http://baselinescenario.com/2011/01/13/goldman-sachs-we-consider-our-size-an-asset-that-we-try-hard-to-preserve/

After you’re done there, here is my response to a friend of mine.  Think of it as an extended comment on the referenced blog.

I completely agree with “this 67 page report is irrelevant.”  Goldman Sachs had to do it for PR, so they did all the window dressing and enacted nothing of substance.  Even the good things to come out of the report, like focusing more on clients (or at least disclosing when they’re betting against them), were supposed to have been done back in the 1990’s after the junk bond, pardon, high yield crash, and resulting S&L crisis. 
 
All that being said, one of the comments showed a lot of insight into macroeconomic financial policy.  You simply can’t break up the big banks without providing an equal amount of net capital or dollars (purchasing of government debt) into the system that would result from credit contraction.  In the first world war and 1920’s, Germany financed itself by buying its own debt and monetizing it.  This eventually killed Germany and produced Hitler. 
 
 If you break up the banks without providing the support, you get massive asset devaluations and a Great Depression.  If you break up the Federal Reserve, you leave the printing presses in the ever-so-capable hands of congress and the President, which hasn’t worked except in singular, unsustainable instances in the history of the world.  If you put us on a gold standard, you get a world that lacks the ability to respond effectively and in a coordinated way during a crisis- and we will always have a crisis.  You also entice extreme amounts of protectionism and nationalism, which also led to two world wars and a Great Depression.
 
Forcing banks to hold more equity should be done by investors and bondholders.  It actually IS done to a large extent by the market, but it’s ineffectively handled because of an apparent lack of long-term focus of the average investor.  People have a nice way of forgetting crises about 5 years after they happen.  I haven’t read the papers that were referenced, but they need to consider the following: banks have the ability to take on debt extremely cheaply.  Think about it this way:  I pay 1% on a money market over $500,000.  That is the same as me getting a loan from that depositor.  If I were an average business in today’s environment, I would have to pay about 6.5% for that same amount of debt, except I wouldn’t even be able to get it because I have too much debt-to-equity, ironically.  Equity, then, might not be expensive relative to the general market for all businesses, but it is extremely expensive relative to the rest of the bank’s capital structure.  If you want banks to hold more equity, we need to make it much more expensive for them to hold deposits.  Imposing huge FDIC insurance fees is one alternative.
 
The assertion that banks have a goal of being too big to fail is a preposterous one.  Stockholders suffered extensively and have continued to suffer massively in the institutions that were systemically important.  Lehman got wiped out.  AIG was effectively wiped out.  Bear Sterns was basically wiped out.  WaMu was wiped out. Merril lost over 2/3 of its value before acquisition.  Citi shareholders lost nearly all their value- down from over $50.00 at one point to $4 today.  Bank of America emerged a little better, but they still took a killing.  The ONLY people making money in these stocks were the shorts and now are people who took a risk and bought once the values had signaled near-insolvency.  All former shareholders felt plenty enough pain not to want to have to go through the same thing again.  Too Big to Fail is not a myth; however, it’s not a strong incentive in-and-of-itself.  If you want people to be more careful when creating financial empires, install huge FDIC premiums, require far more equity capital, and put a law in place that states that the heads of any bailed out organization will be jailed for life and all their assets and their families’ assets will be seized.
 
As a student of economics, we know that size matters.  It creates huge efficiencies and allows companies to invest in things that smaller ones can’t.  It even allows customers who would otherwise be forced out of the banking system to hold accounts and get loans, because the costs are insignificant to large organizations- just look at Bank of America.  Goldman’s assertion that its size is an asset doesn’t stem from the implicit government guarantee that comes with that size, but rather the scale and scope that is necessary to create profit and support clients’/communities’ economic vitality in a system based on credit.
 
If we don’t want to have a system based on money and credit, we can all go back to bartering and walking to the stream for our daily water.  Because of the ugly side of capitalism, one day we’ll probably be back there for a while, anyway

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First, Colonial received a major investment from a now bankrupt business, Taylor, Bean, and Whitaker.  This company funded and facilitated a huge number of mortgages, particularly in the southeast region.  But that’s old news.

Second, Colonial’s failure was leaked prior to its actually being shut down and placed into receivorship.  This is a huge issue.  There are two schools of thought on this.  The first is the most simple: somebody leaked the information at BB&T, Colonial, or the FDIC out of pure stupidity.  There’s a good reason that the public isn’t notified when a bank is going to close.  It saves that bank, usually, from having a run and costing the FDIC even more money.  The second reason is a little more complex and underhanded.  Somebody might have purposely leaked the news that the extremely strong BB&T was going to buy the deposits of the very weak Colonial, because Colonial was already seeing a run on deposits.  The first instance is extremely problematic; the second, extremely smart.  We’ll have to wait and see what really happened.

Third, Colonial bank received TARP money after getting a similarly large amount of private investment.  It received $550 million tax payer dollars, to be exact.  Recently, the TARP inspector general (aka TARP czar) raided offices of the bank alleging fraud that probably would have kept the bank from receiving funds.  As an FYI, a number of bankers and investment professionals that I have spoken with agreed with me when I was astounded and angered that Colonial received funds in the first place.  They’ve been failing for quite some time.  There goes $550 million down the tubes that was only supposed to be invested in the strongest and/or most systemically important financial institutions.  There’s a scandal brewing here, just wait.

Finally, and this is the biggest future news of all, the FDIC is going to run out of its self-funded reserve for losses.  This means that it’s likely that it will tap its line of credit at the Treasury.  This isn’t the first time this has happened, and you shouldn’t panic, but it’s one more bit of shocking fall out from the financial disaster that we’re desperately trying to get behind us.  Let me repeat, the FDIC is about to run out of its own money and start relying on taxpayers.  Can the government handle it? Absolutely.  Does this highlight how bad our situation was and continues to be? Absolutely.  Most importantly- Are your deposits still safe? Absolutely.

CNNMoney’s David Goldman reports that f ollowing a year and a half courtship, which at times looked more like a messy divorce, Yahoo! and Microsoft announced that they have finally struck a deal on a search partnership.  Under the 10 year agreement, Microsoft’s Bing will power Yahoo! sites while Yahoo! will provide search technology and its global sales force to Microsoft. 

Full Story: http://money.cnn.com/2009/07/29/technology/microsoft_yahoo/index.htm?postversion=2009072908

Found: A Construction Company Attracting Investors

China’s economic climate shows increasing signs of life with the latest evidence being the IPO of China State Construction Engineering Corp.  Joe MacDonald of BusinessWeek reports that the builder of such Chinese icons as the “Water Cube” and Shanghai World Finance Center (China’s Tallest Building) ended its first day of trading up over 56.2% after surging 80% early on.  The company raised $7.3 billion making it the the largest IPO since Visa’s 19.7 billion offering. 

Full Story: http://www.businessweek.com/ap/financialnews/D99O243O0.htm

Rational Free Market or Siding with Evil?

Yesterday’s news that the CFTC will soon publish a report stating that speculators were to blame for oil’s fast rise (and subsequent crash) in 2008 certainly came as a breath of fresh air to many stung by those high prices.  This was not the case with Jon Birger of Fortune magazine.  In his article published late Tuesday, he defends the practice of speculation primarily relying on the fact that futures markets are not set up to take delivery and therefore prices must, in general, line up with overall supply and demand.  He goes on to say that removing speculators from the market would provide strong incentive for those who can buy and sell these contracts to hoarde the supply, thus driving up the price even higher, akin to when the silver market was cornered in the 1970′s.  Moral of the story: Be careful what you wish for; you just might get it.

Full Story: http://money.cnn.com/2009/07/28/news/economy/oil_prices_speculators.fortune/index.htm?postversion=2009072816

Proof of his argument: http://business.timesonline.co.uk/tol/business/industry_sectors/natural_resources/article5528333.ece

Noted:  Mortgage applications fell by 6.3% for the week ended July 24, 2009.

Let me explain myself.

There are two groups of bankers paying high rates right now.  One camp pays them because they have to do it.  They’re on the verge of going out of business and have to pay high rates in order for you to leave your money there.  As long as you’re FDIC insured, you should take advantage of these poor souls. 

The group that I want to deal with in this post is the banker who pays high rates because he wants to do so, not because he is desperate to keep your money. 

This group is exceedingly smart, forward thinking, and low-risk taking.  He’s paying rates on short term CD’s at current market rates.  That is, for CD’s with around 30-days to 2 year maturities, he’s paying somewhere between .5% to a little less than 2%, respectively.  That’s not how he’s being smart though. 

What the smart banker is doing is locking in long term CD money now in anticipation of substantially higher rates coming in the future.  He’s paying around 4% (which by the way isn’t really all that high of a rate compared to rates over the last 20+ years) on 5 year CD’s.  Right now, that CD is losing him money, but over time, he’ll make a killing on it. 

Here’s why:

With the Federal Reserve and the Federal Government already having promised, guaranteed, or directly put 11 trillion dollars into the economy, there is going to be inflation.  You cannot put that amount of money into our economy without devaluing our currency, i.e. causing substantial inflation. 

(Read Fed. Charman Bernanke’s latest comments on inflation here)

If words like inflation, devaluation, the mirage of the Federal Reserve, etc., don’t mean much to you, let’s put it in terms of something everybody understands: gas.

Everyone needs it, everyone wants it, and you have to use it almost every day.  Now, let’s say everyone had to drive as much as they do now with the car that they have right now, BUT there was only enough gas on earth for everyone to have three gallons per month.  The price of gas would be unbelievably high, right?  Gas would be VERY valuable. 

 Alright, now take that same scenario and let the oil countries produce so much for everyone to have one thousand gallons a month.  The price would be extremely low right?  It wouldn’t be nearly as valuable.   That second scenario is what is going to happen to the value of our dollar over time because there are just so many dollars available right now. 

When inflation hits, and it will, interest rates will naturally go up in line with how bad that inflation gets.  This means that bankers will have to pay you higher rates on your CD’s.  So right now, the smart banker is using his forsight and knowledge to pretend to be paying people a “high” interest rate on 5 year CD’s, all the while knowing that you’re being a fool for falling for his little trap. 

My point is: Before you just go after the highest rate, look at the longer term implications.  If something seems too good to be true, it probably is.  Bankers paying high rates on short term money are probably going out of business soon.  Those paying “higher” rates on long term money that locks you into a very long holding period are probably taking advantage of your ignorance about inflation. 

Remember, inflation runs somewhere between 2% and 3% per year in good years.  We’re about to enter a period of high inflation (think something similar to the late 1970′s and the Nixon/Carter years).  Do you really think that 4% on a 5 year CD is a great rate in light of the fact that just 12 months ago you were getting 5.35% on 1 and 2 year CD’s?  Do you really think that if prices at the grocery store are rising at 5-10% per year that you’ll be happy about basically losing money on your CD?  If you’re fine with all that, then by all means, get that 4% CD.  If that scenario scares you, put your money in something much shorter term and settle for the lower rates in anticipation of being able to get a much higher, inflation-adjusted rate in the fairly near future. 

If you don’t believe me when I say 4% is a historically very low interest rate, check out what rates on 6-month CD’s have done over time here.  Keep in mind these CD’s have terms 4.5 years shorter than what you’re locking in if you take that 4%, 5 year CD.

(For all you who care about political correctness, insert “she” in the smart banker references wherever you deem appropriate.)

 You see this all the time with all kinds of products and businesses.  You even see this specifically with banks during the best of times as areas grow and mature.  Branches close or are consolidated pretty regularly. 

 The next set of issues I’d like to deal with are a bit more complex, but truly set the stage for one of the biggest “bubbles” in the history of the world, and more specifically, Georgia.  They are:

1.  Explosive population growth and projections of continued growth

2.  Unsustainable growth in debt, and

3.  Sub-prime mortgages

 The latter two were (and continue to be) national issues.  The population growth was more specifically in Georgia, but we also saw it in places like Las Vegas, Phoenix, Florida coastal areas, and some other pockets around the country.

 Growth in population is generally a wonderful economic driver.  At one point Georgia was home to some of the fastest growing populations in the country.  For years, counties like Coweta, Henry, Cobb, and Fulton experienced unprecedented and what seemed like endless growth.  This shift was happening as the business environment got much better and more sophisticated in the Metro-Atlanta region.  Georgia is also one of the best states for entrepreneurs and most  businesses because of pro-business labor laws and a helpful tax code.  When coupled with a generally good climate, lots of relatively cheap land and homes, and some good ole’ southern charm, Georgia and specifically Metro-Atlanta looked like a wonderful new place to call home.

 All of this sounds great so far, doesn’t it?  Why on earth would population growth be a “cause” of a banking melt-down?  The answer is simple- people thought that it would continue, without interruption, forever. 

 Builders and banks especially believed this enormous myth.  The faster the populations grew, the faster banks lent money to builders who built increasingly larger numbers of homes.  They failed to realize that just like the much larger economy, population growth is generally cyclical unless you’re in a third world country. It might always be growing, but sometimes it grows faster than others, and there will almost always be some upper limit.  When the growth in number of homes that banks were financing the construction of began to rapidly exceed the number of families moving into the area, there became a huge oversupply.

 Banks were eventually forced to foreclose on a huge number of the new constructions.  These were houses that had never been lived in and in many cases weren’t even finished.  Because of the huge oversupply, banks were forced to write down values at a rapid rate.

 Everyone also knows that homes have to sit on a piece of land.  Banks were increasingly financing more and more land to be developed into subdivisions to support this huge, “infinite” population growth.  It’s the land, especially, that has and will continue to bring down the community banks.  This is where the largest write downs have been.  Land, if it sells at all, is only selling for thirty to fifty cents on-the-dollar.  That means for every dollar a bank had loaned on a piece of foreclosed land, it can only sell it if they’re willing to lose seventy cents on it. 

 What ultimately caused the housing boom and bust in Georgia, as with everywhere else, were subprime mortgages.  There’s a twist to this story for community banks in Georgia however, and it’s very important.  Most community banks don’t actually provide the funds for the mortgages that they make.   The banks that have failed so far in Georgia actually held almost no “Sub-Prime Mortgages.” 

 The problem was the home ownership and building boom that those mortgages created.  Community banks were the ones that generally financed the builder’s land purchase and construction costs.  That builder would then sell the house to whoever could get the financing, and then pay off the community bank with the proceeds from the sale.  The community bank didn’t care who bought the house, but they should have.

 A large and growing number of the sales would never have happened under more “traditional” environments.  Everyone is well aware of all the asinine practices that were going on in the mortgage market like stated income loans, Alt-A mortgages, 105% loans, etc.  Had community bankers and regulators been more aware of these buyers, they might have been able to better slow down this clearly overheated market. 

 Finally, there was an unbelievable explosion in the level of debt for average households across the nation.  Because everyone and their mother and sometimes even their dead grandmother could get a mortgage, there was a huge expansion of mortgage debt.  Also, because home values were rising at an unprecedented rate and people were spending far more than they actually made, there was also an extremely big boom in home equity lines of credit.  It is now well known that this level of debt creation could not be sustained.  When home prices plummeted, home equity lines became worthless and the huge amount of debt outstanding relative to the new values of homes created a recipe for disaster for many banks.  To summarize Warren Buffett:  Debt is like gasoline in a car.  It can make the car go 100mph in a heartbeat.  But, when the car crashes, it’s also the gasoline that blows it up.

 Through all this, a very important lesson was re-learned by many bankers: past performance does not necessarily indicate future performance.  Populations will not grow endlessly, home values will not rise endlessly, people will not be able to sustain high levels of debt endlessly. 

 In the next couple of posts, I’ll be moving on from these more general issues that contributed to the Georgia debacle and diving headfirst into more complicated, but critical problems that brought down our banks.

 Let’s be honest, Hank Paulson may have screwed over BofA shareholders in the very short term and put the taxpayer on the hook for a pretty big loan, but it’s my belief, as I’ve said here before, that without this massive intervention we’d be in a financial nuclear winter.  Not only would Merrill have gone out of business, but BofA and consequently the entire system would have failed.

Kaffee: *Colonel Jessep, did you order the Code Red?*
Judge Randolph: You *don’t* have to answer that question!
Col. Jessep: I’ll answer the question!
[to Kaffee]
Col. Jessep: You want answers?
Kaffee: I think I’m entitled.
Col. Jessep: *You want answers?*
Kaffee: *I want the truth!*
Col. Jessep: *You can’t handle the truth!*
[pauses]
Col. Jessep: Son, we live in a world that has walls, and those walls have to be guarded by men with guns. Whose gonna do it? You? You, Lt. Weinburg? I have a greater responsibility than you could possibly fathom. You weep for Santiago, and you curse the marines. You have that luxury. You have the luxury of not knowing what I know. That Santiago’s death, while tragic, probably saved lives. And my existence, while grotesque and incomprehensible to you, saves lives. You don’t want the truth because deep down in places you don’t talk about at parties, you want me on that wall, you need me on that wall. We use words like honor, code, loyalty. We use these words as the backbone of a life spent defending something. You use them as a punchline. I have neither the time nor the inclination to explain myself to a man who rises and sleeps under the blanket of the very freedom that I provide, and then questions the manner in which I provide it. I would rather you just said thank you, and went on your way, Otherwise, I suggest you pick up a weapon, and stand a post. Either way, I don’t give a damn what you think you are entitled to.
Kaffee: Did you order the Code Red?
Col. Jessep: I did the job I…
Kaffee: *Did you order the Code Red?*
Col. Jessep: *You’re Goddamned right I did!*

Tom Cruise = Chairman Towns?  I don’t think it’s much of a stretch. 

And from Mr. Paulson

“During my tenure, the world experienced a financial crisis unprecedented in our lifetimes. The crisis presented a relentless series of novel challenges that required swift, innovative, and dramatic responses. I am proud to have been among the many public servants—in the Congress and at Treasury, the Federal Reserve, the FDIC, the OCC, and other agencies of the government—who came together to confront these challenges and to prevent a far more damaging meltdown of our financial system.”

…”Our financial system underpins our modern economy; commerce today requires a string of payments, whether that string of payments is for delivering a gallon of milk from farm to consumer or for delivering a new product from idea to production. And that string of payments depends on trust. Our financial system works because consumers and investors have confidence in the strength of financial institutions. Last fall, that confidence was largely gone…”

…”Fortunately, the most dire of consequences were averted. I am proud that, along with many others, I brought what experience, talent, and efforts I could to right our nation’s course.”

…”having had the benefit of some time to reflect, and to consider views expressed by others, I am confident that our responses were substantially correct and that they saved this nation from great peril.”

…”Moreover, all public officials involved, including Mr. Bernanke and me, believed that the failure to consummate the merger would likely create immediate financial market instability, would threaten the viability of both firms, and would call into serious question the judgment of Bank of America’s leadership.”

And finally, “I explained to [Bank of America's CEO, Ken Lewis] that the government was supportive of Bank of America, but that it felt very strongly that if Bank of America exercised the MAC clause, such an action would show a colossal lack of judgment and would jeopardize Bank of America, Merrill Lynch, and the financial system. I further explained to him that, under such circumstances, the Federal Reserve could exercise its authority to remove management and the board of Bank of America. By referring to the Federal Reserve’s supervisory powers, I intended to deliver a strong message reinforcing the view that had been consistently expressed by the Federal Reserve, as Bank of America’s regulator, and shared by the Treasury, that it would be unthinkable for Bank of America to take this destructive action for which there was no reasonable legal basis and which would show a lack of judgment.”

Summed up in two sentences:  “Mr. Paulson, did you order the code red?!”  “You’re Goddamn right I did!”

(Find Mr. Paulson’s full testimony here)

For the FDIC’s story on the closing, check out this link: http://www.fdic.gov/news/news/press/2009/pr09102.html

I’m taking notes and talking to a lot of people in an effort to give everyone an inside play-by-play of what happens from the perspective of an employee. 

Stay tuned!

1.  Astronomical growth in number of new banks

 2.  Too many bank presidents, and

 3.  “Flipping” Banks

 As I’ve said before, none of the reasons for this can be stated without bringing in one or several of the others, but for the sake of simplicity, we can think of the three above as the kindling that started the fire.

As stated in the Wall Street Journal article, there was an explosion in the number of banks chartered in Georgia.  I can remember a time when the Georgia Department of Banking and Finance’s monthly newsletter contained anywhere from 10-20 banks in formation for years on end.  Money to start these banks flowed in like floodwater.  There were numerous success stories of banks starting and three years later selling for triple the initial investment.  What people failed to realize is that banks are not all that different from chain restaurants. 

What do I mean by that?

Banks all offer basically the same thing.  They all offer very similar core products.  They all claim to be service oriented.  They all want to be YOUR bank.  Chain restaurants do the same thing.  They have extremely similar food (no matter what they claim).  They all offer “great service and great times.”

Everyone knows when there gets to be too many Applebee’s, Chili’s, and O’Charley’s in one area- one of them goes out of business.  There simply aren’t enough good customers willing to provide enough profit for them all to do extremely well. 

It’s no different in banking.  The only difference is that banks can pretend to find good customers for some time before anybody realizes that there’s a huge problem.  If all of a sudden Chili’s started accepting checks where 10-15% of them got returned, they wouldn’t be able to hide the loss.  On the other side, if Chili’s suddenly starts to literally bribe people to come eat with them by offering free food, they’re probably not going to last long. 

Banks are able to do both of these.  Loans can be made to people or businesses that are extremely unlikely to pay.  Deposits can be brought in by giving away  a lot of money with high interest rates.  Neither of these shows up as problems until years later when those loans that were once deemed safe, start to turn risky.  If you couple those loans with a huge depreciation in the value of the collateral, you get a recipe for disaster.  Throw in deposits that were overpriced to begin with costing even more relatively huge amounts of money to keep, and you’ve got a bank failure. 

Moral of the story:  There were way too many banks, so the natural result in our capitalist society is that there will be an equally large number of them to go out of business.

Similarly, there were too many bank presidents.  As Robert Braswell so conveniently alluded to in the article, basically anybody with a decent background in banking could raise enough capital to start a bank.  Let me emphatically point out that banking is different from almost any other business.  It takes FAR less capital (relatively) to start a bank than it does almost any other business.  This means that if there are losses, they go out of business fairly quickly.  This is where regulators and investors fell asleep at the switch. 

Everyone can’t run a bank.  Even some great bankers eventually fall prey to things like hubris, greed, and flat out being too busy to mind the store.  When you’ve got a few great bankers trying to do business with a ton of terrible ones, you get an equally likely recipe for disaster. 

 Bad bank presidents will grow too quickly with expensive deposits and risky loans.  They won’t manage risk effectively at all.  They won’t do enough homework on their loans or ensure that processes are in place to ensure that fraud is adequately controlled.  They can definitely prosper for a long time, but eventually the music has to stop.  It did.

 With all the bad bank presidents running around and getting approval from regulators because of the flood of capital, good presidents were put into quite a pickle.  They had to compete.  If they didn’t grow as fast as everyone else, they were considered terrible.  This meant that they had to do a lot of the same things that the bad presidents were doing.  And, in the end, if it looks like a duck, walks like a duck, and quacks like a duck; it’s a duck.  Good bank presidents with real knowledge of how to do it the right way eventually became bad.  Because of the extremely competitive nature of banking, it doesn’t take many bad apples to ruin the barrel.  This one is thoroughly ruined.

 Finally, as I’ve already alluded to, banks were being built up and sold in 3-5 years with massive amounts of profit for the people who started them.  Not everyone was doing this.  A lot of people were building banks that they wanted to preserve and run well into the future.  The problem is that investors and regulators only saw the huge growth, huge number of sales at extremely high prices, and no (apparent) losses. 

These banks were being built up with expensive deposits and loans that were built on a real estate bubble that eventually had to explode.  We saw the same thing with the “dot-com” bubble in the late 1990’s.  The reason why this was so much more painful was because of the nature of banks.  I’ve already detailed this to a large extent in “Smoke and Mirrors” in an earlier post.  Basically, banks are built on relatively small amounts of real money.  If something goes wrong, it doesn’t take much to bring one down.  If a lot of things go wrong, you get the current situation.

To get back to the “flipping” analogy- everyone has seen the shows on HGTV, TLC, etc. that show a really crappy house being turned into a nicer and much more expensive one.  The banks were the same way.  They were made to look pretty on the outside, but if you looked behind the curtain, they had deteriorating wood, old electrical wires, and weren’t in all that great of areas.  But, because they looked pretty, i.e. big profit, big growth, seemingly no bad loans- they got snapped up just as fast as somebody could start a new one.  Just as the home flipping business went, so too did the banks. 

In the next part of this series, I’ll delve further into some of the more difficult to explain aspects of the implosion.  Stay tuned.