Humor: The Story of the Banks in Iceland

It started with bankers in the U.K. asking 'Where can we find some pansies to sell this CDO crap to?"

UK "We are going to make ourselves rich by selling wothless CDOs dressed up as jewels to your fishermen banks"
Iceland "Yeah we are getting rich.... Big Party."
UK "We will even sell short and bet against the crap we sold you"
Iceland "Hey, this stuff melted down and is worthless."
UK "By the way we expect you to tax all your citizens 3 million dollars each to make up for our 'losses'".
Iceland "FU - stuff it. We voted and ain't paying."
UK "We'll start seizing your international assets till you pay."
Iceland "FU. Enjoy some volcanic ash."
UK "Stop.... you're sinking our economy!"
Iceland "Maybe you should of thought about that before you demanded repayment on the worthless crap you sold us."
UK "Choke....cough.... choke...."

Analysis: SEC vs. Goldman

The civil fraud charges filed by the Securities and Exchange Commission Friday accused Goldman Sachs of "defrauding investors by misstating and omitting key facts". These financial charges also mark a new era of government regulatory enforcement of Wall Street. No longer will the SEC simply come to consent decrees with financial firms where they do not admit guilt and in most cases pay a small fine viewed as a cost of doing illegal business.

One immediate question is how do the SEC charges filed against Goldman Sachs change the playing field? Do these charges even mean anything in a broader regulatory context? In my opinion, the actions from the SEC on Friday defines a new playing field by Washington marked with the following game-changing alterations:

a) A broader effort to get the derivatives market properly regulated to minimize the possibility of future meltdowns.
b) The Goldman Sachs charges are expected to be the first of a lengthy string of government actions against multiple firms that contributed to the financial meltdown. The lack of accountability by firms which accepted bailouts is no longer acceptable to main street and their representatives in Washington.
c) A dismantling by regulation of firms that are "too big to fail"; including the scaling back of previous government legislation that allowed the merger of commercial and investment banks.
d) The teeth of the SEC are back in place. For the last twenty years the SEC has been a toothless enforcement entity; forcing state AGs to take a leading prosecution role in financial malfeasance. This is likely to be the start of a change where the federal government will have deep roots in the policing of problems involving large financial firms.

The roll out of these regulatory reforms are expected to take years; however as noted by an AFP news article "We suspect that after Friday, others on Wall Street may have a harder time sleeping."

Another good clip is Ratigan on MSNBC where he compares Goldman Sachs to an automobile manufacturing company that deliberately took critical component from the inside of cars (CDOs) and then sold the cars as being great investments while betting on the side that the cars they created would all blow up spectacularly. An apt analogy - watch it here.

Even a year later - WaMu failure still in the headlines

Washington Mutual was a bank that desperately deserved to fail. Even a year after its demise, WaMu is still making the headlines. One example is is the CNN Money article below...

WaMu: The Forgotten Bank Failure

The biggest-ever bank collapse didn't lead to chaos, but Americans will pay the price for its unsound lending for years to come.

Washington Mutual is long gone, but its lax lending could haunt us for years.

The Seattle-based institution collapsed in the largest-ever U.S. bank failure last September. WaMu ran out of cash after business customers, unnerved by the implosion of Lehman Brothers, withdrew their uninsured deposits.

After the chaos surrounding Lehman's demise, WaMu was put to rest with little fuss. Regulators seized the nation's sixth-biggest bank on a Thursday night — a departure from the customary Friday — and sold it to JPMorgan Chase for $1.9 billion.

The move wiped out WaMu's 56,000 shareholders of record and left bondholders nursing billions of dollars in losses. But the WaMu deal spared the federal deposit insurance fund and thus was, unlike so many federal actions over the past year, an unalloyed positive for taxpayers.

http://finance.yahoo.com/loans/article/107676/wamu-the-forgotten-bank-failure.html?mod=loans-home >

The Math that Destroyed Wall Street...... and Main Street

Wired magazine recently presented a good article about the underlying math which destroyed Wall Street.

Recipe for Disaster: The Formula That Killed Wall Street

Page 3 actually outlines the basic math of the Copula Function approach which underlies the CDO market.

The Ascent of Money

Earlier this week, PBS ran a special two hour program "The Ascent of Money". The program is an excellent overview of current financial crisis placed in context of other historical events. The show includes some excellent commentary and interview clips.

It can be watched online at:
http://www.pbs.org/wnet/ascentofmoney/

Fannie and Freddie

Obviously the biggest news on Wall Street this week was the Federal Government seizing Fannie Mae and Freddie Mac before both of these mortgage giants failed in a catastrophic manner. These companies have been faltering for many months while looking for lines of credit to bail them out, the government went one step further and completely took over the firms while giving top executives the boot.

The entire situation is also another example of intervention not allowing proper capitalism to play out in the market. The term “moral hazard” comes to mind in which businesses do not take responsibility for their risky behavior; this only entices other businesses to take poor risks. Especially in an environment where it appears that “gains for privatized and losses are socialized”.

While the government takeover may have buffered the mortgage market in the short term and cheered up Wall Street on Monday, the long term picture is much less clear. The U.S. tax payer is going to be stuck with the tab. The question remains on just how big the tab will be – estimates range from $250 billion to $5 trillion. The actual cost is very dependent on how the housing market and associated credit recovers. One recent article outlined how the seizure of these mortgage giant is the taxpayer’s risk (If takeover tanks, we're holding bag).

Similar too many previous government interventions, this action with Freddie and Fannie may help alleviate the short term crisis, but the toll down the road will be much greater and more painful.

WaMu CEO given the Boot

Past HingeFire articles have outlined in detail the issues at Washington Mutual and urged banking customers to pull out funds over the FDIC limit. News today shows that Washington Mutual has ousted CEO Kerry Killinger. WM stock is down over 15% in mid-day trading.

It is also interesting that Washington Mutual agreed to further oversight by the Office of Thrift Supervision concerning aspects of its operations. This demonstrates the high level of concern regarding the solvency of the institution from a regulatory perspective.

Crushing the American Family

Once in a while a cartoon comes along which really drives home a point. Despite political pundits waving their arms and claiming that we are not technically in a recession, the circumstances facing American families are so dire these proclamations are nearly meaningless.

The credit crunch, housing market, gas prices, job losses, and rising food costs have left consumers in a tough position. Families are having to cut back many activities and purchases simply to cover necessities - this is not good news for the two-thirds of the economy dependent on consumer spending.

Well for the good news - At least we are not technically in a recession!

Is Your Bank Next?

A slew of mainsteam press articles a month back stated that the credit crunch was over. Not so fast! As outlined in articles on HingeFire in May (see Is the Financial Crunch over?) the financial sector is ripe for continued turmoil.

The top headline news today outlined the shares of U.S. banks plummeting amid stability fears. Sizeable regional banks such as Wachovia, WaMu, and National City are near the top of the list that investors believe have the likelihood to fail.

‘"It's the cockroach theory. You don't just have one bank failure -- when you have a big bank go under, there's always more than one," said James Ellman, president of hedge fund Seacliff Capital, who is short some financial stocks.’

The failure of IndyMac in many ways was a standard run on a bank. Panicked depositors lined up outside the doors pulling out $100 million a day causing what regulators called the second-largest bank failure in U.S. history. It was clear to regulators, politicians, and investors that IndyMac was in trouble, leaving only the question of degree. This type on depositor driven panic could easily happen to other struggling regional-type banks.

'One woman leaned on the locked doors, pleading with an employee inside: "Please, please, I want to take out a portion." All she could do was read a two-page notice taped to the door.'

At some point the FDIC will not be able to handle the level of defaults. While the FDIC has staffed up expecting more failures, the federally sponsored insurance agency is primarily focused on merging banks in trouble. The FDIC does not have deep pockets to bail out a chain of sizeable cascading failures.

Regional banks are not the only concern. Fannie Mae and Freddie Mac are in deep trouble. To avoid total financial market panic, the White House administration has ask Congress this past weekend to approve a plan that would provide a credit line of some $300 billion to the troubled GSEs and buy their stock. The Fed passed measures to allow both Freddie Mac and Fannie Mae to borrow at its discount window. Clearly, the government's hand was forced by a $3 billion Freddie auction scheduled for today that would have revealed the extent of the disaster without government intervention.

Is your bank next?

Will you be lined up at the door of your local institution begging to get your money out while the door is slammed in your face?

This is a time to carefully evaluate the safety rating of your local bank where you have deposited your money. If the bank looks the least bit shaky then your should get your funds out before a wide-spread panic develops.

Is the Housing Crisis at its apex?

The news cycle continues a downward cycle on housing. Homeowners can not open a newspaper, turn on the news, or browse online without immediately getting hit with the latest negative housing commentary.

On the front page today, US foreclosure filings surge 48 percent in May. The continuous stream of downbeat real estate news may be a sign that the housing market has finally hit the bottom. In the same way, that the endless stream of news on how to get rich speculating on real estate in 2005 marked the real estate market peak. Interestingly, the spin today is how to get wealthy buying real estate foreclosures.

There is continuing statistical evidence that indicates that housing has turned the corner. In many markets, the number of days on the market is falling, along with the amount of unsold inventory. Coupled with the rate of price decreases slowing as buyers and sellers come into alignment of the new expectations regarding the proper value for a house now that the speculative bubble has burst.

The mortgage situation is also easing, as banks have returned to traditional lending standards. Financial institutions now have an improved comfort level for underwriting and re-selling proper quality loans – the credit crunch is slowly moderating.

The summer of 2008 may mark the actual bottom of the real estate plunge on a national level; some markets will face further price correction. However the path out of the crisis across the country will still be lengthy and painful, extending well into 2009.

Nuveen finds a way out

Investment firms such as Nuveen that offer leveraged Muni Closed End Funds have been suffering an inordinate amount of stress over the past few months. The auctions of preferred securities issued by the companys' municipal closed-end funds continues to fail; leaving most of the firms in a situation where they need to either forced to redeem their preferreds or make other financing arrangements.

Earlier HingeFire articles outlined the issues in the market (see Auction Rate Stress Continues: Muni Bond Funds Impacted and Revisiting: Muni Bond Fund shorts).

Nuveen has obtained a commitment of up to $1.75 Billion to refinance the struggling auction rate preferred securities. This enables the company issue variable-rate demand-preferred instruments to replace the current ARPS. This effectively alleviates the pain be endured by Nuveen and places the firm’s Closed End Fund (CEF) products back into a liquid situation. The company has also taken steps to remarket the new shares with another financial firm.

These measures are excellent news for the holders of the Nuveen muni CEFs – most whom are common investors looking for tax-free income with minimal risk.

Nuveen gets infusion for auction rate securities

Quick Takes: Is the Financial Crunch over? More heads rolling

A slew of articles have appeared recently that the housing-driven credit crunch is over. Merrill Lynch’s Thain is the latest executive to make this claim. Are the financials about to recover or are these characters simply “talking their book” – to state it in Wall Street terms? Thain states that the upcoming losses at banks will be reduced moving forward even though the consumer will exert a drag on the U.S. economy over the next 6-12 months.

Coupled with the Wall Street Journal headline “The Housing Crisis Is Over” – it provides investors with hope that the worst may be in the rear view mirror. Housing may have hit the bottom according to some analysts. “A bottom does not mean that prices are about to return to the heady days of 2005. That probably won't happen for another 15 years. It just means that the trend is no longer getting worse, which is the critical factor.”

Of course there are pundits who take the other side of the coin, presenting an outlook for housing that shows another 20-30% drop in prices nationwide. This will be coupled with a drop in consumer spending that drives the next wave of the credit crunch further causing chaos at the banks.

Most likely the reality over the next couple years will be situated between the two extremes of rosy forecasts and dismal down-siders. Despite the recent recovery of financial stocks, most investors do not feel confident buying into this sector – most believing that the bounce-back is temporary.

Heads Rolling

The boxes continue to be dropped off in corner offices. The president of bond-rating firm, Moodys, has been sent packing. Brian Clarkson, is viewed as a casualty in the complicity of credit-rating firms in the sub-prime meltdown.

“The resignation comes amid heightened scrutiny by investors, regulators and lawmakers into the role of Moody's and its rivals in the meltdown of complex mortgage-related securities, many of which received top triple-A ratings from the credit raters, only to be downgraded sharply in the past 12 months when the housing downturn worsened.”

Quote of the Week

"Capitalism without failure is like Christianity without hell" – Warren Buffett

Once again Warren and Charles provided some zingers at their annual meeting news conference. One theme this year focused on the irresponsibility of banks in the continuing credit crunch. From their perspective, “the pain many financial institutions are feeling because of the credit crunch is well deserved”.

The chairman and vice chairman of Berkshire Hathaway Inc. said Sunday that the financial companies that engineered sub-prime mortgages and the investment funds that bought securities backed by those mortgages didn't deserve much sympathy for their subsequent losses.

The two billionaires emphasized that investment banks should not be rescued by the government. Failure and its associated lessons are an important part of capitalism. Continuing to rescue institutions that are “too large to fail” sends the wrong message about risky business behavior in the financial sector.

Buffett did state that “the Federal Reserve's bailout of Bear Stearns Cos. probably prevented a crisis among investment banks”.

Another section of the commentary focused on the “R” word. Buffett outlined that the country is obviously in a recession even if the conditions do not meet the classical definition of two quarters of negative growth.

Conflicts entangle Auction Rate Market

“Safe as cash,” proclaimed the brokers as they sold billions of auction rate securities to investors. Now the market is locked up. Both investors and issuers have taken a big hit.

Have the investment bankers felt any pain? No! In fact they still make out like bandits even as the market refuses to thaw. Any way you slice it, the end game in the auction rate market for Wall Street firms is “heads I win, tails you lose.”

The entire market is rife with conflicts of interest. First the investment bankers marketed the securities as safe as cash in their own internal auction market and refuse to step in to keep the market liquid as over 70% of the weekly auctions fail. The Wall Street firms are still paid for their “services”, even though no securities are sold. Furthermore the bankers make big money when issuers directly redeem the auction rate notes.

To pour more pain on the fire, the investment bankers for the most part refuse to allow the notes to trade on a secondary market and demand that the auction rate securities be marked to face value. The places issuers in a situation where they can not buy back their own securities at a discount, at a time no investors will purchase them for face value. Of course, a wholesale discounted market would force the Wall Street firms to mark down similar securities on their own books; leading to billions more in losses.

At some point, local and state governments are going to demand action to fix this situation, and refuse to be held hostage by the Wall Street firms. The first step is to demand a transparent auction market where these securities can be sold for a discount or premium from face value. This is the only way to unfreeze the auction rate market and restore investor confidence.

A proper stand: Canada will not bail out Investment Banks

The governor of the Bank of Canada says he will take a tough stand with financial institutions that wind up near bankruptcy because of poor decisions.

Maybe it is time that the United States adopted this policy. Mark Carney says the central bank won't bail out Canadian financial institutions like the U.S. government did when the Bear Stearns brokerage, one of the giants of Wall Street, ran afoul of the subprime mortgage mess.

The absurdity of the U.S. Federal Reserve bailing out Bear Stearns simply to avoid a short term financial panic in the credit market is becoming more apparent as further details are being revealed about the situation. The action will only drive more bail-out calls. It teaches a lesson to Wall Street that firms can privatize the gains, and socialize the losses. There is no reason to adopt any type of reasonable risk control if the government will be available to bail out the investment banks every time the bad decisions come home to roost. This will only drive the investment banks to maximize revenue by taking more risk.

The most current variant of the Fed’s flawed policy is opening the discount window to the investment banks in the past few weeks; in the past this lending facility was reserved for commercial banks. The Wall Street banks have been hitting up window for over $38 billion per day far more than all the commercial banks in the U.S. combined. To think that some congressmen squawked and demanded an investigation when Countrywide Financial was provided with $50 billion over several months; these legislators are strangely silent on Wall Street hitting up the Fed for nearly the same amount each day.

Even more shocking is what the Wall Street is doing with the borrowed money. The intent of the Fed action is to inject liquidity into the system in order to ease the credit markets. The Investment Banks have been happily utilizing the low cost Federal loans as capital to fund large scale gambling. The major Wall Street institutions have used the Fed cash to implement international interest-rate “carry trades” with the intent of squeezing profit out of the market. This naturally will lead to hefty bonuses for the Wall Street staff; assuming the positions don’t implode over the coming months. No concern is given to loosening the stranglehold of tightening U.S. loan conditions or unwinding the derivatives that sparked the credit crisis.

If Wall Street is not using the discount window cash for its intended purpose of easing the credit markets then the spigot should firmly be shut off. The Bank of Canada has the right mind-set when it comes to dealing with investment banks – these risk-driven firms should be responsible for their own calamities.

Bring back Glass Steagall

The Great Depression brought about many needed regulatory reforms. These acts served to curb excess speculation, and to keep the funds of bank depositors safe. One of the primary reasons for the insolvency of many commercial banks in the 1930s was the loaning of money for stock market speculation in a market that allowed absurd levels of leverage. Many of these banks owned brokerage security operations, and found an easy path to executive riches by pressing these loans on depositors prior the 1929 crash.

The Glass-Steagall Act tamed this circus by prohibiting banks from owning financial companies. This created a wall that stopped the ridiculous activities of banks that were not in the best interest of customers. Coupled with the creation of the FDIC and other reforms included in the act, the Glass-Steagall legislation protected both bank account customers and investors. The act prohibited a commercial bank from offering investment and insurance services while maintaining better regulatory scrutiny on capital ratios.

Unfortunately, the provisions that separated cross-ownership were over-turned by the Gramm-Leach-Bliley Act of 1999. Financial companies spent more than $300 million in lobbying over 20 years in their attempts to repeal Glass-Steagall.

Not merely content to simply mine the riches offered by the combination of insurance underwriting, securities underwriting, and commercial banking; Wall Street championed unregulated derivatives. The securities industry claimed that these contracts would distribute risk and regulating derivatives would impede economic development. Supported by the Federal Reserve the merged financial industry drove the wide-scale introduction of derivatives into traditional commercial banking markets such as mortgages.

Since 1999, the derivatives have grown on a parabolic curve. There are now over $516 trillion in derivatives outstanding.

In a short eight years, the rapid proliferation of derivative contracts has become the Trojan horse that is likely to undermine the entire modern banking system. The collapse of Bear Stearns should act as a warning for the entire financial market. It is time for regulators to step in and properly unwind the most troubled instruments, while providing concrete oversight to the entire derivatives industry. Obviously the lunatics have been found unfit to run the derivative financial asylum. Deregulation has run amok, and financial checks and balances must be restored to protect the economies of major nations.

Investment banks’ culture of risk is diametrically opposed to the purpose of commercial savings banks which is the preservation of customers’ assets. The introduction of derivatives as the primary under-pinning for the mortgage industry with little regulatory oversight was an event that was obviously going to end in a calamity; similar to giving liquor and a car to a chronic drunk.

The continuous reduction of the protections of Glass-Steagall, by politicians in Washington driven by banking PAC money, is the root cause of the current painful credit crunch which is undermining the entire U.S. economy. In order to fix the core problems, the protections created by Glass-Steagall after the harsh lessons of the Great Depression must be restored by Congress. A clear separation of commercial and investment banking must be reestablished.

A recent PBS Frontline outlined The Long Demise of Glass-Steagall.

Schwab YieldPlus Funds Tank

For years, Charles Schwab marketed the YieldPlus funds as "a safe alternative to money market funds that preserve principal while being designed with your income needs in mind." Charles Schwab also represented that its YieldPlus funds were designed to provide "high current income with minimal changes in share price."

The Schwab YieldPlus Fund Investor Shares (SWYPX), and Schwab YieldPlus Fund Select Shares (SWYSX) have declined over 30% since July of 2007. Unfortunately for investors these funds had large investments in risky mortgage-backed securities. Morningstar now ranks these two funds as last among ultra-short-term bond funds. So much for the Schwab claim in the marketing literature, “The [YieldPlus] funds provide higher yields on your cash with only marginally higher risk [and therefore] could be a smart alternative.”

An earlier HingeFire article from October (see Grandma’s Money Market Fund feels the SIV pinch) outlined the risks of brokerage money market funds, and why investors should be wary of these instruments.

Now Schwab is offering investors a mere 5 to 12 cents on the dollar of their losses, and demanding that the account holders quickly take the offer. This, of course, drove investors to contact law firms to launch class action suits on their behalf.

Is there a future for Quant Funds

It appears the Quantitative Funds have been stranded on the lee shore, and a crowd is desperately trying to find a way to shove the ship off the beach. Even if re-floated the quantitative industry is mired in a cross-wind about its future direction; not knowing whether to tack or jibe in order to catch air in the sails.

The recent draw-downs during the credit crunch have raised the question if the mathematical wizards can navigate the waters; or if the conjurers would be better off safely ashore teaching theory at a university. Is there even a future afloat for these funds? The trends of lower cost IT, more powerful computers, mountains of instant data, and new modeling techniques can play both for and against these funds. The bottom line is that a proper definition of risk still haunts the players.

Earlier HingeFire articles (see Quants search for new math) discussed the confusion as these funds search for a new formula that will pull alpha out of the market while not leaving the funds sunk every few years. The current methods have proven to be more akin to gambling than investing.

Advanced Trading recently addressed the fund dilemma - Quants Searching for Alpha: Do the Pros Outweigh the Cons?

The Meltdown: Iceland

For many recent years, Iceland was touted as the new model for Europe. Investment poured in at record levels, lifting the entire economy of the small island nation. The geo-thermal energy was offered as an excellent power source for heavy industries such as smelting, while the onshore banking industry was presented as the new breed.

The local currency, the krona, was riding high while the government offered an environment where interest rates were much higher than other nations. The nation was splashed across the financial press as the next business center.

It only took six months for all the optimism to dissolve and the island to adopt a siege mentality. Government officials and the local press blame unscrupulous speculators for the meltdown that has left the nation’s financial infrastructure on the brink of ruin. The krona has sunk 25%, the stock market 40%, inflation has sky-rocketed, and the local interest rates sit as an unpleasant 15.5%. It is obvious that the island’s central bank does not have the liquidity strength to bail out any of the nation’s larger floundering banking institutions, effectively leaving banks un-backed. Bear Stearns recently suggested the tiny nation was about as safe an investment as Kazakhstan.

Consumer spending has slowed to a crawl as on-shore prices has risen greatly in the import driven economy. There is increasing recognition that the growth over the past few years was the classic definition of a bubble, however few in power are prone to admit it. Instead the leaders blame the demise on outside speculators with a Vegas mindset who want to make a profit on the pain of the nation.

In the past, Iceland was hailed as the new model of success. Now the fear is that mainland Europe will follow the model of this small nation, and crumble on a mass scale. Iceland may only be the leading edge of a cycle of credit defaults that will rip the European financial system asunder.

Iceland first to feel the blast of global cooling
Tiny country is like a canary in a coalmine signalling crises in toxic economies

Come Watch the Death of a Bond Insurer

This week the market gets front row seats in the death of a bond insurer. In February, the forebearance for ACA Capital Holdings was extended to April 23rd. This date approaches in a couple of days and is unlikely to be extended. The outcome at this point is obvious according to most pundits, the complete implosion of the bond insurer.

The open question remains of what impact this event will have on the municipal bonds which are insured by ACA. In most cases, the expectation of the bond insurer failure is already priced into the munis. However this can not be a good sign for the jittery auction rate or municipal markets.

At minimum, mid-week will be the time to pull up a chair, grab a drink, and see how the entire situation with ACA unfolds. Will some firm magically step up and save the bond insurer? Will regulators from New York State step in? The flak from the implosion splatter across the Wall Street landscape? Will it give CNBC something to talk about instead of the mediocre first quarter earnings?

One recent BusinessWeek article outlines how Wall Street used ACA to hid loads of subprime risk with the eventual unintended consequence of sinking the entire business, including the bond insurance operations.

An associated story outlines the failure of S&P, the only credit-rating agency to follow ACA, to properly cut the companies rating in a timely manner. On December 19th, the rating agency cut ACA’s grade from A down to CCC overnight; immediately turning gems into junk.