Extend and 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?
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 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:
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
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 the chart below say about where banks view asset prices to be headed?
Banks win on asset inflation. Banks potentially lose on asset deflation. Rising
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|
|5- Have accounting changed that forced asset liquidation for mal-investments (see Accounting)||Done|
|6- Change Margin requirements or Leverage Pricing|
|ISE had instituted special rebates for specific option liquidity providers - April 1||Done|
|NYSE Euronext's U.S. Options Exchanges Announce New Pricing and Fee - April 5||Done|
|ISE to Introduce a Modified Maker/Taker Fee Schedule - March 29||Done|
|New interest rate futures contracts and futures options on Eurodollar & US Treasuries||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|
|Phantom volume at 3 am on Sunday night||In Process|
|Is volume merely hiding in plain sight, dark pools and structured notes?||In Process|
|The obvious overhang of CFTC position limits||In Process|
|The cross-pollination of inter-continental routing capabilities||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 -> China revising currency peg (China biggest US collateral holder)||Expect|
|12- Increase the Velocity of Money by instilling an inflation worry in the public||Mixed|
|13- Place restrictions on market shorting (i.e. shortages on key dates)||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).
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.
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?
Sign Up for the next release in the Extend & Pretend series: Commentary
(1) 03-06-10 All You Need To Know About Bank Balance-Sheet Fraud The Market Ticker
(2) 08-03-06 Paul McCulley and Doug Noland Both Praise Hyman Minsky Economic Dreams
(3) 04-06-10 New NYSE Options Pricing Pyramid Promotes Derivative Driven Market Melt-Up Zero Hedge
(4) 04-08-10 Home equity horror Reuters
The last Extend & Pretend article: EXTEND & PRETEND - Hitting the Maturity Wall!