Banks Are Ill-Prepared for the Coming Tsunami

Up, Up, and Away? That's what the stock market seems to be saying, but the line above is pointing in the other direction. ALLL stands for "Allowances for Loan and Lease Losses," and the graph indicates that only 20% of all bank assets reside in banks with sufficient allowances set aside to cover their nonperforming loans. In other words, as more and more loans become delinquent, banks are under-reserving for possible defaults. Instead, they are puffing up their current earnings in hopes of appeasing regulators and attracting investors (and, of course, paying their top executives).

A new wave of defaults will arrive in 2010 as option ARMs (adjustable-rate mortgages) do what they were designed to do: explode. These are teaser loans that start borrowers off at absurdly low monthly payments for the first few years. The payments might be interest-only (leaving the principal untouched) or even less (allowing the balance owed to increase). Then, once the introductory period expires, the payments on principal begin. That's when the rubber finally meets the road.

These products were perfect for speculators flipping properties in an overheated market. Borrowers could sell for a profit before the loans re-set. But option ARMs will prove deadly to homeowners who have suddenly lost their jobs and, thus, the income to cover the higher payments due after the re-set. The U.S. economy has shed jobs for twenty months in a row (a total of 6.9 million) and is expected to continue doing so at least until the middle of 2010. The mortgages, alas, allow no grace periods for unemployed borrowers. [Hours after I posted this, FDIC Chair Sheila Bair revealed in a statement that "the FDIC is urging its loss-share partners to consider the borrower for a temporary forbearance plan, reducing the loan payment to an affordable level for at least six months." The initiative applies to banks that have acquired failed FDIC-insured banks and would offer relief to "unemployed and underemployed" borrowers.]

Almost $100 billion in option ARMs will reset between now and the end of 2010. Mounting foreclosures are inevitable, and hundreds of banks will be forced to close. Surviving banks will be hit by the feds with a double whammy: "special assessments" to help indemnify insured deposits as well as stricter capital-reserve requirements to backstop defaults. Turning a profit will be a tall order (as described here). Lending to entrepreneurial start-ups--and creating jobs--will be out of the question.

But bank CEOs don't mind. They already have theirs.

Photo Retrospective: Ted Kennedy

[click for slide show]

Also, the Boston Globe has a video timeline here.

Where Exactly Is All That TARP money?

Not here. As far as savings go, Americans have gotten religion. We now owe less money collectively than we did a year ago, as the graph above shows. Not only do we want to get out from under; lending institutions are forcing us to submit to tighter discipline. They are making money less freely available now to protect themselves from risky borrowers.

But this is bad news for an economy built on expanding consumer debt. The reduced demand for goods and services has resulted in massive layoffs during the past nineteen months, feeding a vicious cycle of lost incomes and delinquent loans. Policy makers in Washington last fall tried to stanch the bleeding with the infamous TARP, a program designed to force $700 billion through the nation's banks into the hands of tapped-out consumers. It was a frantic attempt to keep the debt addiction going.

A funny thing happened on the way to recovery:

[THERE it is...]

Instead of recycling the money as intended, the banks are sitting on it. Notice (above) how excess bank reserves have soared since September's meltdown in the credit markets. Once burned, banks are now twice shy about building their balance sheets on the backs of distressed consumers. Instead, they are hunkering down until the storm passes.

TARP was supposed to mitigate the pain. It has not done that, nor has it helped to spread the pain evenly. It has selected and protected a privileged group of survivors, a class that, more than made whole, is actually profiting from the crisis. During the Obama relief rally, banks have made money by underwriting each other's stock offerings and trading each other's stock. They have not made it by making new consumer loans or modifying existing ones.

They said that taking TARP money was the patriotic thing to do. They lied.

Population Grows, Workforce Doesn't

For the first time since World War II, the U.S. Gross Domestic Product has shrunk for four straight quarters (and five of the last six). Another post-WW2 first: we are completing a ten-year period with no net new jobs (see chart above). Wages and salaries, which drive recoveries in spending (not to mention tax collections), fell 4.7 percent in the 12 months through June, the biggest drop since records began in 1960. In other words, we have more dependents than ever before in a shrinking economy less able to support them.

Today brings the "good" news from the Bureau of Labor Statistics that "only" 247,000 jobs were lost in July. Numbed by monthly losses twice as large earlier this year, we are coaxed by the media to accept that a quarter-million new pink slips somehow bespeak an imminent recovery. I again remind you that the BLS data are "adjusted," and perhaps this month adjusted more than usual in order to pump up consumer and investor psychology (see Chris Martenson's take here). For now we have an Economy of Hope, but not yet one of results.

[update, September 4: Sure enough, the BLS has revised the July number to 276,000 jobs lost, a number nearly 12% uglier than the preliminary estimate. The final "official" number will not be known for another month.]

Lake Umbagog Slide Show

Begin here
(courtesy Boston Globe)

How To Destroy a Currency

Deficit Spending 101

[Thanks to Jake at EconomPic Data]

70 Years Ago Today...

...Donn Fendler disappeared on Mount Katahdin. Nine days later he emerged from the woods battered and bug-bitten. He has been writing and talking about his ordeal ever since. Today's Bangor Daily News has a retrospective here.

Double Dip?

May flowers bring June showers, according to the latest unemployment data from the Bureau of Labor Statistics. Because "only" 322,000 jobs were lost in May, incurable optimists were persuaded that the worst of the recession was behind us. After all, the hit was at least twice as big for each of the months in the December- March period. But Thursday's press release was grim. 467,000 jobs were lost in June, as the unemployment rate rose to 9.5%. There are fewer people working in the U.S. today than when former President George W. Bush first took office, even though the workforce has grown by 12.5 million since then.

Almost as bad, the average work-week declined another tenth of an hour to 33.0. Big deal, you might say, what's a measly six minutes? Well, six minutes spread across the entire workforce is the wage-equivalent of tens of thousands of jobs. Take it from Uncle Sam, who sees the difference in payroll withholdings that come into the Treasury.

The attenuated work-week bodes ill for a quick job recovery, as there is significant slack capacity building up among the workforce still employed. When business begins to improve, employers will add back hours to the workers on hand before they re-hire laid-off workers. Another damper on job creation will be a ten percent increase in the federal minimum wage scheduled for later this month, from $6.55 to $7.25 an hour. Congress thought it was doing workers a favor when it legislated the increase two years ago, but the intervention instead will have employers calculating twice before expanding payrolls. Bet Congress would like to have that one back.

While unemployment data are traditionally viewed as lagging indicators, this time may be different. Credit is being crunched faster than the Fed can print it, depressing consumption. This de-leveraging will make employers extra cautious about hiring. They'll need to see not just green shoots, but a veritable rain forest before they make the leap. Meanwhile, the shrinking purchasing power of the American consumer perpetuates a vicious cycle, as illustrated below.

Deja Vu

Source: Eichengreen and O'Rourke (2009) and IMF

Another Great Depression? It is still to early to tell, but so far the current decline in global industrial output is closely tracking what took place 80 years ago (see graph above). Here in the U.S., we are running at less than two-thirds capacity. In fact, we are seeing a utilization rate last seen in the 1930s:

There will not be a bunch of new investment in industrial capacity until utilization gets back into the 80s. Meanwhile, employers appear loath to hire back laid-off workers. The average layoff has reached 24.5 weeks, a 60-year high:


Indeed, almost half of all displaced workers now collecting unemployment insurance will exhaust their benefits before returning to work (unless, that is, Congress borrows yet more money to extend the benefit period a second time). As a result, delinquent consumer loans, from credit cards to home mortgages, will likely increase, further pressuring the banks carrying those loans on their balance sheets.

Bank failures are becoming THE story in 2009. On Friday the Federal Deposit Insurance Corporation continued its weekly ritual of Whack-a-Bank, closing five more and bringing the year-to-date total to 45 (complete list here). Despite going on a hiring binge a year ago, the FDIC stills does not have enough bank examiners to keep up with the growing caseload. Thus, the implosion of the banking sector will play out in slow motion for at least the rest of this year--and probably beyond.

[update, July 31: The FDIC announced today the closing of five more banks. The total for 2009 now stands at 69, at least until next Friday.]

All of which makes the odds of an upside divergence in the topmost graph rather remote. [For a more detailed discussion of the headwinds facing the economy, check out John Mauldin's latest weekly newsletter--The End of the Recession?--and scroll down to The New Normal...]

Class of '09 Hits Job Market, Class of '69 There First

Look behind the headlines of May's unemployment figures. The "improvement" in the number of jobs lost was no improvement at all. Sure, the loss of 345,000 jobs in May sounds better than the 504,000 jobs lost in April. But let's get one thing straight: the May number does not replace the April number. It adds to it. Things have gotten worse.

And things have gotten worse, it can be argued, at the same rate. Hours were reduced for many retained jobs, as workers were sent home on unpaid furloughs rather than fired. The shortening of the average work week in May by 0.1 hours, spread over the entire workforce, was the payroll equivalent of 250,000 lost jobs. Add that number to the headline number, and we're back to approximately 600K, the norm for the last six months.

Digging deeper, we find that one part of the workforce is adding jobs: those 55 and older (see chart above). Their retirement nesteggs decimated by back-to-back busts in stock and home values, these folks are highly motivated to remain in or to re-enter the workforce. Their earnings will be used to rebuild net worth, not to consume. Displaced are Generations X, Y, and Z, who collectively lost over 6 million jobs over the past year. They would be the ones more likely to spend their paychecks, increasing the velocity of money and stimulating the economy. But ya can't spend what ya don't earn (and can no longer borrow).

With Baby Boomers cannibalizing the job prospects of younger workers, economic recovery will not come anytime soon.

June 20, 2009
Monterey, MA

May 26, 2009
Peru, ME

Going Parabolic

This is not your usual garden-variety recession. Because total debt in the U.S., public and private, exploded to four times GDP (a once-in-a-lifetime ratio) over the past twenty years, the unwind now underway will be protracted and brutal. As of the end of March, almost 8% of all single-family mortgages were classified as delinquent, up from 3.7% the year before and 1.6 % in March 2006. (Click on the graph above.) The problem? Too many houses--and not enough homeowner equity to justify all that construction.

We began 2009 with 19 million empty homes in the U.S., the most EVER. The vacancy rate stood at 2.9%, the highest since record-keeping began in 1956. Housing starts in April fell to a seasonally adjusted annual rate of 458,000, the lowest since record-keeping began in 1959. Applications for building permits, an indicator of future construction activity, fell to a seasonally adjusted annual rate of 494,000, the lowest since record-keeping began in 1960. In other words, we are seeing numbers NEVER seen before. The overhang is so huge that if all housing starts halted today, it would still take more than two years to work through the inventory at the current pace of sales.

Nationwide, 649,917 homes received at least one foreclosure-related filing in the first three months of this year--more than double the number in the year-earlier period--despite a government-whistled timeout on foreclosure activity at the nation's biggest banks. Now the grace period is up, and banks are racing to liquidate repossessed property before they go belly-up. Largely because of home-mortgage defaults, 33 banks were seized by the FDIC between New Year's Day and yesterday, resulting in a cumulative drawdown of $5.4 billion in the agency's Deposit Insurance Fund (money used to indemnify trapped depositors). Today the 34th failure was announced: BankUnited FSB, with a price tag of $4.9 billion all by itself. That leaves $8.6 billion in the DIF before the hat goes out (again) to the taxpayer.

Can the banks earn their way out of this mess? Not if the economy continues to tank, a likely outcome in light of rising interest rates. The 10-year U.S. Treasury note is fast approaching 3 1/2% (see graph below):


As one would expect in an environment of rising interest rates, applications for home loans have started to decline. According to an index compiled by the Mortgage Bankers Association (MBA), applications this week are down 14% from the week before--and 43% from the April peak. The "green shoots" represented by the refinancing spurts last winter and earlier this spring (graph below) are getting weed-whipped:

[below: updated for week ending June 26, 2009]

Getting back to parabolae, check out the spike (below) in the price-to-earnings ratio of the S&P 500 companies. A reversion to the mean would require either a dramatic increase in earnings or a dramatic decrease in stock prices. Which is more likely? Choose between these two answers: (A) the latter, or (B) definitely the latter.


[update, 05-28-09:]
More data were released today by the MBA in its quarterly National Delinquency Survey, which found that 9.12% of all residential mortgages in the first quarter were delinquent (at least one payment past due), the highest level since the data series began in 1979. Add to that another 3.85% that were somewhere in the foreclosure process, and you've got 1 in 8 loans in trouble. Homes entering the foreclosure process rose from Q4's 1.08% to a record 1.37%.

Headwinds

(click for larger image)

Economic recovery will be delayed and difficult, and here are two reasons why. First (chart above), the personal savings rate among Americans has turned abruptly upward. That means that purchases of discretionary consumer items will likely remain depressed for some time. Second (chart below), interest rates are headed up despite the recession because the U.S. Treasury is flooding the market with long bonds--too much supply, too little demand. And higher rates are a drag on economic growth. The Federal Reserve hopes to counteract that drag by buying up U.S. bonds. Unintended consequence? Inflation.

Shooting Against the Messenger

In the Emperor-has-no-clothes Department (and you thought E.D. stood for erectile dysfunction), financial analyst Meredith Whitney has been opening eyes ever since credit markets went limp in August 2007. Until then, big investment banks ruled. They were posting huge profits by peddling risky derivatives to greedy investors, as well as to unsuspecting state treasurers (that means you, Dave Lemoine) reaching for a few extra basis points of yield on cash reserves. But then skeptics like Madame Whitney began looking closely at (and behind) the banks' balance sheets and said "Hey, guess what, you guys are technically insolvent!" The CEOs at Citigroup and Merrill Lynch soon lost their jobs.

So began a cascade of defaults and bank runs that resulted in the disappearance of some of the biggest names on Wall Street--Bear Stearns, Lehman Brothers, even Mother Merrill. Executives in Brooks Brothers suits began jumping out of windows. Some had parachutes; some hit the pavement. It got so bad that bank operators masquerading as government officials (stand up, Henry Paulson) devised all sorts of taxpayer-funded programs to bail out their brethren. Rarely have acronyms sparked such acrimony: TARP, TALF, and TICKED OFF, to name a few. Congress went along, as it is paid to do.

Is the worst now behind us? Whitney thinks not, despite the fact that bank stocks have pulled out of their nosedive to zero. She believes the recent rally has been cleverly orchestrated by Oligarchy Inc. to provide a brief window of opportunity for teetering banks to issue new stock to smitten investors. Financial statements for the first quarter were massaged, nipped, and tucked to look almost good, earning most banks passing marks in the so-called "stress" tests just concluded by the Treasury Department. Those getting "Incompletes" were given time to raise additional capital. Capital requirements were calculated by extrapolating those puffed-up Q1 earnings.

Whitney insists that those "earnings" are not replicable. She points out that banks are sucking liquidity out of consumers' wallets, cutting credit lines to cardholders by $1 to $2 trillion. And as consumers retrench, sales-tax collections by state governments shrink (never mind the meltdown in income-tax payments caused by nearly 6 million layoffs in the past sixteen months). State and municipal spending accounts for 12% of GDP, so the wind-down becomes self-reinforcing. A V-shaped recovery, in Whitney's view, is highly unlikely. So, for that matter, is an L-shaped recovery.

She is thinking of a shape that is more, um, flaccid. Her pessimism, it must be acknowledged, has begun to grate on some industry cheerleaders. Despite her prescience thus far, she is bound to get it wrong at some future point. It happens to the best of them. But if you're thinking about betting against Whitney and buying into the financial-sector euphoria, you have to ask yourself, "Do I feel lucky today?"

[update, 05-27-09:]
The Federal Deposit Insurance Corporation just released its Quarterly Banking Profile, which shows that the number of "problem banks" in the U.S. increased in the January-March period from 252 to 305, with combined assets at risk approaching a quarter of a trillion dollars. Another 21 banks failed during the same period, the largest number since Q4 1992, shrinking the Deposit Insurance Fund from $17.3 to $13 billion. One bank in five lost money during the quarter. "Noninterest revenue is up at larger banks," pointed out FDIC Chair Sheila Bair, "particularly trading revenues"--meaning that profits were made not by floating a sinking ship, but by rearranging the deck chairs. Even after first-quarter charge-offs of $37.8 billion in bad loans, non-current loans and leases rose by $59.2 billion, or 26%. Of all loans and leases, 3.76% were non-current, the highest level since Q2 1991.

Biennial Budget 2.0: Pathetic

You would think that an elected official, his last campaign behind him, would exhibit some independence and leadership. You would expect a willingness to confront tough issues head-on and to develop long-term solutions. No posturing, no sugar-coating. A termed-out executive has a rare opportunity to concentrate on the job at hand without the distraction of the next election--to do what is right, not just what is politically expedient.

If you think Maine's governor is rising to such an occasion, think again. John Baldacci seems content to go out not with a bang, but with a whimper, the lamest of ducks. Yesterday Baldacci released a do-over of his proposed 2010-11 budget after reviewing new projections that state revenues will likely come up a half-billion dollars short during the biennium. "This budget makes serious and difficult reductions," he insisted, yet in the same press release he observed that "there are no additional layoffs in this proposal." Say what?

Republicans were perplexed. "I was surprised not to see more significant structural changes going forward," said Senate minority leader Kevin Raye. Current economic and demographic trends suggest that we will not soon be able to afford the level of government spending to which we became accustomed during the past decade. If revenues in Fiscal Year 2010 are going to decline by $200 million, then spending needs to be reduced by the same amount. Yet Baldacci's proposed cuts address only 15% of the shortfall. Where will the rest come from?

$68 M of federal stimulus money (originally targeted for new jobs)
$24 M from the "Rainy Day" fund (none left for Baldacci's successor)
$35 M from income- and property-taxpayers
$16 M from more aggressive collection of tax receivables
$9 M from reduced payments to healthcare providers
$7.5 M from phantom savings yet to be identified
$6 M in "shared" revenues from cities and towns

If that looks like smaller government to you, I have a great deal on a bridge that I would like to sell you.

The latest revenue projections, attenuated though they may be, still look unrealistically high. FY2010 is going to be a real house of horrors, as credit-card defaults, commercial real-estate foreclosures (did you see the winning bid on Boston's John Hancock Tower?), and bank failures will wreak considerable havoc in the national economy. All those "green shoots" that the Fed chairman has been talking about are about to get napalmed. There is no way that Maine's general-fund revenues in FY2010 and FY2011 will remain nearly flat with FY2009, as the Governor currently expects.

But that's O.K., a politician's best friend--a New Commission (fanfare, please)--will do the heavy lifting, tasked with "streamlining" state government. Baldacci, a politician to the end, will do the spotting.

The "Snickers Recession"

[Source: U.S. Census Bureau]

Gonna be here awhile? Yes, we are. Some people look around and think they see "green shoots" springing up in the economy--you know, the same way pilgrims to religious shrines swear they see tears running down the cheeks of Mother Mary. Look at an inert object long enough, and you will eventually see what you want to see. The human brain, after all, is hard-wired to look for change.

The graph above is an ill omen for an economy built on rampant consumerism. It says that stuff is just not selling. While business inventories in the U.S. fell in February by 1.3% (a welcome precursor to recovery), sales fell as well, leaving the inventory-to-sales ratio virtually unchanged. That ratio needs to come down before businesses decide to ramp up orders. The best that can be said about the economy, according to Paul Krugman in today's N.Y. Times, is that "things are getting worse more slowly."

Bank stocks have rallied furiously in the last six weeks, leading some to believe that better times are just ahead. This morning Citigroup (trading at just a buck not too long ago) reported a lower-than-expected loss. Earlier this week Goldman Sachs and JPMorgan Chase also posted decent results. But can those profits be replicated in quarters to come? I say no, and here's why. First, last year's fourth quarter was a "kitchen-sink" quarter for the banks, which all took massive write-downs to make this year's Q1 look good by comparison. In fact, Goldman, in a clever piece of bookkeeping legerdemain, orphaned its hideous month of December by changing its fiscal year!

Second, most of the recent profits were generated by trading activity, where the firms either placed bets on securities themselves or collected fees from other investors doing the same thing. Heightened volatility in the stock market enabled these players to harvest sizable short-term gains. When the market takes its next leg down--and it will--volatility will get crushed, along with the trading positions. Then the banks' investment divisions will get back to doing what they did all of last year: taking losses.

Third, banks will be forced to write down heavily, perhaps as early as the second quarter (the one we are in now), for looming losses in home mortgages, credit-card debt, and commercial loans. Anticipating more pain ahead, JPMorgan increased its loan-loss reserves by $10 billion, or over 50%. Goldman is getting ready for the next wave of defaults by issuing $5 billion in new stock, signaling both that it will need the cash and that it does not expect its stock price to advance from here. Betting on a recovery is betting against Goldman.

Mainers were just reminded of a fourth headwind facing the economy: imminent corporate bankruptcies. Yesterday Portland's television reporters, as they usually do when they want "hard" news on the economy, went to the Maine Mall to talk to shoppers, who were asked about the announcement that the mall's owner, General Growth Properties, Inc., was filing for Chapter 11 bankruptcy protection. None of the shoppers knew that GGP was being pushed to walk the plank by bondholders. Normally bondholders avoid the courts for fear of a haircut, but no longer. As the Financial Times reports, those protected by credit default swaps (CDS) are now highly motivated to push for bankruptcy, which triggers face-value payouts on the bonds. That default insurance was written by the AIGs of the world.

Which means that, thanks to the TARP bailout, you and I will be paying it.

[update, 05-18-09:]
At an auction last week to settle the credit default swaps on GGP's bonds, the secured debt was priced at $0.43 on the dollar, which would seem to put federal taxpayers on the hook for the other $0.57. Worse, the discount signals no visible end to the crash in commercial real estate.

Dennis Is Wall Street's Menace

Congressional oversight is often lacking, but not now. U.S. Representative Dennis Kucinich of Ohio is not your typical capitalistic crony, warming a seat on Capitol Hill while cozying up to wealthy campaign donors. He means business--and means for Big Business to be accountable.

While polling single digits as a presidential candidate in 2004 and 2008, Kucinich insisted that he was Main Street's guy. "The rest of these people," he said of his opponents, "are candidates of a radical corporate structure that takes the wealth of the nation and puts it in the hands of a few." He opposed the TARP legislation passed by Congress last fall, concerned that Treasury Secretary Henry Paulson, an ex-Wall Streeter, was being granted too much power. It was like appointing a fox to guard the hen-house.

Hens should now feel comforted. As Chair of the House Domestic Policy Subcommittee, Kucinich serves as the resident bad-ass rooster on steroids. Last week he went after Bank of America, suggesting in a letter to the Securities and Exchange Commission that the mega-bank had duped its shareholders by withholding material information prior to December's vote approving the merger with Merrill Lynch. Specifically, shareholders should have been alerted about billions in bonuses to be paid to outgoing Merrill executives, bonuses that Kucinich derides as "little more than a farewell gift from senior management to themselves." [For more on the New York Attorney General's investigation into the bonuses, go here.]

Bank of America's stock has been trading like a champ, more than tripling in six weeks. Investors obviously feel that the government has BofA's back and that taxpayers will pick up the tab for civil penalties stemming from any violation of SEC regulations. Meanwhile, Dennis the Menace is prodding the Treasury Department and Federal Reserve to reveal what they knew about the bonuses--and when. After all, they were essentially conservators of the damaged Merrill franchise ever since the September announcement that Bank of America would be taking over. Watch feathers fly if Kucinich can prove a cover-up.

[update, 04-23-09:]
The Wall Street Journal is reporting this morning that Treasury Secretary Hank Paulson and Fed Chair Ben Bernanke encouraged BofA CEO Ken Lewis, in effect, to commit securities fraud. Quoting the report, "Mr. Lewis, testifying under oath before New York's attorney general in February, told prosecutors that he believed Messrs. Paulson and Bernanke were instructing him to keep silent about deepening financial difficulties at Merrill, the struggling brokerage giant." Not only that, Paulson and Bernanke threatened to fire Lewis and to remove BofA's entire Board of Directors if the company persisted in trying to back out of the Merrill deal. The AG's letter to Congress, just released, can be found here.

All-American Boy Goes Out a Champion

Carolina's Tyler Hansbrough

"A New Level of Absurdity"

Cut the Congressman some slack, please. U. S. Representative Spencer Bachus of Alabama, the ranking Republican on the House Financial Services Committee, is extra cranky these days from massive indigestion--dysPPIPsia, if you will. He has been reviewing the Treasury Secretary's latest plan to relieve America's biggest banks of toxic assets, and he smells a rat. The last straw came last night when a Financial Times reporter intimated that banks were seriously considering buying such assets, not selling them. Or maybe buying and selling them. Bachus is outraged, and you are...confused?

O.K., let's walk through this slowly. First, some background. Recall that last July Merrill Lynch tried to find a buyer for $30 billion worth of toxic assets that the company was carrying on its books. Lo and behold, they found one: Lone Star Funds, a private-equity firm based in Dallas. Lone Star agreed to pay 22 cents on the dollar for this crap, but only if Merrill would finance 75% of the purchase with no added collateral. In effect, Lone Star was risking only 5.5 cents on the dollar. Merrill, however, got to book 22, a price inflated by the leverage involved.

Tim Geithner's PPIP (acronym for "Piss-poor Plan for Inflated Pricing"--no, just kidding) attempts to jump-start the moribund toxic-assets market with the exact same mechanism: use leverage to mark up the asset prices. Let's go back to the Merrill example. Merrill had more toxic assets than the $30 billion it sold to Lone Star, a lot more. Now Bank of America has them after agreeing to take out Merrill in September. Upon closer inspection, Bank of America found Merrill's portfolio to be so toxic that it tried to back out of the deal in December. But Treasury had the shotgun, and Bank of America had to acquiesce (though Treasury sweetened the deal with another $20 billion in TARP dough).

So how is Bank of America going to find buyers for the old Merrill junk? Simple. Use PPIP. Bank of America agrees to finance up to 86% of the purchase, the same way Merrill did with Lone Star. One major difference: the FDIC guarantees the loan, which means Bank of America will never have to write it off. Second major difference: the U.S. Treasury partners with the private-sector buyer 50:50. Third major difference: the Federal Reserve finances a portion (exact percentage to be determined) of the private-sector equity offer. The whole scheme is a Rube-Goldberg contraption designed to lever up an itty-bitty private-partner bet into an artificially high sticker price that Bank of America and its peers can then use to mark up their portfolios and boost their tangible capital ratios.

Also benefitting will be the Pimcos and BlackRocks of the world who hold corporate bonds issued by Bank of America et al. In fact, they are among the privileged few handpicked by Treasury to bid for toxic assets, some of which they already own. The worst thing that can happen to them is that they place their bets on mortgage-backed securities, collect the coupon while they wait for price appreciation, and walk away from their loans if the assets tank further (not unlikely). They still profit on the turn-around, and meanwhile their bond positions have recovered. The banks, their balance sheets fortified, take a giant step back from insolvency. Pimco's Bill Gross calls it a win-win-win. [update, 07-09-09: make that win-lose-draw. Pimco has withdrawn from the PPIP auction amid new "uncertainties" about the program's design.]

The third winner in that equation is supposed to be the taxpayer. But this is a zero-sum game, with no new wealth created. Somewhere, somehow, there has to be a loser. Minyanville's Mr. Practical points to the taxpayer: "banks on average have most of their illiquid assets marked at $.60 on the dollar, while a private investor in order to risk money might be willing to pay $.30 on the dollar. If this is going to work, the government (you) will have to make up the difference, which could be around $3 trillion....so while the program will show initial success (it’s most likely all pre-arranged) on a small amount of assets, it will eventually expose more losses down the road and more need for capital."

Private-equity managers are salivating at the opportunity. Tom Barrack, founder of Colony Capital, wants to raise $4 billion to buy distressed banking assets. In an interview with the Financial Times, Barrack opines that the traditional private-equity model just doesn't work like it used to. “Private capital needs to change its thinking. Today, the opportunity is to become a regulated institution, not to run away from regulation,” he said. Translation: the only suckers left are taxpayers. As Dr. John Hussman of Hussman Funds explains: "You can play hot potato with the toxic assets all day long, and the only outcome will be that the public will suffer the losses that would otherwise have been properly taken by the banks' own bondholders."

But taxpayers, as well as their duly elected representatives, are starting to wise up. The claw-backs of bonuses awarded to AIG managers are a warning that obscene profits under PPIP will not go unnoticed and may be subject to punitive retroactive taxation. Rep. Bachus promises to do what he can to stop Wall Street from "gaming the system to reap taxpayer-subsidized windfalls.” Make sure your rep does as well.

[update, 04-07-09:]
The Wall Street Journal is reporting this morning that the Treasury Department, following criticism that PPIP 1.0 practically guarantees premium prices for toxic assets, will open up the bidding process to smaller investors. More competition means better pricing--and better protection for taxpayers. Also depressing prices is the sheer supply of toxic debt, which is increasing faster than Treasury can auction it off. The International Monetary Fund now estimates that toxic debt will balloon to over $4 trillion in the months ahead. That's more than the Obama budget!

[update, 05-27-09:]
In a rather belated response to Sen. Bachus's concern that Wall Street banks might use PPIP to offload exposure onto the taxpayer while keeping the assets, FDIC Chair Sheila Bair (according to Bloomberg) said at a news briefing today that banks will not be allowed to bid on their own assets. JPMorgan Chase & Co. and Bank of America Corp. are among the banks yearning to do just that. Left unanswered was the question as to whether banks can buy assets from other banks. I wouldn't put it past the robber barons to devise paired transactions solely to mark up their inventory--I'll overpay for yours, you overpay for mine, quid pro quo. A suddenly suspicious Congress has added to the legislation authorizing PPIP an amendment imposing conflict-of-interest rules and demanding that purchases of toxic securities be arms-length transactions.

[update, 06-03-09:]
The FDIC has placed its Legacy Loan Program on hold. In a statement today, Chair Bair said: "Banks have been able to raise capital without having to sell bad assets through the LLP, which reflects renewed investor confidence in our banking system. As a consequence, banks and their supervisors will take additional time to assess the magnitude and timing of troubled assets sales as part of our larger efforts to strengthen the banking sector."

Mama Bair
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