Stress Test BS

With the stress test behind us, we can all breathe a sigh of relief.

The nation's biggest banks aren't insolvent.

Decisive action by the Fed and Treasury has kept the nation's economy from careening into the abyss.

Ah... these giddy feelings are wonderful.

The only really distressing thought is that so many of "my fellow citizens" are so completely clueless that they'll believe this corn-littered raft of crap coming out of Washington and regurgitated by the various morons in the financial press and mainstream media.

Now you know my take on the "stress test." Time for the rest of the story, or "Why Bernanke, Paulson, and Geithner need to be thrown in prison.

Overview

• "More Adverse" scenario is already here
• Capital requirements "fudged" -- complete with nuts
• Government will backstop the need for funds

More Adverse Scenario

Prime Delinquency
One of the main assumptions that went into the test of these banks was that defaults on prime mortgage loans would not exceed 3-4%. That's important because so much of the potential losses to the banks (roughly $455 billion is attributable to residential mortgages and consumer related loans) are mortgage driven. That would be really bad. The really bad news is that this level of default on prime mortgages isn't some "way out there" unlikelihood. Just how probable is it?

Fannie Mae's Q1 2009 report shows that 3.15% of their prime mortgages are three or more months past due. If you haven't paid your mortgage for the past quarter of the year, what are the odds you're suddenly going to make a payment next month? You'd better have one helluva couch with magic cushions.

It's a safe bet that we've already hit this key level in the "more adverse" scenario. Naturally enough, not a thing was said about this in the news. You certainly didn't hear Geithner or Bernanke mention it, even though this information was available prior to the release of the stress test results.

As a quick aside, the amount of total mortgage related losses predicted in the "more adverse" scenario is also laughably optimistic. Where the test results were predicated on losses just south of $1,000 billion by the end of 2010, the IMF is expecting between $2,400 billion and $4,100 billion, Roubini is expecting losses to exceed $2,000 billion, and Karl Denninger of Market Ticker is expecting between $2,500 billion and $3,000 billion in residential mortgage losses. Once again, the "adverse scenario" is wildly optimistic.

Unemployment -- dreaming of jobs
Another key metric of the "more adverse" scenario was that unemployment could hit 8.9% by the end of 2009 and go all the way to 10.3% by the end of 2010. Unemployment is a key measure impacting banks because unemployed people:

1. Tend to stop paying on their credit card
2. Tend to stop paying on their car payment
3. Sometimes even stop paying on their mortgage
4. They don't purchase additional financial "products"

Again, this "more adverse" scenario is currently being hit. Mainline, (U-3) unemployment hit 8.9% in April. U-6 (which is what the labor market actually feels like to real humans as opposed to Bureau of Labor Statistics droids), hit 15.8%. Did I mention that this is for April? Don't expect these numbers to turn around by the end of the year. In fact, don't expect them to improve by the end of next year either.

The "more adverse" scenario is actually the "dreaming of candy and unicorns" scenario.


Capital Requirements

The other side of the stress test was an evaluation of the banks ability to withstand the losses under the various scenarios. You might expect that this is more straightforward -- a loss of $100 dollars burns through $100 dollars in capital. If we were talking about this a decade ago, you'd be right. We would be measuring the capital cushion of the banks in terms of their Tangible Common Equity (basically the value of the assets of the company minus liabilities, and most importantly, minus things that would be worthless if the company had to liquidate (like deferred taxes and goodwill). In a nutshell, TCE is what a bank actually can use to absorb losses in its loan portfolio.

The initial plan for the stress test was that it would consider the banks need to raise capital in light of their potential losses (from the unicorns and candy scenario) as gauged by the TCE of the various banks.

Well, that was dumb. This turned out to be a horrible way to measure the ability of the banks to withstand the losses they are facing. The numbers looked really bad this way. The "stress test" would hardly be effective at convincing investors that all was okay when the results clearly indicated that large chunks of sky had been crushing banks and would continue to do so for the forseeable future.

Instead, the banks were able to negotiate with the Fed to instead use consider their Tier 1 Common Captital. This worked out much better for the banks. Naturally. Some samplings of Tier 1 ratios vs. TCE ratios (note that TCE ratios don't hit 5% at any of these guys):
That whole "capital cushion" that banks are supposed to maintain to avoid getting shut down by their regulator... Well, yeah, not so much. Fortunately, banks intend to increase their revenues in order to help fill the huge enormous gastly gaping void.

Right.

All of this seems really odd until we get to the final point, after which everything starts making sense again.


You're the Backstop

If you have even half a pulse it is obvious that the banks are seriously short on capital. However, instead of the FDIC shutting the banks down, breaking up their assets and selling them in pieces off to solvent banks, Tim Geithner has committed to the government backstop them. If the banks can't raise the money they need in the market, then the government (or the Federal Reserve -- which isn't really part of the government) will provide them the capital they need. Heads they win, Tails you lose.

You can fast forward to about 9:30 into Charlie Rose's interview with Geithner for that gem.

Here's what I'm wondering. Why bother going through the sham of a "stress test" if the insolvent banks aren't going to be allowed to fail anyway? It seems pretty clear to me that the results were known more or less in advance and that the only purpose was to convince investors that "everything was going to be alright."

Frankly, I think we are about to get Fed'rolled (in the spirit of Rick-rolling).

It's now quite reasonable that the results of the test dribbled out in leaks over the course of a week or so. The "stress test" was purely a marketing tactic. At the end of the day, you are on the hook to either pay off the enormous loan the Treasury will need to backstop these insolvent banks, or suffer dramatic inflation at the hands of a rapacious and completely opaque Federal Reserve bank.

All the purported good news has helped drive financial stocks higher, which has in turn played a key role in helping some big names sell new shares to the public -- increasing their capital cushion. Increasing the capital cushion is good, necessary even. What I find to be seriously fraudulent is the government taking an active role in lying about the health of these companies in an effort to put lipstick on a zombie so that people will be duped into investing in them.

Before the schadenfreude sets in, it's worth considering some of the trends that have been analyzed of late over at Zero Hedge. Basically, the smart money has been heading out of the market. The large institutional buyers, yeah, they're not playing because the valuations are making no sense whatsoever. Instead, the growth in price is coming on decreasing volume.

There's talk of panic buying -- people calling their broker in a rush to buy to avoid missing out on the "bull market." While a fool and his money are soon parted, the government shouldn't be actively trying to punch him in the nose as a distraction for the pickpockets.

Thank goodness for the new-found transparency in Washington!

Senior Secured Debt and Thugocracy

The current fiasco with Chrysler is illuminating. Two things are very clear:

• The bulk of the people interviewed appear to have basically no clue about contracts and/or contract law
• President Obama has forgotten that "the point" of the Executive branch is the enforcement of US Federal law

Chrysler's situation is pretty rough, $39.3 billion in assets and $55.1 billion in liabilities. What to do about that is where things get interesting.

The senior secured lenders to Chrysler are owed $6.9 billion. In order to really appreciate the actions of President Obama, we need to know what it means for a debt to be senior and secured.

We're gonna have to start by defining some terms. Otherwise, you could hit the far end of this article not one bit more aware of what's coming than the morons in the media. That's not acceptable.

Secured Loan / Secured Debt
In a secured loan, the borrower pledges some asset as collateral for the loan -- making this a secured debt for the lender. If the borrower defaults on the loan, the pledged asset becomes the property of the lender. Your car loan is a good example: if you stop making payments, the lender has the right to take THEIR car back. Because the lender has the right to the pledged asset in the event of default, secured loans are less risky and tend to be available at relatively low interest rates.

Unsecured Loan / Unsecured Debt
An unsecured loan is one where the borrower does not pledge any asset as collateral in the event of default -- making this an unsecured debt for the lender. In the event of a bankruptcy, unsecured debts have a general claim on the assets of the borrower AFTER the secured debts have been paid. This places unsecured creditors at a higher risk of loss in the event of default, which tends to result in significantly higher interest rates for unsecured loans. Your credit card is an example of an unsecured loan.

Senior Debt
A senior debt is one which takes priority over other debts owed. In the event of a bankruptcy liquidation, senior debts are paid first. Because of this reduction in risk to the lender, senior debt tends to be less expensive, (lower interest rate), than debt that has a lower repayment priority. Your home mortgage has a senior claim on the house.

These differences are why your home mortgage rate is between 5 and 7 percent, and your credit card is between 10 and 33 percent.

Back to the matter at hand.

The senior secured lenders to Chrysler are owed $6.9 billion. By law, these lenders have first dibs on the pledged Chrysler assets in order to satisfy this debt. There are only two legal provisions to change this:
* either both parties agree to a change in the terms of the loan,
* a bankruptcy judge changes the terms of the loan.

Obama's team has offered to pay these senior secured creditors $2.25 billion for their $6.9 billion claim (32.6 cents paid back for each dollar of senior secured debt).

Some of the senior secured creditors have taken this offer. In particular, those banks who were recipients of TARP funds have agreed.

What I find to be especially appalling is that the US Executive branch is villifying those people who hold a valid contract and aren't even so audacious as to insist on its enforcement. These "holdouts" are asking to be paid 36.2 cents for each dollar of senior secured debt.

It is President Obama's job to enforce US Federal law. His attempt to stir up popular sentiment against those whose legal rights he doesn't like is at odds with his sworn duty.

One of the senior secured lenders who originally was holding out for 36.3 cents on the dollar was Perella Weinberg. They changed their position after they were threatened that the full force of the White House press corps would destroy their reputation if they didn't agree to the lower payout rate.

That isn't enforcing the law, that's thugocracy.

You might be wondering if there are any long term consequences to this whole fisaco. If you aren't you should be -- unless you don't think it takes much wondering.

Think back to the definitions at the top of this. Certain types of loans are less expensive because of their inherent risk to the lender. If a lender can't trust that a secured claim will be enforced, their risk exposure isn't being meaningfully improved -- that means the loan will be more expensive unless they are just completely stupid.

President Obama says he wants to get the credit markets "working again". Maybe he should stop kidney punching their legal underpinnings.

What do you think your next mortgage rate will be if lenders are taught that their senior secured debt will be treated like (or worse than in the case of the Chrysler mess) a lower-priority unsecured debt? Do you really want to pay 20% interest on your next home loan?

What about your favorite "small business"-- vintage clothing store, coffee shop, ethnic restaurant? What are the odds that they can secure relatively inexpensive financing if pledging their assets as collatoral doesn't reduce the interest rate they pay on their operating line of credit? Will there be new "little businesses" if credit is only obtainable at credit-card-level interest? Or, will there just be the already-established big chains-- plenty of Wal-marts, but no independents?

These are the sorts of unintended consequences that come from the President of the United States publicly insulting and back-alley-threatening people who "holdout" hope that he will keep just over one-third of the promise he made to enforce contracts.

Goodbye Democracy, hello Oligarchy -- rule by the privileged few. Hope you're already friends with the few. 'Cause "he's" gonna make you an offa you cannot refuse, and if you do refuse, he cannot be held responsible for the actions of his associates....

Politics, Chicago-style.

Relevant links:

Bloomberg
Business Insider
FinancialStability.gov
The Atlantic
Wikipedia: First Lien
Wikipedia: Senior Debt
Wikipedia: Unsecured Debt
Chrysler Ultimatum and the holdouts

Look, a Distraction! I Mean, Bonus

This is actually funny in a very sad and cynical way. 

Daily wrap up from Talking Points Memo.

The administration (Bernanke, Geithner, Frank, and Obama -- as well as Bush, Paulson, and Greenspan) disparately need the general public (GP) to not stampede (either literally or figuratively in terms of cursing the memory of Greenspan).  However, the GP is getting screwed so severely royally that they are actually noticing -- considering the absolute lack of uproar over the destruction of the dollar's buying power since the Fed was formed in 1913 (down by 95%) it takes a hell of a lot for the GP to even be aware that the pot of water is warm.

However, they're upset now.  That anger has to go someplace.  It is politically non-productive for the anger to be directed at those actually most responsible for the current crisis (Federal Reserve, Treasury, Laws, FDIC, GSEs, and decades of regulatory agencies malfeasance).  So, there needs to be a tangible enemy for people to be mad at.  Bankers with their large salaries and bonuses are a great target because people can't relate to them, the natural jealousy regarding their income level, and they are in fact actually responsible for specific losses.

They're clearly a great target, even a correct target for anger.  Just not the best or most important target if we want to avoid messes like this in the future or have this one suck less.

With the disclosure of where something like $110 billion of the AIG bailout money went (more or less shipped immediately to other banks due to AIG's counterparty obligations) people are mad.  They're forgetting that the POINT of the AIG bailout was to make these stupid counterparties whole. And, when you consider the list of counterparties, you're sorta left realizing that the Fed and Treasury knew more or less who the big ones were when they made the deal with AIG.  But, we don't want people angry about that.

So, let's raise a big stink about the bonuses, because that's a simple, tangible thing that the GP can sink their teeth and rage into.  And the gilded idiots most responsible for the mess we are in can continue to try fixing it by juggling more of the land mines that caused the current mess.

Wow.... I hadn't meant to write that much.  I just really dislike how attention is being diverted from the actual problem.  Railing about symptoms is like insisting on Rogaine for part of your cancer therapy.

Honesty, from Moody's!

When sued for their clearly retarded ratings practices (giving toxic crap securities a AAA rating), Moody's actually told the truth. Well, they tried to use the truth as a defense, and the judge threw it out.

“Generalizations regarding integrity, independence and risk management amount to no more than puffery,” Moody’s said in court papers. As such, alleged “misstatements of this nature are insufficient to sustain a claim under the securities laws.”

If you use the term "puffery" as a normal person, their defense was spot on. However, they're using it to try dodging responsibility for their basically fraudulent ratings business. The judge wasn't having it.

Read more at Bloomberg.

If you can't sell it for money, it probably isn't an asset

So, I had meant to stop caring so much about the idiocy in the financial sector.

It turns out that while I am quite idiot resistant, I have failed at being idiot proof.

Bernanke Says Mark-to-Market Accounting Rule Should Be Improved

Here's a choice quote from Mr. Bernanke earlier today, Feb 25, 2009:

“Accounting authorities have a great deal of work to do to try to figure out how to deal with some of these assets, which are not traded in liquid markets.”

Actually, they don't have a great deal of work to do. Instead, they simply have to recognize that if you can't sell something, it isn't an asset. That's pretty simple. Oh, and the collarary is that value of something is a function of what a seller and buyer can agree on. This talk of "no market" is a crock. Here's an actual honest translation:

Banks are capitalized with lots of crap that nobody is willing to buy at anything near the price necessary for the banks to not be insolvent by so many hundreds of billions of dollars that your hand cramps writing the zeros. Instead of letting these bankrupt companies fail and wiping out their bondholders, we absolutely must let them claim that a pile of crap that they can't sell to anybody for more than $400 is actually worth $30,000,000 or so -- just as soon as this "illiquid" phase passes and idiots with more money than brains (I'm looking at you Sovereign Wealth Funds) are willing to pay those kinds of prices again.

The solution to this problem is actually pretty simple -- enforce the damn law! Banks have capital requirements -- when they fail to meet these requirements the FDIC comes in, makes the depositors good (up to $250,000 per account), and then does one of two things: if there is anything left over splits it up with the bondholders and preferred shareholders, or sells the remainder of the "assets" to another bank (hopefully one that isn't completely broke).

Instead, the Federal Reserve and Treasury are using us retarded, moronic taxpayers as ablative shielding to protect the personal income of the bankers and the investments of the bondholders.

I'm reminded of the scene from Liar Liar, where Jim Carey provides some of the best legal advice ever offered: "Stop breaking the damn law!"

"Depression Economics" -- Balderdash!

I had meant to stop reading and writing about the economic situation. So.... Um... Yeah.

I read an excellent article today about the foolish notion of "depression economics", how common sense is exactly wrong when it comes to hard economic times. The rebuttal linked below is something I wish I was competent enough to write. Fortunately for you, I'm competent enough to link to it. :)

Does "Depression Economics" Change the Rules?

Enjoy.

The next time somebody talks to you about the "Paradox of Thrift" you can respond with the "Consequences of Waste" -- which incidentally doesn't even require a paradox!

Efficiency vs. Resiliency

Last year, the financial sector took a pretty universal beating. In fact, unless you were in bear mutual funds or short-selling stocks, it was pretty dismal year. Over the past decade or so, communication barriers have fallen and that's helped improve the efficiency in the financial systems world wide. Cheap oil in the 80s and 90s helped foster global specialization as high-end products could be produced with cheap labor in developing economies. As a whole, the world became more efficient.

The downside was that all markets became more brittle. The improved efficiency helped to ensure there would be fewer shocks, but that their impact would travel further, faster, with fewer inefficiencies to dampen them or contain their spread.

There is a bright spot though, one that I think is well worth looking at as we head into 2009. Credit Unions. Because credit unions didn't go nearly so crazy during the housing and commodities bubbles, they are on much more solid financial footing than the rest of the financial sector -- and without massive taxpayer bailouts.

I think there is an analogy to the Credit Unions in our larger economy, and that is small towns. Big cities are places of specialization. In fact, that's no small part of why and how they exist. When everything is going well, these big cities will prosper, but their very efficiency has made them brittle. 2009 will see entire states getting hammered as their major cities crumble through over-specialization and lack of resiliency. New York, Michigan, California, New Jersey.

On the other hand, you have small towns (and different fingers). Small towns don't tend to be efficient -- that isn't the point. They're not filled with just a few kinds of specialists. Instead, they're home to generalists, people who can and do a wide variety of things. While very few small towns are actually completely self-sufficient, they are substantially closer than urban areas are.

Those that called the 2008 housing and commodities bubbles are expecting 2009 to be even worse wit 2010 being bad as well. I think that's going to make resiliency even more important going forward.

After several months of reading and writing about the collapse, I think I'm going to switch gears and try to learn about how small towns can improve their self-sufficiency. If nothing else, it should be a more positive experience for me than reading about yet another asinine plan of the US government to reward incompetence and use the taxpayers to absorb losses caused by irresponsible investors, regulators, bankers, and ratings agencies.

Small towns don't ride the crest of the wave in bubbles, but they don't crash upon the shore when the bubble bursts either.

fstab repair

Sometimes, bad things happen to good people. That's sorta unfortunate.

Sometimes, bad things happen to me, and that's really bad.

Today, I managed to make a typo in an entry in /etc/fstab. So, when I rebooted, the filesystem check failed (since I had spelled the path to the filesystem wrong and apparently the boot scripts aren't smart enough to recognize the difference between a non-existent device and a bad superblock). I needed to fix the typo in /etc/fstab, but the root filesystem was mounted read-only.

So, if you've got a busted /etc/fstab with a root filesystem that is an LVM partition, here's what you do.

First, you're going to need some sort of boot media, I use NimbleX-2008 for helping me through screwups like this. It's a 200 MB download from: NimbleX.net.

Boot to a command prompt or X and open a terminal window. If you don't use LVM for your root partition, you will probably already have your root partition mounted for you under /mnt/something-or-other. However, if you do use LVM, you need to know the name of your volume group. Mine is 'thump'.

Activate the volume group with (this is the step you won't remember if you're me):

lvchange -ay thump

Use lvscan to make sure it's now active:

lvscan

Then create a mount point for it and mount it. For me, that looked like:

mkdir /mnt/thump.root
mount /dev/mapper/thump.root /mnt/thump.root

Next, fix the silly typo in the fstab -- making sure to fix the one on your real disk, not the NimbeX instance's.

vi /mnt/thump.root/etc/fstab

Reboot, and you have your computer back. And now, I don't have to hunt through google to remember to use vgchange -ay to be able to see my root partition the next time I make this goof.

We now return you to your regularly scheduled economics and policy musings. :)

Market Cap -- what it means

While reading about the Citigroup bailout I saw a rather dumb statement in some of the news coverage.

Okay, okay, I saw a great many dumb statements, but most of those were of the ordinary "this bailout is a sad but necessary step to ensure the stability... blah blah blah variety." What stood out this time was a blatant misunderstanding of how the stock market, and indeed, free exchange, works from somebody who should know better.

Here's the statement that got my attention:

Given that Citigroup's entire market value on Friday was $20.5 billion, "instead of taking that $20 billion in preferred shares we could have bought the company," he says.

On the surface, that sounds pretty reasonable. After all, Anil Kashyap, the Edward Eagle Brown Professor of Economics and Finance at the University of Chicago's Booth School of Business should know what he's talking about.

There's just one problem.

This statement is only correct given circumstances that basically never exist.

So, here's an explanation of what Market Valuation actually means, so the next time somebody smart says something dumb like this you too can be annoyed. As a side note, I've said things like this myself -- without realizing I was just grossly wrong. Live and learn.

What does Market Value or Market Capitalization mean.

From Wikipedia: "Market capitalization represents the public consensus on the value of a company's equity."

Again, this statement is only sort of correct.

The market cap is the based on the price "negotiated" between the most recent buyer and seller of the stock.

Each stockholder has their own perceived valuation for their shares. Each knows the minimum amount they would sell for. Each potential buyer of a stock also has their own perceived valuation for the shares and each knows the maximum they would pay.

At any given time, many shareholders aren't currently interested in selling their shares because their valuation doesn't match a buyer's. If I held Citigroup stock and felt it was worth $60 a share, I'm not going to sell -- not today anyway.

The market cap of a company is based on the price of the last sale -- independent of the size of that sale. As few as 1share may have changed hands, but that still sets the market cap. The only time the price of the last sale is indicative of the actual cost to buy all of the outstanding shares is when all of the existing shareholders would be willing to sell for that price.

That clearly wasn't the case last Friday when only 1billion of the 5.45 billion outstanding shares changed hands.

The current share price is best information about the perceived value of a company, but it most certainly doesn't reflect the price at which all outstanding shares could be purchased.

Thinking of market cap that way is just sloppy thinking.

Bailout blues

It has been a while since I could stand to write about the economy. I've continued reading and paying attention, but the amount of "stupidity in the system" is just painful.

The US has put the taxpayer on the hook for $7.7 trillion dollars, so far, as part of the bailout. That's half of the estimated 2008 GDP. It's probably a bit over half of the GDP for 2009.

The scary thing is that we've still got a long ways to go. Expect rising unemployment until 2010. With that will come more corporate bankrupcies as the US economy is forced to give up the asinine notion that it can be consumer driven. That only works as long as folks are willing to lend you money. We're coming to the point where nobody is that stupid.

Well, nobody, but the Federal Reserve and the US Government.

The Federal Reserve today put together a $200 billion dollar package of financing for supporting consumer finance (credit cards, student loans, auto loans, and Small Business Admin loans). The Treasury will be backstopping it from the $700 billion TARP bailout. The goal seems to be that if the central bank and the US government can get enough debt off the books of banks, things will be okay.

The problem is that much of that debt is going to default. Who would you rather have holding bag when it does, Citigroup, or your nation's central bank?

That's a trick question. You don't get a choice. haha :(

So, hunker down. At this point, the real question seems to be when the US or the Fed are going to be forced to default or effectively default by firing up the printing presses.

Happy Thanksgiving.
Be glad you don't live in Iceland, or Russia, or Europe, or China. Things will be even worse there.