16 April 2009

Zombie Update ~ "Ben's Un-shrinkable Balance Sheet"

Oh, well. The plan to monetise everything and devalue old buckaroo by 50% might even work....

We had some fun yesterday on CNBC talking with Larry Kudlow, Melissa Francis and Dick Bove about the banks. It is pretty clear to us that the residents of Bubbleland want a rally in financials and they are going to have one, with the active assistance of American International Group (NYSE:AIG) and the Federal Reserve System.

Our friend David Kotok likens the market mood to cabin fever. So be it. All we can say is that the first agenda item with Citigroup (NYSE:C) in Q2 should be a new management team, a new board and then a voluntary restructuring a la General Motors (NYSE:GM) or dare we even say it, MCorp? Yeah baby. This zombie dance party ain't over. No sir.

We'll be publishing our thoughts on a voluntary restructuring of C on Friday in honor of the C earnings announcement. All this in the nature of being constructive. Another hint: remember that the three FDIC insured bank affiliates of the organization formerly known as Lehman Brothers are still operating in bankruptcy, albeit not a pretty sight. Two are rated "F" by The IRA Bank Monitor, a third is inactive.

By the way, after the CNBC interview, Dick Bove kindly got on the telephone to the FDIC and clarified the story with respect to whether the year-end 2008 data from the FDIC included the losses for both Washington Mutual and Wachovia. This point also was illuminated in a weekend exchange among several subscribers to our Advisory Service, who noted that the financials for Wells Fargo (NYSE:WFC) contain the assets but not the revenues of the affiliates of Wachovia Inc that were acquired on 12/31/08 by WFC.

Analytics note: The rollup for WFC in The IRA Bank Monitor is a "WFC only" view of the organization's revenues and losses, but shows the balance sheet information for the Wachovia bank units. Thus there are no ratings for the Wachovia units in the current WFC rating. This situation will be remedied when the units of WFC report Q1 2009 results, which will be made available in real time to users of the consumer and professional versions of the Bank Monitor. We'll be discussing this data issue and provide an update on the Q1 2009 harvest of FDIC call reports further in the new IRA Picking Nits Blog. We look forward to your comments.

FDIC claims all of Washington Mutual's numbers were included in the fourth quarter results (this even though the bank did not file a Q3 call report). FDIC also confirms via Bove, who now hangs his hat at Rochdale Securities, that the Wachovia numbers were included in the non-performing statistics, but not the default statistics (and apparently no revenue items, etc).

Thus in our view, even with the adjustment already made to the Q4 2008 numbers in the FDIC's Quarterly Banking Profile, the 2008 loss rate data from the FDIC is still not complete because it does not include the charge-offs or revenue components for Wachovia prior to the close with WFC.

We are not saying that the GAAP treatment of this event is incorrect, but what we are saying to our colleagues at the FDIC is that the historical record for Q4 2008 for all federally insured depository institutions seems incomplete without the Wachovia bank unit income statement and charge-off data. We'll relay any comments on this from FDIC.

All we can say about financials is that the worst lies ahead in terms of loss rates. The Sell Side is desperately trying to breathe life back into the equity of financials that is clearly impaired, at least IOHO. As we told the subscribers to IRA's Advisory Service last week and have told readers of The IRA, the real point of friction is the ability to fund, not equity to absorb loss via equity.

So long as Goldman Sachs (NYSE:GS) can issue FDIC-insured debt, they can bluster on about repaying the TARP funds. Nobody in Bubbleland seems to notice that the entire market for repo, loans and anything else outside of corporate debt is basically facing the Fed. Indeed, one reason for our still bearish cast is the lack of anything resembling real action in Washington to restore private market function.

The team of Summers & Bernanke seemingly are embarked upon a strategy of cold storage and public subsidy for the very toxic waste that has the US banking system in a state of paralysis. This studied inaction, this slow motion excuse for doing nothing about the root cause of the financial crisis, is digging a very deep hole for the Federal Reserve System and the US economy, IOHO.

To that point, this week we feature a comment by Michael Pento, a veteran of the NYSE who acts as Chief Economist for Delta Global Advisors (www.deltaga.com), regarding the Fed's bulging balance sheet and the implications for the abortive reflation scenario being followed by the Bernanke Fed to take the heat off of the Obama Administration. Pento's view is shared by many of our colleagues in the money markets, who look at the Fed's monopolization of the private collateral lending and wonder what the central bank will do several months from now when these prescriptions have failed to entice investors back into many orphan asset classes.

Our additional view to his comments is that the Fed's balance sheet expansion represents the inflationary cost of cleaning up the bubble, a cost we do not yet see reflected in the dollar because investors have no place to hide in a sea of fiat paper greenbacks, a point made by John Makin of AEI at our last Deflating Bubble session. By implication, Pento suggests that how investors and risk managers manage the reality of a several fold, permanent increase in Fed credit is Topic A for 2009 and beyond.

"Ben's Un-shrinkable Balance Sheet"
Delta Global Advisors
April 14, 2009

As he stated again clearly today, the Chairman of the Federal Reserve has deluded himself into thinking that when the time comes, he will be able to shrink the size of the Fed's balance sheet and reduce the monetary base with both ease and impunity. He also has deluded himself into thinking inflation will be easily contained.

It is very important that he does not fool you as well.

The Fed believes low interest rates should not be the result of a high savings rate, but instead can exist by decree, a conviction which has directly led consumers to believe their spending can outstrip disposable income.

The result of such thinking has been a rise in household debt from 47% of GDP in 1980 to 97% of total output in Q4 2008. As a result of this ever increasing burden, the Fed has been forced into a series of lower lows and lower highs on its benchmark lending rate. Keeping rates low is an attempt to make debt service levels manageable and keep the consumer afloat. Problem is, this endless pursuit of unnaturally low rates has so altered the Fed's balance sheet that Mr. Bernanke will be hard-pressed to substantially raise rates to combat inflation once consumer and wholesale prices begin to significantly increase.

Banana Ben Bernanke has grown the monetary base from just $842 billion in August 2008 to a record high of $1,723 billion as of April 2009. But it's not only the size of the balance sheet that is so daunting; it's the makeup that's becoming truly scary.

Historically speaking, the composition of the Fed's balance sheet has been mostly Treasuries. And the Federal Open Market Committee would typically raise rates by selling Treasuries from its balance sheet into the market to soak up excess liquidity. However, because of the Fed's decision to purchase up to $1 trillion in Mortgage Backed Securities (and other unorthodox holdings), it will not be selling highly-liquid US debt to drain reserves from banks. Rather, it will be unwinding highly distressed MBS and packaged loans to AIG. Not to mention the fact the Fed would have to break its promise of being a "hold-to-maturity investor" of such assets.

Moreover, not only are the new assets on the Fed's balance sheet less liquid but the durations of the loans are being extended. According to Bloomberg, the Fed is contemplating extending TALF loans to buy mortgaged backed securities to five years from three after pressure it received from lobbyists and a failed second monthly round of auctions. That means when it finally decides it's time to fight inflation, the Fed will find it much more difficult to reverse course.

But because of the extraordinary and unprecedented (some would say illegal) measures Mr. Bernanke has implemented, only $505 billion of the $2 trillion balance sheet is composed of U.S. Treasury debt. Today, most Fed assets are derived from the alphabet soup of lending programs including $250 billion in commercial paper, $312 billion of Central Bank liquidity swaps and $236 billion in mortgage-backed securities.

Thus, our economy has become more addicted than ever to low interest rates. But because bank assets will now be collecting income at record low rates, when and if the Fed tries to raise rates it will only be able to do so on the margin. If Bernanke raises rates substantially to fight inflation, banks will be paying out more on deposits than they collect on their income streams. Couple that with their already distressed balances sheets and look out!

Additionally, not only do the consumers need low rates to keep their Financial Obligation Ratio low, but the Federal government also needs low rates to ensure interest rates on the skyrocketing national debt can be serviced. Our projected $1.8 trillion annual deficit stems from the belief that the government must expand its balance sheet as the consumer begins to deleverage. In fact, both the consumer and government need to deleverage for total debt relief to occur, else we're just shuffling debts around and avoiding a healthy deleveraging entirely.

In order to have viable and sustainable growth total debt levels must decrease, savings must increase and interest rates must rise. But that would require an extended period of negative GDP growth-a completely untenable position for politicians of all stripes. Ben Bernanke would like you to believe inflation will be quiescent and he can vanquish it if it ever becomes a problem. Just make sure you don't invest as though you believe him.

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