EXTEND & PRETEND: Manufacturing a Minsky Melt-Up!
A distracted and preoccupied amateur is no match for a determined, organized professional with a strategy. Though the collapse of the shadow banking system was a near fatal miscue for the global bankers, they have been quick to adjust their strategy. With an army of MBAs, quants and lobbyists they have reworked their strategy at the expense of the still comatose and shaken taxpayer.
It is the first anniversary since April 2nd when FASB 157 was suspended and with it the suspension of ‘mark-to market’ accounting. The US congress held a gun to the head of the Financial Accounting Standards Board a year ago. Congress left FASB no choice but to change their guidelines under the perception that it was a deferral allowing time for the banks to adjust the toxic and devalued assets on their books. Where are we a year later with Mark-to Market still ‘on hold’ and Mark-to-Myth endorsed by the Federal Reserve Bank examiners? Frankly, the ‘happy face’ media doesn’t want to talk about it, so I will. As an investor, unlike politicians and the media, I must face reality or I will pay the ugly consequences.
In January's EXTEND & PRETEND - An Accounting Driven Market Recovery, I outlined the accounting changes that had been implemented to ignite a market reversal and rally from the March 2009 low. These accounting changes ranged from the deferral of FASB 157 in March 2009, the Commercial Real Estate Loan Workout Policy in October 2009, the three cauldrons easing in November 2009, the deferral of FASB 166 and 167 in December 2009 and the System Wide Federal Bank Examiner Reinforcement Training in January 2010. The changes were executed in a controlled and almost militaristic operation. The market has reacted with a 58.4% retracement of the 2008 decline and a 70% increase from the lows in the DOW industrial, trumpeted eagerly by the nightly news. This was Stage I.
Before we discuss Stage II, which will be the manufacturing of a “Minsky Melt-Up”, let’s briefly review the extent to which Stage I has created distortions in the accounting of public traded financial fiduciaries. We will then be able to see clearly how they have created the launch pad for Stage II.
STAGE I – AN ACCOUNTING ORCHESTRATED RALLY
The Friday Night Lottery
Almost every Friday night the FDIC seizes from 1 to 5 local or regional banks as insolvent failures. Saturday morning we wake to find these bankrupt banks have been magically merged with another bank. It all seems so normal. But does that speed and ease sound realistic to you?
According to Karl Denninger at The Market Ticker who follows these matters very closely, on March 6th he reported:
I am constantly amused by those people who claim there is some vast "conspiracy" in this country when it comes to banks, balance sheets, and fraudulent lending and accounting. There is no conspiracy. It is, in fact, "in your face" fraud. The FDIC does us the courtesy of explaining it virtually every Friday night, right on their web page. I am simply going to take last night's bank closures, which numbered four. One of them has no "deposit insurance fund" estimated loss available, because they didn't find someone to take the assets - they're just mailing checks. But the other three do.
1- Waterford Bank, Germantown MD: $155.6 million in assets, $156.4 in insured deposits. They were "underwater" by $800,000, right? Wrong: Estimated loss, $51 million. That is, the assets of $155.6 million were overvalued by approximately 30% at the time of seizure.
2- Bank of Illinois, Normal IL: $211.7 million in assets, $198.5 million in deposits. They were "underwater" by $13.2 million (which is why they were seized), right? Wrong: Estimated loss $53.7 million. That is, the the assets of $211.7 million were overvalued by more than 25% at the time of seizure.
3- Sun American Bank, Boca Raton FL: $535.7 million in assets (so they claimed anyway), $443.5 million in total deposits. Heh, why did you seize them - they have more assets than liabilities? Oh wait: Estimated loss: $103.8 million, so the actual assets are worth $443.5 - $103.8, or $339.7 million. That is, the assets of $535.7 million were overvalued by a whopping 37% at the time of seizure.
This isn't new, by the way. In August of 2009 I went through Colonial Bank's failure based on BB&T's presentation to its shareholders on the "merger" - and gift it was given by the FDIC. It too showed that Colonial had been carrying assets on their books at a ridiculous 37% above where BB&T ultimately marked them as a whole.
Folks, your bank is being assessed deposit insurance premiums to pay for these losses. You are paying these losses through increased fees and interest expense on your credit cards and all other manner of borrowing. You are paying for outrageous, pernicious and endemic balance sheet fraud. There is no conspiracy. It is right under your nose. One of these three banks, based on their balance sheet, wasn't even underwater - it was "to the good" by nearly $100 million dollars. The balance sheet was a flat, bald-faced lie. You want to sit for this? Why should you?
Now let's ask the inconvenient question:
Are the big banks - specifically, Citibank, Bank of America, Wells Fargo and JP Morgan - all similarly overvaluing their assets?
Why should we believe they are not? You can go through more than a year's worth of FDIC bank seizure information and in essentially every single case you will find that overvaluations of somewhere from 20-50% have in fact occurred, yet not one indictment for book-cooking has issued.
So let's be generous and assume that the "big banks" are over-valuing their assets by 25% - the lower end of the range of what the FDIC says is, through actual experience, what's going on, and add it all up.
This totals $7.49 trillion smackers.
The FDIC's experience with seizing banks thus far suggests quite strongly that all four of these entities are lying about these valuations, and that were they to be seized the loss embedded in them (and for which you, the taxpayer would be responsible) is somewhere between $1.49 and $2.99 trillion dollars.
Incidentally, neither the FDIC or Treasury happens to have either $1.49 or $2.99 trillion laying around, and it is highly questionable if they could raise it, should that become necessary. Now of course neither you or I can prove this is correct. However, we can look at the FDIC's own published bank closing statements, and derive from them a pattern stretching back more than a year now that has disclosed that in essentially each and every case the banks in question have overvalued their assets by anywhere from 20-40%, and that as of the day of the seizure such an overvaluation was in fact a continuing and ongoing practice. (1)
This was precisely what was in the process of happening, as I outlined in EXTEND & PRETEND - An Accounting Driven Market Recovery.
If you were a bank, why would you lend to small business or the consumer with their inherent risks when you could play the Friday Night Lottery? As A bank CEO you would ensure that you have plenty of cash ready to buy and take over the depositors (whose assets you desperately need), while having most of the bad debt written off and then likely getting very favorable FDIC guarantees for quickly taking the banks off FDIC’s highly depleted balance sheets. I imagine every US bank CEO & his/her Board of Directors watch these results closer than the March Madness basketball rankings!
To facilitate these bankrupt banks being taken over so quickly, there is obviously a considerable amount of very secret negotiations (non transparent, non public bidding) taking place behind the scenes. Like we saw with TARP (Troubled Asset Relief Program), it is amazing how much money gets spilled when everyone is in a frenzy to feed at the government trough.
It’s Only Going to Get Worse
The biggest financial issue with local and regional banks is their commercial real estate loans with building and construction loans being the worst.
The official government stance as stated in the February report from the Congressional Oversight Panel makes for sobering reading. It forecasts $200 to $300 billion in losses coming from commercial real estate (CRE) loans. The report notes these were not considered in the famed stress tests, since that process looked only through 2010, when the losses from CRE will peak later. It outlines that:
- Between 2010 and 2014, about $1.4 trillion in commercial real estate loans will reach the end of their terms. Nearly half are are presently underwater, that is the borrower owes more than the underlying property is currently worth.
- Commercial property values have fallen more than 40 percent since the beginning of 2007.
- Increased vacancy rates, which now range from 8 percent for multifamily housing to 18 percent for office buildings, and falling rents, which have declined 40 percent for office space and 33 percent for retail space, have exerted a powerful downward pressure on the value of commercial properties.
- The largest commercial real estate loan losses are projected for 2011 and beyond; losses at banks alone could range as high as $200-$300 billion.
- The stress tests conducted last year for 19 major financial institutions examined their capital reserves only through the end of 2010. Even more significantly, small and mid-sized banks were never subjected to any exercise comparable to the stress tests, despite the fact that small and mid-sized banks are proportionately even more exposed than their larger counterparts to commercial real estate loan losses.
- A significant wave of commercial mortgage defaults would trigger economic damage that could touch the lives of nearly every American.
- Empty office complexes, hotels, and retail stores could lead directly to lost jobs. Foreclosures on apartment complexes could push families out of their residences, even if they had never missed a rent payment. Banks that suffer, or are afraid of suffering, commercial mortgage losses could grow even more reluctant to lend, which could in turn further reduce access to credit for more businesses and families and accelerate a negative economic cycle.
- It is difficult to predict either the number of foreclosures to come or who will be most immediately affected. In the worst case scenario, hundreds more community and mid-sized banks could face insolvency. Because these banks play a critical role in financing the small businesses that could help the American economy create new jobs, their widespread failure could disrupt local communities, undermine the economic recovery, and extend an already painful recession.
The Chair of the Congressional Oversight Panel, Elizabeth Warren, in an interview with Charlie Rose on NPR stated:
CHARLIE ROSE: Commercial real estate, what are we looking at.
ELIZABETH WARREN: Oh golly -- 2,988 banks that by the terms of their own regulators are too concentrated in commercial real estate. These are the medium size banks. By the end of this year, half of all commercial real estate loans will be underwater, and they are coming in ‘11, ‘12 and ‘13.
The reason this is such a bad problem anyway -- think about that, nearly 3,000 banks out of a total of 8,000 -- it’s the very banks that do small business lending who are about to get socked in the nose on real estate, commercial real estate losses.
CHARLIE ROSE: So we’ll see banks going under because they’ve got too many loans out there are not being repaid?
ELIZABETH WARREN: We’re seeing banks that don’t want to lend because they see every dollar that comes in the door and say "I’ve got to hold on to it to try to fill my commercial real estate hole or else I will be gone."
ELIZABETH WARREN: Oh golly -- 2,988 banks that by the terms of their own regulators are too concentrated in commercial real estate. These are the medium size banks. By the end of this year, half of all commercial real estate loans will be underwater, and they are coming in ‘11, ‘12 and ‘13.
The reason this is such a bad problem anyway -- think about that, nearly 3,000 banks out of a total of 8,000 -- it’s the very banks that do small business lending who are about to get socked in the nose on real estate, commercial real estate losses.
CHARLIE ROSE: So we’ll see banks going under because they’ve got too many loans out there are not being repaid?
ELIZABETH WARREN: We’re seeing banks that don’t want to lend because they see every dollar that comes in the door and say "I’ve got to hold on to it to try to fill my commercial real estate hole or else I will be gone."
Home Equity Loans (HELOCS)
I find it amazing that with all the talk about government programs to keep people in their foreclosed homes, with government incentives to increase home sales, with new home construction at a near standstill and home prices finally reaching some sort of bottom (near term), we never talk about the billions of Home Equity Loans that were taken out from 1996 onward. Does it pass your common sense test that people would stop paying their mortgage, car payments, credit cards and yet still pay their Home Equity Loan? I don’t think so. But the banks have written down next to nothing here. This is the issue with Mortgage write-down. If you write down the mortgage, by definition the Home Equity Loan is now a 100% write-off. Ouch! Doesn’t anyone remember this graph which was so prevalent only a few years ago?
This is an absolute huge problem and is presently being hidden behind all the mortgage foreclosure coverage. Amherst Securities, according to Reuters " has said "commercial banks hold approximately $767 billion of the total $1.05 Trillion of second mortgages outstanding, with the Big 4 holding over $400 billion alone." Reuters estimates that if the banks mark down the entire portion of home equity debt that exceeds home value values, the net of estimated reserves would be:
$37.2 billion for Wells Fargo
$29.9 billion for JP Morgan
$28.6 billion for Bank of America
$11.5 billion for Citi
=====
$107.2 billion
If we were to write down these unsecured home equity lines by only 40%, then the potential increase in regulatory capital for these 4 banks increases by: $3.1B for Wells Fargo, $1.3B for JP Morgan, $2.1B for Bank of America and $1.0B for Citigroup. Nothing is being done, nor is anything being forced by Federal Reserve Bank examiners to be done.
I could go on about shadow housing inventory, ‘jingle’ mail and ‘strategic defaults’, the python in the pipe with Option-ARMS, the failure of HAMP etc., but I am sure you have heard all you want to hear about housing to know the banks have yet to effectively address the issue. Like landmines the issues still lay on their balance sheets.
Because of this situation, the banks still minimally require 40% higher collateral values. So how are they going to get it?
STAGE II -- MANUFACTURING A MINSKY MELT-UP
My grandfather, who was proud to keep his farm during the depression, had an expression that I haven’t heard in a long time. He was fond of warning that: “Banks lend you an umbrella when it is sunny and then demand it back when it starts to rain!” It has been a long time since we have had a ‘rainy’ economy for any protracted period of time, but to this prairie farm boy the economic weather forecast doesn’t look that good. We therefore need to remember some basics of banking. First, banks make money borrowing short and lending long. This strategy is inherently risky. This is why banking requires extensive regulatory laws and ever vigilant bank examiners. Neither are to be ‘tampered’ with, which our politicians now seem oblivious to.
Secondly, inflation and deflation are different for banks. The Consumer Price Index and how much food, energy, consumer staples etc have increased is not highly relevant to banks. Inflation or deflation to banks is about asset price increases or decreases. It is about whether their collateral positions are increasing or decreasing. I don’t mean to be too simplistic here since cost of money is critically important, but it serves to make the point that bank strategy is driven by their view of the direction of asset prices and whether their loans are covered, their capital ratio requirements are secure or what a new risk adjusted loan is worth to them.
What does this chart to the right say about where banks view asset prices to be headed?
Banks win on asset inflation. Banks potentially lose on asset deflation.
Rising asset prices:
1- Make Collateral more valuable or easier to secure for banks
2- Raise borrowing levels with which to finance higher priced asset prices which increase interest payments and fees.
If banks thought collateral values were headed lower, here is what they would do:
| 1- Freeze new loans secured by collateral that will potentially deflate | In Process |
| 2- Seize existing loan collateral on defaulted loans before collateral falls below book value | In Process |
| 3- Demand higher collateral levels for loans | In Process |
| 4- Charge higher rates and tighter terms | In Process |
Banks need asset values to continue to climb. Now that the markets have reached ‘nose bleed’ levels and appear to be at the stage of looking for a consolidation, the banks need another strategy to ignite asset prices further. The banks must see higher asset prices to have any hope of achieving satisfactory Capital Ratios with the known amounts of bad and toxic debt still on their books. Is it any wonder banks are now making their profits primarily in their trading operations driving asset prices higher and with their Interest Swap where they are squeezing collateral call levels? (see: SULTANS OF SWAP: The Get Away!)
MANUFACTURING A MINKSY MELT –UP
If the banks wanted to get collateral values up, and manufacture a ‘Minsky Melt-Up' here is what some of their strategy elements would call for:
| 1- Have the Federal Reserve reduce Fed Funds Rate to Zero | Done |
| 2- Have the Federal Reserve hold down rates for a historic length of time i.e. a “very extended period” | Done |
| 3- Have Federal Reserve flood market with money (i.e. Quantitative Easing) | Done |
| 4- Have Government initiatives that support asset appreciation (i.e. housing, auto programs) | Done |
| Done | |
| 6- Change Margin requirements or Leverage Pricing | |
| Done | |
| Done | |
| Done | |
| Done | |
| 7- Spin or exaggerate economic news through the media in a positive manner only | In Process |
| 8- Decrease risk premiums and increase levels of speculation | Returning |
| In Process | |
| In Process | |
| In Process | |
| In Process | |
| 9- Establish a Carry Trade that will flow monies to US assets (i.e. re-establish Yen Carry Trade) | In Process |
| Market Melt Up? More Like Yen Meltdown | In Process |
| 10- Weaken the US$ to solidify Carry Trade returns and reduce currency risk | Expect |
| 11- Give the market a surprise jolt - like China revising it's currency peg (China biggest US collateral holder) | Expect |
| 12- Increase the Velocity of Money by instilling an inflation worry in the public | Mixed |
| Expect | |
I am not saying that a successful Minsky Melt-Up will be achieved or in fact could be successfully manufactured. Frankly, I would be very skeptical if it weren’t for the fact that former Federal Reserve Chairman Alan Greenspan specifically said this could not happen (He also stated that market bubbles could not be identified by the Fed nor addressed with Monetary Policy (yeh right)). His views have typically been my contrarian indicator which has given me an investment edge over the years. Before reading Alan Greenspan’s ‘Greenspeak’, consider that we presently have unstable economic policies, risk premiums have been high and the Fed has successfully inflated a bubble in the Bond Market over the last 20 months through QE (Quantitative Easing).
…Greenspan said “because the markets themselves are asymmetric: they melt down, but don’t melt up!” Mr. Greenspan argues:
(1) the ironic result of successful stabilization policies is a journey to excessively-thin risk premiums, and if
(2) history has not dealt kindly with the aftermath of protracted periods of low risk premiums, and if
(3) asset prices do not tend to melt up but do tend to melt down, then
(4) logic implies that the fattest fat-tailed secular risk to price stability is deflation, not inflation.
(2) history has not dealt kindly with the aftermath of protracted periods of low risk premiums, and if
(3) asset prices do not tend to melt up but do tend to melt down, then
(4) logic implies that the fattest fat-tailed secular risk to price stability is deflation, not inflation.
How so? If bubbles are the ironic externality of successful stabilization policies, then those policies can be successful only so long as there are asset classes that the central bank can inflate into a bubble. When there are no more free and clear assets to lever up, the game ends in a debt-deflation. As the great Hyman Minsky intoned, stability is ultimately destabilizing! That is the logical consequence of too-successful inflation stabilization. Don’t call it a conundrum, but rather a dilemma, if the Fed were to set and achieve a too-narrow target zone for inflation. (2)
If according to Hyman Minsky, protracted periods of market stability leads to instability and a market meltdown, does this preclude therefore that protracted periods of market instability negate the possibility of a market melt-up (per Greenspan)? I intentionally phrased the logic for this argument in perfect ‘Greenspeak’ fashion so we can all remember exactly how we got ourselves into this global predicament in the first place.
CONCLUSION
This is a well executed strategy. It has been almost militaristic in its execution - all the elements from a solid communications program (i.e. CNBS hype), accounting and regulatory changes (FASB 157, 166, 167 deferrals et al ), government statistics (does anyone actually still believe the CPI, Labor Report or other government statistics any more?), and public’s sentiment through the controlled market perception barometer pumped at them every evening on how well the DOW Industrials are doing. The US economic and financial situation has now reached a point where the potential crisis could be referred to by our government interventionists as a matter of national security. This is precisely why I am leaning towards a Minsky Melt-Up being successfully manufactured.
There is an old market saying: “Don’t fight the Fed!” This market guideline has never been truer. In fact today it is more appropriate to say:
“It is impossible to fight central bank planning”
To fight the central party planning (i.e. shorting an artificial market) exposes your wealth to being officially confiscated!
Sounds like something Karl Marx would have said?
