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Goldman Sachs: Connections Run Amok?

Here’s is a little reported story worth keeping an eye on: some people are concerned about the extent of Goldman Sachs reach into our regulatory and legislative process. I know that’s not real news. Anyone who followed the AIG debacle closely would have seen the apparent preferential treatment Goldman received from the Paulsen Treasury.

With all the sensitivities about proper behavior you’d have thought the bank would try to keep a low profile. At least by their normal headline grabbing standards.

Nope.

Now a juicy story emerges from last September.

Back then it was the New York Fed in the lead on banking issues. Among its actions was the fast track approval of Goldman Sachs as a bank holding company, along with the provision of $10 billion in capital. This is not to mention the hasty approval of the use of AIG bailout money to pay off it counter-parties, amongst whom Goldman Sachs was very prominent.

Now I am not going to cry foul on any of this because everything may well be above board.

But.

During that time the New York Fed’s Chairman, Stephen Friedman, sat on Goldman’s board. Which raises all sorts of red flags of potential impropriety especially since it would be the Fed that regulates a bank holding company.

Worse: in December Friedman bought a sizable number of Goldmans shares, which have since gone up $1.7 million in value.

This could all be proper. It could all be very well covered by all the necessary paper work. And it could also be that Mr. Friedman and Goldman are as honest as the day is long.

But, surely this situation is outrageous. It smells of a kind of preferential treatment that we need to rid ourselves of as quickly as possible. Much of the weakness in our economy right now stems from the actions of our large banks. Especially those deemed to ‘big to fail’. Goldman is one of those banks.

So why on earth is one of our top regulators sitting on its board? More to the point why is he buying more stock in one of the companies he oversees as a regulator?

It is situations like this that raise the specter of a potentially unhealthy relationship between our large banks and the government. The amount of personnel that swap jobs back and forth alone is dangerous because of its erosion of objectivity. But to have the most senior regulator sit on the board of a regulated bank under his jurisdiction is plainly absurd.

This is why I am skeptical of the administration’s ability either to understand or to resolve the banking crisis. Too many of its senior players are inextricably connected with Wall Street.

Add this story to the unseemly amount of coziness surrounding the stress tests and it is no wonder that some of us suspect the fix is in before the game starts.

Bankers like those at Goldman are out for themselves. Good for them. But they should be kept at a distance from the levers of regulation and legislation. In fact the bias should be against them.

Remember who brought the economy down and who has the most at stake. And who could profit the most from tilting the playing field.

That’s what makes this story about Friedman so terribly upsetting. The regulators constantly harp on about the risks of banks being too ‘interconnected’. I has always assumed they meant interconnected in a financial sense.

Maybe we should be more concerned about interconnectedness of the influence peddling kind.

Who’s running the show?

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Stock Market Fizz

I don’t usually talk about the stock market. It has very little to do with the real economy. The old adage that the market has predicted six of the last four recoveries is entirely apposite. Still even I find it hard not to notice the current run up in stock prices. The question being asked is: are we at the beginning of a new long term upward trend in stock prices?

No.

The market is always trying to play up whatever glimmer of good news it comes across. Right now we have seen a few, and I mean a few, signs that the decline in our economy is slowing. The housing market appears to be approaching the bottom. Production has dropped like a stone but also shows a little life. And consumer sentiment is no longer catastrophically bad, it is merely really depressed.

So the stock market has bounced a bit over the past few weeks.

Be wary.

It is not at all unusual for the market to bump around during recessions, and a prolonged period of gain is also not unusual. Even in the height of the Depression there were months of gains.

But corporate profits remain weak. Unemployment is rising – we are expecting bad data this week. And banking is mired in its self inflicted crisis.

So treat this recent run of gains as fizz.

The smart money is still invested in safe places, and unless you’re Warren Buffet with cash to burn, so should you be.

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No Stress? No Sweat!

The flood of leaks related to the bank stress tests due to be released this week has me thinking: why? Why, that is, are we getting treated to an almost daily series of ‘off the record’ and ‘unofficial’ flow of information about them? It makes no sense. Unless the administration wants to dull our faculties so much that we ignore all the flaws.

In which case it might be working.

The New York Times has an article written by the normally sober David Leonhardt that is positively breathless in its optimism. Reading it is like being handed the administration’s sugar coated version of the truth. Leonhardt argues that ‘using these results, the administration seems prepared to argue that, while a few banks may need additional money, the broad financial system is healthier than many investors fear’.

“Using these results, the administration seems prepared to argue that, while a few banks may need additional money, the broad financial system is healthier than many investors fear.”

My that makes me feel so much better.

It trivializes the amount of capital shortfall there seems to be in the system. A “few banks may need additional money”. OK then. Move along. Nothing to see here. Come on: move along.

So all this fuss over potentially failing banks was just a little storm over nothing. Apparently. Or so the administration now wants us to believe.

It gets worse. Now we hear that weaker banks, those very few who need just a little cash. Very few remember. Well they get six months to raise fresh capital before they’d be forced to take government money. Six months. Half a year before we fix our banking system. Talk about punting.

The administration’s entire strategy seems to be to talk the crisis down into a manageable little blip that is nothing more than a nuisance. The banks are just fine. One official is quoted by Leonhardt as saying none of them are insolvent and that “these losses are manageable”.

Presumably that’s why the market has discounted the stocks of Citi and Bank of America to a historically low level. It was all a silly misunderstanding.

I suppose I wouldn’t be as annoyed about all this were it not for the fact that the tests were rigged in the first place. Not only did the banks provide all the information, but the tests only applied to loan portfolios. Think about that for a moment. What’s missing? Derivatives. that’s what.

Yes. These stress tests avoided taking into account the very asset class that brought down AIG, and which has been sending shudders of fear through Wall Street since the crisis arose last year. The tests treated our major banks as if none of them had big capital markets positions that could implode at any moment. Of the biggest banks only Wells Fargo fits that description. All the others have huge derivative overhangs. And it is the tangled world of the capital markets that the real monsters lurk.

Were a ‘normal’ bank like Wells to hit the rocks it would be relatively easy to clean up. Yes it’s huge, but it isn’t as riddled with counter-party entanglements as its peers. The standard FDIC reorganization playbook would work just fine for Wells. No one has a playbook for a banking version of AIG. In fact the only people who would know how to unwind the mess at a Citi or a B. of A. are the morons who created the mess. It’s a bit like hiring a gang of fraternity brothers to clean up your house just after they trashed it. Except these idiots get paid by the million. We’d probably get treated to more of those ‘retention’ bonuses that so angered us all over at AIG.

So derivatives traders have been able to instill so much fear in the administration that no one wanted to admit there may be a lingering problem in bank portfolios laden with capital markets systemic risks. We simply ignored them. Presumably hoping that the monsters would all go away of their own accord.

Which means the stress tests weren’t that stressful.

What a shock.

So the combination of incessant leaks and weak tests has rendered the whole process a farce. We will learn that a few banks need to raise capital. But we will also be told that they’re jolly good people giving it that old college try. The others will presumably pass with flying colors. The banking crisis will end forthwith.

There are instances in the past where banks were thought to be on the brink and managed to come back to life without major government intervention: the Latin American loan crisis is one such instance. Leonhardt manages to make a reference to it. Frankly I don’t think it’s a very good analogy at all. The systemic risks are now far greater; the derivatives business has skyrocketed in size since then; fewer banks were involved, which meant that many banks were perfectly healthy all along; the economy was not contracting on all fronts as it is now; and the losses were concentrated in one sector, unlike now when we haven’t even entered the usual loan loss period brought one by deteriorating commercial real estate and credit card portfolios. In other words the Latin American loan crisis is a very bad analogy.

Which is another cause for concern.

The administration’s apologists are scrambling to clutter the argument with misdirection and poor analogies.

The fact remains that we have several large banks that are weak. No matter how you cut it they are inadequately capitalized. Usual sources of private capital are unavailable for the very banks who need it the most precisely because the stress tests look rigged. The obvious fudging that the administration is doing is counter productive. It prevents private investors being able to distinguish clearly which banks are safe investments. Yes the tests will appear to give the right information. But can we really trust it?

Especially when we hear the banks have been ‘negotiating’ the results.

But that’s another story.

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Fiat on the Rise?

News has emerged over the weekend about the plans that Fiat has after its deal with Chrysler is consummated. The story is an ideal example of the way in which recessions produce opportunities as well as the more often described disasters. Somewhere the great economist Joseph Schumpeter is smiling: the ‘creative destruction’ he saw in the inevitable cycles of capitalism reveal the next path toward new wealth, just as it lays bare the folly of the old path.

Of course he also said that a ‘depression is just a cold douche for capitalism’, so perhaps he had less empathy for the unemployed than we might want from one of our leading thinkers.

Still he had a point.

Fiat is attempting to use its new and strengthened competitive position by cobbling together a vast auto empire from the ashes of Chrysler and GM.

Its plan is complex, with many moving parts, but its timing is impeccable. Essentially Fiat wants to spin off its car making operations, based in Italy with eleven factories, into a new auto group, and then add in the European operations of Chrysler and GM. The latter include brands such as Opel, Vauxhall, and Saab. The various European parts of the defunct American auto makers consist of ten more factories, mainly in Northern Europe – in particular Britain , Germany, and Sweden. None of these countries have much appetite right now for further plant closings, so they may well be supportive with cash grants as well as other subsidies and pressure on local unions to ease the plan’s implementation.

Were Fiat to pull all this off the new car maker thus created would rank second worldwide to Toyota ahead of Ford and Nissan/Renault and roughly on a par with Volkswagen. GM would be reduced to a third rank, but would have part ownership in the new company.

This is heady stuff and demonstrates the advantage that the non-US auto industry has at the moment. Not only are they ahead technologically and operationally, but they are better capitalized and thus in a much stronger position to dictate the outcome of what appears to be the inevitable shake-up in the industry now that GM and Chrysler have foundered. With worldwide demand at a low ebb the industry has vast overcapacity that needs to be eliminated. Not only this, but the assets within the industry need to be allocated to those shareholders and managements most able to create value.

This was Schumpeter’s point: basic economic forces will always force assets into the hands of the most able. Thus new opportunities are always emerging even in the depths of recession. While Schumpeter’s theories represent something of a backwater his imagery certainly is vivid. And his larger point seems to have validity.

Just ask Fiat: there’s money to be made in this recession. Too bad for Chrysler and GM. But that’s capitalism for you.

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Bank Capital: This Week’s Hot Topic?

Just a gentle reminder to you all that we’ll be hearing a great deal about bank capital once again this week. Well at least it makes a change from Chrysler. The auto and banking industries have become the ugly stepchildren of this recession: both mired deeply in the muck and both very expensive to fix. Or maybe they’re the poster children of Reagan era and how not to run a business?

Either way when the bank stress tests get released later this week, assuming the administration doesn’t cave in once again to pressure from the larger and weaker banks [you know who they are!] we will be focusing our attention back on the adequacy, or otherwise, of their capital. From any impartial perspective one or two of them are well below ‘adequate’, so as soon as we learn that they have failed the stress tests we should be treated to a barrage of opinions about how to correct their deficiency. Just as naturally, there will be howls of outrage from the banks in question, with each claiming that its position is just fine thank you, albeit it a little weak on the surface.

I am continually baffled at the ease with which folks like me seem not to understand the essential strengths of banks like Citibank and Bank of America, both of whom think that their assets are a lot less shaky than anyone else does. You’d think that after all their efforts to come clean and explain their balance sheets with clarity and honesty the market would understand by now that their apparent abundance of toxic assets is a mirage created by the market’s misunderstanding of those asset’s underlying value.

Setting aside my sarcasm: the problem I have is that the above comment seems to be exactly in line with where Tim Geithner’s thinking as been. He has said that he is with the banks in believing that their assets are worth more than they could currently fetch on the market. Consequently he has been inclined to take a more benign view of their capital adequacy than someone like me: I tend to be swayed by little things like what the bank’s balance sheets actually say rather rather than what the bankers would prefer them to say.

All of this is by way of warning: we are about to see whether the administration has the fortitude to deal with the banking question, or whether it still wants to punt the problem downfield and hope for the cavalry to arrive from somewhere else.

The early indications are not hopeful.

Geithner is still plugging his plan to ‘solve’ the lack of capital at Citi and B. of A. by converting some of the government’s preferred stock into equity. Recall that when the government handed over cash to the banks they gave us back an IOU in the form of preferred stock.

Now, the problem with Geithner’s plan is that preferred stock already counts as capital: it is a component of ‘Tier 1 capital’ as defined by international agreement. So swapping it for equity does nothing at that level. The only ‘improvement’ that such a swap would produce is to increase an even more arcane ratio called tangible common equity [‘TCE’] which used to be of lesser importance until the Treasury realized that it was cheaper to window dress that ratio through these preferred-for-equity swaps than it was actually to fix the banks properly.

Plus there’s a big downside for taxpayers in the Geithner plan – I can hear you all shouting ‘surely not!’. Preferred stock throws off a nice annual dividend. So the taxpayers get money back on their loan if it is accounted for as preferred stock. Not just that, but in the event of further losses and therefore hits to capital, equity gets run down before preferred. So preferred stock is safer than equity.

So let me get this straight:

Geithner’s plan is to swap our preferred for equity, which has absolutely no capital bolstering effect other than window dressing TCE, while it weakens the safety of the taxpayer loans and eliminates the dividend we were receiving.

I don’t want to appear negative. In fact I would love to support the administration. It’s just that this plan is stupid. It sucks. It is a sign of weakness. And it needs to be dumped quickly.

Hopefully by the end of this week we will learn that it was simply a ruse and that the administration was determined all along to face down the bankers and take the harsh measures necessary to deal once and for all with the weak banks.

I can hope can’t I?

What’s the alternative?

Can you say ‘zombie’?

Addendum:

The argument rages on through the weekend. Here’s how it gets convoluted: the two really weak big banks, Citi and B. of A. are contradicting themselves in their anxiety. On the one hand they are arguing they are sufficiently capitalized and therefore need no further government aid. And on the other they are trying desperately to raise capital. If their public position about their capital position is correct why do they bother going to market?

Ummm. I don’t know either.

It just seems odd to me. Well I suppose that one can never have enough capital. So raising some more is always a good thing.

Right?

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