The Age of Hubris Comes to a Head

Despite collapsing earnings, shattered stock prices, ousted CEO’s, bankruptcies and quasi bankruptcies in the case of Citigroup, Bank of America and AIG, the hubris and arrogance of former financial masters of the universe continues.

As if Merrill Lynch rushing through bonuses before announcing massive losses was not enough, AIG has just upped the ante in the sheer arrogance stakes by taking US taxpayer money and paying bonuses to the very people who blew the place up. Not only that, it seems that some so-called retention bonuses are being paid to employees that are being dismissed, from the NYT:

Mr. Cuomo did not name the bonus recipients, but the numbers are eye-popping, given A.I.G.’s fragile state. The highest bonus was $6.4 million, and six other employees received more than $4 million, according to Mr. Cuomo. Fifteen other people received bonuses of more than $2 million, and 51 people received bonuses of $1 million to $2 million, Mr. Cuomo said. Eleven of those who received “retention” bonuses of $1 million or more are no longer working at A.I.G., including one who received $4.6 million, he said.

How’s that for hubris? Retention bonuses for people who weren’t retained. There goes the argument that you need to pay people bonuses to keep them. However it appears that AIG may have gone too far with this latest tactic. Outrage is being expressed by every politician up to and including the President. Public outrage is reaching a crescendo and to make matters worse, every time AIG makes a statement they just incite more loathing.

Take for example the latest justification for paying derivatives traders bonuses. “It’s in their contracts and the contracts cannot be reneged upon”, “if the American government starts interfering with contracts and changing the rule of law, the U.S. will be no better than a banana republic.” But hold on, isn’t the US government, aka U.S taxpayers, the majority shareholder?

Consider what would have happened if the government had not bailed out AIG . They would have gone into bankruptcy and then all contracts could be legally modified or completely voided. But for some reason we must obey the rule of law because the company whilst for all intents and purposes is insolvent, is not officially in the hands of receivers. Was it not Adam Smith who opined that an economic system that is allowed to operate without a moral foundation would soon lead to an amoral, if not immoral, society?

But why so much outrage over $165 million in bonus payments when we also now know that approximately $49.5 billion of taxpayer money was used to make counter-parties whole to CDS contracts written by AIG? From the FT.com:

AIG paid out $22.4bn of collateral related to credit default swaps, $27.1bn to help cancel swaps and another $43.7bn to satisfy the obligations of its securities lending operation. The payments were made between September 16 and the end of last year.

Goldman Sachs, which has also accepted US government support, received payments worth $12.9bn. Three European banks – France’s Société Générale, Germany’s Deutsche Bank and the UK’s Barclays – were paid the next-largest amounts. SocGen received $11.9bn; Deutsche $11.8bn; and Barclays $7.9bn.

Can anyone really register surprise that Henry Goldman Paulson was in charge as Goldman Sachs became the biggest beneficiary of public funds injected into AIG? Tim Geithner is not without blood on his hands in all this either and if the policy of privatizing the profits and socializing the losses is to change, Geithner needs to go, simple as that.

Scandals such as Enron and Worldcom pale in comparison to the magnitude of what is currently unfolding. Whilst it is now obvious to all and sundry that the global financial complex grew too large and powerful, it is not yet obvious the extent to which public outrage will compel lawmakers to act.

It is no longer useful to talk about lack of transparency or poor risk management. From Countrywide to Bear Stearns, Lehman, Merrill Lynch, Citigroup, Fannie and Freddie and AIG there has been lies, obfuscation and outright fraud. The age of hubris cannot come to a close until the executives of financial institutions are held accountable for their actions. It remains to be seen whether the level of public outrage is sufficient and the political will exists to make that happen.

Toughest Times Ahead Says CBA's Norris

Addressing the American Chamber of Commerce in a function today, CBA's Chief Executive Floyd Norris has this to say:

"There's no doubt that the toughest period in the Australian economy still lies ahead of us," Mr Norris told an American Chamber of Commerce in Australia function on Tuesday.

Norris also went on to say that he couldn't rule out a cut in the final dividend for this year. after ANZ and more recently NAB have said they will cut dividends by about 25%.

Amongst other things, Norris said that funding costs remain high and thus further interest rate cuts could not be guaranteed to be fully passed on to customers. In addition CBA was seeing a uptick in delinquent loans but that it was not yet significant.

There's not much in Norris' comments that should be surprising to anyone with their finger on the pulse. Rudd's handout programs will do little more than cushion a deteriorating economy. As the government digests that reality in the second half of this calendar year, the will be calls for Rudd stimulus mark before the year is out.

Also out today, the RBA released the minutes of their March meeting laying out their reasons for leaving interest rates unchanged. As usual I don't recommend you read the minutes unless you want to go to sleep so here is crux of it.

The question for policy was whether further stimulus should be added at this meeting, or whether, having reduced rates at each meeting since September, the Board should pause for a further evaluation of the situation. Members could see reasonable cases for both courses of action.

On balance, they judged that, having made a major change to monetary policy over the preceding several meetings in anticipation of weak economic conditions, the best course for this meeting was to leave the cash rate unchanged. Members believed this would leave adequate flexibility for policy at future meetings.

Clearly the RBA is leaving the door open, my expectation continues to be that the RBA will cut to at least 2% before we reach a cycle trough. The one bright spot the RBA mentioned and which has been reinforced by the data in recent months is housing activity, especially in the First Home Buyers segment.


In recent months there has been a bump in the dollar amount of lending finance for new and established dwellings whilst finance for investment properties has fallen back to levels last seen in November 2002. The RBA commented that:

In a sign of increased demand for housing, patterns of housing finance indicated an increase in housing loan approvals of about 10 per cent over the past few months, partly spurred by the increased incentives for first home buyers to enter the market. However, credit growth had remained low as borrowers had evidently taken advantage of the extra cash flows created by lower lending interest rates to increase debt repayments.

Further signs of an increased level of activity in the secondary housing market were significant rises in auction clearance rates in both Sydney and Melbourne in February, and a component of the Westpac-Melbourne Institute consumer sentiment survey indicated that current conditions were conducive to buying a dwelling.

Increasingly we hear calls from those in the real estate industry that home buyers should get in now while interest rates are near historic lows, clearly some are listening to that call. However I can't help think that some buyers are being sold a lemon.

I continue to believe that the housing industry is only being propped up by the FHB grant and handouts from the Rudd the redistributor. It will be interesting to see if the increase in the FHB grant is extended beyond June and to what extent the Housing market can continue to hold up. I get the feeling there will be more than a few cases of buyers remorse in the next 12 months or so.

Major US Banks Are Profitable....... Oh Puhlease!

Putting aside the media's facile obsession with explaining every tick of the tape with an event, lest''s examine the supposed reason for the beginning of this rally. The idea that Citi was profitable in the first two months of 2009.

The argument goes that writeoffs are non-cash and therefore don't affect cashflow or profitability. That's great if you ignore the balance sheet. Remember write-offs are euphemisms for mistakes and in this case it is the reversal of falsely booked profits in prior years.

Write-offs are taken through the P&L and then written off against equity in the balance sheet and if a company has no equity it's out of business, especially if it is a bank that has to maintain a certain level of equity. Where would Citi be if it didn't get $45 billion of equity injections and $300 billion of assets guaranteed by the government.

As for excluding credit losses that argument is even more ridiculous, a bank is in the business of extending credit and thus credit losses are part of the business, how can you possibly exclude them? That's like saying GM is profitable if you exclude what it costs to make cars.

Anyway Krudlow the Clown and his clueless minions Jerry the echo Bowyer and Dick Bove bought into the whole scenario. Luckily Joe B was there to tell them what morons they are. Remember that Dick Bove was the same guy that said a year ago to buy Citigroup at $30, that they didn't need to cut their dividend and that the credit crunch was over! This guy is a bank analyst and yet he clearly doesn't know how banks work. Watch this incredible display below:

Market Rally Continues

ps. I said something else in that post a year ago and that is that I watch too much CNBC, some habits are hard to break.

An Unprecented Age of Financial Idiocy

Seriously, could you possibly get a more incompetent gaggle of fools running major US financial corporations? The denial, obfuscation and outright lies that have continually been offered up in defense of continuing losses and write-offs have reached comical proportions.

Anyone with a clue, knew that Bank of America clearly paid too much for Countrywide and Merril Lynch. Countrywide was a disaster teetering on the brink of bankruptcy when B of A bought it. However Merril is an even more monumental blunder, given the terms of the government rescue announced today. We now know that Merril was not worth even a tenth of the $29 per share price tag B of A paid.

Much has been said about Ken Lewis, the CEO of B of A as being one of the best CEO's on Wall Street, that doesn't say much for the rest of them. Lewis' blunders in the last 12 months demonstrate that he is at best completely and utterly incompetent.

Whilst Vikram Pandit is not responsible the postion that Citigroup now finds itself. The fact that he has continually defended Citi's financial supermarket model only to turn around and start splitting up the company because it is insolvent proves that he had no idea what he was doing.

So now today the stockmarket is celebrating because the US government has made the biggest US bank a ward of the state alongside Citigroup. It makes you wonder who is stupider, the CEO's on Wall Street or stock market traders. This article siums up the sorry state of the situation, from marketwatch.com:

Government giving $20 billion to Bank of America
Guaranteeing losses on over $400 billion worth of Citi, Bank of America assets

The U.S. government on Friday announced it was injecting $20 billion into Bank of America and guaranteeing losses on over $400 billion of assets both from Citigroup and the Charlotte, N.C. lender.

In a statement released Friday, the Treasury Department and the Federal Deposit Insurance Corporation said they will invest $20 billion in Bank of America (BAC) from the Troubled Assets Relief Program in exchange for preferred stock paying an 8% dividend.

The government also will provide Bank of America protection against the possibility of unusually large losses on an asset pool of approximately $118 billion of loans, securities backed by residential and commercial real estate loans and other such assets, which have been marked to current value.

Bank of America will absorb the first $10 billion of losses while the government will share losses from there, up to $10 billion. If that pool of assets sees losses of over $20 billion, then the government will absorb hits on 90% of them.

A similar guarantee was provided to Citigroup: Uncle Sam is on the hook for $301 billion of assets, with Citi (C) taking the first $39.5 billion of hits, and then the government absorbing 90% of the rest.

The Federal Reserve also is ready to backstop "residual risk in the asset pool" if necessary.

The government relief comes as Bank of America stock skidded to a 17-year low, following Thursday's report in The Wall Street Journal that such a relief program was near. Investors were unnerved by the additional losses at Merrill Lynch.

Both Bank of America and Citigroup (C) detailed billions of dollars during the fourth quarter, and that doesn't even include the estimated $15 billion of losses from Merrill Lynch.

Indigestion problems for Bank of America

I expended a lot of time criticizing B of A for their acquisition of Countrywide almost 16 months ago. In fact I have been critical of every one of these major takeovers such as JP Morgan's purchase of Bear Stearns and Washington Mutual.

The problem with these acquisitions is not that there are not some valuable assets up for grabs, it is that they simply paid too much for them. Every quarter, we learn that the value of assets on the major banks balance sheets are not what they were worth just one quarter ago.

Thus whatever the acquiring banks thought was fair value to pay for these assets turned out not to be. So is it any wonder that B of A is now balking at the Merril acquisition? From Bloomberg:

Bank of America May Receive U.S. Aid for Merrill Lynch Purchase
Bank of America Corp., the biggest U.S. bank by assets, may get more aid from the government to help absorb losses tied to this month’s acquisition of Merrill Lynch & Co., three people familiar with the matter said.

Details are likely to be disclosed on Jan. 20, the people said. That’s when Bank of America may post its first quarterly loss in 17 years as it digests the purchases of Merrill Lynch and Countrywide Financial Corp. The combined company has already received $25 billion from the U.S.

Bank of America, based in Charlotte, North Carolina, told regulators in December the takeover might be abandoned because of Merrill’s worse-than-expected results, said the people, who declined to be identified because the talks are private. The government insisted the transaction go forward because its collapse would create new turmoil in the financial system, they said.

“Bank of America has all kinds of problems with its acquisitions,” said Gary Townsend, president of Hill-Townsend Capital LLC in Chevy Chase, Maryland. “They’ve been so acquisitive, they find themselves with very little in tangible equity.”

The part in bold is the point here, the major banks are woefully under capitalized and as I have been saying for some time, the equity injections are not enough, they are just absorbing the losses, they are not being restored to financial health.

Again lets be clear, the major US financial institutions are insolvent, the only thing preventing their equity from going to zero is that the US government is standing behind them.

However according to Chris Whalen, who has been spot on with respect to the problems at the major US banks, the US government's presence may not be enough to stop the equity of firms like Citibank, B of A and JP Morgan from going to zero. Click on the image below to hear Whalen's latest thoughts.


JPMorgan Chase Earnings

Another Kitchen Sink Quarter for US Banks

Remember all the talk a year ago about how US financial institutions were going to have a kitchen sink quarter in 4Q07? That is they were going to take big write-downs on toxic assets to clear the decks and start fresh. That didn't work out so well as subsequently Bear Stearns and Lehman brothers folded, the remaining investment banks disappeared by becoming bank holding companies, WaMu became the biggest bank failure in history and AIG and now Citigroup were effectively nationalized.

So here we are again, just about to get earnings after probably the worst quarter so far in this recession. Once again alanysts are too optimistic with their forecasts, there will be massive writedowns and losses from the major financial instituions again. Deutsche Bank's announcement today is just a taster, from Bloomberg:

Deutsche Bank Reports EU4.8 Billion Loss on Trading

Deutsche Bank AG, Germany’s biggest bank, reported a loss of about 4.8 billion euros ($6.3 billion) in the fourth quarter after the worst financial crisis since the Great Depression pummeled its debt and equity trading results.

The bank fell as much as 8.4 percent in Frankfurt trading. The loss, which compares with a profit of about 1 billion euros a year earlier, also reflects increased provisions for debt backed by bond insurers and “other exceptional gains and charges,” the Frankfurt-based bank said in a statement today.

click on the link for the full story. Also out today a nasty report from Morgan Stanley estimating that HSBC might have to raise $30 billionand half it's dividend, from marketwatch.com.

HSBC Holdings may need to raise $30 billion

HSBC Holdings may need to raise $30 billion in equity and slash its dividend in half, analysts from Morgan Stanley said Wednesday in a research note that challenges the perception that the bank is one of the strongest in the world.

HSBC Holdings (HBC) , Europe's largest, is unusual in that it hasn't accepted cash from any government during the credit crunch.

Morgan Stanley has long had a bearish stance on HSBC, with the broker in November estimating a capital shortfall of $25 billion that it could fill by raising $15 billion in capital and cutting its dividend in half.

But now the brokerage says HSBC needs to raise between $20 billion and $30 billion and is still calling for a halving of its dividend.

The note penned by a team led by Anil Agarwal says the group's Asian franchise isn't as well capitalized as thought. By Morgan Stanley's reckoning, HSBC's Hongkong and Shanghai Banking Corp. division has one of the lowest reserves of any Hong Kong bank, and needs an extra $5.8 billion.

Plus, HSBC has already padded its U.K. and U.S. businesses by roughly $11 billion, leaving little cushion at the group level. Morgan Stanley estimates that further losses in the U.S. will require another $5 billion in equity. And it says it can't rule out HSBC not paying a dividend for two years.

There is a good chance Morgan Stanley may be wrong, but even if they are only half right a $10 - $15 billion dollar capital shortfall is no laughing matter.

As repeated here many times, the capital injections to date for major financial instituions are just the beginning, the banking sector still needs vastly more capital to restore some semblance of normalcy. Citigroup proved that point recently when they were effectively nationised with another $20 billion injection. Now out of desperation they are selling a stake in their prized brokerage operation to raise yet more capital.

Impaired Assets Continue to Rise for Aussie Banks

Impaired assets continued to rise in the September quarter for Australian banks according to the RBA's quarterly bulletin. Actually it would be more accurate to say they shot up, rising by approximately $4.4 billion, the largest increase since September 1994.

However it is the percentage of impaired assets to total assets which is of most relevance. They also rose sharply to 0.52% from 0.36% in the June quarter. Despite the sharp increase it is still historically low and due mainly to specific impairments rather than system wide deterioration.

Impaired assets as a percentage of the total could go back close to the 1.0% level and still not be particularly bad. I have little doubt that it will get to those levels, it is only a matter of time.

The more interesting question is when does the normal deterioration in this part of the credit cycle turn into a system wide blowout as has happened in the US? Probably not until unemployment really starts to bite and households and corporates being defaulting on their debt on mass.

It is not clear if we will get to that point in Australia, but it cannot be ruled out as a possibility.

Citibank Gets Bailout

The United Socialists of American government decided to bailout Shitigroup by guaranteeing $306 billion of Citigroup's assets and injecting a further $20 billion in equity.

Citigroup Gets Guarantees on $306 Billion of Assets

Citigroup Inc., facing the threat of a breakup or sale, received $306 billion of U.S. government guarantees for troubled mortgages and toxic assets to stabilize the bank after its stock fell 60 percent last week.

Citigroup also will get a $20 billion cash injection from the Treasury Department, adding to the $25 billion the company received last month under the Troubled Asset Relief Program. In return for the cash and guarantees, the government will get $27 billion of preferred shares paying an 8 percent dividend. Citigroup rose as much as 41 percent in German trading today....

....The government’s preferred shares come with warrants to buy 254 million Citigroup shares at $10.61 each, allowing taxpayers to profit if the stock rallies following the government’s investment, according to a term sheet that accompanied the agencies’ statement. Citigroup is required to pay a quarterly dividend of no more than 1 cent a share for the next three years, down from 16 cents in the most recent quarter.

....Terms of the asset guarantees mean Citigroup will cover the first $29 billion of pretax losses from the $306 billion pool, in addition to any reserves it already has set aside. After that, the government covers 90 percent of the losses, with Citigroup covering the rest from assets, including residential and commercial mortgages, leveraged loans and so-called structured investment vehicles....

Let's be clear, Citigroup is insolvent, it's as simple as that, along with Fannie and Freddie and AIG they are being propped up by the government. I guess we should expect a pop in Citigroup stock folowing the bailout announcement, however you definitely wouldn't buy Citigroup stock for yield, since they won't be paying much in the way of diviends in the next 3 years. And if you think Citigroup is going to have any earnings in the next year, think again. They'll be taking writedowns and making losses for at least another 12 months.

Claims by CEO Pandit just last week that Citi had adequate capital ring hollow, and for anyone paying attention that was obvious. As I said yesterday and have been saying for a month, the capital injections under the TARP program would not even come close to being adequate because of the amount of losses linked to toxic assets on bank balance sheets.

Macquarie Bank 1H09 Profit down 43%

Macquarie Bank today announced that 1H09 profit fell -43% from the previous year to 217 cents per share. However that headline number disguises the extent of the deterioration in MQG's business. In the review section of the Appendix 4D, the company had this to say:

Subsequent to balance date there has been a further significant deterioration in equity markets which has impacted the market prices of our co-investments in listed specialist funds. If the market prices at the date of this report had been used in the Group's assessment of recoverable amount rather than the 30 September 2008 prices then profit after tax would have been reduced by approximately $130 million.

So Assuming that the value of MQG's satellite funds are not going to revcover materially in the next 6 months, MQG's forecast profit of 483 cents a share is looking to be on shaky ground. For some reason the stock ralled more than 16% today, probably because whilst the result was bad, there were no nasty surprises.

I'll repeat something I said many times last year and early this year when I talked about US banks and the outlook for profits going forward. The easy money leverage up environment is gone, and since Macquarie has largely depended on that for growth they will have to get used to a lower earnings base for the next few years.

More Visits to the Confessional for the Big 4

Back in February I asked the question Time to Buy the Big 4? and concluded that it wasn't. Then in August after even bigger declines I said Still Not Time to Buy Aussie Banks. If you bought the major banks back in August you haven't made any headway, but we have learned a few extra things we didn't know back then.

Firstly we knew Allco and ABC Learning Centres were in trouble but we didn't know they would be insolvent less than 3 months later. Below are the exposures of each bank to both.


It also should be noted that CBA holds 4.456m ABS hybrid notes at a carrying value of $220m whilst NAB has no direct exposure to Allco it does have exposure to entities within the Allco group. NAB also has a $20m exposure to the recently insolvent Rubicon group. In addition NAB made the following announcement today.

NAB to strengthen further its capital position

National Australia Bank (NAB) has launched an institutional placement of shares to raise approximately A$2.0 billion to strengthen its balance sheet and take advantage of organic growth opportunities. The placement has been fully underwritten by Goldman Sachs JBWere, Merrill Lynch and UBS AG, Australia Branch.

I must say I nearly fell off my chair laughing when I read the heading of the announcement. As if raising capital was a sign of strength. The truth is they need the capital to cushion the writeoffs coming down the pike.

I said months ago that the news for Australian banks would get worse before it got better. Now it is getting worse and is not likely to get better for some time and thus there is no reason to go out and buy the major banks with your ears pinned back just yet.

Whitney on the Future of Financials

I've posted about Meredith Whitney a number of times. She's been out in front of the problems facing the major banks for more than a year now. She talks commmon sense backed up by facts and as the finaical crisis has played out she has been vindicated in her views and I implore readers to listen to what she has to say in the interview below.

Future of Financials

Amongst other things she says:

Securitization market is not coming back.

Pullback in credit extension to consumers like we've never seen before.

Unemployment could approach double digit levels.

Wall Street analysts are anywhere from 30% - 70% higher than her forecasts for the banks and she thinks she is on the high side.

Banks will come back to the market for more capital.

More dividend cuts.

Citibank will go to single digits.

Well worth a watch.

Did Someone Say More Capital?

Last week I noted in "Bank Injections just the Beginning" that US banks would need much more than the $50 billion that has been injected by the TARP program to date. The story below is about UK banks, but it is a pre-cursor to what is coming down the pike for US banks. From the TIMESONLINE:

Banks may need further support from taxpayers as recession bites
Britain's banks may need to raise capital above and beyond the £50 billion of taxpayer-underwritten money already earmarked for them.

The Bank of England's report into financial stability today suggests that a recession as severe as that of the early 1990s would lead to credit losses of £130 billion for Britain's six biggest financial institutions and possibly wipe out the entire government-backed funding package.

Not only will US banks be getting more capital but I think one or more of the large players, GS, C, MS for example will be forced to merge with another entity just to survive.

ANZ Profit Down -23%, Waffle on Outlook

ANZ today unveiled a -23% drop in cash earnings which had largely been flagged to the market well in advance. Basically ANZ suffered from a few large exposures to weapons of finacial mass destruction as NAB did. As can be seen below those exposures led to a huge spike in credit loss provisions.

On the all important outlook for 2009, ANZ bascially admitted that they don't have a clue.:

Commenting on the 2009 outlook for ANZ, Mr Smith said: “Market conditions globally remain difficult and unpredictable. The restructure of our business announced in September is designed to accelerate progress with our Super Regional Bank strategy, lift customer focus and drive performance improvement.

“Managing a large commercial bank means managing through a range of conditions. While we expect choppy conditions to continue in 2009, ANZ is well positioned to manage this cycle, to continue to invest and maximise the opportunities which arise.

“We have the foundation, a clear direction and the capacity to deliver performance and value to our shareholders over the longer term,” Mr Smith said.

That is corporate speak for we don't have a clue. Again, as with NAB if you think these these banks are relatively stable and can maintain earnings and therefore dividend levels then they may not be such a bad place to be as interest rates continue to be cut. However, given the outlook for credit can how much certainty can you put in that scenario playing out?

Impaired Assets Rising But Not Yet Alarming

The Reserve Bank released it's monthly bulletin today along with certain financial statistics. Regular readers will recognize the chart above. It is the total dollar amount of of impaired assets at Australian financial institutions and also those assets as a percentage of total assets.

Whilst impaired assets are rising sharply, as noted before they are still far from alarming levels. You nwould need to see impaired assets rise above 1.0% of total assets to get worried. However, given the current trend and the events of recent weeks, you should expect impaired assets to continue rising over the next 18 months.

Whilst the globe is currently roiling from the worst economic crisis in recent memory, large corporate failures and home foreclosures in Australia are still relatively tame. However, it is dangerous to think that becasue we dig up rocks and send them to China that we will somehow come out of the current turmoil relatively unscathed. Expect corporate failures to ramp up over the next 12 months and for the major Australian banks to make frequent visits to the confessional.

Time for the Big 4 to Show Their Cards

Yesterday we learned the extent of the big Aussie 4 banks exposure to Lehman Brothers. Commonwealth Bank has an exposure of less than $150m, ANZ appoximately $120m NAB less than $100m and WBC less than $10m. Those amounts are not necessarily what will be lost but the banks will proabably need to take some kind of specific provision against them.

Expect this game to continue. The banks are 'all in', they have placed their bets and now it is time to show their hands. The difference in this game though is that noone wins, some just lose less than the others. Stay tuned, their are plenty of hands yet to be played.

Forget the Broker Dealers, Bigger Problems Loom

Away from the noise of Wall Street, ordinary citizens are going about their business as usual. However if you are in any way connected to or interested in financial markets, these are indeed interesting times.

6 months ago there were five large independent broker dealers in the US. Today there are only two. How many will there be in another 6 months? Nouriel Roubini thinks none of them will independent.

Does it really matter? Do we really need them? I would argue not. What benefit have these institutions brought to the economy? They have proved themselves incompetent by losing every dollar they have ever made. And this is not the first time.

What good are institutions that leverage themselves to the hilt, slice and dice dubious pieces of paper in the name of financial innovation and then infect all corners of the financial markets with their toxicity? Absolutely nothing and good riddance to them.

Besides, there are bigger problems out there in the form of AIG, Washington Mutual and Wachovia - and they are just the ones we know about. Citigroup itself is hardly out of the woods and it is doubtful if they survive in their current form.

The latest on AIG and WaMu is that their ratings have taken another hit. From marketwatch.com:

WaMu, AIG downgraded

Washington Mutual shares (WM) stumbled 9.4% to $1.82 after Standard & Poor's late Monday cut its ratings on the company and its Washington Mutual Bank unit because of increased market turmoil. S&P cut the counterparty credit rating on Washington Mutual Inc. to BB-/B from BBB-/A-3 and the rating on Washington Mutual Bank to BBB-/A-3 from BBB/A-2. The outlook is negative....

....Fitch on Monday evening downgraded AIG's rating to A from AA-, and said the company has an "extremely limited" ability to raise capital for its holding company

That doesn't sound good for AIG. from Bloomberg:

AIG's Ratings Cut by S&P, Moody's, Threatening Quest for Funds

American International Group Inc.'s credit ratings were downgraded by Standard & Poor's and Moody's Investors Service, threatening efforts to raise emergency funds to keep the company afloat.

The ratings reductions occurred after two people familiar with the situation said that the biggest U.S. insurer by assets is seeking $70 billion to $75 billion in loans arranged by Goldman Sachs Group Inc. and JPMorgan Chase & Co. to replenish capital.

$70-$75 billion, jaysus! On the weekend it was $40 billion. Also an AIG failure would not be good for anyone it seems:

"I don't know of a major bank that doesn't have some significant exposure to AIG," said Kenneth Lewis, chief executive officer of Bank of America Corp., in a CNBC interview. An AIG collapse would "be a much bigger problem than most that we've looked at," he said.

Why is that?

"The bigger problem here is that AIG is a bigger balance sheet, the tentacles go further and we don't have the same relationship between the Fed and an insurance company as we do with some of the others," said Liz Ann Sonders, chief investment strategist at Charles Schwab & Co. in a Bloomberg Television interview.

That's about it in a nutshell. Isn't this wonderful world of interconnected global financial markets marvelous? Hank containment Paulson was careful not to rule out government intervention. My bet is that AIG will qualify for the 'too big to fail' doctrine if it does indeed come to that.

How about Australia? There seems to be almost eerie silence form our banks and other financial institutions. It would be wishful thinking to assume our banks will be unscathed. We already know ANZ has CDS exposure to some major US corporate names. I think it's safe to say that BNB and all it's satellite companies are toast. MQG will find it tough to stay in one piece and there have been some rumblings about SUN's portfolio of assets.

But forget about the sideshow surrounding the Broker Dealers. The main event is the main street banks and insurers. If a couple of these go belly up in short order, we could be in for some real fireworks.

Still Not Time to Buy Aussie Banks

Back in February I posed the question; Time to Buy the Big Four? At that time I noted that:

...considering the pummeling their counterparts in the US and in some parts of Europe have taken, the share prices of Australian banks have held up relatively well. That's mainly because their profits have held up well and they have steered clear of the sub-prime meltdown....for now.

'For now' is the important part. As we move further into the sour end of the credit cycle we can expect profits to slow and bad debts to rise.

As we now know, ANZ and NAB weren't able to avoid some the problems of their overseas counterparts. CBA and WBC have been able to ....so far. Whilst CBA and WBC have avoided subprime related problems, as predicted they have had to raise their doubtful debt provisions significantly and as noted last week, impaired assets are now rising sharply.

6 months ago I predicted that investors would get opportunites to pick up bank stocks at more attractive prices down the road. Since then all 4 major banks stocks have moved lower, ANZ and NAB considerably so.

I see no reason to change that view. 6 months ago signs were beginning to appear that the Australian economy was slowing - following the US and European lead. Those signs have now been confirmed and in such an environment coupled with continued strains in credit markets, banks will continue to do it tough.

Impaired Assets of Aussie Banks Start to Climb

I first posted this graph back in February. Since then, impaired assets have increased sharply. The more important line in the graph is the "impaired assets as a percentage of total assets." It has also turned up sharply but is still very low by historical standards.

If we consider that the impaired assets ratio peaked at 0.69% in 2002 and that it was fairly mild as far as credit cycles go, we can probably expect that ratio to climb well above that level this time around given the explosion in credit in the intervening period and the great unwind now underway.

It should be noted as well that the graph above only includes data until the end of March 2008, before any of the announcements by NAB and ANZ. Also the Australian economy really only started to show clear signs of slowing after March.

As the economy slows further and unemployment rises into 2009 putting further pressure on households, impaired assets will rise in the household as well as the corporate sector. Whilst the RBA may decide to cut interest rates aggressively in such an environment, there is much doubt surrounding the ability of banks to pass those cuts on to customers as they contend with higher funding costs.

Repeat After Me: This is Not a One Year Event

Regular readers, (do I have any of those?) may recall a post I made back in October of last year titled; Repeat After Me: This is Not a One Quarter Event. At that time, writedowns by financial institutions were seen as one-off, short term interruptions to business as usual.

My suggestion was at the time that it would take much longer to play out, and here we are in the midst of 3Q08 and we have more evidence that things continue to deteriorate and hence the title of today's post.

On Tuesday JP Morgan visited the SEC confessional revealing that it took a $1.5 billion write-off on mortgage-backed securities and loans. The company commented that;

"Trading conditions have substantially deteriorated versus the second quarter,"

Also owning up to more pain was UBS which recorded its fourth straight quarterly loss on sub-prime related writedowns. The company said in a statement that;

UBS does not expect to see any improvement in the adverse economic and financial market trends'' in the second half of the year, the bank said, adding that it will continue to reduce staffing, costs and risky assets.

So now that you know this is not a one quarter event, but I'm here to tell you this is not one year event either, it will be several. The important point for stockmarket investors is, when will all this be priced into the stockmarket? Of course noone knows the answer to that, however I think it's safe to say, not yet.

There Should be No Surprises

There should be no surprises about the recent writedowns, profit warnings and rising bad debts from Australian financial institutions. For those paying attention to events in both the U.S and Europe it was really only a matter of time until Australian financial companies started to own up to problems of their own.

However, Australian financials, particularly the major banks, have weathered the storm relatively better than their US and European counterparts. Have our financial institutions been more prudent and better managed? Or are we just playing catch-up?

If the U.S was the starting point for the current problems we inhabit it may be instructive to look there for some answers to the questions posed above. Over the past 12 months we have seen roughly the following sequence of events.

• A flat out denial of any problems by major financial institutions.

• Then an admission of some problems, writedowns were taken, assurances that dividends would not be cut and that balance sheets were adequately capitalised

• Then more writedowns, CEO's sacked, rising bad debts, dividend cuts, job losses and capital raising but assurances that further capital raisings would not be necessary.

• Then surprise surprise, more writedons, more dividend cuts and in some cases completely eliminated, further capital raisings, asset sales, government bailouts and bankruptices.

Of course, the above sequence hasn't been the same for all financials, some have moved through various stages at different times, some skipped over some stages whilst others will never enter some stages (e.g bankruptcy). However, investors by now should have picked up on some general themes. Companies won't announce bad news until they absolutely have to and assurances from management that everything will be fine, cannot be believed.

What have we seen to date in Australia? Rising provisions for bad debts from major banks, writedowns from NAB and provisions for CDS exposure from ANZ. Profit warnings from both companies, just last week SUN announced a tripling of bad debts and a significant fall in earnings whilst NAB's CEO was forced to walk away from the top job along with plenty of assurances that things will be OK.

So does that mean we can expect dividend cuts, capital raisings, bankruptices and government bailouts in the coming months for Australian financial institutions? Not necessarily but it pays to be cognizant of what we have seen overseas in the past 12 months and as investors, plot a course of action accordingly.

Remember that during the rollercoaster ride of the last 12 months analysts have continually been calling for a bottom in financial company stock prices only to see them put in new lows each time.

Rather than ask, is it time to buy Australian financial companies? A better question might be, Given the relatively small amount of bad news from Australian financial companies, what is the likelihood that all the bad news is out there and that stock prices have fully relected it?