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The U.S. economy and housing – part II

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foreclosuremapAug09               Foreclosure rates and Unemployment by state

Risky lending practices have led to a stellar rise in home prices and subsequent plunge when the housing bubble started to burst in the so-called sand states of California, Florida, Nevada and Arizona. It is no surprise that delinquency rates for missed or late mortgage payments have spiked strongly in those areas but also around the country.

In the second quarter of 2009 according to the Mortgage Bankers Association (MBA) delinquency rates for one-to-four-unit residential properties have reached a seasonally adjusted rate of 9.4 percent of all loans outstanding. These numbers set the record for highest late payments rates ever recorded.

Foreclosed properties are also at record high with 4.3 percent at the end of the second quarter, leading to a total combined 13.7 percent of loans past due, also the highest amount of non-current payments in the history of the MBA survey. A welcomed exception are loans 30 days past due which are still well below the record set in the second quarter of 1985.

A sure sign that mortgage problems are being driven by economic recession rather than non-conforming lending practices is the increase in foreclosure rates with prime fixed rate loans. Foreclosure filings are now spreading to areas hit by the economic downturn. The combined percentage of foreclosure filings in the sand states has decreased slightly to 44 percent from 46 in the first quarter.

The State of Oregon is a good example with its unemployment rate rising to 11.9 percent in July compared to last year, at the same time foreclosures in the state are up a whopping 84 percent. The problem seems to be unemployment rather than toxic loans. Many first time home owners who bought at the peak of real estate prices simply have not enough equity in their homes and cannot afford current mortgage payments due to the weak economy.

Of course the actual foreclosure rates are very hard to predict. Government moratoriums have effectively created a hidden backlog of foreclosures that one day have to be dealt with. There are also more warning sign of homeowners under duress emerging as fewer are catching up on lapsed mortgages.

A report from Fitch Ratings found that cure rates for prime loans collapsed to 6.6 percent in July from an average 45 percent for the years 2000 through 2006. Cure rates have also fallen dramatically for non-conforming loans of Alt-A and subprime category. Fitch looked only at a return to current payment for loans bundled into securities, excluding GSE and non-securitiezed loans. 

This dramatic shift in the recovery of delinquent loans towards current payment is partially caused by the economic recession and fall in home prices, which puts a significant number of homeowners under water with little hope of ever recovering their investments. With toxic loans from non-conforming lending practices on the one hand and economic recession on the other, it is no surprise the outlook for both the economy and housing remains highly uncertain.

Few signs of a turn around in housing are starting to emerge. According to Case/Shiller nationwide home prices are showing tangible signs of improvement month over month in June and May of this year. In some areas where prices have fallen dramatically investors are coming back to the market hoping to snap up properties on the cheap.

The Outlook remains uncertain and yet a recovery will by and large depend on the pace of turn around in the economy. While it is no secret that recessions caused by a slump in businesses of the financial services industry tend to last longer, on average almost five years, the depth of the economic trough and the pace of recovery is still unclear.

Key to answering the question whether we will have a V, W, U, or L shaped recovery lies with the American consumer. In the past abundance of credit fueled conspicuous consumption and a debt driven economy. No wonder many are fearing a new found admiration for frugality that is exemplified by an increased savings rate in the U.S. today.

Even though less consumption in the U.S. would almost certainly have implications reverberating around the global economy, the results of this dramatic shift in behavior would be felt most severely in the U.S. itself. While there likely will have to be some shift towards a more export driven economy it is hard to imagine that policymakers in the U.S. are willing to completely adjust to this new set of paradigms without recourse to pre-crisis conditions.

In fact strong signs of reoccurrence of pre-crisis behavior are starting to emerge. Reports of once-again record compensation packages among employees in the financial services industry have angered critics who see the industry at the center of the economic storm and would like to see more humbleness instead of the same old greed.

Even more daunting is another bad habit that many consider at the heart of the financial meltdown through its manipulative prowess in credit distribution behavior. Many banks still stuffed with risky mortgage loans from frothy days of real estate exuberance are once again engaging in what some call resecuritization of real estate mortgage investment conduits.

At the heart of Wall Street’s newest innovation is the re-remic, an impaired bond that does not necessarily have a natural buyer but by splitting it into two bonds may find a buyer for both of them. Investors who take on a really risky pool of securitized loans agree to lose money first if the deal goes sour. Investors in the safer pool of assets get paid first, therefore securitized loans in this category are slapped with a AAA-rating. Sound familiar?

The financial meltdown shooting out from non-conforming lending practices is in part credited to the failed securitization of mortgage loans deemed useful by false credit ratings. Yet, here we go again relying on financial repackaging of inferior securities dubbed suitable once again by rating agencies.

Sifma and the European and the American Securitization Forums (ESF and ASF) are ambitiously drafting new rules to rebuild confidence in structured credit markets reacting to a call from financial regulators to enhance transparency in this notoriously shrouded over-the-counter market. There is clearly a consensual desire to clean up the securitization markets, no wonder given its impact on the current financial crisis.

Initiatives aimed at standardizing issuer disclosure, facilitating and broadening investors’ access to transaction information and enhancing the usability of information are all welcomed but do they really justify the inherent risks purported by this form of financial engineering? Wall Street’s history and its future always has been and always will be abusive in nature, which should give everyone a moment’s thought, unless the crisis was for naught.

While this initiative has been started more than a year ago it does not seem to get into gears. The first drafts of reform were to be implemented at the beginning of 2009 but new rules are still in the workings and have not taken off ground yet. The MBAs proposal to standard procedures for servicing non-conforming residential mortgage loans and ASF’s Project Restart aimed at the securitization market are now trying to put the squeeze on regulators to let more players get sucked back into this ailing market.

So far the magic wand of enhanced transparency did not help to lift the freeze in in the securitization market. During Goldman Sachs’ second quarter the securitization powerhouse was only able to sell $12.9 billion in securitized loans, with meager $496 million outside of safe government agency bonds. That dwarfs in comparison to upwards of $30 billion at the beginning of 2007.

Inquisitive minds might argue that policy makers are not too successful in their attempt to hawk back to pre-crisis conditions. The emperors new clothes in the form of enhanced transparency seems not sufficient to once again resurrect bad habits from the dawn of the credit crisis.

Nevertheless much will depend on future success of the credit-distribution-lifter in form of securitized mortgage or other asset backed loans. Without it the American consumer might well be maxed out, with it the financial services industry and investors will probably once and for all loose their last shirt over it. Much like the Federal Reserve also Wall Street seems to be damned if they do and dammed if they don’t.

While these contradictions contribute to the overall uncertainty credit markets in general are still not healthy. Recently the Fed extended its Term Asset-Backed Securities Loan Facility (TALF) for another six months. It was scheduled to expire at the end of 2009.

In the UK, Bank of England governor King detonated a bomb last week when it became known that he voted for an even bigger increase in the bank’s quantitative easing policy. The minutes of the August meeting revealed King wanted to expand the program by 75 billion instead of 50 billion pounds.

In this apparent game of confidence policymakers are hitting the monetary accelerator full throttle to make sure the public can have trust in their abilities to revive the economy. Yet under these strange conditions a sustained recovery in housing, the economy and on Wall Street seems to be still ways off.

The U.S. economy and housing – part I

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UShouseprices

In 2006 when the housing market popped in the U.S. the sound of fear and uncertainty was heard in hallways of financial institutions around the world. In the meantime most investors have lost their last shirt and millions more their providing jobs over it.

The world’s central banks spear-headed by the Federal Reserve have pumped trillions of dollars into moribund financial institutions to shore up their liquidity and to guarantee the perpetual flow of credit. To this day bankers can prod themselves with mission accomplished, financial Armageddon has been avoided and instead of the Great Depression, Great Recession has taken over the tabloids.

No doubt the Greta Depression is not a very appealing alternative, it is therefore understandable that the captains of this financial fire-sale rescue have become the new heroes of the establishment. The leader of the pack is of course Ben Bernanke, chairman of the Federal Reserve Open Market Comedy, who as a scholar of the Great Depression has led the great rescue operation of 07/08/09 by pumping up the balance sheet of his institution and shoring up liquidity on Wall Street.

Today sure enough reports surfaced of Bernanke’s reappointment as Fed chairman coming January. His guaranteed position at the helm of the Fed serves the current establishment and was therefore all but certain, though his well accepted speech at economist heaven at Jackson Hole last weekend might have helped.

In his speech did he not suggest that financial institutions cannot by themselves, no matter how carefully done, take full responsibility of their liquidity risk management? This sounds surprised but it really should not. According to Bernanke, central banks now and forever must be prepared to provide liquidity and credit provisions to financial firms in trouble.

I can only imagine the applause that erupted on trading desks of Wall Street’s most venerable institutions. From now on no risk can be too big and no bonus too gratifying, ‘cause Ben the savior will always be there to provide the necessary dough and pay with taxpayer’s money for the tab.

Unfortunately for helicopter Ben his success will not be measured by the smirks on the faces of bankers alone but rather by the strength of the economy and health of the job market. This will by and large depend on the recovery in the U.S. housing market. July’s data for existing home sales have been very encouraging, up 7.2 percent from June at the fasted pace of sales rates in ten years. Still much of it is in the from of distressed sales but even there the rate is declining to 31 percent from 50 earlier in the year.

Supply is still heavy but not as strong as it once was, obviously there is light at the end of the housing tunnel. Prices are still coming down nationwide, with the median sales price falling another 2 percent on the month at $178,400. But there is more good news.

In Southern California, one of the hardest hit areas during the downturn of the U.S. housing market, home sales and prices show a surprise recovery. The specter of homeownership is starting to reemerge from the short hibernation of the last couple of years. Its no surprise really and if you can believe it, it never rains in Southern California.

In Los Angeles County sales were up a staggering 19 percent in July compared to last year and the median home price rose to $321,000 but this is still much lower than peak median Southland home sale price of $505,000 at the height of the real estate bubble. Despite its recent rise the median home sale price remains at 2002 levels and is 47 percent below its peak level. Foreclosures are still dominating the sales and suppressing prices but that could change within the next twelve months.

In the San Francisco Bay Area even high end sales are recovering with homes sold at or above the $500,000 range, the highest since September 2008. With jumbo loans reemerging the high end market finally has a pulse again. This is propping up median prices which are still 40.6 percent from peak values but 36.2 percent off the lows in March 2009.

In New York City foreclosures in the five boroughs were up 14.8 percent in July compared to last year. Auction events usually draw crowds of thousand people and more participating in the bidding and snapping up bargains. So far this year Auction.com has auctioned more than 20000 foreclosed homes across the nation for $1.4billion.

Investors are rediscovering their appetite for risk in real estate assets in a big way, with some properties going for cents on the dollar at foreclosure auctions. Private-equity players are turning to IPOs in a rush not to miss the fun at the biggest buying bonanza of troubled real estate assets since the bubble burst. Since June big boys like Apollo Global Management, Colony Capital and Starwood Capital have filed with the SEC to launch their IPOs of new real estate investment trusts (REIT).

The specter of returns in excess of 100 percent is what makes the investor’s heart beat faster. Some are still cautious and think the biggest buying opportunities are twelve months out, but with federal financing programs like TALF and PPIP low cost financing of troubled assets is a win-win-win situation, for some even the best one in the past 50 years. Of course this strategy is not without risk, the economy is far from healthy and the job market is still declining, which could make expected bargain prices still a bad deal if the underlying value does not come back.

Asked if the housing market could set itself up for another bubble, perpetual housing bear and U.S. economist Robert Shiller entertained at least the possibility (see video). According to Shiller low interest rates and high affordability are positive, high inventory of unsold homes and recent experience are negative for the housing market. An exceptionally weak recovery would of course trump everything else and push the U.S. economy closer to depression.

Historic facts do not support those eager housing bulls now crawling out from under their covers. Historically, from peak to trough, it takes more than four years for housing prices to bottom. Since prices nationwide peaked in 2007, for some areas prices will still have to fall further. Moreover, usually it takes 10 years for house prices to fully recover.

For the housing market to turn around the economy needs to recover first. Now the annoying thing is that for the economy to recover the housing market needs to recover as well. A strong interdependence is here at work and the economy reinforces housing and vice versa. In other words what happens to housing is crucially important to the economy.

Another bear, Nouriel Roubini, who correctly predicted the recent downturn in the debt fueled U.S. economy suggests the recession is far from over. In many other advanced economies, similar to the U.S., the bottom in the economy is quite close but has not been reached yet. In the U.S. overcapacity, a damaged financial system and still overleveraged households will dampen any strong recovery in the economy and therefore in the housing market.

Even if some would insist to dip once and then end it, Dr. Doom’s diagnosis is a double dip recession. The dilemma is with monetary policy, because Bernanke and friends are damned if they do and damned if they don’t, mob up excess liquidity that is. All things equal according to Mr. Roubini the economic recovery will be anemic rather than robust.

In the past during economic downturns the economic model of the Federal Reserve has worked like a rubber band, you pull it hard and the economy snaps back. If asset prices plunge on one side a re-inflation trade props up asset prices somehow somewhere else. This time the rubber band could just have popped.

Historically downturns caused by financial crises are not typical cyclical recessions and last on average of 4.8 years. Growth spurts can occur and inventory restocking will contribute to positive growth in the coming quarters, but at this point it is unclear what would come after that.

The key to the gates of heaven or Dante’s inferno for a recovery in housing and the economy are the credit markets. Availability of loans for people and businesses is critical in any sustained recovery going forward. Yet the shadow banking system with its many corridors and lifts of credit distribution is still dysfunctional.

While the recession is raging the ratio of private household debt to the nation’s total economic output rose to 97 percent in the first quarter, up from 45 percent in 1975. Americans are saving more to pay down debt and savings rate has jumped to 5.2 percent of disposable income by the second quarter of this year. Roubini thinks savings rate has to go much higher, and this will hold down consumption. Shockingly, savings going up a percentage point decrease spending by more than $100 billion.

This newfound frugality might be well underway and the world has to prepare for a cutback in consumer spending and residential investment. It is difficult to see what could replace the American consumer in the global economy.

Krugman – one unflinching Keynesian economist

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FriedmanMarxKrugmanKeynes

Today employment in the US is lower than it was ten years ago, the stock market is lower than it was ten years ago. Keynesian economics has created a two tier society, with the investor-ownership class on one side and the working poor on the other.

Keynesianism has brought an end to the democratization of capital markets and helped to foster a politically inept society with less opportunities for fewer people. Before the advent of Keynesianism bubble economics occurred rarely and if it did it was linked to natural product cycles. Today bubble economics are part of the intricate mechanism of capital flows almost unhinged from natural product cycles and rather dependent on artificial and corrupt political initiatives.

US economist and Nobel laureate professor Krugman is a very outspoken representative of governement-spending-saved-the-world defenders of Keynesianism. In times he is so convinced by his ideas that he does not shy away from indulging policy makers with his nuggets of knowledge.

A good example for how far Mr. Krugman was willing to go, was his fierce attack of Germany finance minister Steinbrueck in December of last year. Steinbrueck warning of crass Keynesianism, in the midst of the largest government economic rescue effort in history, caught Mr. Krugman’s anger and earned Germany a collective boneheadedness from the professor.

Of course in the meantime more and more green-shoots are becoming evident and most national economies have stopped their abysmal plunge, with some even showing humble signs of growth in the second quarter. Mr. Krugman and other Keynesian economists find themselves now in a somewhat awkward position having to defend themselves over their radical support for stimulus.

Professor Krugman ventures deep into wonkish territory in his defense for deficit spending and why we should not fear it in the context of higher interest rates. Interest rates are of course important because as a discount to future earnings they are the most important factor in determining our wealth. Deficits and interest rates are the topic of one of his most wonkish blog posts in the New York Times to date.

The core of professor Krugman’s post is a positive correlation between GDP and interest rates and a negative correlation between interest rates and deficits. The core fallacy of Keynesians is what follows, lower GDP merits higher deficit spending and nobody needs to fear high interest rates because they are inversely correlated and therefore lower with higher deficits. This is despite the fact that most would acknowledge that deficit spending is inflationary.

deficits-interestchart shows neg. correlation btw. T-Note interest rates and government deficit spending

Most economic formulas (S-I = G-T is the one Professor Krugman is using), to the contrary what economist want you to believe, are not universally true laws of nature like a physical law or even most scientific laws. Economists of course believe that the only true science is economics.

In mathematics a formula about events at some future time-horizon always acknowledges uncertainty of a predicted outcome inherent in its logical argument. Economists though using mathematics merely extrapolate a present situation into some future time-horizon rather than acknowledging uncertainty. In other words they think what is true now has to be true also in the future. It seems to me that Keynesians are the world’s champion in extrapolating the facts ad infinitum.

The problem is not i.f., deficit spending. The problem is rather not knowing when its enough and when to withdraw, not knowing when to hold ’em and when to fold ’em is the real problem. It is this uncertainty that’s inherent in their economic formulas and yet they do not account for it. Keynesians live for the here and now, they completely discount the future. The crisis of 2007,08,09 should be proof enough that it can’t be done.

Economists are wrong about the economy nine out of ten times. Some Keynesians think they are right because they have not been wrong so far. I got news for ya, not being caught with a lie is not the same thing as telling the truth.

RIBH – a bank in Central Eastern Europe prepares for the worst

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RaiffeisenchartMar09                                         RIBH chart Mar. 10, 2009

Raiffeisen International (RIBH) is a bank holding company that does all its business in Central Eastern Europe (CEE). This region was particularly hard hit when the economic crisis stopped capital flows into CEE. The different national economies are still in the grip of a severe contraction, but the worst outcome seems to be averted at least for now.

Economists and financial experts thought financial institutions with strong exposure to CEE could suffer huge losses. If national economies were in danger of defaulting on their balance of payments accounts the only way out would be a steep currency devaluation.

This would drive foreign currency loans into default and financial institutions towards insolvency. Luckily this horror scenario has been avoided so far. Regional currencies have stabilized and the decline of CEE economies has slowed. Though the situation still bears significant risks.

Today Herbert Stepic, CEO of Raiffeisen International (RIBH), presented operative results of his company for the first half of 2009. RIBH about the size of a large regional bank in the US with a balance sheet of about €77 billion does all its business in CEE and therefore serves as litmus test for the credit performance of this part of Europe.

Stepic himself pointed out that the firm was resilient in light of economic headwinds and offered €78 million profit as proof. This was down about 86% from last year mostly on currency effects, a global recession and massive increases in loan loss provisions.

All regions, Central Europe, Southeastern Europe, and Russia reported lower net income and higher provisions. For the first time results were negative for GUS Others (Belarus, Kazakhstan, Ukraine). Provisions were particularly interesting because of continuing concerns about credit quality in CEE countries.

Certainly an increase of 380 percent in provisions for loan losses is nothing to be proud of, total allowance has now reached €2.5 billion, but RIBH seems to deal with the situation which is bad yet not out of control. The continuing involvement from international institutions like the IMF, EU, WB and EBRD has certainly helped to alleviate some of the worst fears for CEE and its major debtors.

RIBH financial highlights in 1H 2009 (vs. 1H08):

  • balance sheet €77.9 billion, down 9% on currency devaluation and lower lending activity
  • Deposits from customers down 4% to €42.3 billion, with corporate down 13% or €2.3 billion
  • ratio of customer loans to deposits up 4% to 127% (from Dec. 31, 2008)
  • shares of own funds (equity plus subordinate capital) at 10% of total assets
  • equity at €6.2 billion, down 5%
  • net trading income increased 29% to €119 million
  • income from investment and pension funds declined €9 million or 44%
  • risk weighted assets corporate €27.7, retail €17.3, total €54.7 billion
  • NPL at 6.8%
  • allowance for impairment losses 2.5 billion, up 52% from Dec 31, 2008
  • loan loss provisions increased to €969 million or 380% from €201 million
  • provisions corporate €386 (45), retail €579 (155), total €969 (201) million
  • total write downs €25.6 million (27.1)
  • loans and advances to banks, money market business €5.25 (4.34) billion
  • direct loans to banks €753 million (3.0 billion)
  • loans and advances to retail customers, credit €24.4 (27.8), money market €7.6 (8.0), mortgage loans €17.4 billion (17.2)
  • deposits with central banks particularly in CEE down 55% to €2.0 billion
  • total derivatives (credit and others) €589 million (€865 million, Dec 31, 2008)
  • derivatives at fair value €555 million (€843 million, Dec 31, 2008)
  • net income from derivatives (including hedge accounting) €19 million (€72 million, Dec 31, 2008)
  • liabilities in the form of derivatives (hedging) €42 million (€51 million, Dec 31, 2008)

RIBH1H09-2RIBH1H09-1

Another stab at Goldman’s earnings

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2Q0910-Q-GS-cashflow

Accounting statements in accordance with the actual business are more and more becoming complex and bloated fixtures of financial institutions. At the end of third quarter 2008 Goldman Sachs listed six recent accounting developments on its consolidated financial statement 10-Q.

This changed dramatically for the most recent quarter and Goldman’s 17 accounting changes opened a new frontier for wild west style accounting. Though these days reading a financial statement and understanding it is almost impossible, tenacity can pay off and hopefully reveal some insight into the health of Wall Street’s former behemoths.

Under cash flow from operating activities there is a fixture called trading assets at fair value. There is nothing peculiar about this other than the fact that its value jumped beginning with the fourth quarter of 2008. Inquisitive minds might remember that a significant accounting change took place during this quarter.

The Financial Accounting Standards Board (FASB) introduced FAS 157-3 in October 2008. Staff Position 157-3 acknowledged the use of management estimates or assumptions in “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active”. In April 2009 this accounting rule was amended to FAS 157-4 to accept this kind of fair value estimates also to not orderly transactions with significantly decreased trading activity.

Goldman’s worst quarter ever was the third quarter ending August 29, 2008. This was the quarter before the accounting changes were implemented. During nine months ending August 2008 (GS fiscal year used to start in December before the firm changed its status to a bank holding company), cash flow item trading assets at fair value registered a meager inflow of $37.9 billion. A year earlier the company had even outflows of $92.7 billion on the same position.

From January to June 2009, in the first two quarters of the new bank holding company, inflows into this category of cash flow from operating activities had already taken off at $172.39 billion. A year earlier in the six months to May 2008 inflows came in at only $28.8 billion. The firm of course does not further specify trading assets at fair value and which assets create its cash flow. 

Since assets are designated fair value therefore not easily convertible to cash it is reasonable to assume that cash flow generated is associated with non-current assets. Associated cash flows are added back or subtracted from the income statement depending on inflows or outflows respectively. In that sense $172.39 billion of fair value inflows might have substantially contributed to positive earnings during the first two quarters of 2009.

I think is is fair to say that accounting change FAS 157-3 threw a lifeline to even our most venerable institutions on Wall Street. In the Huffington Post Nathan Lewis asked the question: Do We Need Goldman Sachs? Without FAS 157-3 this question would be redundant. Most likely GS would have already drowned in the stormy sea of mortgage backed securities and credit derivatives.

Could it be that recent celebrations on Wall Street are nothing but a smoke screen blowing hot air into the face of investors? In its August monthly report a congressional oversight panel (COP) evaluating troubled assets on the books of large and smaller BHCs came to the conclusion that a substantial portion of toxic assets from mortgage backed securities and real estate whole loans still remains on bank balance sheets.

Goldman Sachs and Bank of America are two examples of masterful deceit sanctioned by the appropriate agencies. I am beginning to think that former New York AG Spitzer is right and democratization of capital markets is no more.

Written by Alfred

12. August 2009 at 4:53 pm

Merrill’s impact on Bank of America

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In September 2008 after bankruptcy of Lehman the financial industry as a whole nearly collapsed. Subsequent contraction of international trade was tangible proof for the serious threat Lehman posed to the stability of the system. Ben Bernanke putting the proverbial gun to Ken Lewis head while trying to rescue another Wall Street titan, Merrill Lynch,  broke the law but might as well have saved international commerce and the world from the brink of disaster.

A government report from the congressional oversight panel (COP) on troubled assets from financial institutions concludes that banks’ balance sheets are still clogged with possible future losses from hundreds of billions of impaired assets (also….). In the report’s data something else is being revealed too, with respect to Bank of America’s acquisition of former investment bank Merrill Lynch.

After the merger with Merril BofA’s most toxic level 3 assets jumped 127 percent to $126.9 billion in the first quarter of 2009. Loan quality in the form of 90+ day past due loans ballooned from $5 billion at the end of 2007 to $141.7 billion as of March 31, 2009. BofA’s credit derivative exposure to sub-investment grade assets experienced a significant uptick from little more than $500 billion to about $1.65 trillion over the last 15 months.

Under these conditions Lewis’s reluctance to close the deal is understandable, so is Bernanke’s assertiveness on this issue. The following diagrams reveal survival of the financial system and the well being of international commerce might have been at stake in those crucial days of late 2008. It seems that BofA will chew on this piece of financial crap from Merrill’s almost bankruptcy for years to come.

All the while executives at the firm and elsewhere are starting to rejoice again on better than feared earnings for the most recent quarter and reward themselves with another round of lavish bonuses. Wall Street star analyst Richard Bove in a note to investors cut short any hopes for a sustainable recovery in financials claiming bank earnings won’t improve in the third or even the fourth quarter.

COPreportAug09-pastdue COPreportAug09-creditderiv

Written by Alfred

12. August 2009 at 12:19 pm

Goldman’s 10-Q reveals – balance sheet still bloated

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Goldman Sachs Group has tripled their growth forecast for the second half of this year. Inflation adjusted economic growth is supposed to jump to 3 percent annual rate. Yet even the mega bulls at GS do not think this growth spurt is sustainable, and anticipate a decline to 1.5 percent in late 2010.

Will the American consumer be able to return and then keep up with lavish spending habits? This is the 64 thousand dollar question. In the past US consumer spending powered both the US economy and the rest of the world. After the crisis there still exists a possibility of painful adjustments to household and corporate balance sheets mainly in debt fueled economies.

Indebtedness of US private households peaked at 132% of disposable income at the end of 2007. This ratio had fallen to 124% at the end of March, 2009, but is still too high. As a reaction US consumers are spending less and saving more in recent months. As people continue to struggle to repay their debt the savings rate is expected to gradually return to a range of 7% to 10%.

There are also those who disagree and are not convinced that higher savings will ipso facto result in lower output. Michael Darda, chief economist at brokerage firm MKM Partners, anticipates a strong recovery in stocks and the economy. Obviously an increased savings rate is only a temporary phenomenon according to Darda.

Even if Darda is right and we will return to old habits, can we be sure this is really what we want? A return to a debt fueled economy got us into trouble in the first place. These are rather conflicting interests between corporate and business protégés and basically everybody else.

The leader of the pack on Wall Street is investment firm turned bank-holding company, Goldman Sachs. Yesterday GS released its consolidated financial statement for the second quarter of 2009. On first impression we see a great quarter and a reoccurrence of the firm’s unmatched earning power. Taking a closer look reveals quite a different picture. The 10-Q statement for the second quarter tanked GS stock by 2.01% yesterday, down $8.65 since August 6, 2009.

GS 10-Q unaudited condensed consolidated financial statement makes certain estimates and assumptions. Most important are fair value measurements and accounting for goodwill and intangible assets. Actual results could be materially different from these estimates.

The firm’s assets and liabilities are generally separated into two categories, cash instruments and derivative contracts. In determining their fair value, hierarchy levels two and three are significant because of the use of judgment and estimate for price transparency. Government agency securities, certain mortgage products, and certain money market securities are considered to be level two, if not actively traded.

Cash instruments are considered to be level 3 if they are infrequently traded and lack price transparency. Such instruments include private equity and real estate fund investments, collateralized debt obligations (CDOs), less liquid mortgage whole loans and securitization products (backed by either commercial or residential real estate), and acquired portfolios of distressed loans.

Over the counter (OTC) traded derivatives contracts are always valued as level three, and therefore subject to least price transparency. In such cases the transaction price is often used as the best estimate of fair value. In addition the lowest level of input in any financial instrument determines its level within the value hierarchy.

In October 2008, the Financial Accounting Standards Board (FASB) issued FAS 157-3, approving the use of management estimates or assumptions to determine fair value in not active markets. In April 2009 this rule was amended to FAS 157-4 and applied fair value assumptions to not orderly transactions of assets and liabilities with significantly decreased activities.

These new FASB rules have tremendously helped financial firms to hide potential losses of mostly impaired mortgage backed securities under level two and three of fair value accounting. For Goldman Sachs trading assets at fair value increased to $355.2 billion in 2Q09 from $338.3 billion in 2Q08.

Composition of assets held at fair value has changed and Goldman has replaced risky collateralized debt obligations with safer US government agency debt during the most recent quarters. Though the firm has not at all shied away from derivative contracts and as of June 2009 held a net position of $90.0 billion at fair value.

Although compression efforts across the industry have helped to decrease the notional amount of derivative contracts outstanding, the firm’s gross fair value exposure was still a staggering $1.093 trillion. Purchased $3.19 trillion of credit derivatives were partially offset with $2.96 trillion in written contracts. Net of collateral only $90.0 billion contributed to trading assets at fair value.

Net purchased protection total derivative exposure was $227.02 billion as of June 2009, with $212.1 billion level 2 and $15.0 billion level 3. A $137.5 billion cash collateral helped to reduce the risks associated with these derivative contracts. At the end of the fist quarter 2007 cash collateral for derivative contracts at fair value was a meager $27.7 billion, representative of an easygoing and low risk culture on Wall Street at the time.

For the first time the financial statement provided some insight into the composition of the firms staggering exposure to derivative contracts. In the second quarter 2009 the firm held a gross exposure of written high risk credit derivatives with credit spreads of 501 to 1000 basis points or greater over Libor. $73.3 billion had a term exposure of 5 years or greater and a total of $526.9 billion a term exposure of zero to five years or greater.

These contracts were partially offset with purchased credit derivatives and their fair value was also greatly reduced. Nevertheless it poses a staggering exposure to potentially toxic assets in a harmful environment of severe credit contraction.

From trading assets held at fair value at the end of the second quarter $332.7 billion were still level 2 and $54.4 billion, with economic exposure of actually $50.3 billion, at level 3. In the first quarter of 2007 Goldman owned financial assets at fair value of $231.6 billion at level 2 and $47.6 billion at level 3. Fair value of level 2 and 3 assets as determined by FASB 157-3,4 are subject to the firm’s estimates and assumptions and not mark-to-market.

Probably the most contentious issue with the business of accounting in financial firms has been and still is the issue of securitization activities. Goldman Sachs securitizes commercial and residential mortgages and other financial assets. This has undoubtedly been the driving force of a debt fueled economy in the past, but will it remain so in the future? The latest data reveal securitization has virtually come to a standstill, and this shutdown of the consumer is behind rather tepid assertions of economic recovery.

During the three months ending June 2009 Goldman only sold $12.9 billion in securitized products, of which $12.4 billion were primarily safe government agency securitizations and only $496 million of other financial assets. In the first quarter 2007, $16.8 billion in residential mortgage securitizations and $14.8 billion in other securitizations, primarily collateral debt obligations, were transacted.

Total shareholder’ equity was $62.8 billion at the end of the quarter. As of June 2009 the firms equity was about fourteen times leveraged to hold total assets of $889.5 billion. During the first quarter of 2007 shareholder’ equity was still 25 times leveraged. This apparent reduction of leverage in the current quarter is not attributable to general deleveraging. Shareholder’ equity has benefitted greatly from increase in retained earnings and additional paid-in capital.

There were some positive developments as well during the most recent quarter. At the end of the first quarter of 2007 financial assets at fair value subtracted $36.9 billion from cash flows from operating activities. That has dramatically changed in the most recent quarter and trading assets at fair value attributed $172.3 billion to cash flow. This form of associated cash flow from the sale of non-current assets is added back onto the income statement and helps to improve the firm’s earnings.

Overall Goldman Sachs’ balance sheet has improved but is nowhere close to the optimism infused during its earnings report. Fair value accounting with level 2 and 3 still unreasonable high pose tremendous risk. Securitization activities, fuel to a consumer driven economy, ceased to exist. Yet financial firms and other Wall Street combat optimists are again celebrating.

The debate over reigning in the financial industry’s notorious ingenuity and lavish executive compensation is ongoing, all the while bankers are still celebrating. A conflict of interest in this mission impossible to control Wall Street is a done deal with no recourse to moderation. Public outrage is therefore understandable and some are even beginning to ask the question: Do We Need Goldman Sachs?

Formerly disgraced AG from New York and now resurrected from the dead Eliot Spitzer in a recent interview with finance blogger Henry Blodget declared an end to democratization of the market place. He had one advise for retail investors: Don’t play! (video)

Bloated and vague balance sheets of Goldman Sachs and others are testament to a culture on Wall Street hostile to a broad base of a public investment community. They want their game to be elitist and government and regulators have supported them in the past and will continue to do so also in the foreseeable future. Though we must fear that change is nothing but lip service.