"Why It’s Not Different This Time" by Bill Powers. FSO Editorial 02/03/2010

FSO Editorials

Why It’s Not Different This Time
by Bill Powers
Editor, Powers Energy Investor
February 3, 2010

One of the most difficult things to do in both investing and in life is to determine how much history can tell us about the situation in front of us. While there can be all sorts of rationalizations as to why “this time is different” (probably the four most expensive words in the world of finance), an in-depth look at history tells us that human nature does not change and our future is rarely materially different from our past.

The recently published book by Carmen Reinhart and Kenneth Rogoff titled, “This Time is Different: Eight Centuries of Financial Folly,” dispels many of the financial myths that are taken as dogma by our policy makers and the financial press. One myth that is skewered by the authors is the popular opinion that a government must have debt nearing 100% of GDP to cause a currency crisis or default. The authors detail how a number of countries have defaulted with debt less than 50% of GDP. The authors also discuss the importance of confidence in the occurrence and timing of both bank and government crises. The authors had the following to say about confidence:

“Economists do not have a terribly good idea of what kind of events shift confidence and of how to assess confidence vulnerability. What one does see, again and again, in the history of financial crises is that when an accident is waiting to happen, it eventually does. When countries become too deeply indebted, they are headed for trouble. When debt-fueled asset price explosions seem too good to be true, they probably are. But the exact timing can be very difficult to guess, and a crisis that seems imminent can sometimes take years to ignite. Such was certainly the case of the United States in the late 2000s. …all the red lights were blinking in the run-up to the crisis. But until the ‘accident’, many financial leaders in the United States – and indeed many academics – were still arguing that ‘this time is different’.”

“This Time is Different: Eight Centuries of Financial Folly”
By: Reinhart and Rogoff

Another great source of the insight into today’s financial difficulties was a documentary I recently watched on PBS created by Niall Ferguson titled “The Ascent of Money: A Financial History of the World”. (The four part series can be found at http://www.pbs.org/wnet/ascentofmoney/) The dashing Mr. Ferguson also wrote a book of the same title. I found the documentary exceptionally helpful in putting today’s real estate troubles and currency debasement into perspective. Mr. Ferguson clearly details how the US real estate market went “stark raving mad” during the bubble that led to the savings and loan crisis in the 1980’s and the recent run-up in real estate prices during the first decade of this century. Mr. Ferguson’s documentary also lays bare how poor financial policy and excessive indebtedness can disable even once rich countries. The Ascent of Money provides Argentina as a case in point of a country that has tremendous resources but has economically underachieved over the past century for exactly such reasons.

Why is our near term financial future not likely to be dramatically different from our recent past? I am strongly of the opinion that we are likely to repeat the financial crisis of the 2008/2009 period in the near future, since nearly all of the problems that were the root cause of the recent financial crisis are still in place and many have gotten worse. For example, real estate foreclosures set a record last year and are set to hit a new record this year. Already in 2010, we have witnessed the largest commercial real estate default in history with Tischman/Speyer’s default of Stuyvesant Town/Peter Cooper Village in New York which the firm bought for $5.4 billion in 2006. According to a January 25, 2010 article in the Huffington Post, Fitch Ratings now values the property at $1.8 billion. With commercial real estate values down already by 40% and falling, there are many more defaults coming. Residential real estate, which has been propped up in recent months by massive mortgage backed securities buying by the US Federal Reserve and other unsustainable gimmicks, such as the first time home buyer credit, is headed for more carnage in 2010. With millions of adjustable rate mortgages resetting over the next two years, nationwide apartment vacancies now at over 8% on average nationally and the employment picture remaining bleak, housing prices are set for another major drop.

The biggest reason I am sure we headed for another economic dizzy spell is that the US banking sector is now even more dysfunctional than it was prior to the bank crisis of 2008/2009. For example, several large and poorly managed institutions, CitiBank and Bank of America (BofA) being the poster children, have now become even more unruly.

To make matters worse, several large and poorly managed US banks are completely focused on repaying TARP (so management teams can generously bonus themselves) and crowing about 2009 “earnings” while continuing to mark large amounts of toxic assets to fantasy valuations. I am in agreement with Bill Fleckenstein, author of the Daily Rap, who views 2009’s big bank earnings as somewhat of a chimera. Mr. Fleckenstein has likened 2009 bank earnings to the record phony bank profits of 2007. These profits were also created by the marking of many illiquid and increasingly toxic assets to internal models rather than to a price that remotely resembled reality.

If anyone thinks that bankers have reformed themselves after many public apologies and semi-admissions of poor judgment, one should look at what management teams at banks are doing, rather than what they are saying. Think banks have de-leveraged their balance sheets and reduced their incredibly profitable over-the-counter (OTC) derivatives business? Think again. To see for myself whether banks have finally taken a more conservative approach to the derivatives business, I went to the website of the Office of the Comptroller of the Currency (OCC), a division of the US Treasury, to review Q3 2009 derivatives data.

What I found was truly appalling. The below data was taken from Table 12 of the OCC’s presentation detailing the derivatives business of five of the nation’s largest FDIC-insured banks [Note: You can find a listing a every OCC quarterly derivatives report since 1995 at the following website: http://www.occ.treas.gov/deriv/deriv.htm ]:

Q3 2009 Derivative Holdings of Banks (All Figures $ Billions)

Bank	Total Assets	Total Credit Derivatives	Total of all Derivatives
JP Morgan	1,699	6,380	72,591
Goldman Sachs	114	938	41,033
BofA	1,460	2,011	38,089
Citibank	1,186	2,507	29,465
Wells Fargo	1,066	282	4,192

(Source: OCC)

Compare the above bank holdings of mostly over-the–counter derivatives with those held a year ago by JP Morgan, BofA, Citibank, Wells Fargo and Wachovia which was bought by Wells Fargo. Goldman Sachs is excluded in the below table since the company had yet to become a bank holding company:

Q3 2008 Derivative Holdings of Banks (All Figures $ Billions)

Bank	Total Assets	Total Credit Derivatives	Total of all Derivatives
JP Morgan	1,768	9,177	78,510
BofA	1,359	2,480	36,193
Citibank	1,207	2,939	32,705
Wells	574	1	1,427
Wachovia	664	321	3,900

(Source: OCC)

Examining the OCC data for each of the companies in the above tables provides significant insight into how each firm manages its business and its attitude toward risk and leverage. The only firm in either of the two tables that is clearly not interested in running a significant derivatives business is Wells Fargo. Wells is also, by most measures, the best-run bank in the US. Prior to the firm’s purchase of Wachovia, it had approximately $1 billion of credit derivatives and $574 billion in assets. Wells has made significant progress in its efforts to run off the derivatives book that was part of the Wachovia purchase. Now I see why the company’s former CEO, Richard Kovacevich was so vehemently against taking TARP funds. He was probably the head of the only big bank in the US not drowning in derivative losses.

While it has become nearly unanimous in the analyst community and in the financial media that JP Morgan’s CEO is the world’s smartest banker, a look at his track record over the last couple of years would indicate otherwise. While Mr. Dimon might spin his firm’s purchase of Bear Stearns as strategic and a good deal for shareholders given that the US government was backstopping billions in losses, almost no one in the financial media has recognized JPM’s purchase of Bear for what it really was -- it was a bailout of JP Morgan. Since Bear was widely known for having the most toxic book of assets on Wall Street, was a large writer credit default swaps and JP Morgan was far and away the largest holder of credit derivatives in early 2008, I have a hard time believing that Mr. Dimon and company did not have a lethal amount of exposure to Bear Stearns. While many in the press have portrayed JPM’s acquisition of Bear as “good for the country” and praised Mr. Dimon for “stepping up to the plate”, little has been said about JPM’s long history of running the world’s largest book of over-the-counter derivatives while having the full backing of taxpayers. More importantly, while JP Morgan has been praised for promptly paying back its $25 billion of TARP funds in 2009, it should be noted that JPM received and will not repay an additional $54 billion of taxpayer assistance in its take-over of Bear Stearns.

In early 2008, the Federal Reserve lent Bear Stearns $25 billion to stave off insolvency and then backstopped JPM’s purchase of the firm for $1.1 billion with an additional $29 billion of loan guarantees while JPM was required to absorb only the first $1 billion in losses related to its acquisition. Good deal for taxpayers? I do not think so. Does President Obama count the $54 billion that is likely to be lost as part of the JP Morgan bailout in his calculation of how much he will have to tax banks to get all of the TARP money back? I doubt it. Has JP Morgan significantly reduced its exposure to over-the-counter derivatives? Clearly the company has not, as evidenced by the above tables. Finally, what have taxpayers received in return for bailing out JP Morgan? Certainly not new loans. According to a January 15, 2009 article from Reuters, the bank reduced its wholesale and consumer loan books by 22% and 11% respectively in Q4 2009 compared to Q4 2008.

I am literally dumbfounded at the size of the derivatives book at Goldman Sachs. It is beyond my comprehension how a Congressional panel attempting to get a better understanding of the causes of the financial meltdown did not bother asking Goldman CEO Lloyd Blankfien how his company can hold only $114 billion in assets and yet hold $938 billion in credit derivatives and a whopping $41 trillion in total derivatives on its books. While I am sure Mr. Blankfein’s answer would be that his firm has hedged its risks and its “net exposure” is far less, I have a hard time believing this explanation. While Mr. Blankfein boasted in front of the same panel about how his firm now his little exposure to consumer credit risk and a further downturn in real estate prices, I wonder how many credit default swaps Goldman holds on the sovereign debt of overly indebted countries such as Greece, Spain, Ireland, the UK and the US? Taxpayers will never know the firm’s risk until there is a problem and a bailout is needed. Based on publicly available information, I was not able to determine much about the nature of the $938 billion of credit derivatives the firm holds on its books. I think it would be rather sporting of Goldman to share the nature of its credit exposures with taxpayers since it is a federally insured depository institution and hence is able to help itself to as much nearly free money as it wants from the Federal Reserve window.

Consider Mr. Blankfein’s comments in front of a recent Congressional panel:

“The Federal Reserve is now our primary regulator. As a Financial Holding company, we are subject to the Fed’s capital and leverage tests. Over the last 18 months, our balance sheet has fallen by a quarter and our capital has increased by over half…”

If this is the case, and I have no doubt it is, then I cannot imagine how leveraged Goldman was 18 months ago. Once again, going back to the OCC’s Q3 2009 Quarterly Report on Bank Derivative Activities, we get at least some insight into the risk Goldman has on its books. According to Table 4 of the report titled, “Credit Equivalent Exposures”, Goldman has only slightly more than $21.3 billion in risk-based capital. However, the firm has $79.4 billion in bi-laterally netted credit exposure and an additional $103.4 billion in potential future credit exposure for a total of $182.9 billion in total credit exposure. According to the report, Goldman has an 858% total credit exposure to capital ratio. The next highest total credit exposure to capital ratio is JP Morgan with 290%. While the folks at Goldman Sachs are infinitely smarter than me based on their 2009 bonus pool of approximately $20 billion, I wonder if they are nearly three times as smart as the folks who work at JP Morgan? I doubt it. More importantly, by paying out bonuses to its employees in 2009 that are nearly equal to the firm’s total risk based capital, Goldman Sachs vastly increased the likelihood of a second taxpayer funded bailout, should the firm have miscalculated the risks embedded in its massive book of derivatives. To help put into perspective the size of Goldman’s bonus pool relative to the size of the firm’s risk capital, I think it is helpful to define risk-based capital.

The OCC defines risk-based capital as the following:

“The sum of tier 1 plus tier 2 capital. Tier 1 capital consists of common shareholders equity, perpetual preferred shareholders equity with noncumulative dividends, retained earnings, and minority interests in the equity accounts of consolidated subsidiaries. Tier 2 capital consists of subordinated debt, intermediate-term preferred stock, cumulative and long-term preferred stock, and a portion of a bank’s allowance for loan and lease losses.”

Source: http://www.occ.treas.gov/ftp/release/2009-161a.pdf

In other words, risk-based capital is a firm’s entire capital structure outside of the firm’s collateralized debt. Therefore, should Goldman have forgone bonuses in 2009, the $20 billion that was paid out would have been kept as retained earnings and would have nearly doubled its risk-based capital.

How could FDIC-insured Goldman pay such large bonuses when it has huge exposure to credit derivatives? Couldn’t their regulators demand that the firm boost their capital ratios? Sounds logical to me. Considering that the OCC was established as a bureau of the US Treasury in 1863, with a mandate to issue rules and regulations governing bank investments, lending and other practices, I do not see how the OCC is doing its job. Poor supervision of derivatives is a reflection of the incompetence of both Federal Reserve Chairman Ben Bernake (Goldman’s primary regulator is the Federal Reserve) and Treasury Secretary Timothy Geithner to whom the Comptroller of the Currency reports. Both Bernake and Geithner have the duty of regulating banks and setting adequate capital ratios but neither seems very interested in doing his job. Maybe Congressman Ron Paul is right that it is time to abolish the Federal Reserve. Given Mr. Geithner’s most recent testimony in front of Congress, I doubt he will be in his job for much longer. We can only hope that the Obama administration has the backbone to replace Geithner with former Federal Reserve Paul Volcker who seems to be the sole voice of reason in the world of financial institution regulation.

Probably the most egregious example of a firm that has completely fabricated the value of its assets to post phony profits is Bank of America. Given that BofA has some of the most toxic assets of any ongoing financial institution after its purchase of MBNA, Countrywide and Merrill Lynch, there is little doubt the company is set to suffer more credit losses in addition to the billions it has already written off. The company’s $35.7 billion in non-performing loans in Q4 2009, up from $18.2 billion in Q4 2008, should give its regulators and US taxpayers pause. With assets that are more toxic than an EPA Superfund site, BofA relied on trading profits and its ability to mark-up its portfolio for its 2009 “profits”. These profits allowed the firm to repay $45 billion in TARP money to the government in December. Given the very uncertain nature of many of the firm’s businesses, I can find little justification for TARP repayment other than to get out from under governmental oversight on pay. With BofA far too big to fail and far too big to manage its risks effectively, I see the current version of Bank of America as a very messy accident waiting to happen.

Based on the size of the derivative books and the increasing lending losses of many of the country’s largest banks, the lessons of the financial crisis have been lost on many of the bad actors who appear poised to repeat them. Regulators and Congress need to recognize that we have a highly unstable banking system that needs to reduce its dependence on derivatives and proprietary trading for profits. Many big banks continue to reduce their loan books due to mounting losses and thin margins and have intensified their focus towards the highly profitable proprietary trading and over-the-counter derivatives businesses. I thought the opposite was supposed to happen after the financial turmoil of the last two years. It has been 18 months since the banking crisis started and there is still no sense of urgency in Washington towards making financial reform a reality.

Lastly, now that the US federal debt is quickly headed towards 100% of GDP and the projected federal deficit for 2010 is expected to be approximately 10% of GDP, drastic action is needed in Washington to avoid a collapse in confidence in the US dollar. The status-quo is no longer sufficient to keep foreigners buying US debt. The non-stop printing of US dollars through quantitative easing (i.e. the Federal Reserve’s purchasing of Treasury notes with money created out of thin air) is not stabilizing the country’s economy; rather it is making it more unstable and vulnerable to crises of confidence. While balancing the budget is not easy and is going to require many painful choices, it is the only path that will make our economic system more robust.

So how does one protect oneself from the devastating effects of an outright collapse of the banking system or a devaluation of the US dollar that may be on the horizon? I believe the only way is through the ownership of investments that cannot be printed out of thin air. My two favorite categories are shares of oil and gas producing companies and shares of precious metals producers. I am also a strong believer in holding some gold and silver bullion.

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