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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

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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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sc

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.

Bernanke in a town-hall meeting, shopping for popularity

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bernankeintownhallmeeting

Last Sunday Ben Bernanke, chairman of the Federal Reserve responded to questions from the public in a town-hall style meeting. For the first time in history an acting Federal Reserve chair stepped into the arena that is usually the prerogative of obligations among elected officials. We truly live in interesting times.

What could have provoked this extraordinary move by the chairman given the daunting unpopularity of cumulative actions taken by the Fed in the last twenty four months? The answer is already given in the question. Ben Bernanke is shopping for popularity in order to better his approval ratings. His term as chairman ends in January 31, 2010, when he is up for reappointment by president Obama.

I can only imagine it must have been scary and embarrassing for the chief to step in front of the very same audience he led down over the course of the last ten years. He certainly did not mean to inflict any harm upon his fellow countrymen, but together with his predecessor Greenspan he helped lay the foundations of a shaky economy based on bubble economics.

Sure he gave birth to many millionaires and even some billionaires, but for most people Greenspan’s and Bernanke’s policies were rather harmful. Certainly one cannot expect any sensational outcome of such meetings with both a preselected audience and preselected questions. Organizers won’t let that happen though the chairman won’t suffer any lasting damages. It would have been nice though to read Bernanke’s mind.

To his defense the chairman admitted that he was disgusted from bailing out giant Wall Street firms like AIG, Bear Stearns or Merrill Lynch and rescuing them from going bankrupt. Though we certainly respect his wish not to reside over a second Great Depression, of course we have to believe him that there were no other options at the time. I might also add we are not yet with absolute certainty out of the woods with regard to another Great one.

Asked about his too-big-to-fail policy he seemed to indicate sympathy for the public’s frustration and promised to make it better in the future. Though his credibility was called into question by reiterating his opposition to an independent outside audit of the Fed. Why no audit if he has nothing to hide? Yes there is the issue of independence of the Fed, but just how much independence was there say in the last ten years?!

The Federal bank closest to Wall Street, and therefore in a special position with regard to the nation’s largest financial institutions, is the Federal Reserve Bank of New York. During the financial crisis Federal Reserve and Treasury Department officials made all major decisions, but the New York Fed executed them.

In the meantime the New York Fed has been criticized as too close to Wall Street. William Poole, a former Fed president, missed a longer-run perspective among the Fed’s staff. They adopted a trader mentality instead and did not pay enough attention to a system skewed towards too much risk taking by numerous bailouts of large Wall Street firms.

The Fed’s board of directors is composed of powerful bankers and corporate titans like Jamie Dimon, the head of JPMorgan Chase, and Jeffrey Immelt, General Electric’s chief. Richard Fuld had to resign after Lehman’s bankruptcy and Stephen Friedman called it quits over a conflict of interest with the other board he served, of investment power house Goldman Sachs. The corporate-federal officials network seems too tight to ever disintegrate.

It is not only the Federal Reserve that has to fear for its independence. The lobbying departments of large financial institutions have expelled their tentacles even into the Financial accounting Standards Board (FASB) of the United States and the International Accounting Standards Board (IASB) of Europe.

According to a recent report by an international team of former regulators and corporate officials, the Financial crisis Advisory Group deplored efforts by politicians to prescribe changes on accounting standards. The integrity of valued assets on the books of financial institutions should not be called into question in an effort to save those institutions from potentially harmful bets gone awry. In April, 2009, FASB already caved in to heavy financial lobbying and paused fair-value accounting rules for illiquid assets.

Beside all the regulatory and statutory powers bestowed on elected or appointed officials their most potent tool still remains the integrity of the person and organization in question. It is by no means sufficient for Fed chair Bernanke to communicate his objection to the bailouts on Wall Street even if it is within such an elaborate setting of a town-hall meeting. There is not enough meet on the bone to undo what has already happened.

A Gallop poll, conducted in mid-July, found that only 30% rated the Fed as doing an excellent/good job. The bank had the lowest score out of nine government agencies and it was down sharply from the 53% who still approved of the Fed’s job in 2003. This time even the CIA and the Internal Revenue Service scored better than the Fed. Bernanke will have to do better. It will most certainly be like walking a tightrope.

Hearing on Speculative Position Limits in Energy Futures Markets, July 29, 2009

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CLU9Sep09WTIcontract-andFFtarget

Donald Casturo, Managing Director, Goldman, Sachs & Co, in his opening testimony during the second day of hearings at the CFTC, blew into a familiar horn with respect to speculative actions in trading energy future contracts. Maybe so because of his position as head of trading and managing the commodity index business at Goldman or maybe it was just something that comes with the job as a trader.

In his defense Casturo referred to convergence at settlement of a future’s contract price with the spot price in a physically deliverable commodity like oil, as vital to well-functioning futures markets.Therefore prices in the future’s market are determined only by supply and demand fundamentals the same way spot prices are.

This makes a lot of sense under normal circumstances but we surely don’t live in normal times. The convergence argument does not take into account that fundamentals are not really that important considering the accommodative stance of the Federal Reserve. Who is going to take the other side when everybody and his cousin are assuming that the Fed will trash the dollar in order to revive an ailing financial industry? By doing so the Fed will increase commodity prices and inflation over the long run. After all that’s what they have done for the last thirty years.

From this it clearly follows that future prices can influence spot prices in such a way detached from market fundamentals. Excessive speculation therefore will drive the spot price in the direction of the shape of the futures curve. To pinpoint such a shift away from fundamentals is of course extremely difficult. Speculators seem to say we are innocent until proven guilty, and see their business in trading energy as legal.

CFTC and others might not be able to refute it but might recognize their illegitimate actions on the basis of common sense. I hope that the CFTC hearings will help them and the public to acknowledge today’s peculiar situation in energy markets and commodity trading in general and act accordingly as outlined in section 4a of the CEA  (Section 4(a) of the Commodity Exchange Act) to protect the public interest.

In order to illustrate this point I charted the monthly price of the front month WTI crude oil futures contract (CLU9) including FOMC decisions on the Fed Funds rate since 2006. The last of a series of restrictive steps was implemented in June 2006, FOMC raised interest rates by 25 basis points to 5.25 percent in that month. After that rates were kept steady at that level for more than a year. Over that time period the price of WTI oil was range bound between $60 and $80.

In September 2007, two months after two Bear Stearns hedge funds had defaulted, FOMC changed course and lowered their target rate by 50 basis points. During September for the first time ever the price of WTI cut through $80 threshold like a knife through butter. Unprecedented cumulative cuts of 125 basis points in January and 95 basis points in March and April the following year saw similar price jumps in WTI crude oil future contracts.

The price of oil kept increasing from about $85 at the end of 2007 to almost $150 in June of 2008 even though the economy was already in a severe recession as determined by NBER since the end of 2007. As one might argue that this was not recognized until many months later, unprecedented actions taken by the Federal Reserve should have proven otherwise. Speculators kept pouring money into commodities and were driving up prices to unsustainable levels.

During the CFTC hearing commissioner Bart Chilton was chastising the industry for their go slow attitude and reiterated CFTC’s commitment to swift action. He was particularly concerned with the London loophole and look-alike contracts traded on London futures markets. In the connection with hedge exemptions traders can buy and sell these OTC contracts on unregulated electronic exchanges with almost no position limits attached to them. These contracts were traded outside of the commissions oversight.

The policy debate according to Chilton is to find the right balance between the amount of commercial hedging and speculation. Within the CFTC he seems to be the driving force behind stronger regulation. In his statement he acknowledged the commission did not perform its due diligence function with as much zeal as it should have last year. No such words coming from chairman Gensler.

In fact there seems to be a rift between Gensler and Chilton on the role speculators played during the commodity bubble of 2008. In last years report CFTC blamed supply and demand fundamentals rather than speculators for the run up in oil prices. Chilton seemed to suggest that this year’s report would deviate from that view, but chairman Gensler merely talked about updating but not necessarily reversing the 2008 findings. CFTC will release the new report next month.

Tyson Slocum is Director of Public Citizen’s Energy Program, an organization that supports the public in helping to ensure households have access to competitive priced energy markets. In doing so they are vitally interested in functioning energy markets and fair prices. Public Citizen is neither funded by the government nor by the corporate sector.

Slocum’s independence represented the true public view on the issue of energy prices, which should be determined only by supply and demand fundamentals. He suggested to the CFTC to implement: 1) aggregate position limits across all energy products and markets for all index traders, swaps dealers and proprietary traders. 2) increased transparency of OTC contracts and clearing them through a CFTC controlled exchange. 3) investigation of potential market integrity concerns.

The Intercontinental Exchange (ICE) according to Slocum operates OTC and Exempt Commercial markets (ECM), both are not effectively regulated by CFTC, yet their overall market penetration has exploded in the last couple of years. ICE’s electronic exchange volume increased 567% from 2004 to 2008 (from 35 million contracts to 237 million) and the company’s OTC platform has seen volume grow 700%, from 31 million contracts in 2004 to 247 million in 2008.

Major investment firms like Goldman Sachs, JP Morgan Chase/Bear Stearns, Morgan Stanley, Citigroup and Bank of America/Merrill Lynch invest in commodity index funds by buying huge amounts of energy and other commodities future contracts in OTC markets. The same firms hedge their exposure to these markets in offsetting portfolios of future contracts on regulated exchanges. These hedges are very often exempt from position limits. Since many firms operate index funds and at the same time function as swap dealers they manage to evade CFTC regulation not once but twice through OTC markets and hedge exemptions.

GS operates the long only GSCI index fund, with 65% of its 24 commodities being in the energy space and only 25% in agricultural commodities. The CME has a 20000 contracts hedge exemption on the GSCI index fund. When GS radically changed the weighting of the index in the summer of 2006, selling about $6 billion worth of gasoline futures contracts, future prices fell by nearly 10 percent.

To gain inside into physical movements of energy products large energy traders like Goldman Sachs are acquiring energy infrastructure assets like pipelines and storing facilities or in some cases even outright oil and gas fields. Highbridge Capital Management, a hedge fund controlled by JP Morgan Chase, bought a stake in oil and natural gas trader Louis Dreyfus Group. As of November 2008  Morgan Stanley paid $452 million to lease storage facilities for 2009. In January 2009, investment banks like Morgan Stanley and Citigroup stored about 80 million barrels of oil in takers at sea. According to a Wall Street Journal report financial speculators were snapping up leasing rights in Cushing, the most important delivery point of physical crude in North America.

In August 2006, Goldman Sachs, AIG and Carlyle/Riverstone took over pipeline operator Kinder Morgan for $22 billion, thereby controlling 43,000 miles of crude oil, refined products and natural gas pipelines, in addition to 150 storage terminals. In 2005, Goldman Sachs and private equity firm Kelso & Co. bought a 112,000 barrels/day oil refinery in Kansas operated by CVR Energy. In May 2004, Goldman spent $413 million to acquire royalty rights to more than 1,600 natural gas wells in Pennsylvania, West Virginia, Texas, Oklahoma and offshore Louisiana from Dominion Resources.

Goldman Sachs owns a six percent stake in the 375-mile Iroquois natural gas pipeline, which runs from Northern New York through Connecticut to Long Island. In December 2005, Goldman and Carlyle/Riverstone together invested $500 million in Cobalt International Energy, an oil exploration firm.

During yesterday’s hearings senator Sanders characterized the situation in the financial industry as heads, bankers win; tails, everyone else loses. Looking at the vast increase in scope of energy specs, their many loopholes in electronic exchanges where thousands of contracts are evading CFTC regulation with the speed of light, or the explosion of hedge exemptions to those very same traders that are fleeing into the dark pools of OTC markets, makes me think he is on to something.

The goal has to be to avoid extreme volatility in energy and other commodity prices for the sake of the common good. To achieve this we must implement Tyson Slocum’s suggestions and constitute strict aggregate position limits, close all possible loopholes and absolutely assure market integrity. In the nearby future big investment firms like GS and Morgan Stanley have to make a decision, whether they want to continue their lucrative trading venues or switch to the physical part of the commodity business. Either commercial or non-commercial, we should not allow this huge firms to be both at the same time.

Is CRE the next accident to happen?

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Commercial real estate is shaping up to become another causality of the financial crisis and CRE mortgage delinquencies and loan defaults are now starting to pile up on the balance sheets of US financial institutions. That is of course on top of losses from residential real estate, consumer credit and the securitization markets that sort of connect all the sore spots on Wall Street.

$817 billion of total CRE-loans are still outstanding in June, 2009, and about 29 billion have run into trouble. In the month of June loan delinquencies soared by $10 billion heating up the debate about future CRE losses by financial institutions.

But that’s not all. About $105 billion worth of troubled loans have been worked out. A majority of those loans experienced an averaged loss of almost 64 percent. Delinquency rates on CRE are up to 4.5 percent in the second quarter from 3.6 percent in the first quarter, 2009.

Similar to residential real estate CRE property prices have also collapsed. Moodys/REAL Commercial Property Price Index (CPPI) has not bottomed as of April 2009:

CREallPropertynationalindex

In CRE much like with residential real estate many loans have been securitized and actual losses to financial institutions and investors will therefore depend largely on two conditions. First, the total amount of loan defaults will be substantial given the collapse in prices. Second, FASB statements 166 and 167 will determine how big the losses are or if they can be deferred onto some future time horizon.

FASB statements 166 and 167 refer to securitized loans in special purpose entities, and require banks to consolidate insufficiently capitalized SPEs onto their balance sheets. Although this should foster more disclosure for investors its impaired with whims of possible rule-bending.

FASB determination to implement these rules is another uncertainty factor. In April, 2009 FASB halted fair value accounting to stop the hemorrhaging of impaired financial assets. Statements 166 and 167 are supposed to take effect in the first fiscal quarter beginning after November 15, 2009.

Some are already preparing for the worst. Bank of America now expects to bring about $150 billion back onto its balance sheet under the new FASB rules. This 150 billion off-balance-sheet assets comprise of $12 billion home equity conduits, $85 billion card securitizations, and other variable interest entities make up the remaining $53 billion. Maybe BofA is just lucky.