Even after substantial gains this year, a whole slew of financial stocks still trade below book value. As written
about back in January, a good portion of the insurance stocks traded
close to half of book value. While the fears from the financial crisis
have mostly dissipated, the stocks continue to meander below book value
even with strong earnings profiles.
Investors continue to
More and more in fashion lately in the financial world is companies taking huge write-downs of some flopped acquisitions. Even the big-name players with tremendous resources to scrutinize the acquisition can't escape this fate.
Microsoft had to own up last July to a $6.2-billion write-off of the acquisition of aQuantive, a digital advertising company that Microsoft bought for $6.3 billion cash in 2007. The size of the write-down is significant even for Microsoft. For comparison purpose, Microsoft operating operating profit in Dec. 2012 quarter was $7.8 billion.
Nevertheless, Microsoft can at least have some consolation as just four month later, shares of tech giant HP suffered a 11% plunge partly because of a massive $8.8 billion write-off at Autonomy, a British software company it acquired in 2011 for around $10 billion, due to 'serious' accounting issues.
This is not just limited to the typically high-flying tech sector either. Last week, Caterpillar, the manufacturer of mining and construction equipment, also said it would need to write off $580 million in 4Q, 2012 goodwill related to a 2011 acquisition in China citing possible accounting fraud.
According to Bloomberg, goodwill, basically the amount paid over the book value of the target firm in an acquisition, in the S&P 500 companies have more than doubled on a per-share basis as companies have paid an increasingly higher takeover premium over the underlying asset value (i.e. goodwill) for the past decade.
Why do you think these companies supposedly with some of the best financial minds in the world at their disposal would overpay that much for another company? A large part of it is that M&A is still one of the quicker and easier way to generate some positive buzz juicing up company stock. Hungry for future top-line growth (which is usually tied to executive pay) in a lack-luster world economy, corporation executives are more inclined overlook certain "ambiguity."
Furthermore, increasing foreign acquisition in new/developing markets has also increased the risk of accounting discrepancy or min-interpretation more than most people have realized. Of course, the unprecedented synchronized QEs from world's central banks have a big hand in over-valuation in almost all asset class as well.
It typically takes at least 2-3 years for companies to realize the full synergy, or discovering the dog, of an acquisition. Bloomberg quoted Erin Lyons, a Citigroup Inc. credit strategist, that some 44 companies listed on U.S. exchanges are potential candidates for write-downs, and that three S&P 500 companies -- Frontier Communications Corp. (FTR), Nasdaq OMX Group Inc. and L-3 Communications Holdings Inc. (LLL) -- have more goodwill than market value.
So it looks like goodwill could turn nasty pretty soon for the U.S. companies, particularly the tech sector, which historically tends to have a bigger goodwill appetite than other industries.
"As long as the music is playing, you've got to get up and dance. We're still dancing.”
Bloomberg News reports that Bank of America Corp. (BAC), the best performer in the Dow Jones Industrial Average for 2012, has more than doubled since the start of the year “as the company rebuilds capital and investor confidence.”
My friend Meredith Whitney just upgraded BAC to a “Buy,” a call that is a little late given the stock’s performance to date. But at just 0.5x book value, to be fair to Meredith, you could argue that the bank is still undervalued. And many people do in fact believe this. If we accept the basic bull market thesis for BAC being touted by Whitney and others, what is a reasonable valuation for BAC?
Let’s set some assumptions.
First, if you believe the bull market thesis for BAC, you must assume that the bank is going to prevail in the massive litigation it faces with respect to legacy mortgage securities. This is a considerable assumption, but Whitney and the rest of the Sell Side analyst community seem to already have taken this leap of faith. For the sake of their clients, let’s hope they are right.
BTW, watch some of the more critical bank analysts ask BAC and other TBTF banks about the adequacy of reserves for civil litigation and put back claims by Uncle Sam in the Q4 earnings calls this January.
Second and more important even than the litigation is the question of business model. Earlier this week, BAC CEO Brian Moynihan said that he was satisfied with a high single digit market share in the US mortgage sector. Wells Fargo (WFC) is close to 40%. BAC at < 10% market share nationally is perhaps a more profound assumption than the question of the BAC mortgage litigation. BAC was once the dominant player in mortgage lending, both directly and through third part originations (TPO). To have this bank’s huge balance sheet at such a low level of deployment is bad for the real estate market and for future earnings.
Thanks to Senator Elizabeth Warren (D-MA) and the ill-considered Dodd Frank legislation, the TPO market has virtually disappeared. The lending capacity once represented by Countrywide, WaMu and Lehman Brothers is gone. BAC is still purchasing some production from outside providers, but the volumes are miniscule compared with the pre-2007 period. Thus the question comes: When Street analysts are showing a positive revenue growth rate for BAC and its peers, from where precisely is this revenue going to come?
Because of Dodd-Frank, Basel III and the Robo-signing settlement, the largest US banks are being forced out of the mortgage market. Earlier this week, I talked about this dynamic on CNBC’s “Fast Money.” Suffice to say that analysts who assume that BAC will double in 2013 may not understand the new drivers – or lack thereof -- of revenue and earnings in all of the TBTF banks.
That said, I think it may be reasonable for BAC and even much maligned Citigroup (C) to double in the next twelve months, but not because of revenue or earnings growth. If BAC hits street estimates for revenue in 2013 (+3-4%), is this a sufficient driver to justify a double in the stock? No, but a doubling of the dividend is a good enough reason for cash starved investors. In a very real sense, the biggest driver for stocks like BAC or C is not internal revenue growth but the zero rate policy of the FOMC.
During 2012, the preferred stocks of names like BAC and C have appreciated more than 15 points in price. Yields for preferred issuers like the TBTF banks and General Electric (GE) have fallen by almost two points. Is this because the revenue growth or earnings of these names have been growing? No, these metrics are flat to down. The appreciation of these securities has been driven by the FOMC and the Fed’s ridiculous zero rate policy. ZIRP does not create jobs nor is it helping bank revenue.
"Reduced expenses for loan losses and rising noninterest income helped lift insured institutions’ earnings to $37.6 billion in third quarter 2012," notes the FDIC in the most recent Quarterly Banking Profile. "Two out of every three insured institutions (67.8 percent) reported year-over-year NIM declines, as average asset yields declined faster than average funding costs." The fact that the TBTF banks are relying on fee income and line items like investment banking to hit revenue and earnings targets is very telling.
So when you see Sell Side analysts like Meredith Whitney being so constructive on the TBTF banks, even with the poor operating performance, investors need to ask themselves a question. Is the prospective appreciation of BAC and C the result of strong business fundamentals? Or is the prospective appreciation of these stocks more a case of traumatized investors fleeing to the fantail of the Titanic to avoid the icy cold financial repression of zero interest rates? Keep in mind that most of the improvement in earnings which seems to impress Whitney and other analysts has come as a result of expense reductions, mostly credit costs. Efficiency ratios for the large banks are over 60%, of note.
Even if you believe that BAC is going to escape the most horrific outcome in the mortgage litigation, the valuation target that is reasonable for this bank, C and the other TBTF institutions such as JPMorgan Chase (JPM) and WFC, is probably between 1 and 1.25x book value. So yes, given that valuation framework, you can justify a doubling of BAC from current levels to say $20-25 per share. But keep in mind that this stock was trading at $40 back in 2008 and over $50 in 2006 prior to the acquisition of Countrywide. Are we likely to see BAC go to over 2x book value again? Well, maybe, but not because of strong earnings or revenue growth rates.
Should names like BAC or C manage to get above 1.25x book, it will be because of the Fed and ZIRP. And as and when Fed interest rate policy changes, look out below. As I noted on CNBC, without the benefit of a strong mortgage origination and securitization business, the TBTF banks are going to become far less volatile and far more boring. Even the marginally higher capital levels of today, pre-Basel III, will imply lower asset and equity returns. And this is not a bad thing.
Yet investors are really not prepared mentally or emotionally for a market where the large banks are not delivering double digit revenue and earnings growth, whether organically or via M&A. Most institutional investors, keep in mind, have no idea how the TBTF banks actually make money. So when well-meaning Sell Side analysts predict wondrous stock price appreciation for the Zombie Dance Queens, the proverbial sheep on the Buy Side sing with joy -- and rush into the interest rate trap so lovingly constructed by Chairman Bernanke and the Fed. Keep in mind that the corollary of ZIRP is massive interest rate and market risk on the books of all banks. Think trillions of dollars in option adjusted duration risk.
Without the benefit of gain on sale from mortgage origination and securitization, it is difficult to construct a long term bull scenario for any US bank, large or small. As and when the Fed normalizes interest rates, the business models of the TBTF banks are going to be far less exciting. Mark-to-market losses on securities will wipe out stated earnings. New and innovative ways of presenting “pro forma” earnings will appear on the scene. The TBTF bank CEOs will rightly blame Washington.
In this future banking market, names like C which currently trade on a 2 beta will have higher dividends, but relatively flat earnings and revenues. Cost cutting, not growth, will fund these payouts to investors. Occasionally you will see big numbers from these names when the investment bankers have an especially good quarter. But overall the TBTF banks are evolving into low growth utilities with nice dividends. This is precisely the way banks used to be before President Bill Clinton’s “Great Leap Forward” in terms of housing and home ownership. And, again, this is not a bad thing.
But investors in the TBTF banks need to understand that the business model for this industry has changed. The business model for banks is going to continue to evolve away from the high-beta, high volatility model of the 2000s to something that looks more like banking in the 1950s. The action in terms of significant volume growth is in the non-bank sector. Get used to it.
Holman Jenkins of The Wall Street Journal reported last week that government may end up making a little money after bailing out AIG. But my friend Robert Arvanitis of Risk Finance Advisors skewers that fallacy below. -- Chris
Mr. Jenkins’ error rests on incomplete accounting and incorrect attribution analysis. In Frederic Bastiat’s terms, we have a confusion of what is seen and what is not seen.
Let’s see if we can unpack that a little.
The one unarguable fact is that AIG lost 95% of value. To say that taxpayers “made out” is like finding a little pig iron after the Chicago Fire, or salvaging a few brass fittings from the San Francisco earthquake.
Goldman Sachs exploited AIG’s triple-A rating to arb their own capital rules against insurer ignorance. It was cheaper for Goldman to “insure” than to hold what bank regulators required for capital.
That’s why ignorance is the right word. Financial guarantee “insurance” is foolish—who takes all the credit risk for a fraction of the market spread? Who claims to be that much smarter than the markets?
AIG strayed far outside the safe world of actuarial pricing and into mark-to-market lines ofr risk taking. Credit risk is not diversifiable like car crashes. But the hunger for revenue drove AIG further and further away from physical risks and ever deeper into (uninsurable) financial market risks.
So when AIG suffered the inevitable bump, they were unable to react like mark-to-market players. This is why, never forget, insurers live in the world of book value and actuarial tables.
But note that Goldman was feeding at the parent, not the insurer-level. Goldman had hedges with a non-insurer sub, NOT insurance policies.
So if the government had not intruded, Goldman may have demanded collateral and driven AIG into bankruptcy. But then Goldman would only have a claim AFTER all the true policyholders, down at the operating insurers, were paid. The US government’s intervention put Goldman first in line.
Finally, we read in crises the “payoff is too great for politicians rationally not to act?” Say what?
Politicians are incapable of understanding basic accounting, lack all insight into financial forces, and are NEVER economic entrepreneurs. When politicians enrich themselves at the public trough, that is crime, not entrepreneurship…
Politicians calculate exclusively in votes, not money. Sometimes, in desperation, politicians will listen to Fed or Treasury when they are told “push this button…” Any upside after that is sheer stupid luck.
Government can only avoid irrational and un-analyzable games of confidence and panic by not exacerbating the risks. In short, the behemoth gets into the bathtub, all the water spills onto the floor, then the behemoth decries a lack of towels. Instead, stay out of the bathtub.
Facebook gave its first quarterly report as a public company yesterday, and it failed to deliver the goods. Unfortunately, but as can be expected, the MSM and the sell side have apparently failed to pick up on the most pertinent aspect of the conference call, which also happens to have been one of the first things uttered by its young CEO. To wit:
We ended June with 955 million monthly active users, over 1/2 of whom used Facebook on a daily basis and over 1/2 of whom used Facebook for mobile devices. We saw more people using our services at the end of June than at the end of March across all key countries, including 3 million more people in the U.S. Growing the network of people who use Facebook and expanding the social experiences available to them remains the foundation of our efforts and the key to our future success.
Let's parse those words... "Growing the network of people who use Facebook and expanding the social experiences available to them remains the foundation of our efforts and the key to our future success."
Should the astute fundamental investor (of which there aren't many of us left, are they?) take Zuckerberg's word as to the key to Facebook's future success? If so, methinks it's time to start stuffing those long term puts under the mattress, to wit...
There's a whole lot more to cover from the call, but this graphica above combined with the CEO's opening comment pretty much sums it up. Go to 22:24 in the following video for more of the same, just 3 months ago! Sometimes you simply have to break things down in simple terms to get everyone to say, "Golly Gee!"
There's an awful lot of chatter in the blogoshpere over the last 48 hours discussing the remote possibility that Morgan Stanley would be able to defend the Facebook offering as properly priced. PUHLEASE! In case my readers and subscribers don't recall my many warnings on this company and the hype job put on it by Goldman and Morgan - reference As I Promised Last Year, Facebook Is Being Proven To Be Overhyped and Overpriced!, let's run through a quick refresher course.
As is often said, a picture is worth more than 982 words...
Facebook last traded during regular hours at $26 and change, although it debuted to much fanfare at $38 and rose to $42 or so. So, what did the esteemed analysts of Wall Street have to say about this investment dog?
Only days ago, we learned from the Financial Times that the 19 largest US banks are $50 billion short of meeting new capital requirements under Basel III accords, with their smaller lending cohorts needing an additional $10 billion. Amazingly (or not), omniscient Fed officials have divined "that most banks should be able to reach the new levels by retaining earnings during the next few years rather than by raising capital in the market" (emphasis ours).
Presumably, this earnings retention would not include most of the aforementioned smaller community banks because Paulson's TARP has trapped them in a Zombiefied state of smothering debt and capital starvation (not unlike what the World Bank and IMF did to its pirated victems circa 1990-2008), aided and abetted by Fed-induced yield starvation .
Who wins? No less than the Federal Reserve itself, because Treasury has recently been auctioning off its preferred stock in the smaller banks at firesale prices, which guarantees the state regulated banks will be folded into the Fed securitization and rehypothecation cartel. Of course, well-connected former bank regulators, such as a former Comptroller of the Currency, will (and already are) profiting handsomely from these transactions, which we detail below, as well as recently in the second segment on Capital Account with Lauren Lyster:
Who loses? While we're far from an endorsement of the Federal and State banking system in principle, the smaller community banks were the last vestige of the pre-securitization/unlimited moral hazard age, when lending meant "skin in the game" (as opposed to feeding mortgages through the GSE/JPM/Goldman slice-o-matic) and when depositors were seen as an asset (and not only as a balance sheet liability).
While it might be argued that many of these smaller banks would have otherwise been resolved by the FDIC in the 2008 maelstrom, ex-Goldmanite Treasury Secretary Hank Paulson put these mom and pop banks into a shotgun government cartel IPO--preserved in TARP salt, only to have the meat picked off their carcasses years later.
"TARP Provided Lifeline to Community Banks"
So reads a subheading in the most recent SIGTARP report. Yet, what follows is a recitation of what happened when the banks grabbed the money (at the other end of Paulson's bazooka)--they discovered it was tied to an anchor thrown overboard.
"707 [banks] were accepted into CPP [Capital Purchase Program]; 351 small-and medium-sized banks remain, along with 83 financial institutions in CDCI [Community Development Capital Initiative], for a total of 434. Treasury describes CPP as a program to provide emergency support to “viable” banks.623 There are signs that some CPP banks face difficulty in exiting TARP. Despite the dramatic efforts to expedite the exit of the largest banks from TARP, there appears to be no corresponding plan for community banks’ exit from TARP. The only exit strategy for smaller banks that has been announced has been SBLF, through which 137 banks exited TARP. A SIGTARP analysis of the 351 banks that remained in CPP on March 31, 2012, shows one-third had missed five or more dividend payments, and 32% faced formal enforcement actions by their regulators."
Hence the smothering spiral of debt and capital starvation.
Why smaller banks, shut out of the NYC securitization, re-hypothecation Collective, can't compete:
"Community banks’ lending to small businesses has decreased recently while large banks increased loans to small businesses. Small banks — those with assets under $1 billion — have steadily lost market share in small-business lending since 1995, according to an analysis of loan data by information provider SNL Financial LC (“SNL”).613 That group of banks now owns just 34% of commercial and industrial loans of less than $1 million that were secured by collateral other than real estate, down sharply from 51% in 1995, according to SNL. During that same period, bigger banks with more than $10 billion in assets doubled their market share of such loans, SNL reported."
Why the POMO tithing scheme is for Primary Dealers only:
"Once a loan is made to a small business or consumer, a community bank typically holds onto it rather than securitizing or selling it,” Timothy Koch, a professor of banking and finance at the University of South Carolina, said at that conference. 612 “Unlike big banks, community banks generate most of their earnings from net interest income on loans, and rely on core deposits by customers in the same community to fund lending,” he said."
"Community banks need capital to pay off CPP investments, and raising that capital has been a significant challenge along with weakened loan portfolios and slow economic growth."
With long term yields below inflation, government securities are already carry negative for banks who can't wash them at the Fed. Hence, Chairman Bernanke is aiding and abetting the executive branch in the destruction of community banks.
On how the TARP death ray "vaporized" an entire set of market choices whose purpose was to provide an alternative to the government agency known as the Federal Reserve:
"Industry experts say the amount of new capital needed by community banks nationwide is substantial. According to analysts with investment firms Raymond James and Barack Ferrazzano Financial Institutions Group, and consulting firm McGladrey & Pullen, LLP, it will take $23 billion in fresh capital for community banks to repay TARP or SBLF funds; to absorb credit losses and boost loan loss reserves; and to meet higher regulatory capital ratios.614 A higher estimate of $90 billion in community bank capital needs came from StoneCastle Partners, an asset management and investment banking firm. It included $43 billion for healthy institutions to acquire weak and failing banks; $28 billion for banks to clean up their balance sheets; $12 billion to boost loan loss reserves; and $7 billion for internal growth.615"
Why smaller banks cannot access the capital markets:
"Banks with assets under $1.5 billion do not have access to capital from private equity firms, mutual funds, foundations, and other institutional investors, according to some who follow the industry. “Capital offerings for less than $20 million to $30 million are often too small for many institutional investors regardless of structure or investment thesis. Institutional investors have fixed costs to cover and deal size minimums. They simply cannot monitor an unlimited number of small investments, no matter how promising,” the Conference of State Bank Supervisors said in a recent white paper.618 Institutional investors also want a bank to have a business plan that allows the investors to eventually realize gains through a stock offering or by selling the bank to a larger institution."
10% of smaller banks in the US are at risk.
FDIC won't be bailing them out.
They will be assimilated:
"Some industry experts predict a wave of mergers and consolidation among community banks over the next three to five years. “Size matters, and a rule of thumb used by many industry experts is that most banks eventually will need to be $1 billion in assets or greater in order to achieve the scale necessary to operate as an independent entity,” according to a white paper published this year by FJ Capital Management, LLC. “The typical merger can save 20% to 40% in operating costs, thereby creating significant earnings accretion for the combined entity.”620 FJ Capital estimated 413 banks are potential merger candidates because they were trading below tangible book value, and had substandard capital levels and/or elevated asset quality issues.62"
A typical single case: Bank of Hamptoms Road (Norfolk, VA)
According to the American University School of Communication, this bank's Troubled Asset ratio has hovered near 100% since the crisis onset and shows no hope of ever going black. It has $115 million of capital and $72 million in reserves against $185 million of non-performing "assets." Note the $60 million of "other real estate." The best thing that can be said about it is that it has stemmed the bleeding from $(215) million to $(95) million in the last year. It's still losing deposits, capital, reserves, and assets at double-digit percentage rates year-over-year.
As late as July 2009, common shares traded above $200 (1:25 split adjusted). The last trade June 8, 2012 was $1.21 (1:25 split adjusted).
The TARP "rescue" drove the shares down 80% over the first 6 months. Then Treasury converted its $84 million in TARP preferreds into common for a 74% notional loss, the board diluted in September 2010, missed the TARP dividend, diluted again in June of 2011, and has been selling off branches throughout.
The bank's recent 10-Q produced these gems. First, the asset attrition spiral continues:
"The Company reported a net loss of $7.9 million for the quarter, compared to losses of $21.4 million for the fourth quarter of 2011 and $31.6 million for the first quarter of 2011. First quarter 2012 results benefited fromlower provision for loan losses [ew: at exactly the moment when non-performing loans are skyrocketing] due to continued improvements in credit quality and reduced operating expenses due to continued progress from the Company's expense reduction initiatives."
Then, yield starvation:
"Net interest income for the first quarter of 2012 was $16.7 million, down from the $17.5 million in the fourth quarter of 2011 and $18.2 million in the first quarter of 2011."
Third, because old habits die hard, unwarranted risk taking:
"Noninterest income was $3.1 million during the first quarter of 2012 compared to ($1.1) million during the fourth quarter of 2011 and $2.1 million in the first quarter of 2011. Noninterest income benefitted fromstrong origination volumes in the Company's mortgage unit which saw revenues increase to $3.3 million from $2.4 million and $1.3 million in the prior year fourth and first quarters, respectively."
No doubt, someone will spin that as a "housing recovery." The increase in compensation costs related to bonuses to mortgage origination officers is relegated to a footnote.
A week ago, the bank holding company of Hampton Roads sold two of its failing branches to Bank of North Carolina (NASDAQ:BNCN), whose statement on the deal specifically mentioned the all-important $1 billion threshold, "Our goal of having a billion dollar presence in the Triangle will accelerate with this acquisition, and we are excited about offering our diverse product and service opportunities in both of these communities." BNCN itself has a TARP ratio of ~50% and rising.
As usual, it's the insiders who take over
The only money-good asset this dog [with fleas] (NASDAQ:HMPR) really holds is that "other real estate" line item, which is perhaps why the bank holding company is the target of a NY liquidation firm:
CapGen Capital Group VI LP and CapGen Capital Group VI LLC, both of New York, New York to increase their investment up to 49.9 percent of the voting shares of Hampton Roads Bankshares, Inc., Norfolk, Virginia, and thereby indirectly increase their investment in Bank of Hampton Roads, Norfolk, Virginia, and Shore Bank, Onley, Virginia.
This, and all the other TARP takeovers may be found in the Federal Reserve's H.2A report, "Notice of Formation and Mergers of, and Acquisitions by, Bank Holding Companies or Savings and Loan Holding Companies; Change in Bank Control."
Enter Eugene (Gene) Ludwig and the MF Global Connection
CapGen's leader, Mr. Ludwig, is a former primary dealer officer (Deutsche Bank) and Comptroller of the Currency, and whose business is "turnaround specialists." He is also the founder and current CEO of Promontory Financial Group, which has been granted special review and recommendation privileges by various Federal regulators to Bank of America, USBancorp, Wells Fargo. Promontory is also a registered lobbyist for several prominent financial firms, including General Motors Acceptance Corporation (GMAC).
Last, but not least, Promontory was engaged by MF Global after a $110 million rogue trader debacle to provide, in part, "a comprehensive review of MF Global’s risk management and internal controls," according to Trustee Giddens' report of June 4, 2012. The report explains:
"On May 26, 2010, Promontory reported to Holdings’ Audit Committee that MF Global had successfully and effectively implemented most of the Promontory recommendations and the CFTC undertakings and established an enhanced enterprise-wide risk management and compliance program and internal controls framework."
Of course, it would be internal controls that would be the demise of the firm, upon which former Crazy Eddie accountant, Sam Antar, recently commented, "All white collar criminals blame poor internal controls. I tried that trick at Crazy Eddie. The Feds were smarter back then."
While Promontory gave public cover for MF Global, Giddens' report reveals a few pages later that alarm bells were being simultaneously rung internally:
"Similar concerns surfaced in internal audit reviews. A Corporate Governance internal audit issued in May 2010 identified MF Global’s risk policies as not congruent with the changes to its broker-dealer business. Among the specific gaps identified by Internal Audit was liquidity risk reporting. Similarly, an Internal Audit report on Market and Credit Risk Management in October 2010 identified “High Risk” areas arising from the lack of controls over risk reporting. The report also reiterated that market risk policies had not been updated to reflect the current operating environment. The report attributed the failures to remediate gaps to staffing and budget constraints."
A land grab shrouded in a banking takeover, wrapped in a financial crisis "rescue."
The TARP zombie/takeover story is playing out with small variations throughout all the ~300 or so small banks which were trapped in TARP-assisted asset spirals. As stated above, many would have failed outright, further burdening the FDIC fund, perhaps to the point of exhaust, which may be the excuse of record. However, TARP gave Treasury a co-opt entry point to control the flow of equity on this sizeable section of community banking options.
The Fed's merger notices are peppered with former officials using their insider positions and PE headhunters to profit from the "rescue." Whether the net result of killing off a whole tranche of Fed-free banking options was intentional, the combination of forced TARP and negative real interest rates will lead to fewer options and more Fed-centralized control of banking, as the process of slicing, dicing, and consolidating works its way up the food chain, aided and abetted by friends of Treasury.
In future reports, we will detail other small bank merger and acquisition transactions by bank regulatory insiders, as well as develop the role of Promontory in the stress test/internal-policy-failure face-save kabuki that dominates the upper echelons of the extreme moral hazard tranche of the financial sector.
Special thanks to elliswyatt for serving as primary research contributor and TARP wordsmith.
Failbook’s Epic Fail: Does Zuckerberg Want Users to Pay?
What is there to say about Facebook?
Why would anyone buy a company’s stock when they have no real profit pedigree? When their advertising profit in 2011 came to just over $1 billion, and their book value is the region of $100 billion, how can that really make any sense other than to the kind of nutcase zombie trader who takes Jim Cramer seriously? The sad truth is that people are just not clicking the ads; Facebook ads receive far fewer clicks than competitors such as Google’s AdSense.
If Facebook was floating with a book value of $5-10 billion (or around $2-4 per share) we would be talking about a serious business proposition, albeit one which is already rather saturated (given that there are 2.3 billion internet users, and Facebook already has its claws into 900 million of them). But at these levels? What are people paying for?
Some say the name recognition and momentum (but that’s just paying for hype) as well as the infrastructure and data that Facebook owns. Certainly five or six years of a big chunk of humanity’s likes and dislikes is a valuable database. But how do they monetise that? Does Zuckerberg have any credible plan?
The most under-reported piece of news of the day is surely that Zuckerberg does seem to have a plan. But it’s not very credible.
Facebook has started testing a system that lets users pay to highlight or promote posts.
By paying a small fee users can ensure that information they post on the social network is more visible to friends, family and colleagues.
The tests are being carried out among the social network’s users in New Zealand.
Facebook said the goal was to see if users were interested in paying to flag up their information.
That’s their plan? That’s Zuckerberg’s big idea? Get users to pay to post premium content!? Did the well-circulated hoax that Facebook planned to get users to pay for use just turn out to be true? If they proceed with this (unlikely) it seems fairly obvious the world would say goodbye Facebook, hello free alternatives.
The truth is that Facebook is a toy, a dreamworld, a figment of the imagination. Zuckerberg wanted to make the world a more connected place (and build a huge database of personal preferences), and he succeeded thanks to a huge slathering of venture capital. That’s an accomplishment, but it’s not a business. While the angel investors and college-dorm engineers will feel gratified at paper gains, it is becoming hard to ignore that there is no great profit engine under the venture. In fact, the big money coming into Facebook just seems to be money from new investors — they raised eighteen times as much in their flotation yesterday as they did in a whole year of advertising revenue. For an established company with such huge market penetration, they’re veering dangerously close to Bernie Madoff’s business model.
On the other hand, they have plenty of time and money to try out various profit-making schemes. Eventually, they may hit on something big; Apple didn’t start out producing huge cashflow or sales, they got there the hard way. But it all seems like a big gamble on an outfit with big dreams but little moneymaking pedigree. I’d consider buying Facebook at $2-4 a share. But current valuations are a joke — and I don’t think the market is falling for it.
We all know that central banks and governments have been actively intervening in markets since the 2007 subprime mortgage meltdown destabilized the leveraged-debt-dependent global economy. We also know that unprecedented intervention is now the de facto institutionalized policy of central banks and governments. In some cases, the financial authorities have explicitly stated their intention to “stabilize markets” (translation: reinflate credit-driven speculative bubbles) by whatever means are necessary, while in others the interventions are performed by proxies so the policy remains implicit.
All through the waning months of 2007 and the first two quarters of 2008, the market gyrated as the Federal Reserve and other central banks issued reassurances that the subprime mortgage meltdown was “contained” and posed no threat to the global economy. The equity market turned to its standard-issue reassurance: “Don’t fight the Fed,” a maxim that elevated the Federal Reserve’s power to goose markets to godlike status.
But alas, the global financial meltdown of late 2008 showed that hubris should not be confused with godlike power. Despite the “impossibility” of the market disobeying the Fed’s commands (“Away with thee, oh tides, for we are the Federal Reserve!”) and the “sure-fire” cycle of stocks always rising in an election year, global markets imploded as the usual bag of central bank and Sovereign State tricks failed in spectacular fashion.
Keep Doing More of What Has Failed Spectacularly
Central banks and states responded by doing more of what had already failed spectacularly. In the ensuing years 2009-2012, they increased money supply and liquidity and lowered interest rates to zero or near-zero. And sovereign states borrowed vast sums to squander on “stimulus spending.” This “doing more of what has failed spectacularly” earned the apt moniker of “extend and pretend.” Nothing was actually fixed, but we were encouraged to believe it had been fixed with a flurry of absurdly complex “reforms” that only increased the power of the central states and banks without actually addressing the underlying causes of the meltdown: extremes of leveraged debt, extreme concentrations of financial wealth that then bought political power, shadow banking and opaque markets for hundreds of trillions of dollars in notional derivatives, systemic fraud and embezzlement, phony valuations assigned to assets and liabilities, and various schemes to misprice risk, among others.
If we had to distill the entire global crisis into the simplest possible statement, we might say that the collateral that supported this great inverted pyramid of leveraged debt vanished, and as a result the entire pyramid crumbled.
Since the global housing bubble was at the heart of the crisis, let’s use housing to explain this simple summarization. If a house that was owned free and clear (no mortgage debt) rose in value from $200,000 to $500,000 during the bubble, the collateral of that asset was valued at $500,000 at the peak. If the house has fallen to $250,000 in the post-bubble decline, the collateral is now $250,000.
Since there was no debt leveraged off of that collateral, the owner experienced no leveraged consequence of that decline. His assets fell, and he felt the “reverse wealth effect,” so he feels poorer even though his asset is nominally worth more than it was prior to the bubble. (Adjusted for inflation, that nominal gain might well vanish into a decline in purchasing power, but that’s another story.)
Compare that to the home purchased for $500,000 with a highly leveraged subprime mortgage in which 3% of actual cash collateral ($15,000) was leveraged into a mortgage of $500,000. (For simplicity’s sake I am leaving out the transaction costs.)
The collateral was leveraged 33-to-1. This is delightfully advantageous if the house continues rising in value to $600,000, as that increase generates a six-fold return on the cash invested ($15,000 in, $90,000 out). But once the house prices slipped 10% to $450,000, then not only did the 3% cash collateral vanish, the collateral supporting the mortgage also declined. The mortgage was no longer “worth” $500,000.
Since Wall Street securitized the mortgage into mortgage-backed securities (MBS) and sold these instruments to investors, then the value of those MBS also fell as the collateral was impaired. And since various derivatives were sold against the collateral of the MBS, then the value of those derivatives was also suspect.
If $1 of collateral is supporting an inverted pyramid of $33 of leveraged debt, which is then the collateral supporting an even larger pyramid of derivatives, then when that $1 of collateral vanishes, the entire edifice has lost its base.
And that's at the heart of current central bank policy: “Extend and pretend” is all about keeping the market value of various assets high enough that there appears to be some collateral present.
In our example, the mortgage is still valued on the books at $450,000, but the actual collateral — the house — is only worth $250,000. The idea being pursued by central banks around the world is that if they pump enough free money and liquidity into the system, and buy up impaired debt (i.e., debt in which the collateral has vanished), then the illusion that there is still some actual collateral holding up the market can be maintained.
Subprime Mortgages Have Given Way to Subprime Sovereign Debt
The implosion of overleveraged subprime mortgages triggered the 2008 global meltdown because the market awoke to the fact that the collateral supporting all sorts of debt-based “assets” had vanished into thin air. Four years later, we have another similar moment of recognition: The collateral supporting mountains of sovereign debt in Europe has vanished. The value of the debt — in this case, sovereign bonds — is now suspect.
The European Central Bank (ECB) has played the same hand as the Federal Reserve: Do more of what has failed spectacularly. Expand the money supply, pump in more liquidity and buy up the impaired debt all in the hope that the market will believe that there is still some collateral holding up the leveraged-debt pyramid.
The ultimate collateral supporting the stock market is the book value of the assets owned by the company, but the notional collateral is corporate profits: equities are claims on the future free cash flow generated by the corporation.
There are all sorts of inputs into this calculation, and markets are supposed to reflect these various inputs: currency valuations, sales, profit margins, costs of labor and raw materials, inflation and so on. Now that markets are manipulated to maintain the illusion that there is enough collateral out there somewhere to support the inverted pyramid of leveraged debt, it’s difficult to know what’s real and what’s illusion.
One of the few ways we have to discern the difference is to compare various markets and look for divergences. If a spectrum of markets and indicators is pointing one way and another market is pointing the other way, we then have a basis for asking which one is reflecting illusion and which one is reflecting reality.
In 2008, the central banks and governments lost control of the illusion that there was sufficient collateral to support a stupendous mountain of leveraged debt. By doing more of what failed spectacularly then, they have laboriously reconstructed the illusion that they control the markets (“Away, tides, for we are the ECB!”) and thus the valuation of collateral.
Once again we are sternly warned not to “fight the Fed,” as if the Fed had the financial equivalent of the Death Star (“You don’t know the power of the Dark Side!”). Once again, we are in an election year where the four-year cycle is supposed to “guarantee” an up year in stocks.
Or maybe 2012 is shaping up to reprise 2008, and the market will wake up to the fact that intervention doesn’t create collateral, it only creates the temporary illusion of collateral.
In Part II: Why A Near-Term Market Rollover is Probable, we will look at key technical indicators that suggest the Fed’s Death Star may not be the ultimate financial weapon in the Universe after all. There is a growing series of global data that suggest the run-up in the equity markets has reached its peak, and that the economic sickness the central banks had hoped to "cure" with all of their money printing is metastasing.
The German criticism of a mess they themselves have enabled (and benefit from via peripheral current account deficits funded via TARGET2 as shown previously here) at the ECB continues, and following public protests by Bundesbank head Jens Weidmann about recent ECB activity, it is the turn of former ECB executive board member Juergen Stark to take center stage. In an interview with the Frankfurter Allgemeine, warned that following the massive expansion in the ECB's balance sheet, in which it is clear to anyone that the ECB will accept used candy bar wrappers as collateral, that "the balance sheet of the euro system, isn't only gigantic in size but also shocking in quality."
Of course, with the ECB now the bad banks' bad bank, this is not at all surprising. Keep in mind that the recent $1.3 trillion balance sheet expansion was supposedly not the equivalent of "printing money" because the ECB made the cash available in the form of a loan in exchange for collateral. The problem is that the ECB accepted literally everything that was not nailed down and proceeded to give 100 cents on the dollar for some unamortized book value associated with it. The end result was the already documented here first encroaching ECB initiated margin calls which may or may not be an added twist in the European liquidity situation. However one thing is certain: the quality of the ECB's balance sheet has deteriorated massively, as the European central bank rushes to catch up to the Fed in terms of asset "quality" backing the currency.
[Stark] added the structure of the balance sheet is a cause for concern because increasingly short-term debt claims are being replaced by long-term ones and this will make it more difficult for the bank to reverse its loose monetary policy.
With his comments, the bank's former hawk Stark is backing Germany's central bank president Jens Weidmann. The head of the Bundesbank told Der Spiegel weekly magazine over the weekend that requirements for banks' cheap loans have been "very generous" and the program calms the situation in the short term, but this calm could be deceptive. He was concerned about the collateral requirements that the banks had to provide.
The ECB's balance sheet soared past the EUR3 trillion level last week partly because the bank has flooded markets with over EUR500 billion in cheap loans for banks.
Of course, this long-term deterioration in prospects for yet another central bank means that it has bought a short-term reprieve, as has been reflected by rising asset prices. However, what happens when the effect of this latest dilution in the value of the paper currency fades, or worse, when the ECB's balance sheet becomes non-performing and confidence in the montary authority is lost?
Well, since that will be "someone else' problem" why worry?
UBS AG, Credit Suisse Group AG (CSGN) and Morgan Stanley’s credit ratings may be cut by as many as three levels by Moody’s Investors Service, which is reviewing 17 banks and securities firms with global capital markets operations.
Goldman Sachs Group Inc. (GS), Deutsche Bank AG (DBK), JPMorgan Chase & Co. (JPM) and Citigroup Inc. (C) are among companies that may be downgraded by two levels, Moody’s said in a statement, adding that the “guidance is indicative only.” Moody’s today cut some European insurers’ ratings based on risks stemming from the region’s sovereign debt crisis.
Well, CNBC has invited me to do a full hour on their show tomorrow for the halftime report (12pm to 1pm) knowing full well I am probably the biggestcontrarian that channel has ever seen. Stay tuned, it should be interesting. I will provide some downloadable valuation models companies and/or sovereigns for my readers to play with to facilitate conversation and get the tweets/emails going during the show - hopefully in my next post later on today.
Now, back to Bloomberg's report and banking, let's recap...
The hardest hitting investment banking research available focusing on Goldman Sachs (the Squid), but before you go on, be sure you have read parts 1.2. and 3:
So, what is the logical conclusion? More phallic looking charts of blatant, unbridled, and from a realistic perspective, unhedged RISK starring none other than Goldman Sachs...
And to think, many thought that JPM exposure vs World GDP chart was provocative. I query thee, exactly how will GS put a real workable hedge, acounterparty risk mitigating prophylactic if you will, over that big green stalk that is representative of Total Credit Exposure to Risk Based Capital? Short answer, Goldman may very well be to big for a counterparty condom. If that's truly the case, all of you pretty, brand name Goldman counterparties out there (and yes, there are a lot of y'all - GS really gets around), expect to get burned at the culmination of that French banking party I've been talking about for the last few quarters. Oh yeah, that perpetually printing clinic also known as the Federal Reserve just might be running a little low on that cheap liquidity antibiotic... Just giving y'all a heads up ahead of time...
And for those who may not be sure of the significance, please review my presenation as the Keynote Speaker at the ING Real Estate Valuation Seminar in Amsterdam, below. After all, for all intents and purposes, Dexia has officially collapsed - [CNBC] France, Belgium Pledge Aid for Struggling Dexia... and its a good chance that it's a matter of time before BNP follows suit - exactly as BoomBustBlog predicted for paying subsccribers way back in July.
A step by step tutorial on exactly how it will happen....
The European banking debacle was predicted at the start of 2010, a full year and a half before this has come to a head. If I could have seen it so clearly, why couldn't the banking industry and its regulators?
Now, back to GS, and considering all of the European falllout coming down the pike, of which Goldman is heavily leveraged into, particulary France (say BNP/Dexia/etc.)...
Warning!This is going to be a highly, highly controversial post. It is long, it is thick with information, and it hits HARD! Thus if you are easily offended by pretty women, intellectually aggressive brothers in cognitive war garb, your government regulators selling you out to the highest European bidder, or the cold hard facts borne from world class research that you can't find from the sell side or the mainstream media, I strongly suggest you stop reading here and move on. There is nothing further for you to see. As for all others, please keep in mind that I warned of Bank of America Lynch[ing this] CountryWide's swap exposure through a subscriber document on Thursday, 01 October 2009, then went public with it shortly thereafter.
There has been a lot of feedback and emails emanating from the last RT/Capital Accounts interview that I did earlier this week, as well as it should be. The dilemma is that I don't think the viewership is taking the topic seriously enough. I explicitly said, on air, that the Federal Reserve endorsed this country's most dangerous bank in shifting its most toxic assets directly onto the back of the US taxpayer through their most sacrosanct liquid assets, their bank accounts. In addition, when the shit hits the fan, those very same assets will be second in line for recovery, for the derivativecounterparties will get first grabs.
Now, maybe its due to the fact that the interviewer was a cutie, or my voice was too deep, or because I didn't appear in my superhero garb, but I really don' think the message was driven home by the interview that I gave on Russian TV's Capital Account introductory show last week. So, let's try this again, but this time instead of donning that suit and tie, I go as that most unlikely of financial superheroes...
To begin with, for those who did not see the Capital Accounts interview on Russian Television, here it is...
Next, we need to see just how pertinent being 2nd in line is in the liquidation of an insolvent investment bank. I do mean insolvent. Yes, I know the big name brand investors who don't look like that rather unconventional superhero standing in front of the Squid headquarters above may believe that BAC has value, but I have told you since 2008, and I'll tell you now - the equity of Bank of America Lynch[ing this] CountryWide is effectively worth less than zero! Yeah, I know, many of those name brand analysts espoused in the mainstream media disagree, and to each their own, but several of Bank of America Lynch[ing this] CountryWide's latest acquisitions, ex. Countrywide, Merrill Lynch, etc. were enough to make it insolvent. Add several negative numbers together and do you think a little financial engineering is going to give you a positive number??? A little common damn sense is all that is needed to fill the bill here.
For those not familiar with the banking book vs trading book markdown game, I urge you to review this keynote presentation given in Amsterdam which predicted this very scenario, and reference the blog post and research of the same:
I invite all to peruse the mainstream financial media and sell side Wall Street's take on JP Morgan's Q1 earnings before reading through my take. Pray thee tell me, why is there such a distinct difference? Below are excerpts from the our review of JP Morgan's Q1 results, available to paying subscribers (including valuation and scenario analysis): JPM Q1 2011 Review & Analysis.
Cute graphic above, eh? There is plenty of this in the public preview. When considering the staggering level of derivatives employed by JPM, it is frightening to even consider the fact that the quality of JPM's derivative exposure is even worse than Bear Stearns and Lehman‘s derivative portfolio just prior to their fall. Total net derivative exposure rated below BBB and below for JP Morgan currently stands at 35.4% while the same stood at 17.0% for Bear Stearns (February 2008) and 9.2% for Lehman (May 2008). We all know what happened to Bear Stearns and Lehman Brothers, don't we??? I warned all about Bear Stearns (Is this the Breaking of the Bear?: On Sunday, 27 January 2008) and Lehman ("Is Lehman really a lemming in disguise?": On February 20th, 2008) months before their collapse by taking a close, unbiased look at their balance sheet. Both of these companies were rated investment grade at the time, just like "you know who". Now, I am not saying JPM is about to collapse, since it is one of the anointed ones chosen by the government and guaranteed not to fail - unlike Bear Stearns and Lehman Brothers, and it is (after all) investment grade rated. Who would you put your faith in, the big ratings agencies or your favorite blogger? Then again, if it acts like a duck, walks like a duck, and quacks like a duck, is it a chicken??? I'll leave the rest up for my readers to decide.
This public preview is the culmination of several investigative posts that I have made that have led me to look more closely into the big money center banks. It all started with a hunch that JPM wasn't marking their WaMu portfolio acquisition accurately to market prices (see Is JP Morgan Taking Realistic Marks on its WaMu Portfolio Purchase? Doubtful! ), which would very well have rendered them insolvent - particularly if that was the practice for the balance of their portfolio as well (see Re: JP Morgan, when I say insolvent, I really mean insolvent). I then posted the following series, which eventually led to me finally breaking down and performing a full forensic analysis of JP Morgan, instead of piece-mealing it with anecdotal analysis.