The Insightful Trader

In a story that smells awfully like a press agent’s plant, New York Times blogger William Cohan apparently decided it’s time to rehabilitate Robert Freeman. Once the partner in charge of Goldman Sachs’s (GS) risk arbitrage department, Freeman pleaded guilty to one count of mail fraud (the case was actually about insider trading) and served four months’ jail time in 1990.

Cohan tries to prove that Freeman was the victim of a prosecutorial “witch hunt.” Is he also trying to say that public opinion is also tarring GS unfairly now? Hard to say, but why else would anyone bring up Freeman of all people, twenty years after the fact?

No one doubts that Rudolph Giuliani, then a crusading US Attorney, played hardball and made some crucial errors in going after white collar crime on Wall Street. Nevertheless, Freeman admitted to breaking the law on insider trading, and the case seemed pretty clear.

Therefore I don’t see how Cohan can call Freeman’s prosecution a “witch hunt.” The more accurate metaphor would be a “fishing expedition” that expanded perhaps too far afield from its central targets: uber risk arbitrageur Ivan Boesky and Michael Milken, the wildly successful junk bond promoter at Drexel Burnham Lambert. Freeman proved to be unlucky but not exactly innocent. A guilty bystander, as it were.

Here are the facts that matter, whether Cohan likes it or not:

As Cohan states, risk arbs in those days did a great deal of research on the phone, trying to ascertain the latest news, the small details, the so called “color” of the deal related stocks they were trading. New color could cause a significant move in the stock, and sometimes provided clues that researchers could assemble into a mosaic of intelligence on whether deals would close.  On the other hand, arbs could take things only so far: SEC rule 10b-5, forbids trading on “material, non public information.”

In the case that ended his GS career, Freeman bought shares of Beatrice Foods, which Kohlberg, Kravis, Roberts (KKR) was in process of taking private in 1986. After Freeman bought, rumors leaked that the deal was not working out. So Freeman did his job and hit the phones to learn what he could. He spoke with Bernard “Bunny” Lasker, a former NYSE chairman, who suspected the rumors were true. Freeman cut his stake in Beatrice. Then Freeman talked to Marty Siegel, an investment banker who represented KKR. (Siegel eventually went to jail for selling inside information to Boesky.)

Siegel confirmed that the Beatrice deal was in trouble, with the now classic line, “Your Bunny has a good nose.” At which point, Freeman sold his Beatrice call options (and some more of his stock, too depending on which account you read), in clear violation of the law. When KKR announced it was reducing the cash portion of its offer for Beatrice, the share price fell. Freeman may have had reason to fear for the option position: if the calls were short dated and near or out of the money, they might have gone worthless on the news.

Wall Street firms have elaborate controls to prevent trading on inside information when they have it. I suspect GS procedure would have required Freeman to tell the firm’s lawyers about his chat with Siegel, at which point GS would likely have considered itself to be “restricted” in its trading of Beatrice shares until the information became public. (If any readers worked at GS then you are welcome to weigh in about this.)

Furthermore, key court precedents established that trading on inside information is forbidden when that information was obtained in a “breach of duty.” That’s common knowledge among Wall Street professionals.  In this case, Siegel, a banker who represented KKR, betrayed KKR’s confidence by passing privileged information to Freeman. As clear a case of a breach as you can find. And yes, Cohan omits this issue from his article.

What Freeman did was illegal and really, really stupid. Yet notwithstanding all this, Cohan says that Freeman deserves a presidential pardon. Yeah, right.

One of Cohan’s whoppers – and this one destroys the credibility of his whole article – has to do with his treatment of Marty Siegel – and by extension, Giuliani. Cohan insinuates that Siegel was an entirely unreliable witness and that Giuliani went out and arrested all the subjects of his insider trading investigations, including Freeman, based on Siegel’s say-so, without corroboration.  Was Giuliani really that foolish? Well, no, not really.

Along with Drexel banker Dennis Levine, Siegel turned state’s evidence on Ivan Boesky, who was certainly dirty. Boesky in turn helped finger Milken (a prosecution that leaves me uncomfortable to this day) and many others. The Boesky and Milken cases were among the biggest white collar prosecutions of the decade, front page news that went far beyond the world of finance. After winning these cases Giuliani ran for Mayor of New York and won. Incredibly, Cohan omitted any mention of Boesky or Milken.

In other words, Cohan failed to tell his readers that Siegel had hit pure gold for Giuliani. Giuliani had every reason to take Siegel seriously.

Having said that, Cohan correctly judged that Giuliani overreached. Giuliani blundered badly by failing to corroborate Siegel’s assertions sufficiently before arresting Tim Tabor and Richard Wigton, both of Kidder Peabody, and then Freeman. Neither Tabor nor Wigton went to trial – the cases fell apart before that – but neither man worked on Wall Street again. Giuliani had ruined them.

So Cohan may well be right when he says that  Giuliani did everything he could to nail Freeman once the Tabor and Wigton cases proved weak. A contemporaneous Times editorial concurred, saying that Freeman was “abused.” But odious as these facts are, they don’t erase what Freeman did.

Cohan also tries to dance around Freeman’s guilt by saying that Freeman got caught only because his subordinate was given immunity in exchange for testifying against Freeman. But that’s standard procedure in any investigation: prosecutors threaten little fish with stiff sentences to get evidence against big fish. More cogently Cohan notes that several other allegations against Freeman proved false. Which may be why even the judge who sentenced Freeman termed him, “basically decent.”

Here’s an intriguing nugget Cohan noted but didn’t pursue. Apparently Freeman’s position limit was $50 million. Yes, quaint as it looks now GS partners really cared about sums that size back then, especially when all of them were potentially liable for the firm’s mistakes. Yet Freeman risked $66 million on Beatrice including his stock and options positions. Did Freeman’s partners know of the limit violation before the investigation?

If not, one could understand how Freeman might have been driven to sell Beatrice options before the bad news hit the wires: fear that his partners would see that Freeman’s excessive risk taking brought with it excessive losses, which is exactly what position limits are designed to prevent. Or maybe Freeman got prior permission to exceed the limit, but wanted to avoid embarrassment when his big bet went bad. Either way, the risk of an insider trading scandal was greater than that of a trading loss, but even very smart traders make mistakes under pressure.

GS lawyers defended Freeman, but then, according to Cohan, Freeman copped his plea to avoid further anguish for his family when Giuliani threatened to bring racketeering charges. So Freeman served only four months; Judge Pierre Leval suspended the rest of the one year sentence and fine him $1 million. The Times actually approved of that sentence when it came down, saying that Freeman deserved “a taste of prison” but also citing Giuliani’s “outrageous tactics.” My sentiments exactly, but that was back in the day when the Times was more able to call things as it saw them.

As for Goldman, it came up smelling like a rose. Giuliani never brought charges against the firm, and so it was spared the fate Giuliani had visited on Drexel Burnham. But in hindsight it would likely not have gone any other way.

GS management committee member Robert Rubin, also Freeman’s boss and mentor, moved up to vice chairman in 1987 during the Freeman investigation (in 1990 he became the firm’s co-head) and Rubin never paid for any of the things that went wrong on his watch. These would include the insider trading at GS, the financial deregulation Rubin championed as Treasury Secretary,  and the de facto bankruptcy at Citigroup (C) where Rubin was vice chairman. Just a thought.

No, the Supreme Court hasn’t ruled lately on these two issues to my knowledge, at least not directly. But unless you’ve been living in a cave, you know that last Thursday, the 21^st, the Court struck down longstanding restrictions on corporations’ political campaign spending. The headline highlights some likely results.

The Citizens United decision allows corporate (and union) donors to pay for ads that will run within 30 days of a Presidential primary or 60 days of a general election. Previously such spending was barred by the McCain-Feingold campaign finance reform law.

As political spending increases, its recipients in old media will benefit. I’ll tell you which companies are best positioned, but it’s too early to say just how much more they can make.

Some restrictions on campaign spending remain. Corporations cannot donate directly to candidates, though they can donate to issue oriented political action committees (PACs) that are at least nominally independent of candidates and their parties. Also, the sources of a PAC’s funding have to be disclosed.

A few numbers illustrate the new potential for political ad spending. A combined total of $5.3 billion was spent for the Congressional and Presidential elections of 2008. By way of contrast, Exxon (XOM) earned $45.2 billion in 2008 on that year’s record oil prices, and $13.2 billion for the first nine months of 2009. Goldman Sachs (GS) will pay out $16.2 billion for wages and salaries, or $498,000 per employee, and still record $13.4 billion in profit for 2009 after making these payouts. My point is, many major corporations can afford to break expenditure records on any given race if they care to.

And many of them have reason to care. For example, if  five votes on a congressional committee stand between you and, say, an arcane tax law change that would yield $40 million annually, what’s $15 million of campaign spending?  One heck of a good investment. Or, take environmental law. To pick an outsize but obvious hypothetical, even $100 million in campaign funds would be chump change for, say,  Chevron (CVX), if in return it got to extract a billion barrels of oil in the Alaska National Wildlife Refuge and earn profits, of, say, $10 per barrel.

But who needs hypotheticals? Last week the President proposed a tax on repurchase agreements, a form of collateralized lending used by large financial institutions. He also proposed bank size limits and talked about preventing banks from using federally insured deposits to finance speculative trading, the so called “Volcker rule.”

Citizens United gave banks new weapons to fight proposals like these. If, come election time, a tough bank regulation bill gets close to enactment (though it’s not likely to get too close, in my view), look for anti-regulatory commercials. They’ll be brought to you by PACs with names like “Depositors for a Sound Banking System.”

Having said all that there are two reasons why I could be wrong about the increase in campaign spending I expect. First,  interest groups already know how to exert influence while working within the pre Citizens United rules. Therefore, it’s possible that the new decision won’t change much.

Secondly, politicians understand the new, post Citizens United campaign economics and many of them will begin to censor themselves, even more than they already do. Expect even some of the bravest to pander to the money that talks on key issues, rather than face deep pocketed opposition. As former Treasury Secretary Paulson once said, “If you’ve got a bazooka and people know you’ve got it, you may not have to take it out.”

So, how to play this? Ad agencies and broadcasters should expect a noticeable, recurring revenue increase during election cycles. I don’t know how anyone could predict exactly how large a bump they will get, and what effect that bump will have on earnings per share, because we are in new territory here. If this type of play interests you, look for pure media companies with heavy domestic exposure and put them on a watchlist.

CBS (ticker symbol, also CBS) would be an obvious beneficiary of this trend; the other networks are part of large conglomerates. Therefore new political ad revenue at those broadcasters might not have much effect on parent company net income. If you want to stretch a point, however, you might also look at News Corporation (NWS), since its Fox News division contributes a disproportionate share of profits to NWS.

Among ad agencies, billboard owner Lamar Advertising (LAMR) would seem to be among the purest domestic plays that could benefit from increased political ads, but be forewarned, it is losing money due to the recession and has a leveraged balance sheet. Two ad majors, Interpublic Group (IPG) and Omnicom (OMC) would seem to be safer bets, but both of them generate around half of their revenues from abroad. IPG has more domestic exposure than OMC.

The recent winter blast across much of the country will only continue the recent trend in energy prices that are putting pressure on an already squeezed American consumer. After dropping dramatically in the latter half of 2008, energy prices, led by oil have, have rebounded significantly aided by a weak dollar.

The increases have been significant, and perhaps more so now than in 2008, in regards to the impact on discretionary consumer spending. Let’s look at recent moves in the past year. Oil, which bottomed at $35 in December of 2008, has now, without much fanfare from the administration or the talking heads on TV, climbed to over $80 per barrel. Crude oil imports averaged about 8.5 million barrels per day in the latter half of 2009.

The result has been that gas prices have made a huge move upward to nearly $2.20 per gallon wholesale in the past year from a low of $.82 a year ago. This is closing in on a 200% increase in just over a year. According to the EIA, we use about 380 million gallons/day in gasoline. Just in direct costs to the consumer, that’s a huge cost increase in the past year when many are already stressed financially. That’s $456,000,000 per day increase out of the US consumers pockets. That’s a lot of discretionary income up in smoke daily. This doesn’t include indirect costs for food products, transportation costs of products, electricity, etc.

Natural gas prices, which were the lone bright star in energy costs through the end of summer have spiked from a low of $2.65 in September to close at nearly $6 yesterday. Though at least our supply situation is much better in nat gas, as more users switch, primarily many of the utilities and recent winter weather, have caused a serious spike in prices in just the past 30 days. So when you factor in that many of the newer homes built in the past decade use natural gas for heating, that’s another hit to the consumer as well as those who use other forms.

Increasing energy prices are one of the most regressive taxes on consumers, affecting those who can least afford them the most significantly, yet not a peep out of anyone in the current administration, who have purposely pursued a weak dollar policy in order to cover our growing indebtedness. We’ve seen a definite move upwards in longer term interest rates the past 30 days which have a direct effect on mortgage rates.

So my question is, who and what is going to lead this economy out of recession, as unemployment remains high, foreclosure levels are at record highs and will probably continue, see here, and now a further squeeze as energy prices are once again seriously affecting consumers pocketbooks. Yet no one is even talking about the effect that these energy prices are actually having on the consumers. The Fed, led by Ben, says they’re keeping an eye out for inflation. I suggest they go to the grocery store and stop on the way home for a fill-up at their local gas station.

If you think housing will bounce back in 2010, check out this graph from Michael David White at ml-implode.com.

The graph shows cure rates, the percentage rate at which delinquent borrowers repay past due amounts so as to restore good credit standing on their mortgages. As recently as June 2007, 80% of borrowers who fell behind one payment were able to catch up. The graph also seems to show that as of September 2007, homeowners who counted on eager buyers to bail them out of overpriced homes began to have a tougher time of it.

In hindsight, the difficulties of borrowers who were two or more payments behind began to intensify a year earlier, in June 2006. One suspects that the graph captures the experience of the really junky mortgages whose borrowers went into early payment default (EPD).  EPDs happen when the borrower defaults within only a few months of taking the loan out.  If their lender sells the mortgage to another investor, that investor may have the right to put the mortgage back to the lender in the event of an EPD.

Thinly capitalized firms can’t survive too many EPDs. It was the epidemic of EPDs that forced a rash of undercapitalized mortgage bankers out of business.  Their bankruptcies helped mark the beginning of the housing crisis.

What does the graph tell us now? Most striking to me is that more than 90% the borrowers who miss two payments fail to catch up. As recently as March 2007, at least half of them succeeded in catching up. Data from the recent monthly Mortgage Bankers Association (MBA) survey and the quarterly FDIC banking industry profiles seem to bear this out. The MBA surveys show that about five million borrowers, or roughly 10%, are at least one payment behind on their mortgage.

The FDIC data show that the current delinquent population presages many more foreclosures to come. We know this because the aggregate amount owed by borrowers 90 days or more past due is in fact much larger than the amount owed by borrowers 30-89 days past due. That’s the reverse of what we expect during normal times.

The FDIC’s third quarter “profile” shows that 8.06% of the home mortgages held by FDIC insured institutions were “non-current,” 90 or more days past due as of September 30. FDIC institutions had $1.929 trillion in home mortgages outstanding then, so there were $155 billion in non-current loans. If we assume that the average borrower owes $200,000 on a mortgage, that would make for 777,000 non-current loans. (The FDIC data don’t count loans made by non-bank financial institutions that are also covered in the MBA survey.)

The FDIC numbers additionally show that 3.15% of the outstanding mortgages are 30-89 days past due. That would be $61 billion worth, and these borrowers correspond to the top two lines of the graph. White used data from MBA and the National Association of Realtors, so the correspondence is close but not exact.

Since the FDIC’s 90+ days late group owes more than twice as much as the 30-89 days group, it only makes sense to guess that lots of people in the 30-89 days late group, just stop paying their mortgage. By definition, everyone who is 90+ days late, was once 30-89 days late, and then fell further behind.

These FDIC data square well with White’s graph. The graph tells us that 30-59 days of delinquency indicate more borrower stress than they used to, and 60 days of delinquency is now a point of no return.

The MBA cites the job market as the culprit for this change in behavior. High levels of long-term joblessness (six months or more out of work) mean that that those who stop paying because they have lost their job, are less likely to find work again in time to catch up on their mortgage than in previous postwar recessions.

Our data have some important implications for the housing market and for housing related stocks. The data help show that there is a large “shadow” inventory of homes that will eventually come onto the market, or that owners would sell if they could. The number of homes officially listed for sale is only part of the supply that weighs on the market .  Clearly the homes that secure loans 60 or more days past due should be counted in shadow inventory, though they are only one part of it  (the Calculated Risk blog does a good job of explaining shadow inventory and all its components).  And a large shadow inventory means, new homes will have to compete with homes offered in distressed sales over the foreseeable future.

Obviously I don’t expect homebuilder earnings to rebound anytime soon. On the other hand, I wouldn’t short the major builders because the government has given them massive tax breaks and seems hell-bent on bailing them out. That’s why I am also reluctant to short banks that got TARP money. Investors who want to exploit this situation, need to short overvalued housing-related stocks that are not likely to benefit from government assistance.

Some largely overlooked news shows that worldwide oil production capacity continues to plateau if not fall. Of course it might be bad form to back up the truck right now on oil stocks, given that oil and stock prices have rebounded so smartly since March. But the long term oil news is bullish.

The news I refer to came out of Saudi Arabia on Friday, November 6. The Saudis all but confirmed the accelerating decline of the Ghawar oil field. With an estimated production capacity of 5.2 million barrels per day (mmb/d), Ghawar accounts for about half the Saudis’ production, give or take, and is the most prolific field ever found. Many experts believe that when Ghawar’s production decline curve accelerates, worldwide oil production, which now runs about 85 mmb/d, will tip into decline as well.

The Saudis expressed their concern, not with an explicit press release, but by concluding a five year, integrated turnkey contract with Halliburton (HAL) to redevelop Ghawar. In other words, Saudi Aramco, which is among the more sophisticated national oil companies (NOCs), felt the need for some outside extra help to keep Ghawar’s oil flowing. The contract calls for HAL to do directional and horizontal oil drilling and to drill 153-185 oil and water injection wells, among other things.

When Ghawar oil production began back in 1951, it might not have been much of an exaggeration to say that all the reservoir managers had to do was stick wells in the ground and enjoy. As time went on, Aramco resorted to enhanced oil recovery (EOR) techniques such as injecting water or other substances into the field to force the oil towards well openings. Aramco also employs other EOR techniques such as horizontal and directional drilling, both of which can be used to angle the well so as to maximize the length of oil well pipe in contact with the “pay zone,” the layer of oil bearing rock.

EOR is standard procedure especially over the later history of many if not most oilfields. It’s natural to pump the easy oil first; as a field matures the rest gets harder to extract. Over time as the oilfield owner pumps out the crude, the pressure which drives oil to the well and up to the surface falls off. In addition, the early, higher quality product of crude oil and natural gas liquids, often gives way to a product increasingly mixed (or “cut”) with water, which must then be separated from the crude before refining takes place. With this background in mind, oil analyst Michael Lynch of GLG Group (h/t, theoildrum.com) has some choice words about the HAL contract.

“The contract makes no mention of Ain Dar, the most mature part of Ghawar…  Ain Dar has been under pressure maintenance by peripheral water injection for over 40 years. Ain Dar began producing salt water in the late 1970s and by 2005 the cut was 42%… Once water became a major problem, many existing vertical wells were converted to short lateral horizontals running along the top 10 feet of the Arab D zone, the main pay [zone for both Ain Dar and other parts of the Ghawar]…Today the entire field still contains a great deal of crude oil but it is much harder to get and the production rates continue to fall off. Halliburton’s mandate will be to deal with the higher and higher water cuts, utilize all known new technology to hold [production] rates as high as possible… It’s a good, long-term contract and a tall order for the company.”

As a side note, the Saudis objected fiercely in 2005, when Matthew Simmons stated in his book, Twilight in the Desert, that Ghawar was in decline and that the Saudis were making strenuous efforts to maintain production. Simmons also highlighted difficult geological problems that the Saudi petroleum engineers faced. The HAL contract would seem to confirm Simmons’s work.

If Ghawar were still in its early phase when oil flowed easily to the surface through highly productive wells, Aramco most likely would not need an EOR program like this. The need for this program is evidence that we may indeed be facing “twilight in the desert,” and that Saudi Arabia’s glory days as a leading oil exporter are winding down. Can “peak oil” be far behind?

Nonetheless, there is reason to be cautious about oil stocks in the short to intermediate term: demand for crude is down. US refineries processed 14.2 mmb/d of crude in October 2009, which is down about 200,000 b/d year on year and down 800,000 b/d from the October 2007 level. No surprise for a weak economy. Furthermore, both Sunoco (SUN) and Valero Energy (VLO) have in fact closed refineries recently. US crude oil inventories sit at about 24 days’ supply, 2 days above the year-earlier level. These numbers don’t indicate tight markets, and I have to wonder if current prices are sustainable.  I just don’t know how far they fall from here, and how long they stay down.

You have to hand it to the humble SIV (structured investment vehicle). To create one, you must employ just about all the abuses the credit bubble made famous.

SIVs had everything: regulatory arbitrage, opacity, reaching for yield, multiple opportunities for bankers to generate fee income, multiple layers of leverage, rating agency incompetence, credit default swaps (CDS), collateralized debt obligations (CDOs) that packaged dodgy mortgage- or asset-backed securities (MBS or ABS), the “originate to distribute” model of lending,  offshore domiciles, borrowings of different priority arranged in tranches (remember tranches?), the global dollar glut  and yes, whimsical names that should have warned investors to stay away.

I mean, who could forget the Whistlejacket SIV? When Whistlejacket failed, someone must have regretted not knowing, just what is a “whistlejacket,” anyway?

But why write about SIVs now, aren’t they soo 2007? I would give three reasons. First, banks are not done unwinding SIVs (not to mention CDOs and CDS) from their balance sheets. They may be out of sight but they are still out there creating mischief. Second, SIVs are still being litigated: as I wrote several weeks ago, a lawsuit over the now-bankrupt Cheyne SIV may help dethrone the bond rating agencies. Lastly, nothing epitomized the credit bubble like the SIV.

SIVs were to the credit bubble what Goldman Sachs Trading was to the Roaring Twenties, the Nifty Fifty to the ‘60s “go-go” markets, and pets.com to the internet bubble.

Ten or twenty years from now, when the consequences of all our actions have become clearer, someone will write the definitive history of the credit bubble. In such books, writers often organize their narratives around a particular item or incident. If any financial historians are reading this, I nominate the SIV; it wins hands down.

Why create an SIV? Commercial and investment banks (often the same company) enjoyed many benefits from SIVs, none of which passes the smell test now. Investment banks got to earn fees on the things, coming and going. Consider: they bought mortgage loans (or car loans, or loans against credit card receivables, among others) and got fees when these were packaged into ABS or MBS. They got fees again when they packaged the ABS or MBS into CDOs. They even got yet another level of fees when these were sometimes packed into, you guessed it, CDO-squareds or even CDO-cubeds. And at this point the investment banks were just getting started.

So the investment bank created the vehicle in which the SIV would typically invest, the CDO. The investment banks then sold notes to finance its CDO purchases. These notes usually came in several tranches such as short term senior notes, subordinated capital notes, and then at the bottom, some equity. The i-banks collected fees on each of these financings too. Not incidentally, the i-banks also had in the CDOs and  SIVs, buyers, or more accurately, stuffees for all that dodgy loan product they had for sale. Oftentimes that loan product was originated for sale because the lender didn’t want to own it in portfolio.

Therefore  in the SIV we had a special purpose investment company that was leveraged up, say, four to one (that is, they had four dollars of debt for each dollar of equity) to purchase CDOs that no one really understood (they were opaque). You couldn’t understand a CDO because each CDO typically owned pieces of dozens of MBS, which in turn were created from hundreds if not thousands of loans. So a CDO could comprise pieces of tens of thousands of loans, which no one had the time to evaluate; and that’s before we even get to an SIV that might own pieces of a number of CDOs. So if a CDO was impossible to analyze, an SIV, was, well,  incomprehensible.

Finally, the amount of leverage SIVs had was not always apparent at first glance. Of course SIV note buyers knew that SIVs were leveraged; they were financing that leverage. But in addition, CDOs often incorporated leverage also. Therefore, an SIV often had multiple layers of leverage, because it owned leveraged vehicles like CDOs.

The SIV would sometimes hedge its credit risk with CDS that supposedly guaranteed the CDOs that it owned against default. That way, in theory, it was safe to borrow so much money and buy bonds with it.

Someone had to manage the investments of the SIV once it was launched, and commercial banks often seemed to benefit by doing that.  Banks normally are limited by law, as to how many dollars’ worth of assets they can have per dollar of equity but by setting up SIVs banks could control additional assets beyond the legal maximum (here’s the regulatory arbitrage). Legally, the SIV owned the assets, the bank did not.  The banks accounted for SIVs as “off balance sheet” items. The banks earned their money by charging the SIV a fee for managing the SIV’s assets. As an aside, banks often domiciled the SIVs offshore, typically in London.

On the other hand, SIVs posed a potential problem for the commercial banks that managed them. The bank was expected to step in if the SIV couldn’t repay its notes. When that happened the SIVs then “migrated onto the banks’ balance sheets.” While the banks were not always obligated legally to back the SIVs, they faced reputational risk if they failed to do so. Bank of America (BAC) and Citigroup (C) are among the banks that became reluctant owners of SIV assets.

Why buy notes issued by something like this? Three reasons come to mind. First of all, the i-banks would find some way to set up the SIVs (and the CDO components too) so that the senior tranches got AAA ratings from Moody’s and S&P. Secondly, the SIVs often had the implied guarantees from commercial banks. There was also the “safeguard” provided by the CDS (another item in our abuses list)  hedge in some cases.

Because the i-banks (and the rating agencies) sprinkled so much holy water on these things, that they could find buyers who didn’t bother analyzing the SIVs seriously. With all the supposed safeguards, the buyers were happy to get a yield that was, well, a bit higher than what you could get on Treasurys because, after all, the SIVs were triple-A. A classic example of reaching for yield.

Thirdly, some of the SIV buyers, particularly international buyers, had LOTS of money to invest, courtesy of the worldwide dollar glut. During the good times they didn’t think much about where they put that money. For example, one of the plaintiffs in the rating agency lawsuit is the Abu Dhabi Commercial Bank.

So there you have it: a product that embodied just about every sharp (or stupid) practice of the late stage credit mania. While we’d love to see financial markets heal even more, not even the wildest green shooter dreams that banks will bring new SIVs to market again. No one will miss them, either, except those of us who fancy the trivia of financial history.

wg4fr6qavc

On Sept. 2, US District Court Judge Shira Scheindlin ruled that a lawsuit filed by institutional investors alleging fraud by Moody’s(MCO), S&P, and Morgan Stanley (MS) may go forward, dismissing the rating agencies’ traditional First Amendment, freedom of  speech defense. MCO and McGraw-Hill (MHP), which owns S&P, declined when the ruling hit the wires, on fears that without the free speech defense the agencies could be open to unlimited legal liability.

The plaintiffs, Abu Dhabi Commercial Bank and King County, Washington (which includes Seattle)  purchased notes issued by the then AAA-rated Cheyne Structured Investment Vehicle (SIV) beginning in 2004. Cheyne went bankrupt only three years later, and that bankruptcy helped spark the money market crisis of 2007.

On the face of it, the investors have cause for anger. Triple-A ratings traditionally mean, safe to buy, forget, and clip the coupons. Having a triple-A issue go bankrupt at all  is an embarrassment for the agencies. Having the issue go from triple-A to bankrupt so quickly means the agencies blew the call about as badly as they possibly could. The court will decide if the blown call happened through incompetence or something worse.

Here’s another reason why I think the investors have a case: the rating agencies have access to gobs of confidential information that other investors don’t see. Their analysts can ask an issuer just about any question and get the answers they want. So the agencies ought to have known, and certainly had every resource to find out, about the flawed mortgage backed securities (MBS) that were folded into the collateralized debt obligations (CDOs) that Cheyne owned. Nonetheless the agencies stamped the junk with a triple-A.

The agencies claim that they relied on models of the housing market that didn’t allow for a nationwide decline in home prices, as opposed to a regional one. Lame as it sounds now, that model had some merit (though not that much), before, say, 2003 when mortgage lending standards started to deteriorate. But if anyone was in a position to know that the game had changed, it was the agencies. They could have demanded sample loan files to get a feel for the underlying collateral, and no doubt the investors will ask about this in court. Loan files are normally highly confidential, kept between the borrower and lender, but that is exactly the kind of thing that the rating agencies can see (and bank examiners certainly do see) but outside analysts can’t.

The agencies’ bank analysts also should have known about deteriorating home loan underwriting. After all, the agencies also rate bonds issued by banks.  If I were representing the investors, I’d ask if the agencies’ bank analysts had learned about weak home loan collateral, and if they talked to the analysts in the groups who rated SIVs. You’d think that someone, somewhere in S&P or Moody’s had some idea about this. Yet they continued to bless structured products with triple-A ratings as quickly as the bonds could get cranked out.

My guess is, a fair number of people at S&P and Moody’s knew quite well that the mortgage markets had gone bad.  After all, some colorful internal S&P e-mails came out in October 2008. One of them mentioned a “house of cards” and another, that “a cow could come up with this structure and we would rate it.”  But who would dare raise a stink, when the agencies’ structured product groups were making the real money (more on that below)? The court will have to decide whether such general awareness in the firms evidenced fraud or not.

The deterioration in loan underwriting standards enabled the housing bubble and made a subsequent collapse almost inevitable. Back in the ‘Sixties and ‘Seventies, Fannie Mae and Freddie Mac ran large databases on loan experience through their computers, and figured out what a sound home mortgage loan looked like. From this exercise came the guidelines that many of us grew up with: 10-20% down, a maximum of 28-33% of income needed to service debt, and a stable work history, among other things.

When Fannie Mae and Freddie Mac’s standards ruled, that meant that in the nation as a whole, house prices had to be related to borrowers’ ability to pay the loans. The advent of liar loans with initial teaser rates, and similar unsound products, broke the relation between house prices and income. Therefore, at least for a time, there was almost no limit to how high prices could go. Again, the rating agencies were in as good a position as anyone to know about this problem early on.

Contrast the recent bubble to the S&L crisis in the 1980s. We did see a housing bubble in Texas, based on the energy boom and bust; there were also problems in a few other areas, notably New England. But bad as the Texas home loan problem got, it did not go national. The recession of 1990 was less severe in other parts of the country, and in any event, home prices remained tethered to borrowers’ incomes in the country as a whole. But that was your father’s home loan problem and the rating agencies are paid to know the difference.

Rating agencies have a tighter relationship with issuers of structured bonds than they do with, say, corporate bond issuers and that may be examined in this case too. In corporate bonds, the agencies heavily consider the ratios of cash flow to interest expense and other fixed charges such as capital leases when they make their bond ratings. IBM, for example can’t grow more cash flow out of thin air in order to make S&P happier. If they want to borrow money in the bond market, they give the agencies their financials and the agencies decide how strong the bond is, and that is mostly that.

But structured product issuers can do all sorts of things to make their issues stronger and get higher ratings for the top tranches. They can assign more cash flow to the top tranches, or they can increase the overcollateralization factors, to name two. So the issuers could and did rejigger a structured product until they got the rating they wanted. Meanwhile, one has to wonder: if the the agency effectively blessed the structure, are they invested in that structure? And would they be reluctant to downgrade the issue even when  new information casts doubt on the issuer’s ability to repay the debt? That’s the subtle potential for conflict of interest that an agency faces when rating structured products.

The more blatant potential conflict, and Judge Scheindlin cited this in her ruling, is that structured product ratings pay the agencies about three times as much as other ratings do.  So the agencies may have had at least some incentive to curry favor with the issuers of structured products — as in, give them a triple-A on the Cheyne SIV, get more SIV business next week. If that turned out to be the case, the agencies came awfully close to selling top ratings for cash.

I only wish that the ramifications of this case stopped with the rating agency business model, but they also strike at America’s influence and reputation for probity. Think of it this way: corporations — and sovereign governments around the world — care about what their bond ratings when they want to borrow money. Despite their flaws, the rating agencies provided a baseline opinion that was respected, and having institutions like those domiciled here, was one of many things that made the United States a country that others wanted to emulate. When the rating agencies fail so grossly, like it or not, it reflects on us. This is the sort of thing China and Russia talk about when they question America’s legitimacy as custodian of the world’s reserve currency. These are the sorts of things that the leading power needs to get right — or fix quickly — if it wants to stay in the lead. Which is why prompt and credible rating agency reform (and a few criminal prosecutions if evidence warranting that emerges in this case) would be a small but significant gesture that could do us a world of good.

    Probably. Of course the market knows about America’s troubles and some of them are priced in.  Currency traders would also remind me that currencies are priced relatively to each other: we speak of yen per dollar, or dollars per euro.  So if you are bearish on the dollar you can’t just prove that the dollar is weak.  You need to show why it is weaker than the alternatives as well. 

    Before doing that I will concede the obvious: other countries also have troubles. We are in recession, and so is just about everyone else. Our Federal Reserve is printing ridiculous amounts of money, but other central banks are too. Our government runs a  large fiscal deficit, but again, other countries do too. Our banking system is weak, but the Brits and the Eurozone have nothing to write home about here either. 
   
  So if other countries are hurting too, why should  the dollar stay weak? I have four reasons, but they boil down to one. We are no longer acting as if we can carry the burden that goes with the privilege of owning the world’s reserve currency. 

   First, we are unique in the large current account deficit we run. That is, we  import more than we export, we have been doing this in size, and we will seemingly continue to do until other countries stop taking our dollars in exchange for goods.  We were lucky earlier this year in that a lower oil price reduced our oil import bill, but oil’s price has doubled off the bottom since then. So, even though Americans buy less imported “stuff” than we used to, we can’t consider the problem solved. As long as we import more goods than we export, we have to make up the difference by selling dollar denominated securities –usually Treasury bonds– to foreigners. So in this way America continues to increase the supply of Treasury IOUs  without regard to the world’s demand for them.

   Which leads us to reason number two: there is a large overhang of dollars held reluctantly in foreign portfolios. This site’s readers know that, but the point is, portfolio overhang is unique to the dollar, as opposed to other currencies. There is no other currency held in such size by people who would likely dump it if they had their druthers.

   Plenty of people try to tell us that this overhang is “not a problem.” They say that the world is used to running on dollars. Governments, banks and corporations are used to doing dollar based transactions, they tell us. Moreover, no other currency can match the deep and liquid market that Treasurys afford. Even though the Eurozone is a huge economic bloc, Eurobonds issued by Italy, for example, are not the same as Danish or German government bonds. So everyone agrees that a complete transition to a new currency regime would take time, but is that truly a reason for doing nothing? It may be that today the dollar is the best place to park wealth, but sooner or later the countries with wealthy central banks will find a way to put their money where they want to. If we don’t make the dollar more attractive, foreigners will eventually take their money elsewhere. It’s that simple.

    Our press also lulls itself into complacency regarding large dollar holders such as the Chinese. It would be hard for China to sell in size, dollar bulls say. The market couldn’t absorb that selling, the dollar would crash, and the Chinese would themselves wipe out the value of their own dollar holdings, bulls argue. 

   On the other hand, others worry that China may reduce its dollar buying going forward. Therefore these days when the Treasury holds an auction to sell more Treasury debt, traders await the results with baited breath to see how easily the market absorbed the supply — and how many foreigners bought. Furthermore  the WSJ reports that the Treasury recently rejiggered its statistics so as to make foreign buying look heavier than it really is (h/t, Trader Mark). Treasury now reports some customers of primary dealers as “indirect” bidders, the closely watched category that also includes international purchasers. What a disgrace, that America is so dependent on other countries, and that we lie about it to ourselves rather than face the problem. 

    As an aside, China is seemingly having a grand old time showing us who controls the dollar’s trade in the currency markets. On June 26 officials at the People’s Bank of China said that they wanted a new, supranational currency to replace the dollar as reserve currency, Bloomberg reported. Dollar Index futures, which trade based on a weighted average of major tradable currencies, gapped down 55 basis points —  a considerable move — to open at 80.12 on the CME the following morning. On the 28th Central Bank governor Zhou Xioachuan said that his country’s reserve policy remains “stable.” The dollar index shot up enough to close the gap of the previous day during overnight trade, though it gave up most of those gains before the Chicago open. Are the Chinese placing trades so as to profit from the statements they make thereafter? I have no idea but the prospect must tempt them. 

   Third on my list of problems unique to the dollar is this: America’s strategic rivals act as if they see an opportunity to weaken us by attacking the dollar’s privileged status. Rusisia’s Vladimir Putin has  made noises about replacing the dollar for years. If Russia can take the dollar down, that would make it harder for the US to finance its 800 or foreign military bases, and give Russia freer rein in Eastern Europe, South Asia, and the Middle East.  Similarly, China has never liked the military power that the US projects into the Pacific. So on this score some of China’s geopolitical objectives may coincide with  Russia’s.

   Also on our list of geopolitical considerations: in yet another chapter in the troubled history of Iran-US relations,   Iran quit accepting dollars for oil in 2007. Might other oil exporters follow suit? Or might they simply accept other currencies in addition to dollars when they sell oil? The latter policy would reduce demand for dollars while still allowing us to pay for imported oil in dollars. There have always been countries that want to see America humbled but I don’t think these attacks on the dollar would have got traction if our rivals were not holding large stacks of dollars they might like to sell if they could. No other major power is in debt to its rivals like we are.

   My fourth reason for ongoing dollar weakness: we don’t have a strategy for maintaining the dollar. We just keep hoping that China and our other trading partners will continue to do what suits us. That’s irrational. Other countries that hold dollars will act in their own interest. We should figure out what that is likely to be and prepare accordingly.

   Instead, the Fed and the Treasury focus on economic stimulus and bailing out weak banks. The US keeps spending and printing money as if it grew on trees. Nor does President Obama talk about retooling our stance as importer from the world. And so the situation drifts. Sooner or later our government will learn what every trader knows: Hope is not a strategy.

Disclosure: Long FXY, may buy UDN on pullbacks.

 Although the S&P  has  stalled out for the moment it had quite a rebound from the March 9 bottom. And until June 12 or so the market shrugged off bad news quite regularly. It’s easy enough to understand a rebound from a panic low, but are we really in a new secular bull market?  The recent Forbes article, “The Real Suckers are in Cash”  tries to prove that case, but comes up short.

  Forbes’s case: the March 9 bottom was THE bottom, the recent stock market strength tells us that that the end of the recession “is plainly in sight.” Housing is bottoming, autos are bottoming, commodities are booming, credit markets are healing, and stock earnings yields provide ample competition for bonds. It looks so good that the cash on the sidelines will have to come in, mostly to stocks but maybe also to commodities, which can keep going as the economy rebounds or if inflation expectations rise.

    Regarding their case for rapid economic recovery the Forbes article  contains at least one outright misstatement: “The U.S.  manufacturing Institute for Supply Management  Index (ISM)  rose to 42.8%S in  May, which usually signals that gross domestic product is expanding rather than  faltering.”  No, it usually  doesn’t. According the ISM, readings lower than  50  on  the  Index  signal contraction.  Forbes reporter  Robert  Lenzner  should  know  this.  I think Lenzner meant to tell us that  GDP was contracting  at  a decreasing rate,  but  that’s not  what he  wrote. Furthermore, the Index measures activity in the manufacturing sector rather than GDP as a whole. While expansion in manufacturing would be good news for the economy, our shrunken manufacturing sector accounts for only about 20% of total US economic activity. 

    Increased home construction traditionally helps boost a recovering economy. Since residential construction is not recovering yet, Lenzner reaches for the bright side and notes  April’s  6.7%  jump  in  pending  home sales when compared with April 2008, as measured by the National Association of Realtors (NAR) Index. There is less to this one than meets the eye. Even though pending sales are up home prices continue to fall, according to economists at BMO, who seem to have provided Lenzner with much of his data. In other words, the housing market shows falling prices on higher volume– not exactly a healthy market yet.  In addition NAR says that April’s strong data may reflect a desire to get home purchases consummated by November in order to qualify for the the $8,000 first time home buyers’ tax credit. Therefore NAR implies that current data may reflect a boost in current sales at the expense of future sales.

     Moreover, as of now, most of the sub prime loans with that originally came with introductory teaser rates have already reset — but the alt-A schedule of loan resets is about to pick up steam. Alt-A loans are supposedly of higher quality than subprime, but more likely to default than prime loans. When these loans reset, many homeowners in higher price brackets, who often got alt-A loans, will be squeezed as the sub primers were, forcing some to default and place more distressed inventory onto the market. Increasing unemployment is forcing more prime mortgage borrowers to default as well.  Housing isn’t just “in the tank” as Lenzner says, it continues to deteriorate. Finally I find it odd that Lenzner actually missed the one positive sounding data point in April’s housing numbers, an increase of spending on improvement of existing residences of  8.9% year on year as reported by the Census Bureau. 

   Another industry that often helps lead us out of recession is automobiles, and Forbes correctly notes that auto sales improved in May by about 100,000 vehicles over April to the best performance of the year. Is this a big deal? Too early to tell, in my view. Sales are down year on year, as one would expect, and they remain anemic, below a seasonal adjusted annual rate of 10 million. No doubt auto sales could rebound off their lows, but what concerns me is the consumption pattern going forward. Does anyone expect the average middle class homeowner to finance a second or third car from a home equity loan (as was often the case in California and Florida?). As I understand it, the industry was geared to produce 16 million units annually before the recession hit; in his March CNBC interview Warren Buffett forecast that 13 million would be the new normal rate going forward, but felt he had to argue with those who forecast that rate rather than 11 million. The difference between 16 million and 13 million: the people who have lost their jobs so far in Detroit’s bankruptcies, and perhaps more to come, especially if the 11 million number should become accurate.

    Still… a rebound to 13 million would be great news. And… much more of that rebound will have to come from savings, not borrowing, because consumers are tapped out and forced to raise their savings rates. They certainly have less home equity to borrow against, too. My verdict: an auto sales rebound should happen, eventually, but a strong rebound is not something to bank on heavily any time soon. I expect consumers, especially those with secure jobs or who need cars to get to work,  to replace cars that need replacing, but less frivolous consumption, especially financed by imprudent borrowing, will be less common than in previous cycles. New employment will have to come from a new industry in this recovery, maybe from green technology if we are lucky, but that too will take time.

    Lenzner asserts that the recent increases in commodity prices imply that the economy ” is about to turn the corner,” presumably because higher commodity prices signal  industrial raw materials demand. That’s a hard case to prove because, not only is the US manufacturing sector continuing to contract, as noted above, but our trade partners such as China, Germany, and Japan, are contracting too since their exports to the US are down year on year. Forbes does not tell us, who is making more of what? I suspect, few companies are actually making much more of anything: as London based portfolio manager and financial blogger Macro Man writes, China has been buying commodities heavily but putting them into storage rather than using them in manufacturing.  The Chinese business magazine Caijin (h/t, Naked Capitalism) adds descriptive color to Macro Man’s charts and statistics. Caijin notes that China has increased bank lending by six trillion yuan since year-end 2008, and that many of these loans have gone into commodities speculation.  Caijin’s writer Andy Xie fears this margin financed commodity buying could come to a bad end. Having said that, I am bullish on commodities longterm, though they may have gotten ahead of themselves here. I agree with Lenzner, that commodities could rise over time with inflationary expectations.

   Forbes also states that there is a large repository of cash sitting on the sidelines that is feeling left behind. Lenzner even says that this sum equals half the market cap of the S&P500. It’s hard to analyze this statement fully, since Lenzner does not name his source. However, veteran money flow analyst Charles Biderman of  Market Trimtabs  told CNBC on June 18 (h/t, Zero Hedge) that sideline cash is nearly spent. Based on his funds flow analysis, Biderman rates the market a sell and is in fact short banks, consumer discretionary, and retail stocks among others. He stated that companies are selling stock “as fast as they can.” According to Biderman, 7 of the 8 times when, by his measures, companies have have sold large amounts of new stock to the public while company insider trading activity is simultaneously bearish, the market has subsequently declined.

    Although Lenzner thinks the ability of the credit and equity markets to absorb new supply is positive, and that has certainly been true up to a point, one might also remember the old Wall Street adage, “When the ducks quack, feed ‘em.” Wall Street can only sell stock when markets have been strong, but the new supply soaks up at least some of the available buying power.

   Speaking of funds flows, Forbes (along with many others) claims that compression in key short rates and spreads (such as LIBOR and the TED spread) proves that the money markets have healed. As stated two weeks ago, I believe these spreads are now misleading indicators. No one knows just how high these rates would be, absent the trillions of dollars that the Fed has lent under its new, extraordinary programs such as TAF, TSLF, PDCF, and so on. In addition, we have Treasury’s explicit guarantee of money market funds, and its de facto guarantee on all liabilities of major banks. One suspects that without these programs, money market rates would be significantly higher. Of course the right thing to do would be to use these guarantees as a temporary shield to forestall panic while the FDIC shut down insolvent institutions and forced banks to mark tradable assets to market. Until that is done, we effectively have a nationalized money market whose indicators tell us how much confidence lenders have in the US government, rather than how much confidence they have in institutions that stand on their own.

   Forbes puts a great deal of store in the comparison of earnings yields with bond yields, in effect relying on the “fed model” to show that stocks are cheap. For those of you who need a refresher, the fed model compares earnings yields to bond yields and says in effect that when earnings yields on stocks are greater than bond yields, investors buy stocks. Given  the earnings estimates Lenzner is apparently using, he says that the yield on bonds provides stocks with room to move to 9,000 or even 10,000 by summer’s end.  I would make three points here.

   First of all, the “fed model”relationship is not set in stone. Up until the late Fifties, investors demanded a higher yield on stocks than on bonds, to compensate for the inherent uncertainty that stocks provide. Later, in the Sixties, investors became more willing to pay up for the growth prospects that stocks also provide, and Lenzner seems to assume this behavior will continue. Could the relationship between stock and bond yields shift again? Value investors, at least, have talked about that in the past year.  Second, I have never liked the fed model with bond yields below 5% or so. Like it or not, if you use the fed model then you are forecasting P/E ratios in excess of 20. That may be reasonable in a stable environment with great growth prospects, but it would be hard to argue that we are back in Nirvana now.  

    Thirdly, Lenzner’s argument says that we can dismiss inflation concerns for the next 2-3 years, and so we need not worry that bond yields will rise and provide more competition for stocks. I would actually agree with the first part — inflation feels tame for now in this environment. The Fed’s extraordinary programs have replaced vaporized assets on bank balance sheets rather than increase the money supply as much as might appear,  and banks are not eager to lend out the money they have. That keeps demand for goods, and hence inflation, low. The real trouble as I see it, is the increasing supply of bonds to finance the government’s fiscal deficit. Seemingly every week the bond market faces an an auction with trepidation. Is this really the time to buy stocks because you are confident that bond yields will stay low? I have trouble with that.

   Of course Forbes covers itself by listing the usual worries: increasing unemployment, decreasing consumer spending, inflationary expectations. Fair enough.  But when I read through the Forbes case, I just don’t see a cogent reason to buy stocks here. And to go higher, we need, not just holders who keep holding, but also, new buyers to push the price up.

   The Federal Reserve and the Treasury did what they had to do to stop the money market panic of 2008. Since then many commentators have taken comfort from indicators that in normal times would point to healthier credit markets: falling TED spreads, falling LIBOR, tighter A2/P2 spreads, etc.

     To which I reply: not so fast. Without the continuing, massive, and unprecedented government interventions in the credit markets, one suspects that these spreads would zoom again. We do not have a self sustaining recovery in the credit markets, because the government refuses to address banking system’s longterm problems. So in the meantime, the Fed and the Treasury are essentially painting the tape. Yes, Virginia, even credit spread numbers can be made to lie.

      Last year’s panic is over, to be sure. We’ve even seen tightening in longer term junk bond rates when compared with Treasurys of similar maturities. But would anyone buy debt from a major bank without Treasury  guarantees? Does anyone think for a minute that commercial paper rates would stay so low without Fed purchases of commercial paper (or more precisely, backstopping SPVs that purchase commercial paper)?And given the Fed’s T-bond purchases, does anyone think that the free market now sets  rates on longer Treasurys? These questions answer themselves, don’t they?

   Here’s another reason why  the falling rate graphs don’t tell the whole story: even with Fed support, the commercial paper market is shrinking. Total outstandings have dropped to $1.248 trillion, the lowest level since 2001. Is that because companies can’t get funding, or because they don’t dare to borrow? Probably some of both. The big banks don’t dare lend as much as they used to because the recession continues to produce increasing losses on residential and commercial real estate loans, credit cards, and toxic securities they can’t sell. Money market funds learned in 2007 that they actually have to do their own credit analysis before they buy anything that the Treasury does not guarantee, so they are pickier than they used to be. And why would corporations borrow more,  when the profits of the S&P500 companies are down 90% year over year?

   We are in trouble now partly because businesses and consumers couldn’t service pre-recession debt loads. Intelligent government policy would cushion the worst fallout from the inevitable deleveraging that is taking place, rather than try to keep total credit outstanding at  June 2007 levels. But rather than tell us the truth, the government seems to be trying to encourage borrowing at prior levels in order to finance consumption  we can no longer afford. This they do by keeping rates artificially low and by keeping weak institutions on life support.

    While the Fed seemingly likes low commercial paper rates, making short term loans to private business (which is what the Fed does when it backstops facilities that buy commercial paper) is not normally thought of as part of the Fed’s mission.  This was an unprecedented step last October, though arguably necessary to prevent a recurrence of the September panic. The Fed, however, doesn’t appear to be getting  itself out of this business.  Money market funds and banks are usual buyers for commercial paper, and if we repaired the financial system properly, they might do more of that business again.
 
  Speaking of repairing the financial system: this year the FDIC has closed a small insolvent bank almost every week but somehow we don’t want to close the big banks that would seem to be troubled — banks like Bank of America, (BAC), Capital One Financial (COF), Citigroup (C), JP Morgan (JPM), and Wells Fargo (WFC). This does not make sense. I understand, some people are afraid that if the FDIC takes over big weak banks,  the government would have to own them, or parts of them, for years while selling off the bad assets. After all, the  FDIC needed seven years to wind up the business of Continental Illinois after it failed in 1984, and that rescue might eventually look like a walk in the park compared to fixing a complex institution like Citigroup. 

   On the other hand, the longer taxpayers continue to support these banks, the weaker these banks get, and the more we will have to pay later. Given the declines we’ve seen  in corporate profits, businesses are laying off 600,000 employees a month in order to cut costs commensurately. Need we say that does not bode well for banks who lend to consumers? Banks that lend to companies who sell to shrinking businesses may not make out so well either.

    Meanwhile, if the FDIC simply got on with the job, private investors and other banks would purchase pieces of the weak banks, new lending capacity would be created, and real confidence restored. Surviving  financial institutions would find private funding without government guarantees, and there would be less need for government intervention in the credit markets.

     In 1933 the government closed the insolvent banks but thereafter people believed in the surviving institutions’ solvency and were comfortable lending to them. On a smaller scale (relative to the economy, at least) the FDIC cleaned up the bad S&Ls in the early 1990s by closing them down and selling the impaired assets, which worked out pretty well in the end.  Until the government helps to re-create a financial system that private business can believe in, the government will have to keep supporting the financial system with extraordinary actions by the Treasury and the Fed. And it will presumably do so until reality forces policymakers to change — either through horrendous bank credit losses that even the new accounting rules can’t hide, or when the bad dream of a failed Treasury auction actually comes true.