The Devils Are (Still) Here

Kyle Bass said it was a must read, and that was good enough for me. All the Devils Are Here, by Bethany McLean and Joe Nocera, offers a chronological account of how Wall Street executives created, and then abused, the instruments that led to the global financial crisis of 2008. The whole alphabet soup is explained--ABCP, CDO, RMBS, SIV, etc.--as well as the motivations of the chefs cooking this toxic brew.

The scary part is this. Time and again, smart men and women (O.K., men mostly) suspended their better judgment, allowing risk to metastasize. The dereliction was so pervasive as to appear inevitable. The story told here strongly suggests, furthermore, that the dereliction is ongoing. It comes from human nature. Character breeds success, which then undermines character.

So much for the villains. How 'bout them victims? There was a veritable tsunami of dumb money sloshing through global markets in the mid-aughts. There probably still is. We know that in August 2007 some of that dumb money, about $20 million worth, leaked from the State of Maine's Cash Pool into an SIV-Lite called MainSail II, which was heavily invested in residential mortgage-backed securities (RMBS). Maine bought at the exact top of the market for such securities--the very definition of "dumb money." Within weeks MainSail II was downgraded by Moody's from Prime-1 to junk, and the vehicle's assets were frozen. By the end of August, Maine could not be sure that it would get any of its money back.

According to UMaine's Richard Borgman (who gives the blow-by-blow account here), this was not a prudent investment by the Treasurer's office. For months defaults on home loans had been rising, home prices falling, and subprime lenders failing. In July 2010 (before Maine invested in MainSail II) Standard & Poor's and Moody's had each placed hundreds of tranches of RMBS on review for possible downgrade. The handwriting was on the wall, and Treasurer David Lemoine failed to see it. In Borgman's opinion, "there was a lack of understanding of the investment and an over-reliance on ratings and the broker." One year later Lemoine made a stick-save by putting the investment back to the broker, Merrill Lynch. But for a whole year the $20 million was dead money.

Fair question: if Maine's Treasurer was in over his head in 2007, are MainePERS fund managers, with their "passive" investment style, in over their heads now? If so, a lot more than $20 million is at risk.

Toward the end of their book, the Devils authors lift a trenchant passage from Alan "Ace" Greenberg's The Rise and Fall of Bear Stearns. Greenberg was formerly CEO (until 1993) and Chairman of the Board (until 2001) at Bear Stearns and was 80 years old when the firm that he helped build went belly up in 2008. Reading this, one cannot help but think that the money is getting ready to stop one more time:

The interdependent relationships between banks and brokerages and institutional investors strike most laymen as impenetrably complex, but a simple ingredient lubricates the engine: trust. Without reciprocal trust between the parties to any securities transaction, the money stops. Doubt fills the vacuum, and credit and liquidity are the chief casualties. Bad news, whether it derives from false rumor or verifiable fact, then has an alarming capacity to become contagious and self-perpetuating.

Quote for the Week, Dec. 25-31, 2011

Credit is suspicion asleep.
--William Gladstone

Queue It Up

"The Wind That Shakes the Barley"


The Emerald Isle seen shimmering.
And simmering.
Pragmatists debate fanatics in barroom brogues.
Andrea Corr sings the credits.
Trailer here.

Quote for the Week, Dec. 18-24, 2011

This is how government grows--by claiming to correct the mistakes it earlier created, all the while constantly shaking down the taxpayer.
--Congressman Ron Paul

The Beginning of the End

If you have not gotten enough of Kyle Bass about the capital flight from Europe, go here for an interview two days ago on CNBC.

Now speaks another voice, Michael Platt, founder of BlueCrest Capital Management, a $30 billion hedge fund. Over the past eleven years, BlueCrest has returned nearly 14% on an average annual basis and has never had a down year. John Paulson, eat your heart out! Platt tells Bloomberg [below] about the sovereign debt crisis and the serial insolvency of most European banks:

Late yesterday one of the Big Three ratings agencies, Fitch, issued downgrades for eight global banks, including our beloved Bank of America. BofA's Viability Rating was dropped from a- ("strong") to bbb ("good") and its long-term Issuer Default Rating from A+ to A, still a couple of notches above Johnny B (Goode). The calls follow similar moves from Standard and Poor's last month and Moody's in September, thus completing a tricky trifecta for BofA. Such downgrades can trigger collateral calls, reducing a firm's liquidity. In extreme cases a downgrade can put a company out of business (witness MF Global).

Go here for a refresher from Gary Shilling on why all these banks are such a miserable investment.

Fed Head MIA

Hilarious. From ZeroHedge.

Quote for the Week, Dec. 11-17, 2011

He knows nothing; and he thinks he knows everything. That points clearly to a political career.
--George Bernard Shaw

Now You See It, Now You Don't

"I simply do not know where the money is."

This is what former MF Global CEO Jon Corzine will tell the House Agriculture Committee on Capitol Hill in his testimony today. Corzine was forced to resign last month amid allegations that his firm improperly commingled clients' funds with its own investment capital. All the money went out the door in some highly leveraged speculation. And never came back.

How can this happen? Reuters correspondent Christopher Elias describes how in a must-read article, MF Global and the Great Wall Street Re-hypothecation Scandal. Now, if "re-hypothecation" sounds to you like something sinister and best not tried at home, you would be absolutely right. But the big banks and brokers do it all the time. In fact MF Global, before it collapsed, warned its customers in its Customer Agreement as follows (and where you see the world "collateral," think anything of yours with cash value):

7. Consent To Loan Or Pledge

You hereby grant us the right, in accordance with Applicable Law, to borrow, pledge, repledge, transfer, hypothecate, rehypothecate, loan, or invest any of the Collateral, including, without limitation, utilizing the Collateral to purchase or sell securities pursuant to repurchase agreements [repos] or reverse repurchase agreements with any party, in each case without notice to you, and we shall have no obligation to retain a like amount of similar Collateral in our possession and control.

In other words, Mr. Client, we are going to pledge to someone else what rightfully belongs to you. And you can't opt out. If you want to do business with us, you have to play along. The problem, explains Elias, is that the same collateral gets pledged over and over, from one counterparty to the next:

With collateral being re-hypothecated to a factor of four (according to IMF estimates), the actual capital backing banks' re-hypothecation transactions may be as little as 25%. This churning of collateral means that re-hypothecation transactions have been creating enormous amounts of liquidity, much of which has no real asset backing...Considering that re-hypothecation may have increased the financial footprint of Eurozone bonds by at least four fold, then a Eurozone sovereign default could be apocalyptic. [emphasis mine]

Expounding on the Elias piece, Zero Hedge uses a familiar metaphor to describe the risk to the global economy:

The collapse of the weakest link in the daisy-chain sets off a house of cards that eventually will crash even the biggest entity due to exponentially soaring counterparty risk: an escalation best comparable to an avalanche - where one simple snowflake can result in a deadly tsunami of snow that wipes out everything in its path. Only this time it is not something as innocuous as snow: it is the compounded effect of trillions and trillions of insolvent banks all collapsing at the same time, and wiping out the developed world and the associated 150 years of the welfare state as we know it.

Hyperbole? We shall see.

What's That Smell?

I love the smell of napalm in the morning, says Robert Duvall's character in Apocalypse Now. We are getting a whiff of that on the morning after this CBS 60 Minutes piece on alleged fraud at Countrywide Financial (now a division of Bank of America):

Now, none of this is really news. If you have been following this blog, you know that Bank of America is freighted with huge successor liabilities inherited not just from Countrywide, but from Merrill Lynch as well. Consumer fraud, investor fraud, breach of fiduciary duty, obstruction of justice--you name it. That the Obama Administration has done so little to hold these companies accountable is a sure sign of whose shed has the biggest Tool.

Maybe, if the feds don't do it, the states will. The Attorneys General of the fifty states have been trying for a year or more to reach a settlement with BofA and other Wall Street lenders over foreclosure abuses. But the dollar figure being floated around for the industry to buy immunity is, in the eyes of at least one AG, too small. So last week Martha Coakley of Massachusetts announced that her office is striking off on its own and suing BofA, Wells Fargo, JP Morgan Chase, Citigroup, and GMAC. To her chagrin, Martha will be forever remembered as the heavily favored Senatorial candidate who lost Ted Kennedy's seat to a little-known Republican runt, Scott Brown. But she has been a crackerjack AG, going after some of the big banks in 2008 when few others did.

The news flow on Bank of America continues to, um, reek. Aside from this latest legal attack, there was the credit downgrade announced by Standard & Poor's late Tuesday of BofA and 36 other global banks. Indeed, the share price of BAC common was headed for a toilet spin until a gang of central banks injected a stiff dose of monetary heroin the very next morning. And how's business, you ask? BAC's share of mortgage loan originations in the U.S. has declined from about 25% to around 10% in Q3 2011. That's in a market that is expected to soften by 25% in 2012. Hmm, wonder what that combo is going to do to revenues.

But faithful shareholder MainePERS is hanging tough, I tell ya. HANGING TOUGH!

[update, 12-07-11--]

Mississippi PERS just reached a settlement with BofA, recovering $315 million from a soured investment in toxic mortgage-backed securities peddled by Merrill Lynch in 2006 and 2007. The settlement awaits approval by Federal District Judge Jed Rakoff. Yup, that Judge Rakoff.

Quote for the Week, Dec. 4-10, 2011

Long ago I proposed that unsuccessful candidates for the Presidency be quietly hanged, as a matter of public sanitation and decorum. The sight of their grief must have a very evil effect upon the young.
--H.L. Mencken

Monday, Monday

can't trust that day...

Oh Monday morning,

you gave me no warning

of what was to be.

--The Mamas and Papas

This morning investors in the Western world are hoping to recoup some of last week's losses. Stock futures are up big in the pre-market. But beware the pop and drop. The credit and currency markets are warning of what is to be:

Sovereign bond yields are rising, even in the Euro core.
Signs of depression and default.

The euro is losing value against the U.S. dollar.
Bad for stocks.

Inter-bank interest rates are rising--exponentially.
Howard Simons explains.

The question du jour is whether the Federal Reserve is going to prop up European banks the way it did the biggest U.S. banks three years ago. Remember TARP? Bloomberg reveals how the Congress-approved TARP investments in 2008-09 were just the tip of the iceberg. The Fed also provided under-the-table loans and guarantees totaling $7.77 trillion, or ten times the TARP support. The interest rate charged was as little as .01 percent, boosting net interest margins at recipient banks and allowing them to generate $13 billion in "free" income at a time when they were essentially insolvent. Find out what your favorite bank made in Bloomberg's interactive chart.

The enhanced liquidity also allowed these teetering institutions to merge, becoming Too Bigger To Fail. Total assets at the six biggest U.S. banks amounted to $9.5 trillion as of this past September 30, up 39% in five years. During the near-meltdown, the Big Six--JP Morgan Chase, Bank of America, Citigroup, Goldman Sachs, Wells Fargo, and Morgan Stanley--received $160 billion from the U.S. Treasury and $460 billion from the Fed in emergency relief.

Now, three years later, they're still staggering.

Quote for the Week, Nov. 27-Dec. 3, 2011

I do not insist upon the special supremacy of rag money or hard money. The great fundamental principle of my life is to take any kind I can get.
--Mark Twain

Ticking Time Bomb

Investment fund manager Kyle Bass gives a brief, clear explanation of the doomsday outlook in Europe and Japan. Well worth six minutes of your time:

"That is how spring-loaded this debt scenario is. When your debts get to become many multiples of your revenue, any slight movement in the cost of your debt [i.e. in interest rates] causes an enormous crisis right away....

I don't believe the E.U. survives in its current state...The bond market is telling you that it has already exploded."

Quote for the Week, Nov. 20-26, 2011

The only real purpose of European bank regulators is to make U.S. regulators look conservative and prudent.

--John Mauldin

Closing Up Shop

Ann Barnhardt ceases operations as a commodity broker:

"The reason for my decision to pull the plug was excruciatingly simple: I could no longer tell my clients that their monies and positions were safe in the futures and options markets – because they are not. And this goes not just for my clients, but for every futures and options account in the United States. The entire system has been utterly destroyed by the MF Global collapse. Given this sad reality, I could not in good conscience take one more step as a commodity broker, soliciting trades that I knew were unsafe or holding funds that I knew to be in jeopardy....

The futures and options markets are no longer viable. It is my recommendation that ALL customers withdraw from all of the markets as soon as possible so that they have the best chance of protecting themselves and their equity. The system is no longer functioning with integrity and is suicidally risk-laden. The rule of law is non-existent, instead replaced with godless, criminal political cronyism."

Here's your money back. Have a nice day.

Complete customer notification here.

[update--]

Karl Denninger weighs in with the following:

"Nothing that has come out of the CME, the SEC or Washington DC has restored my confidence that MF Global is, in fact, a one-off situation. In point of fact The Fed is now requiring margin on certain repo transactions where they never did before, implying that there may well be additional snakes in the grass and additional unrecognized and intentionally hidden risks of this sort.

Read Ann's entire missive. Yes, it's highly partisan, but given what has just happened and Obama's continued insistence that "no crimes were committed" (yet no grand juries have been convened to investigate, so how would he know?) it is entirely justified."

Complete commentary at market-ticker.org.

BAC: Both Sides of the Trade

Let's see how the world's top hedgies viewed Bank of America as an investment choice for the three months ending September 30.


John Paulson is nibbling again.











After cutting his stake by almost two-thirds in the year ending June 30, 2011, Paulson has added back 3.9 million shares since, despite seeing the value of his BAC holding decrease by over a quarter of a billion dollars in the third quarter alone.

He was buying from...


David Tepper, who sold his remaining 10 million shares.













Tepper at one point had over 30 million shares, but it's all gone now. The fund disclosures came on the same day that BofA announced that it was selling 10.4 billion shares of China Construction Bank for $6.6 billion. This was the second step in a two-stage liquidation. Less than three months earlier BofA had sold 13.1 billion shares of CCB for $8.3 billion. The after-tax gain for this latest transaction was $1.8 billion, or half the net from the earlier sale.

Hedge fund managers are not the only ones who play in the stock-market casino. So do members of Congress. CNBC reports that BAC is the third-most owned stock among that august group, trailing only General Electric and Procter & Gamble. Surely a stock loved by Congress critters is a buy, right? Right?

Yeah, right. I will fade that crowd every time.

[update, late Friday evening, 11-18-11--]

Bank of America is getting sued. Again. Not for mortgage fraud this time, but for underwriting risky bonds issued by the now-defunct MF Global without proper disclosure. Reuters has the story here. The plaintiffs are pension funds which, having bought said bonds, are now seriously underwater. MainePERS should take note and perhaps lawyer up as well. Successful damage suits would be one way to offset portfolio losses (that, plus the tried and true way of dunning taxpayers).

But wait. We own many of these miscreants, thanks to our brain-dead strategy of diversification. So we would be suing ourselves.

[Cue head-slap.]

PIIGS Fly

Their bond yields, that is. Here they are, in order of increasing risk. [n.b.--Portugal and Ireland have already gotten their bailouts, so they are replaced below by France and Belgium.]

Yields on 10-year sovereign bonds:

France: on the way to 4%, supposedly a triple-A credit.

Belgium: no government, no Med coastline,

now pushing 5%.

Spain: catching up quickly, now over 6%.

Italy: red-lining over 7%.

Greece: in a league of its own.

Quote for the Week, Nov. 13-19, 2011

All rapidly accumulated wealth is either the result of luck or discovery, or the result of legalized theft.

--Honoré de Balzac

Song for the Day

Well, how'd you do, Private William McBride?
Do you mind if I sit here down by your graveside?
I'll rest here awhile in the warm summer sun,
I've been walking all day, Lord, and I'm nearly done.
And I see by your gravestone you were only 19
When you joined the glorious fallen in 1916--
Well, I hope you died quick and I hope you died clean,
Or, Willie McBride, was it slow and obscene?

--lyrics from Eric Bogle's "No Man's Land"

The Dropkick Murphys' version.

Queue It Up

Charles Ferguson strikes once more.

Déjà vu all over again.

Frederic Mishkin speaks in tongues.

See this, then go Occupy somewhere.

Trailer here.

Bank Transfer Day in Greece

Make that "Bank Transfer YEAR"

as Greeks offshore their savings [above].

[courtesy ZeroHedge]

Meanwhile, how about capital flight from Italy?

Lenders are demanding higher yields to cover default risk.

Or dumping the debt altogether.

Yield on 10-year BTP

[Bloomberg]

As money leaves, Minyanville's Fil Zucchi worries

about what the government will do to stem the tide.

Confiscation, anyone?

From Barclays Capital:

"The higher yields are not compatible with debt sustainability

and therefor require an upward adjustment

of perceived default probabilities,

which makes the debt less, not more attractive."

[Complete report here.]

Quote for the Week, Nov. 6-12, 2011

If I were to go over my life again I would be a shoemaker rather than an American statesman.
--John Adams (U.S. President, 1797-1801)

Here Comes the Dilution

BofA's image needs buffing.

One of the risks for owners of Bank of America's common stock (reminder: MainePERS owns 2.6 million shares) is the prospect that the firm will issue new shares, thereby inflating the share count and diluting shareholders (discussed here). Senior management has stated repeatedly that that will never, in a million years, happen. The bank's capital cushion, they have said, is as well padded as their own compensation. Or almost, anyway.

Yesterday's release of the company's most recent 10-Q filing with the SEC reveals that such assurances were so much lip service. Scroll down to page 10 and see this:

The uncertainty in the market evidenced by, among other things, volatility in credit spread movements, makes it economically advantageous at this time to consider retirement of issued junior subordinated debt and preferred stock. As a result of these matters, we intend to explore the issuance of common stock and senior notes in exchange for shares of preferred stock and...certain trust preferred capital debt securities...We will not issue more than 400 million shares of common stock or $3 billion in new senior notes in connection with these exchanges.

That's $2.8 billion of new common equity at $7 a share (the current market price rounded up to the nearest dollar). The move actually makes sense from a business standpoint, as it will add to Tier 1 capital (more on that below) and reduce expenses on interest and dividends. But what makes business sense does not always make money for the common shareholder, the low stakeholder on the totem pole.

Bank of America's debt, downgraded six weeks ago, is trading at a discount, and because of this the firm booked a paper profit for the quarter of $1.7 billion (remember DVA?). The debt and capital exchanges now proposed would lock in some of that gain: "The senior notes and common stock would be recorded at fair value at issuance, which is expected to be less than the par and carrying value of the preferred stock and/or the junior subordinated debt." Management assures existing shareholders that the exchanges would be "accretive to earnings per common share." But how? The gains have already been booked, and the share count (the denominator in earnings-per-share) will be greater. Then again, banksters are quite used to having their cake and eating it too. In any case, it remains to be seen how much of this deal gets done. The exchanges must be negotiated with willing creditors. As we have learned this past week, there is no such thing as a voluntary haircut, the Euro-elite notwithstanding.

Back to Tier 1 capital. Bank of America needs more of this in case their debt gets downgraded again. Look at what happened to MF Global earlier this week. A credit-rating downgrade precipitated a liquidity crunch that put the dealer-broker out of business. Could the same thing happen to BofA? Is the Pope Catholic?

So how is business these days? Not so hot, actually. Earlier this week BofA had to cancel plans to institute a $5-a-month fee for debit-card users. The announcement came too late to retain the customers that just moved their accounts elsewhere, but at least there are fewer outraged customers left. A poll released today shows that the rush to the exits may continue. BofA's remaining customers "are the least satisfied among clients of the biggest U.S. lenders and the most likely to defect to competitors." Nine percent are "not at all likely" to stay. Which begs the question, why would that category of users ever exceed zero percent? I mean, what are they waiting for?

Maybe tomorrow is the day that the 9-percenters become the zero-percenters. November 5 is Bank Transfer Day. Have a nice one.

[update, B.T. Day + 1--]

Credit unions have picked up some new customers. Story here.

Stress Indicators

Yield on Greek 1-year note:

203 percent!

Now it takes only six months to double your money lending it short-term to Greece (assuming, of course, that Greece decides to pay you back when the note is due). Of course, you already knew that Greece is toast. But did you know that Italy's debt is also shaky? At six times the GDP, that would make Italy Texas toast.

Italy's line in the sand is 6 percent on the ten-year bond. When BTPs hit that level in July, the Euro-elite summited to announce a plan for backstopping the PIIGies' sovereign debt. Confidence returned [see graph below], but only briefly. The latest assault on 6 percent produced another summit last week. This time the powers-that-be have not been able to talk yields down. Italy is simply not growing fast enough to service its debt at these rates. It looks like the European Union's attempt to ring-fence Greece is failing.

Yield on Italian ten-year bond:
6+ percent and rising.

Warns ZeroHedge:

Keep a very, very close eye on the Italian bond spread, because if Italy falls, Europe falls, and with it fall not only all the largely undercapitalized French banks (all of them), but the US banks that have not tens, but hundreds of billions of gross CDS exposure facing them, which at that point will be perfectly unhedged as all their transatlantic counterparties will be in the same boat as MF Global.

Even uber-Keynesian Paul Krugman is throwing in the towel:

"Eurodämmerung"

BOO!

When we woke up crying in the wee hours of Thursday morning, Eurozone nannies told us not to be afraid. Reassured, we sold dollars and bought euros in the light of day. Now the scariest of Halloween's goblins, Vampire Debt, is back. Sovereign yields are screaming higher. As for currencies:

Now back under $1.40:

the euro retraces Thursday's "bazooka rally."

[courtesy ZeroHedge]

Quote for the Week, Oct. 30-Nov. 5, 2011

Tell me what brand of whiskey that Grant drinks. I would like to send a barrel of it to my other generals.
--Abraham Lincoln [U.S. President, 1861-65]

Queue It Up

Dizzying high-altitude photography.

75-year-old mystery solved.

Because it's there.

Trailer here.

Lizbeth Scott's haunting ode here.

Markets Defer to 'Financial Terrorists'

Global markets are melting up today upon the perception that the Eurozone has effectively solved its debt problem. Do not be misled, advises Max Kaiser, who in this rant [below] likens the Eurocrats responsible for this latest bailout to "financial terrorists." By proposing to leverage the European Financial Stability Fund, unelected ministers are, in Kaiser's words, "mollycoddling banks," undermining national sovereignty, and "guaranteeing economic collapse"--not bad for a long night's work. China, widely assumed to be a guarantor for the EFSF, is merely buying time, says Max, until it can hoard enough gold to immunize itself against the coming contagion.

You must see this:

Meanwhile, ZeroHedge tells us where to look for clues about the creditworthiness of the "ultimate backstoppers" -- Germany and China.

"Note to EU lackeys: there is no free lunch," writes Charles Hugh Smith, who likens the rescue plan to a plutonium life preserver. Heavy and toxic.

[update, 4 p.m.--]

Note to MainePERS: sell the Bazooka rally. BAC has just closed over 7.


[update, morning after--]

The euro-phoria has worn off. Italian ten-year bonds are back over 6%. The risk has not gone away.

Yield on Italian 10-year debt

Quote for the Week, October 23-29, 2011

One must bear in mind that the expansion of federal activity is a form of eating for politicians.
--William F. Buckley, Jr.

'A Terminal Short'

MainePERS, read this:

"Bank of America equity is worthless."

"BAC is the WorldCom of banking."

"...no sustainable competitive advantage."

"BAC deserves more downgrades..."

"...a dishonest accounting mess..."

Read the full Value Investors Club commentary here.

[h/t ZeroHedge]

More below. A pro's pro, Gary Shilling, tells Bloomberg why the big banks are such a rotten investment at this time:

BofA Needs Fed Sanctuary More Than Ever

To whom does the Fed pledge allegiance?

[courtesy Bloomberg]

Bank of America knows that the Federal Reserve has its back. But getting such favorable treatment from the courts will not be so easy. BofA has spent the past several months trying to fast-track a settlement over home-mortgage abuses in what is called an Article 77 proceeding. The bank is hoping that a New York court will agree to cap all related liabilities, henceforth and forevermore, at $8.5 billion. Aggrieved parties would not be allowed to opt out of such a settlement.

Yesterday federal judge William Pauley III offered relief to one of said aggrieved parties by ordering the case removed to federal court. In his ruling the judge found that the settlement agreement "implicates core federal interests" and touches on "the integrity of nationally chartered banks." [Reuters scrutinizes the nitty-gritty here.] Those of you playing at home will quickly recognize that "integrity" and "Bank of America" are not a match. So any protracted exploration of BofA's integrity is likely to be inimical to the firm's best interests.

If Pauley's ruling is upheld upon appeal, the price tag for a settlement will likely go up. Way up. Multiply by ten and work your way up from there. This is an iceberg-sized number that could sink the ship. But creditors and investors need not worry. The Fed has their backs, too. By engineering the mergers three years ago of Bank of America with both Countrywide Financial and Merrill Lynch and now migrating the toxic assets of those legacy firms to a federally insured subsidiary of BofA, the Fed has made sure that the only ones ultimately paying will be taxpayers.

The looting continues.

Smoke and Mirrors

Breaking: BAC reports phantom earnings.

Market watchers were introduced to a new acronym last week: DVA, which stands for "debit valuation adjustment." In its third-quarter earnings report on Thursday, JP Morgan Chase disclosed that it was booking $1.9 billion in a pre-tax benefit from DVA gains. Unschooled analysts immediately hit up their Bloombergs for a quick refresher in DVA. Turns out that DVAs are an accountant's way of making lemonade out of lemons. A company doing bad can make it look like it is doing good. How does it do it?

Last we checked, credit spreads on the big banks were widening, indicating an emerging suspicion among speculators that one or more of these babies might actually default. For any bank, that's BAD. Bonds previously issued by an at-risk bank start trading at a discount as investors begin to worry about possibly losing their principal. The debt shows up on the bank's balance sheet as a liability, which must be paid down over time.

Here is where it gets interesting. The Financial Accounting Standards Board (FASB) has given the banks the green light to mark their debt liabilities to market, viz. "at the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date" (ASC 820). For the issuing bank, that is GOOD. It means that the liability on the company's books can be discounted as the bonds lose value. The company is allowed to book a profit commensurate to the difference between the bond's face value and its market price.

The "profit" is pure fantasy. The company has not actually engaged in a real-time transaction to buy back any of its debt. It is still on the hook for full payment of principal plus interest. The debt is still a lemon. But, as Boston Globe sportswriter Bob Ryan points out, "corporations often employ bookkeepers who can do with numbers what Rajon Rondo can do with a basketball." He means something magical. In the bank's case, the debt liability is simply revalued on the shaky assumption that the company could, if it wanted to, buy back all its debt, all at once, at a momentary price in a thin secondary market fraught with huge friction costs. Not gonna happen.

Even JPM's CEO, Jamie Dimon, confesses to the gimmickry. "The DVA gain," explained Dimon on Thursday, "reflects an adjustment for the widening of the Firm's credit spreads which could reverse in future periods and does not relate to the underlying operations of the company" [emphasis mine]. Yesterday another of the mega-banks, Citigroup, showed that it uses the same cookbook, announcing a third-quarter pre-tax DVA gain of, you guessed it, $1.9 billion. What a coinkydink!

Enter Bank of America, a veritable warehouse of lemons. For its quarterly earnings (announced this morning), BofA squeezed out a DVA gain of $1.7 billion, not quite up to JPM and Citi's level of performance, but still not bad for worst-of-breed. BofA did not stop there. It also recorded a "fair value adjustment on structured liabilities" of $4.5 billion, another phantom gain (see page 5 here). Back out those two accounting treatments, and you get zero dollars of net income. Then back out the proceeds ($3.6 billion) from a one-time asset sale. You are left with a core business that is still losing money hand over fist.

So why invest in any of these behemoths? It is a question that I have put to officials at the Maine State Retirement Fund (MainePERS), which continues to hold substantial stakes in both BAC and JPM, top-ten holdings as recently as fifteen months ago. The reason they fell out of the top ten is not because portfolio managers sold when the selling was good, but because the share prices have collapsed. As of September 30, we (i.e. MainePERS beneficiaries and guarantors) still hold over 2.6 million shares of BAC and over a million shares of JPM. In the third quarter alone, those BAC shares were down 44%, or more than $12.6 million.

I advised to sell the Santa Claus rally, which raised the stock to over $13 a share. Then, eight months later, I said sell the Saint Warren rally, which saw $8 a share. Today BAC has a six-handle, and it is difficult to see from the company's latest earnings report any possible catalyst for a rally from here. Rather, looming bank failures in Europe could be the catalyst for further downside.

[update, 2 p.m.--]

Bloomberg is just out with the explosive revelation that Bank of America has shifted derivatives from its Merrill Lynch unit to a federally insured subsidiary. This has essentially exposed U.S. taxpayers to the risk that these derivatives might blow up, in which event counterparties would have first claims to the firm's assets (including $1.04 trillion in cash deposits) prior to any bankruptcy resolution. William Black, a federal bank regulator during the Savings & Loan crisis of the early '90s, is quoted as saying that BofA has succumbed to the "enormous temptation to dump the losers on the insured institution. We should have fairly tight restrictions on that."

The safe harbor for derivatives counterparties is a legacy of the George W. Bush Administration, which in 2005 championed passage by Congress of the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA), a misnomer if ever there was one, as the ones being protected were reckless lenders and speculators. Consumers, far from being protected, were further subjugated.

Yves Smith at nakedcapitalism.com explains BofA's move this way:

Remember the effect of the 2005 bankruptcy law revisions: derivatives counterparties are first in line, they get to grab assets first and leave everyone else to scramble for crumbs. So this move amounts to a direct transfer from derivatives counterparties of Merrill to the taxpayer, via the FDIC, which would have to make depositors whole after derivatives counterparties grabbed collateral. It’s well nigh impossible to have an orderly wind down in this scenario. You have a derivatives counterparty land grab and an abrupt insolvency...This move paves the way for another TARP-style shakedown of taxpayers, this time to save depositors. No Congressman would dare vote against that. This move is Machiavellian, and just plain evil.

Maybe this is why MainePERS considers BAC a safe investment. If the bank should fail, taxpayers will be picking up the tab.

[update, 9 p.m.--]

Karl Denninger at market-ticker.org uses italics, bolding, AND underlining to reinforce his view:

[T]his sort of movement of liabilities should be flatly prohibited...That the firm's ratings have deteriorated and thus it may be required to post additional capital against these positions by those counterparties does not justify shifting the risk to depositors simply so the bank can avoid posting collateral against a deteriorating credit picture, which for all intents and purposes shifts the risk to the taxpayer since the FDIC has a line of credit at Treasury.

And John Hussman, in his weekly market commentary, has this:

[T]he transfer is clearly driven by the intent to get around capital adequacy regulations, and runs precisely opposite to the right way to create a good bank and a bad bank. It saddles the good bank - the taxpayer insured one - with the questionable liabilities, while "giving relief" to the holding company. This is really preposterous.

Quote for the Week, Oct. 16-22, 2011

If you want to know what God thinks of money, just look at the people he gave it to.
--Dorothy Parker

Queue It Up

Georgian earth-tones in autumn.

Robert Duvall sticks it.

And Alison Krauss too?

Trailer here.

Be There Or Be Square