed the very same undisciplined gamblers who got us into this mess --  by nearly blowing up the financial system -- to walk away with massive bonuses in 2009. It's a variation of what transpired in 2007, when enormous sums were paid on what turned out to be illusory profits, based on what took place in 2008. Banksters of yore will one day gather 'round the fire in fond remembrance of 2007 and 2009, a time in which they made off with profits that didn't actually exist.

Bill Fleckenstein

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