Thursday, May 7, 2009

Banking Swindles, Public Relations, and Other Government Follies

On the afternoon of Thursday, May 07, 2009, the U.S. government will make public the results of the so-call stress tests of the largest 19 banks. This entire process is nothing more than a public relations stunt to give the appearance to investors that all is ‘honky dory’ with the banks. But as I pointed out on a recent post, the balance sheet problems of banks are very significant. The government’s market interference is merely postponing the day of reckoning by conscientiously manipulating and concealing the actual shape of the largest financial institutions. Given the propensity of human nature to reap the benefits of the proverbial ‘free lunch,’ market participants have been practically cheerleading and applauding government efforts. This concealment cannot continue for a prolonged period of time. I expect by September this house of cards will start crumbling. In the meantime, illusions will be given that we have or are “turning the corner.” Don’t believe it. It is coming from politicians (and those who benefit from their actions) who have nonexistent credibility.

These are some of the steps the government has de facto legalized extortion—otherwise known as assisting the banks.

1. The Federal Reserve System exorbitant expansion of its balance sheet is aimed at “helping” the banks by taking on dodgy assets from the banks’ books and replacing them with less risk ones (like Treasurys). This has lessened the write-downs and write-offs financial institutions must undertake. Even with this manipulation, the IMF reckons that approximately $550 billion more in write-downs are on the way.

2. The low interest rate environment, which is a direct result of monetary policy by the Federal Reserve, has allowed banks to practically execute the carry trade of borrowing short and lending long. Banks borrow and pay almost nothing on interest, and subsequently lend the proceeds long-term. In other words, banks pay, say 1% on the borrow funds, and lend the money at, say, 4.5%. Given that consumer credit is tumbling, most of the fees earned by banks has come from refinancing. This is not continuous cashflows. These non-recurring fees may carry through the 2nd quarter reporting season, but not much more after that.

3. Balance sheet manipulations led by the “politization” of the Financial Accounting Board. Mark-to-market rules, which is the mechanism by which a bank’s trading book is adjusted to reflect its most recent valuation, were in effect suspended. This allowed financial institutions to disguise problem assets. This fact alone should have sent shivers to the market, but it simply brushed it off. Furthermore, it is almost impossible given this directive to assess the true value of bank assets.

4. A number of banks, most notoriously Citigroup, engaged in an accounting trick call “credit value adjustment.” The “adjustment” allows firms to record as a profit the amount of the decline in value of its issued debt. For example, if at the beginning of the quarter Citigroup’s debt traded at $100, but it is currently trading at $75, Citigroup records a $25 profit. The assumption is that the company can purchase its own debt at the discounted price. Of course, the bank does not do this because it does not have the money; but for accounting purposes, this is legitimate. Instead of the actual term used, this should be call “creative value enhancement.”
5. Goldman Sachs, the master of deception, switched from reporting earning results on a fiscal year basis ending in November. It will now report on a calendar year basis. The result of this switch: Not accounting a huge loss in December 2008 in their most recent quarterly earning report. On that month alone, the firm lost about $780 million. This would have cut into the $1.8 billion “profit” reported.

As previously mentioned, these manipulations have occurred under the watchful eye and in some instances endorsed by government manipulators, who purport to act for the benefit of the “people”. There is a cliché that says that if you have friends like these who need enemies. One can sweep trash under the rug and hope no one notices. Soon enough, however, people will notice. When that happens, you have better be out of the stock market or be shorting it.

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