Category: accounting rules

Credit contraction has only just begun

A few weeks ago we presented “Unwinding Planet Leverage” at the Spring CMRE dinner ( where I would say many were concerned about the ongoing credit fiasco. On the other hand, after countless capital raises, reassurances from commercial and investment bankers and the Bear Stearns rescue several months ago, sentiment has swung into bullish territory. Time after time I hear the same response from investors, “the Fed will not allow another large bank or investment bank to fail” or “I’m buying stocks since the Fed has things under control”. Oh really?

Today the Financial Times did a piece about potential accounting changes to off balance sheet entities created by our transparent bankers. Evidently, FASB wants to remove all conduits, SIVs, VIEs and any other form of off balance sheet activities consequently returning roughly $5 trillion to bank balance sheets – ouch!

Accounting changes could force US banks to take thousands of billions of dollars back on to their balance sheets in the coming months in a move that is likely to curb further their lending and could push them into new capital raisings, analysts have warned.

Analysts at Citigroup said a planned tightening of the rules regarding off-balance sheet vehicles would force banks to reconsider arrangements and could result in up to $5,000bn of assets coming back on to the books.

The off-balance sheet vehicles have been used by financial institutions to keep some assets off their balance sheets, thereby avoiding the need to hold regulatory capital against them.

Birgit Specht, head of securitisation analysis at Citigroup, said: “We think it is very likely that these vehicles will come back on balance sheet. “This will not affect liquidity because they are funded, but it will affect debt-to-equity ratios [at banks] and so significantly impact banks’ ability to lend.

In the past I’ve discussed leverage at various financial institutions which in some cases actually increased since the credit crisis began last Spring. For example, since the Bear Stearns funeral Citigroup actually increased their leverage from 18-1 to 19-1 while Lehman and Morgan Stanley shifted more of their level 2 assets to level 3. Adding additional pressure to an already strained banking system, the SEC will hear proposals regarding new credit rating systems, specifically asset backed securities.

The U.S. Securities and Exchange Commission may recommend this week that Moody’s Investors Service, Standard & Poor’s and Fitch Ratings include a new designation to the scale created by John Moody in 1909. The changes may force investors to reassess the way they gauge the risk of securities backed by mortgages, student and auto loans and credit cards, said one of the people, who declined to be named before the announcement. The action could force banks to add capital to guard against losses or curb lending.

To be considered “well-capitalized” under U.S. regulations, banks are required to hold five times as much capital against corporate debt than they are for commercial or residential mortgage-backed securities rated AAA and AA by S&P, Fitch
Ratings and Moody’s.

Should the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. order banks to hold more capital, investors in asset-backed securities may balk at buying, making mortgages more expensive, said American Bankers association executive director Wayne Abernathy.

Finally, the Bank of International Settlements is out with a warning on the global credit crisis implying a potential depression from the massive credit contraction.

In its latest quarterly report, the body points out that the Great Depression of the 1930s was not foreseen and that commentators on the financial turmoil, instigated by the US sub-prime mortgage crisis, may not have grasped the level of exposure that lies at its heart.

According to the BIS, complex credit instruments, a strong appetite for risk, rising levels of household debt and long-term imbalances in the world currency system, all form part of the loose monetarist policy that could result in another Great Depression.

The report points out that between March and May of this year, interbank lending continued to show signs of extreme stress and that this could be set to continue well into the future. It also raises concerns about the Chinese economy and questions whether China may be repeating mistakes made by Japan, with its so called bubble economy of the late 1980s.

My Comments: As planet leverage continues to unwind expect numerous rounds of toxic financing as regulators pressure banks and investment banks to raise more capital, diluting shareholders away in the process. Concurrently, regulatory pressure from the Fed will require banks and investment banks to meet margin calls as posted collateral via temporary lending facilities decline in value. Finally, our banking system will move closer to Japan circa 1991-1993.

Fed down to their last few bullets

Wall Street began the week with fear in the financial air as rumors circulated Bear Stearns was unable to meet redemptions from hedge fund clients. The Banking Index probed new lows while T-bill rates followed. Adding to credit concerns were significant spikes in credit spreads, primarily MBS as Fannie/Freddie paper spreads blew wide open exceeding the moves witnessed during the 1998 LTCM debacle. A continuation of margin calls beginning last week pressured hedge fund and other credit related speculators who purged MBS of all flavors to stay alive. Within 24 hours Bernanke and the fearless Fed arrived on the scene with yet another attempt to stop the bleeding:

The Federal Reserve announced today an expansion of its securities lending program. Under this new Term Securities Lending Facility (TSLF), the Federal Reserve will lend up to $200 billion of Treasury securities to primary dealers secured for a term of 28 days (rather than overnight, as in the existing program) by a pledge of other securities, including federal agency debt, federal agency residential-mortgage-backed securities (MBS), and non-agency AAA/Aaa-rated private-label
residential MBS. The TSLF is intended to promote liquidity in the financing markets for Treasury and other collateral and thus to foster the functioning of financial markets more generally. As is the case with the current securities lending program, securities will be made available through an auction process.

Understand this experiment is quite different from the Temporary Auction Facility (TAF) which was introduced several months ago and actually offers cash for MBS collateral. Of course the main objective for the Fed’s TAF was lowering the Fed funds target rate.

I find it interesting that JP Morgan and Bank of America decided to make unprecedented margin calls last week when spreads had already widened the prior week or so. Is 25-1 leverage finally impacting credit availability at the largest commercial banks? How about the immeasurable levels of off balance sheet structured finance experiments gone bad?

Today we read about numerous credit related hedge funds who effectively froze redemptions for partners recently. Of course this is attributed to FASB 157 which went into effect in November, 2007, leading to numerous mark-to-market problems for the mark-to-make-believe world. Some of the twilight zone casualties emerged this morning:

Drake Management LLC, the New York- based-firm started by former BlackRock Inc. money managers, may shut its largest hedge fund, while GO Capital Asset management BV blocked clients from withdrawing cash from one of its funds.
Drake told investors today that it would either liquidate its $3 billion Global Opportunities fund, continue to restrict redemptions or allow clients to shift assets to a new fund. Separately, Amsterdam-based GO Capital prevented customers from taking money out of its $880 million Global Opportunities Fund, saying in a March 11 letter that “current market circumstances don’t allow the fund to sell investments at a reasonable price.”

Hedge funds with more than $5.4 billion have been forced to liquidate or sell assets since Feb. 15 as contagion from the U.S. subprime slump spreads. Others include Peloton Partners LLP’s $1.8 billion ABS Fund, Tequesta Capital Advisor’s mortgage fund and Focus Capital Investors LLC, which invested in mid size Swiss companies.

Finally, as we’ve said from day one, the Fed’s balance sheet is a paltry $866 billion which pails in comparison to the outstanding $43+ trillion of debt in the system. One more bullet has been fired leaving the central planners with fewer rounds of ammunition.

Counting the currency swaps with the foreign central banks, the Fed has now committed more than half of its combined securities and loan portfolio of $832 billion, Lou Crandall, chief economist for Wrightson ICAP noted. ‘The Fed won’t have run completely out of ammunition after these operations, but it is reaching deeper into its balance sheet than before.”

My comments: Bailout talk fills the airwaves so we ask the question: Does Bernanke have enough bullets in the chamber to keep the primary dealers alive until Congress approves a massive mortgage bailout plan? Remember the Fed does not want to destroy themselves so collateral must be blessed by the government in order to keep the Ponzi alive.

Fair Value accounting dragnet: Just the facts

Last month the WSJ reported that SEC examiners would be analyzing valuation techniques related to structured finance in order to verify brokerage securities and loan positions.

According to Chris Whalen:

The Fed’s decision to waive Section 23A of the Federal Reserve Act (Reg W) and allow Bank of America (NYSE:BAC), Citigroup (NYSE:C), and JPMorgan Chase NYSE:JPM) to make large loans to their broker dealer units may be a sign of impending trouble. These loans, which are apparently to support collateralized debt obligations (“CDOs”), are an indication of mounting liquidity problem among the larger Sell Side shops.

The table above, courtesy of Richard Bove of Punk Ziegel & Co, displays data on holdings of these firms which are subject to Fair Value accounting (FASB 157 and 159). Fair Value accounting breaks holding into three categories:
  • Level 1 holdings are relatively easy to value since they are traded daily. Holdings include stocks, treasuries, or commodities.
  • Level 2 holdings are more opaque. This group trades intermittently so holdings are determined by computer models. Holdings include anything from loans, derivatives, restricted stock and thinly traded debt securities.
  • Level 3 holdings are valued solely at the discretion of the holder since there are no comparable issues being traded. Holdings include private equity, residuals from securitizations or complex derivatives.
The past 60 days has truly tested mark to model (Level 2&3) and the results are disastrous. How do we know this? Because mark to market or broker has resulted in transactions well below what supposed book or model values were. In some instances investment grade paper sold for 25 cents on the dollar. Thus, the market has implicated the brokers, banks, hedge funds and rating agencies for obvious reasons.

Looking at the table above we see $5.6 trillion in holdings being held by 8 firms. There is $0.3 trillion that cannot be valued objectively. This is 63% of the combined firms’ common equity. There is $4.1 trillion in Level 2 holdings which we would say are overstated by a minimum of 8-10%. This is 7.9x the combined firms’ common equity.

In summary, the banks, brokers, auditors, SEC, rating agencies and hedge funds will have their hands full trying to value $5.6 trillion in securities, 78.9% of which do not trade on a regular basis.

Allowing the free market to force a mark to market will create relentless write downs for this sector over the next few years. On the other hand continued denial results in perpetuating the twilight zone economy.

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