David Fiderer’s below piece, originally published on the Huffington Post, continues probing the topic of Goldman and AIG. For all intents and purposes the debate has been pretty much exhausted and if there was a functioning legal system, Goldman would have been forced long ago to pay back the cash it received from ML-3 (which in itself should have been long unwound now that plans to liquidate AIG have been scrapped) and to have the original arrangement reestablished (including the profitless unwind of AIG CDS the firm made improper billions on, by trading on non-public, pre-March 2009, information), and now that AIG is solvent courtesy of the government, so too its counterparties can continue experiencing some, albeit marginal, risk, instead of enjoying the possession of cold hard cash. Oh, and Tim Geithner would be facing civil and criminal charges.

Yet as we look forward, we ask, who now determines the variation margin on Greek CDS (and Portugal, and Dubai, and Spain, and, pretty soon, Japan and the US), the associated recovery rate, and how much collateral should be posted by sellers of Greek protection? If Greek banks, as the rumors goes, indeed sold Greek protection, and, as the rumor also goes, Goldman was the bulk buyer, either in prop or flow capacity, it is precisely Goldman, just like in the AIG case, that can now dictate what the collateral margin that Greek counterparties, and by extension the very nation of Greece, have to post on billions of dollars of Greek insurance. Let’s say Goldman thinks Greece’s debt recovery is 75 cents and the CDS should be trading at 700 bps, instead of the “prevailing” consensus of a 90 recovery and 450 spread, then it will very likely get its way when demanding extra capital to cover potential shortfalls, since Goldman itself has been instrumental in covering up Greece’s catastrophic financial state and continues to be a critical factor in any future refinancing efforts on behalf of Greece. Obviously this incremental margin, which only Goldman will ever see, even if the CDS was purchased on a flow basis, will never be downstreamed on behalf of its clients, and instead will be used to [buy futures|buy steepeners|prepay 2011 bonuses|buy more treasuries for the BONY $60 billion Treasury rainy day fund].

In essence, through its conflict of interest, its unshakable negotiating position, and its facility to determine collateral requirements and variation margin, Goldman can expand its previous position of strength from dictating merely AIG and Federal Reserve decision making, to one which determines sovereign policy! This is unmitigated lunacy and a recipe for financial collapse at the global level.

This is yet another AIG in the making, with
Goldman this time likely threatening to accelerate the collapse not
merely of the US financial system, but of the global one, in order to
attain virtually infinite negotiating leverage. Of course, the world will not
allow a Greece-initiated domino, allowing Goldman to call everyone’s bluff once again.

As the amount of gross and net sovereign CDS notional is constantly increasing, as more and more hedge funds join the shorting fray with Goldman as the intermediate (just like in AIG), it behooves any remaining regulators and any sensible Federal Reserve parties to supervise precisely what the terms of Goldman’s collateral margins with various sovereign debt sellers are, especially when it pertains to increasingly distressed CDS, where a liquidity squeeze, again as in the AIG case, would have tremendous adverse downstream consequences. If indeed Goldman’s counterparties are the banks of respective countries, then the parallels with AIG are nearly complete. And we all know what happened then.

Furthermore, we are now convinced that Goldman will join the government in facilitating the engineered market swoon with a bifurcated goal: while the Treasury will take advantage of a sell off to offload as many UST as it can in the rush for safety (which could backfire now that Gold is increasingly seen as a dollar alternative), Goldman (with or without Warren Buffett - it depends on what the actuarial tables say) will jettison its own stock price in order to go private in an increasingly hostile world.

We will discuss all these issue further in the near future, and in the meantime David Fiderer provides yet another nail in the AIG-Goldman coffin.

 

 

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The Times Story on Goldman’s Role In AIG’s Downfall Is More Damning When Placed In Context

 

Placed in a broader context, the front page story The New York Times,
is even more damning of Goldman Sachs than readers might realize.
Goldman played an active role in the destruction of AIG. During Hank
Paulson’s tenure as the firm’s CEO, Goldman engaged in a series of sham
transactions designed to give the false impression that it was buying
credit default swaps as an instrument for risk management. In fact, it
acquired those swaps in order to double down on bets against
collateralized debt obligations, or CDOs, which it knew to be fatally
flawed. In the latter part of 2008, Paulson and his proxies maneuvered
AIG into a liquidity crisis in order to protect Goldman at the expense
of the U.S. taxpayer.

To appreciate how the Times piece fits into a larger picture, you need to understand why these CDOs were so obviously toxic.

The Fatal Flaw Of These CDOs

AIG went bust because it sold credit default swaps for CDOs stuffed
with slices of subprime mortgage bonds. Those subprime mortgage bonds
all had remarkably similar capitalization structures, divided among
different classes, or tranches, of seniority. The top 80% in seniority
had a credit rating of AAA. The bottom 10% was rated A and below.

The bottom 10% was especially vulnerable because of something that
was an open secret at the time. The subprime mortgage market was
riddled with fraud. So the data used by Goldman and others to structure
these bond deals was highly suspect.

Who bought the bottom 10% of these subprime bond deals? A lot of
those lower-rated tranches were not sold directly to investors. Rather
they were stuffed into CDOs. This point is critical. These CDOs were
not comprised of mortgage loans, or even slices of mortgage loans.
Rather, they held deeply subordinated claims on risky subprime
mortgages. Because these tranches were the last ones to get repaid, it
was easy to foresee, at the time these CDOs were put together, that
investors would lose significant amounts of principal.

People marketing these CDOs claimed that they were safe, because the
risks were diversified, and because of excess collateral cover. But
that line of reasoning never made any sense. The lower rated tranches
were like the passengers in steerage on the Titanic. Once the ship
starting sinking, those passengers were the last ones given access to
the lifeboats. As soon as the housing market started sinking, those
lower-rated tranches would be the last ones given access to any
foreclosure proceeds.

AIG thought it was selling credit protection for AAA risk. And in
fact, these CDOs, like subprime mortgage bonds, were tranched in a way
that made them top heavy with AAA ratings. Consider, for example, for Adirondack 2005-2,
a CDO arranged by Goldman, which “sold” almost all of the AAA tranche
Societe Generale, which in turn bought credit protection from AIG. Of
Adirondack 2’s $1.55 billion capitalization, $1.42 billion, or 91%, was
rated AAA.

So how could anyone get comfortable with the notion that 90% of a
portfolio, heavily weighted with deeply subordinated claims on risky
mortgages that were likely to be infected with fraud, represented a
AAA-quality credit risk? It’s a question for which there is no good
answer. If anyone looking at these deals had done proper due diligence
and done a common-sense analysis of the structural risks, he would have
realized three things:
1. The original credit ratings for lower-rated slices of these subprime bond deals were meaningless;
2. The original credit ratings on these CDOs were even more meaningless; and
3. The CDOs were destined in fail in a big and obvious way.

Goldman’s Malign Intent

Obviously, the people at AIG never figured out what was going on
until it was too late. But there’s a mountain of circumstantial
evidence that the people at Goldman had a keen grasp of the fatal flaws
of these CDOs, which they structured. The Times piece is a major addition to that mountain of evidence:

[Former AIG executive Alan] Frost cut many of his deals
with two Goldman traders, Jonathan Egol and Ram Sundaram, who had
negative views of the housing market. They had made A.I.G. a central
part of some of their trading strategies.

Mr. Egol structured a group of deals — known as Abacus — so
that Goldman could benefit from a housing collapse. Many of them were
actually packages of A.I.G. insurance written against mortgage bonds,
indicating that Mr. Egol and Goldman believed that A.I.G. would have to
make large payments if the housing market ran aground. About $5.5
billion of Mr. Egol’s deals still sat on A.I.G.’s books when the
insurer was bailed out.

“Al probably did not know it, but he was working with the bears of
Goldman,” a former Goldman salesman, who requested anonymity so he
would not jeopardize his business relationships, said of Mr. Frost. “He
was signing A.I.G. up to insure trades made by people with really very
negative views” of the housing market.

As further evidence that Goldman used AIG to profit by shorting CDOs, rather than to manage its preexisting risk exposure:

[N]egotiating with Goldman to void the A.I.G. insurance was
especially difficult, Federal Reserve Board documents show, because the
firm did not own the underlying bonds. As a result, Goldman had little
incentive to compromise.

Goldman’s seven Abacus deals [Abacus 2004-1, Abacus 2004-2, Abacus
2005-2, Abacus 2005-3, Abacus 2005-CB1, Abacus 2006-NS1, Abacus
2007-18] were unique among all the CDOs in AIG’s portfolio. For all the
other deals, the collateral manager, the entity that oversaw and
managed the CDO after closing, was entirely independent from the bank
that originally arranged and structured the transaction. For all the
Abacus deals, Goldman acted both as both the arranging bank and the
collateral manager. This is no small technicality. In other Abacus
deals, Abacus 2006-13 and Abacus 2006-17, Goldman used its “sole discretion”
to retire lower rated CDO tranches without regard to seniority. This
approach, under documentation drafted by Goldman, upends the entire
premise of structured finance.

Most importantly, the government never purchased the Abacus deals when
it bought $62.1 billion other CDOs at par, back in November 2008. Why
didn’t the parties feel a need to take the Abacus deals off of AIG’s
balance sheet? It’s an extremely important question, for which we will
not have an adequate answer until we see the actual documentation,
specifically: the offering memoranda, the performance reports and swap
agreements.

Hiding Behind Societe Generale

The Times story also suggests that Goldman used Societe
Generale as a front, to conceal from Frost and others the size of their
cumulative bet against these CDOs.

Mr. Sundaram’s trades represented another large part of
Goldman’s business with A.I.G. According to five former Goldman
employees, Mr. Sundaram used financing from other banks like Societe
Generale and Calyon to purchase less risky mortgage securities from
competitors like Merrill Lynch and then insure the assets with A.I.G.
– helping fatten the mortgage pipeline that would prove so harmful to
Wall Street, investors and taxpayers. In October 2008, just after
A.I.G. collapsed, Goldman made Mr. Sundaram a partner.

Through Societe Generale, Goldman was also able to buy more
insurance on mortgage securities from A.I.G., according to a former
A.I.G. executive with direct knowledge of the deals. A spokesman for
Societe Generale declined to comment.

It is unclear how much Goldman bought through the French bank, but
A.I.G. documents show that Goldman was involved in pricing half of
Societe Generale’s $18.6 billion in trades with A.I.G. and that the
insurer’s executives believed that Goldman pressed Societe Generale to
also demand payments…On Nov. 1, 2007, for example, an e-mail message
from Mr. Cassano, the head of A.I.G. Financial Products, to Elias
Habayeb, an A.I.G. accounting executive, said that a payment demand
from Societe Generale had been “spurred by GS calling them.”

As noted earlier in the story:

In addition, according to two people with knowledge of the
positions, a portion of the $11 billion in taxpayer money that went to
Societe Generale, a French bank that traded with A.I.G., was
subsequently transferred to Goldman under a deal the two banks had
struck.

See here for an analysis of the ten-figure purchases and sales between Goldman and SG.

The AAA Pyramid Scheme Embedded Inside AIG

The Times reports that Goldman tailored the terms of the swaps to exploit these defective credit ratings:

The terms, described by several A.I.G. trading partners,
stated that A.I.G. would post payments under two or three
circumstances: if mortgage bonds were downgraded, if they were deemed
to have lost value, or if A.I.G.’s own credit rating was downgraded. If
all of those things happened, A.I.G. would have to make even larger
payments.

Here’s an example of how terminology for a general news readership can lead to confusion. In the context of the story, the Times
seems to be referencing the ratings of the CDOs, not the subprime bonds
held by the CDOs. The distinction is critical because almost all
subprime bonds were downgraded in 2007, whereas most of these CDOs were
not downgraded prior to May 2008, when they received minor downgrades.

Most importantly, almost all these CDO tranches were rated AAA during November 2007, when, as the Times
reports, Goldman was demanding billions in cash collateral. There is no
way to reconcile a 40% diminution of value, which Goldman repeatedly
asserted, with a AAA rating. It’s like saying 2 + 2 = 11. In effect,
Goldman was admitting that the CDOs’ ratings were a joke.

It was an especially cruel joke on AIG and on the American taxpayer.
If the ratings agencies had severely downgraded the CDOs in 2007 or
earlier in 2008, AIG’s day of reckoning would have come sooner.
Instead, that day coincided with Lehman’s bankruptcy. The ratings
agencies announced their major downgrades of AIG after the close of
business on September 15, 2008. Those downgrades triggered cash
collateral calls and on AIG on September 16, 2008, the same day that a
money market fund, which wrote down Lehman paper, broke the buck and
triggered widespread panic in the money markets.

As noted before, the timing of the CDO downgrades looks suspicious. Eric Kolchinsky, a former managing director at Moody’s, has alleged
that the ratings agency deliberately and deceitfully delayed the
announcements of downgrades of various CDOs. The House Oversight
Committee is still investigating the matter.

Why Goldman Pressured AIG to Hand Over Cash

The thrust of the front-page Times article was that Goldman
aggressively pressured AIG to hand over cash collateral beginning in
2007, Goldman asserted, because, the CDOs “were deemed to have lost
value.” But negotiations were always at an impasse, for an obvious
reason. There was no way to settle on agreed-upon “market value” for
the CDOs. These securities weren’t bought or sold, like Treasuries or
shares of IBM. Nor was there any market benchmark upon which the CDOs
could be valued. The only way to set a price, according to auditors for
AIG and the Federal Reserve, was according to internal valuation models.

The Times reports:

[D]ocuments show there were unusual aspects to the deals
with Goldman. The bank resisted, for example, letting third parties
value the securities as its contracts with A.I.G. required. And Goldman
based some payment demands on lower-rated bonds that A.I.G.’s insurance
did not even cover. A November 2008 analysis by BlackRock, a leading
asset management firm, noted that Goldman’s valuations of the
securities that A.I.G. insured were “consistently lower than
third-party prices.”

The Times reporting suggests that Goldman wanted to control
the dispute by using a nominally independent third party,
PricewaterhouseCoopers, which had shifted into Goldman’s camp:

Adding to the pressure on A.I.G., [David] Viniar, Goldman’s
chief financial officer, advised the insurer in the fall of 2007 that
because the two companies shared the same auditor,
PricewaterhouseCoopers, A.I.G. should accept Goldman’s valuations,
according to a person with knowledge of the discussions. Goldman
declined to comment on this exchange.

Pricewaterhouse had supported A.I.G.’s approach to valuing the
securities throughout 2007, documents show. But at the end of 2007, the
auditor began demanding that A.I.G. provide greater disclosure on the
risks in the credit insurance it had written. Pricewaterhouse was
expressing concern about the dispute.

The insurer disclosed in year-end regulatory filings that its
auditor had found a “material weakness” in financial reporting related
to valuations of the insurance, a troubling sign for investors.

Of course, a highly plausible explanation is that Pricewaterhouse,
like AIG, had assumed that the CDOs’ AAA ratings were credible, until
Goldman set them straight. But again, this gets back to the issue of
whether Goldman knew these deals were toxic from the start. Goldman
opposed proposals that would have enabled it to make its case to others:

When A.I.G. asked Goldman to submit the dispute to a panel
of independent firms, Goldman resisted, internal e-mail messages show.
In a March 7, 2008, phone call, Mr. Cassano discussed surveying other
dealers to gauge prices with Michael Sherwood, Goldman’s vice chairman.
At that time, Goldman calculated that A.I.G. owed it $4.6 billion, on
top of the $2 billion already paid. A.I.G. contended it only owed an
additional $1.2 billion.

Mr. Sherwood said he did not want to ask other firms to value the
securities because “it would be ‘embarrassing’ if we brought the market
into our disagreement,” according to an e-mail message from Mr. Cassano
that described the call.

The Goldman spokesman disputed this account, saying instead that
Goldman was willing to consult third parties but could not agree with
A.I.G. on the methodology.

The dispute would have been more than embarrassing for Goldman. It
would have shed light on the fatal flaws of these CDOs, which, at the
time, were not known to the broader financial community. These flaws
were not known because so few parties took a serious look at the credit
risk, which was largely assumed by a handful of companies: AIG
Financial Products (under a guarantee by its parent) and the monoline
insurance companies. In early 2008, the monolines started settling
their contingent CDO obligations for a fraction of par. As noted earlier,
they were able to do so because they had the backing of their
regulators. AIGFP, which was unregulated, was on its own. Ever
prescient, Goldman never bought credit protection from the monolines.

Goldman did not “own” the cash it held. Rather, the cash represented
margin that could, in theory, be returned to AIG if the CDOs’ value
rose again. Of course, in reality, if you hold the cash you have the
upper hand in any negotiation. Also, the way structured finance deals
work, if early credit losses are worse than expected, the diminution of
value is permanent. The other borrowers in the pool, who never pay more
than 100% of their principal and interest, won’t make up the
difference. Finally, as noted before,
the cash collateral for derivatives, like credit default swaps, is very
different than the cash collateral for a loan or other obligation.
Goldman’s claims had preferred treatment, another reason why, once it got its hands on the cash, it held the upper hand in any negotiation.

How Hank Paulson Used Proxies to Rig the Eventual Outcome

One thing is as certain as death and taxes. During 2007 and 2008
Edward Liddy was repeatedly briefed, at length, by Pricewaterhouse and
by senior management at Goldman, about the firm’s CDO exposure with AIG
and about the valuation dispute. If the matter was so important that
Goldman’s CFO and vice chairman took an active role in negotiating the
circumstances for simply attempting to resolve the dispute, then Ed
Liddy thoroughly understood the matter and the stakes that were
involved. This will all come out when Liddy’s briefing books, and other
related documentation and correspondence, are obtained by the House
Oversight Committee, which is investigating this matter.

Liddy was the Chairman of the Audit Committee
on Goldman’s Board of Directors. Every audit committee of the board of
every publicly held financial institution is briefed in depth about
risk concentrations at the firm. There is no way that Pricewaterhouse
would leave itself exposed by not thoroughly briefing Liddy about these
matters. While it may be a part-time obligation, being Chair of the
Audit Committee at Goldman is a very important job. And during one
all-important week, Liddy did some moonlighting.

A few minutes after he spoke with Goldman’s CEO, Lloyd Blankfein, on
September 16, 2008, and shortly after he first considered a government
bailout of AIG, Hank Paulson unilaterally decided that Liddy should
immediately become AIG’s new CEO. Unlike Liddy, AIG’s CEO at the time,
Bob Willumstad, had relatively clean hands in the CDO saga. Willumstad
had been part of AIG’s management for about three months, and had
joined the AIG board in April 2006, when most of Goldman’s toxic CDOs
had already been insured by AIG.

That same afternoon, Liddy was on a plane to New York, to start at AIG the next day. Liddy was officially made CEO and Chairman of AIG on September 18. And of course, he immediately immersed himself into negotiating the terms of the government bailout facility, which he signed on September 22. Only on the following day, on September 23, 2008, that Liddy chose to make his resignation from Goldman’s board effective.

That was also the week when Paulson spoke to Blankfein 24 times by phone. For further clarification at to why it an innocent explanation of all this is beyond any realm of plausibility, see this earlier piece.

“Who the heck is Dan Jester?” asked Times Opinionator columnist William D. Cohen,
who answered his own question last week. Jester was the former Goldman
deputy CFO who was plucked by Treasury Secretary Paulson in the summer
of 2008 to act as his “contractor,” i.e. someone for whom usual
formalities pertaining to government accountability would not apply.
But Tim Geithner made more calls to Jester, during the fall of 2008, than to any other bona fide Treasury employee, with the exception of Hank Paulson. Cohen writes:

One former A.I.G. executive told me that Jester was calling
many of the shots at the insurer between mid-September, when the New
York Fed decided to go ahead with the bailout, and the end of October
2008, when Jester was replaced at A.I.G. by another Treasury official
because, according to The New York Times, of Jester’s
“stockholdings in Goldman Sachs.” “He was Paulson’s man,” the former
A.I.G. executive told me. “He was the Treasury’s representative, and he
was at every meeting” during that mid-September weekend.

One of the shots being called during that period was the decision for AIG to hand over $18.7 billion in scarce cash to the CDO counterparties in exchange for zero concessions.

At one point, on the following Monday, Sept. 15, as the
A.I.G. situation was spiraling out of control, Jester phoned the three
major credit-rating agencies and asked them to hold off from
downgrading A.I.G. any further, since that additional downgrade would
force the insurer to make even more collateral payments on the spot to
counterparties, further depleting its dwindling cash. Jester’s efforts
weren’t persuasive. “It was pathetic,” the former A.I.G. executive told
me.

There are many people who do not know how to speak forcefully and
effectively to the rating agencies, but that group would not include a
former deputy CFO from Goldman. It would be somewhat analogous to Katie
Couric getting flustered when asked to read a teleprompter. There is no
way that the agencies could have been aware of AIG’s difficulties and
not have been equally aware of their own role in contributing to those
difficulties. Nor could they have been unaware that a downgrade would
trigger AIG’s liquidity crisis. On the same day that the markets were
absorbing the shock from the Lehman bankruptcy, if the government asks
the agencies to wait just a bit longer to see how the evolving
situation plays out with regard to delicate negotiations for a private
bank deal to provide new liquidity for AIG, the agencies would
ordinarily be inclined to pause for a bit.

For those and other reasons,
I believe Jester’s feeble performance was deliberate, that the endgame
was to trigger a liquidity crisis at AIG in order to force a government
bailout, which would be a backdoor bailout of Goldman. The House
Oversight Committee should review Jester’s public and private emails
and phone records to get more clarity on this point.

As Paulson wrote in his new book,
“Much of my work was done on the phone, but there is no official record
of many of the calls. My phone log has many inaccuracies and
omissions.” Why would the electronic records of his phone calls be
inaccurate, or have any omissions? It’s the sort of disclaimer Dick
Cheney would give.

by Tyler Durden via zero hedge
http://www.zerohedge.com/article/ever-increasing-parallels-between-aig-and-greece-and-cds-puppetmaster-behind-it-all

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Remarks at the Reserve Bank of Australia’s 50th Anniversary Symposium, Sydney, Australia

The U.S. Financial System: Where We Have Been, Where We Are and Where We Need to Go

by William C. Dudley

Today, my remarks will focus on the U.S. and global financial systems:

• What went wrong to produce the worst financial crisis in the past 70 years?
• Where are we now?
• What should be our top priorities to ensure that this never happens again?

As always, my views are my own and do not necessarily reflect those of the Federal Open Market Committee or the Federal Reserve System.

With respect to what went wrong, it is important to recognize that the financial crisis occurred for a host of reasons and, thus, there is no single silver bullet to avoid such crises in the future. At the heart of the crisis was a tremendous buildup in leverage, which our regulatory framework failed to prevent. Large amounts of opaque, illiquid, long-term assets were financed by short-term liabilities, and much of this financing occurred in the shadow banking system. When the housing bubble burst, financial asset prices fell and exposed the deep linkages and overall fragility of our system. Interbank funding markets seized up, the shadow banking system crumpled and several major financial firms—banks and nonbanks alike—collapsed or approached the brink of collapse. Extraordinary interventions of governments and central banks around the world were necessary to prevent a complete collapse of the financial system and the broader economy.

As a general matter, regulators did not appreciate beforehand how vulnerable the system was to shocks. In particular, there was a failure to appreciate the important interconnections among the banking system, capital markets, and payment and settlement system. For example, the disruption of the securitization markets caused by the poor performance of highly rated debt securities led to significant problems for major financial institutions. These banks had to take assets back on their books, backstop lines of credit were triggered, and banks could no longer securitize loans, thus increasing the pressure on their balance sheets. This reduced credit availability, which increased the downward pressure on economic activity, which caused asset values to decline further, and in turn, increased the degree of stress in the financial system.

Moreover, regulators did not adequately understand how the dynamics of the system tended to exacerbate shocks, rather than dampen their impact. For example, with respect to capital, firms under stress had incentives to continue to pay dividends to show that they were strong. These dividend payments actually depleted capital, making the firms weaker and vulnerable to credit rating downgrades. When credit ratings were indeed cut, that increased collateral calls, which intensified the pressure on scarce liquidity resources.

Regulatory gaps were another important factor in causing the crisis. American International Group, Inc. (AIG) is a case in point. AIG Financial Products, a subsidiary of the AIG parent company, provided guarantees against default on complex collateralized debt obligations, leveraging the AAA rating of the AIG parent company in the process. This activity was conducted with inadequate regulatory oversight, poor risk management and insufficient capital.

Finally, many of the incentives built into the system ultimately undermined its stability. The problems with incentives were evident in a number of areas, including faulty compensation schemes and risk management that was too narrowly focused on one business area without regard for the broader entity. These incentives created important externalities in which participants did not bear the full costs of their actions.

Turning to where we are now, the U.S. financial system is in much better shape today than it was a year ago. The capital markets are generally open for business—with the important exception of some securitization markets—and the major securities dealers that survived the crisis have seen a sharp recovery in profitability. The largest U.S. bank holding companies, which went through the Supervisory Capital Assessment Program exercise, have more and better quality capital, having raised more than $100 billion of common equity over the past year in the capital markets and generated nearly as much common equity via preferred stock conversions and from gains on asset sales.

However, many smaller and medium-sized banks remain under significant pressure. This reflects several factors. First, such institutions hold assets that are carried mainly on the books on an accrual basis. Compared with mark-to-market assets, such assets adjust much more slowly to changes in market conditions and the economic environment. Second, many of these banks have a much more concentrated exposure to commercial real estate, a sector that remains under considerable pressure. Not only have capitalization rates risen sharply—meaning the investors will pay much less for a dollar of rental income than before—but the rental income streams on these properties also have declined as the performance of the U.S. economy has declined. Together, these two factors have pushed U.S. commercial real estate prices down by about 40 percent to 50 percent from the peak reached in 2006. Loan losses in commercial real estate and consumer and mortgage loans seem likely to continue to pressure smaller banks for some time to come. This in turn means that credit availability to households and small businesses will still be curtailed.

The improvement in the overall health of the financial system and in market function has allowed the Federal Reserve to phase out many of the special liquidity facilities that were enacted in response to the crisis. These facilities were generally successful in achieving their objectives—helping to restore confidence and rebuild market liquidity in a way that safeguarded the taxpayers’ interests. When a full accounting of the special liquidity facilities is complete, it seems likely that the facilities will have generated substantial incremental earnings that the Federal Reserve will remit to the Treasury. Although these incremental earnings were not the objective of these facilities, they are a pleasant outcome relative to the alternative.

As the crisis has abated, our attention has shifted to what we need to do to prevent another crisis in the future. We need to take the necessary steps to build a strong and resilient financial system. In my opinion, three broad sets of actions are needed:

• Effective macroprudential supervision. By this, I mean conducting supervision not just vertically institution by institution, but also horizontally across institutions and markets. We need to better understand how the system operates as a whole and how problems in one area can affect financial stability elsewhere. This means both how the overall system affects individual firms and how the activities of a single firm or market affects the entire financial system.
• Make financial institutions and market infrastructures more robust to withstand shocks and become less prone to failure.
• Change the system so that no financial firm is “too big to fail.”

Macroprudential supervision is essential for two reasons. First, it addresses the problem of gaps in the regulatory regime and the regulatory arbitrage that such gaps can encourage. Second, macroprudential supervision is needed because the financial system is interconnected. Siloed regulatory oversight is not sufficient. Supervisory practices must be revamped so that supervision is also horizontal—looking broadly across banks, nonbanks, markets and geographies. This also means that regulatory standards need to be harmonized across different regions. Without harmonization, there will inevitably be a “race to the bottom” and regulatory arbitrage will be encouraged, rather than inhibited.

Many steps are needed to make financial institutions and infrastructure more robust. For example, we need to strengthen bank capital requirements, improve liquidity buffers and make financial market infrastructures more resilient to shocks when individual firms get into trouble.

In terms of capital requirements, many changes are needed, including global capital standards that put more emphasis on common equity, establish an overall leverage limit and better capture all of the sources of risk in the capital assessment process. Improved risk capture, for example, includes the trading accounts of banks. Some institutions had clearly not set aside adequate levels of capital given the risks that were embedded in their trading positions.

It would also be very desirable to develop a mechanism to bolster the amount of common equity available to absorb losses in adverse economic environments. This might be done most efficiently by allowing the issuance of debt instruments that would automatically convert to common equity in stress environments, under certain pre-specified conditions. Such “contingent capital” instruments might have proven very helpful had they been in place before and during this crisis. Investors would have anticipated that common equity would be replenished automatically if a firm came under stress, and this knowledge might have tempered anxieties about counterparty risk. At a minimum, contingent capital instruments might have enabled common equity buffers at the weaker firms to be replenished earlier and automatically, thereby reducing uncertainty and the risk of failure.

On the liquidity front, there are a host of initiatives underway. The Basel Committee on Banking Supervision is working on establishing international standards for liquidity requirements. There are two parts to this. The first is a requirement for a short-term liquidity buffer of sufficient size so that an institution that was shut out of the market for several weeks would still have sufficient liquidity to continue its operations unimpaired. The second is a liquidity standard that limits the degree of permissible maturity transformation—that is, the amount of short-term borrowing allowed to be used in the funding of long-term illiquid assets. Under these standards, a firm’s holdings of illiquid long-term assets would need to be funded mainly by equity or long-term debt.

With respect to financial market infrastructures, the Federal Reserve is working with a broad range of private-sector participants, including dealers, clearing banks and tri-party repo investors to dramatically reduce the structural instability of the tri-party repo system. Similarly, over-the-counter (OTC) derivatives clearance activity is being pushed toward central counterparties and exchanges. In addition, the Federal Reserve and others are evaluating how greater transparency with respect to OTC derivatives prices would improve financial stability. The Committee on Payment and Settlement Systems and the Technical Committee of the International Organization of Securities Commissions are doing a review of standards for payment, clearing and settlement systems. This work will inform the efforts of the Financial Stability Board to strengthen such standards.

There is also work underway on the problem of how to ensure that financial institutions have compensation structures that curb rather than encourage excessive risk-taking.

Finally, it is critical that we ensure that no firm is too big to fail. This is about both fairness and having proper incentives in the financial system. Having some firms that are too big to fail creates moral hazard. These firms are able to obtain funding on more attractive terms because debt holders expect that the government will intervene rather than allow failure. In addition, too big to fail creates perverse incentives. In a too-big-to-fail regime, firms have an incentive to get large, not because it facilitates greater efficiency, but instead because the implicit government backstop enables the too-big-to-fail firm to achieve lower funding costs.

To solve the too-big-to fail problem, we need to do two things. First, we need to develop a truly robust resolution mechanism that allows for the orderly wind-down of a failing institution and that limits the contagion to the broader financial system. This will require not only domestic legislation, but also intensive work internationally to address a range of legal issues involved in winding down a major global firm.

Second, we need to reduce the likelihood that systemically important institutions will come close to failure in the first place. This can be done by mandating higher capital requirements, improving the risk capture of those requirements and by requiring greater liquidity buffers for such firms.

Although the raging crisis appears to be over, our work is not close to being complete. Making sure this work keeps moving forward and is coordinated internationally is hugely important. Differences in views across countries and regions should not divert the international community from the more important prize—taking the actions collectively that will ensure a robust and resilient financial system.

by Tyler Durden via zero hedge
http://www.zerohedge.com/article/remarks-bill-dudley-australia-dodecatuple-secret-banker-meeting-where-we-have-been-where-we-

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A Bureau of Labor Statistics Study found the median amount saved in retirement plans was just $2000, so this is a serious subject folks.
http://www.bls.gov/opub/cwc/print/cm20050114ar01p1.htm

A lot of people may be counting on government benefit entitlements paid into at a 15.2% wage rate may not be there for them in real terms when they retire or get [...]

by Rich read the rest at http://www.jubileeprosperity.com/financial-planning/baby-boomers-repent-partisan-politics-bend-uncle-sam/

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Marc Faber discusses America’s unsustainable debt load in this interview with Margaret Brennan on Bloomberg TV. An amusing observation: the GDP growth from each $1 of new total debt has dropped from $0.25 to -$0.60. Also some much deserved Bernanke and Krugman bashing. Why it is so difficult to realize that the only way out of the crisis is to cut corporate and sovereign debt, we don’t understand. Ah yes, because for that to happen, equity values across virtually all of the US economy would be wiped out… And that would destroy the myth that there is any real equity value in America.

 

Full Faber interview.

via Gurufocus, h/t Mike

by Tyler Durden via zero hedge
http://www.zerohedge.com/article/marc-faber-if-us-was-corporation-its-credit-rating-would-be-junk

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The choice selections from today’s Art Cashin comments, via UBS Financial Services:

Greek Rescue Rumor And Chippier Consumer Brings Stocks Back From Brink – For much of Friday’s session, fears about the European Union (particularly Greece) sent folks seeking the safety of the dollar. That, in turn, put pressure on oil; gold and stocks as carry trades were liquidated. The carnage began in earnest as the European markets closed. The dollar began to move steadily higher causing the above-noted damage.

The dollar driven selling was not as vicious as the selling on Thursday, but around 12:45 things started to turn rather ugly. They got even uglier as they headed to the day’s lows at 2:00. Rumors circulated that a trading firm in the crude pits was being forced to liquidate contracts.

But, shortly after 2:00, bids began to pop up in stocks as the dollar eased back. With some investigation, traders learned that there were rumors, or at least speculation, that the ECB and others might be cobbling together a rescue package for Greece over the weekend.

Stocks began to cut their losses as did gold. Crude remained hobbled by those liquidation rumors but cut its losses nonetheless. At 3:00, stocks picked up another tailwind. Consumer Credit fell $1.7 billion not the $10 billion some economists had projected. The hope that the American consumer might be willing to consume again helped the late rally.

That late rally was a bit of a mixed blessing. Had they closed on the lows, the probable course of the market might be a touch clearer. A close at the lows would have suggested an “oversold reflex rally” for Monday extending half-way into Tuesday’s session. The rally would then fail followed by a sharp and severe selloff. The late rally took that specificity off the table. We’ll have to review the napkins for clues to the amended course.

Greece And the Gordian Knot – As noted above, the late rally was sparked by speculation that there would be a rescue package announced over the weekend. When no announcement came forward, there was no follow-through on the rally.

The latest speculation is about the inverted yield curve for Greek bonds. That doesn’t allow any wiggle room or time to ease into austerity. Therefore “instant austerity” runs the risk of public backlash, strikes and maybe even unrest in the streets. To buy some time, some folks speculate, that the ECB or some entity could guarantee short term Greek debt – maybe up to one year. That might buy some time. It will be interesting to see if that’s the road that is taken.

Cocktail Napkin Charting – As noted above, the late Friday reversal rally was primarily the result of rumors of a Greek rescue package. There were also technical contributors to the bounce. The S&P made its intra-day low at 1044. That’s its 200 day exponential moving average. Both Walter Murphy and Stock Market Cycles had listed 1043 as a probable target (darn good call).

Friday’s lows will be a critical testing area on any future pullbacks. If they are violated, things could turn very ugly although some see more support at 1030/1035.

For today, the napkins suggest early support in the S&P may be around 1048/1052 with the backup 1040/1043. Resistance looks like 1070/1074 and then 1080/1085. We need to be careful because the Friday bounce may have released enough of the oversold to allow the bears another shot.

Consensus – Watch the dollar and the headlines and rumors from Euroland. If the dollar rallies smartly, things could get very ugly. Stay very nimble.

Trivia Corner Answer - To heir today - The middle son brought the ailing horse an apple every other day. Today’s Question - Heads up! Each of the following 4 letter words can be made an 8 letter word by adding the same 4  letter word to each one. (Example - If we gave you step, ball, hold, work, path & fall….the answer would be “foot”). What word fits - A) Some; Pick; Bill; Book; Rail. B) Line; Style; Long; Boat; Like; Size. C) Ding; Boy; Man; Vampire. D) Kingdom; Way; Nations, State.

 

by Tyler Durden via zero hedge
http://www.zerohedge.com/article/february-8-insights-art-cashin

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Attempts by carry traders to redeem some P&L after a month of agony crashed and burned promptly, accelerating into the close as the Yen funding unwind killed not just the carry pairs but broader equities. Of particular note is the hurt experienced by AUD longs funded with either USD or JPY.

It is officially time for Goldman to enter the stop losses on its various carry trades. The pain for the (leveraged) BRLJPY trade has now become unbearable.

The market took out the Friday’s ES VWAP close and robotic selling panic set in.

This is what a perfectly uncorrelated market looks like. Sarcasm off.

Time to officially bury the Dow 10,000 v2.

by Tyler Durden via zero hedge
http://www.zerohedge.com/article/carry-trade-implosion-precipitates-robotic-selling-close-1055-es-level-breached

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One of the less-reported events this weekend was the not so secret central banker meeting that is taking place in Sidney Australia. Now that factual details are finally emerging it is appropriate to collect some information tidbits about this shindig which has some claiming is reminiscent of a modern day version of the Jekyll Island meeting. From the Sydney Morning Herald.

CENTRAL bankers are an unobtrusive breed by nature and necessity. So it might have escaped the attention of many that Sydney is playing host to a meeting of some of the world’s top money men and women to celebrate the 50th birthday of the Reserve Bank of Australia.

However, a secretive gala dinner at the Art Gallery of NSW to mark the event last night attracted a who’s who of Australia’s political and business world.

Past treasurers included Peter Costello, John Dawkins, John Kerin and Ralph Willis. And, of course, the RBA was well represented, with governor Glenn Stevens and former governors Ian Macfarlane and Bernie Fraser in attendance.

Around 7.15pm, John Howard and his wife Janette arrived, almost at the exact time as Mr Costello, from the other side of the entrance. The pair met, shook hands, and offered a polite ”Good to see you” before moving up the stairs.

The visit by central bankers includes the president of the European Central Bank, Jean-Claude Trichet, the presidents of the Federal Reserve Banks of San Francisco and New York, Janet Yellen and William Dudley, the governor of the People’s Bank of China, Zhou Xiaochuan, the governor of the Bank of Israel, Stanley Fischer, and New Zealand’s Reserve Bank governor, Alan Bollard. Last night, some of these bankers were spotted being bussed from their meeting venue at the Sheraton on the Park Hotel to the Art Gallery. The event was held in the Grand Court, which seats up to 350 people.

They drank champagne before looking at artworks and sitting down for dinner entertained by a jazz trio.

The visit by the central bankers comes as world markets fear a second wave of financial stress if the Greek government defaults on its debts. There is also talk the stresses could lead to a break up of the European Union’s common currency, the euro.

The low profile of the meeting is also a matter of design. Security is tight and the location of events a closely guarded secret.

Today’s meetings will kick off with a session to discuss a paper co-authored by Mr Stevens on the challenges facing central banks. Mr Macfarlane will chair a second session on the financial sector, and the day will conclude with a discussion led by Ross Garnaut on supply side issues.

Last night’s dinner came after meetings at the Sheraton between Mr Stevens, Mr Trichet and Mr Bollard.

So, does the health of the world’s bankers reflect the ailing global market? A NSW Ambulance waited outside the Art Gallery all night just in case.

It has also turned out that the meetings are organized not by the Australian government, but by the BIS.

Sydney - Central bankers are to meet in Australia’s biggest city for two days of talks as plunging stock markets renew fears of a slow and patchy recovery from the global financial crisis, Sydney’s Herald Sun reported Saturday. The paper said representatives from 24 central banks, including the US Federal Reserve and the European Central Bank, are to assemble Sunday and Monday in an undisclosed location.

The organizer of the meeting is the Bank for International Settlements rather than the Australian government, which would help explain why secrecy prevails.

The governors of the People’s Bank of China, the Bank of Japan and the Reserve Bank of India are said to be on the guest list.

The gathering, arranged last year, takes place against a background of world share markets reeling from fears that governments, not just companies, may have difficulty with their balance sheets.

“It’s been a long time since we have seen really serious sovereign risk in developed economies,” Gerard Minack, the head of brokerage Morgan Stanley’s Australian operations, told the public broadcaster ABC. “We don’t have a lot of history to go by, at least in the modern era.”

Minack said the concern was not just about Greece, Spain and other southern European countries - the so called Club Med - but about other economies.

“We are now seeing it spread around the ring of fire that surrounds core Europe,” he said. “I mean, Eastern Europe looks terrible. We know already there are concerns about the Spanish, the Italians, possibly the Japanese.”

It is surprising that two critical concurrent meetings as a G7 event in the Arctic circle would take place while half a world away, both in latitude and longitude, those very countries’ central bankers were meeting at the same time. Of course, that events in Europe, the end of QE in England, the imminent end of QE in the US, and the sudden and much hated by central bankers resurgence of the dollar are happening at the same time is merely a coincidence.

h/t Shannon

by Tyler Durden via zero hedge
http://www.zerohedge.com/article/some-more-perspectives-weekends-secretive-banker-meeting-syndey

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Developing story. The probability of Rakoff turning down SEC Settlement #2 just went up substantially.

by Tyler Durden via zero hedge
http://www.zerohedge.com/article/judge-rakoff-review-sec-settlement-says-major-differences-between-secs-facts-and-cuomos-fili

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We have so far avoided discussing this weekend’s most tragicomic news, which undoubtedly is the Mortgage Bankers’ Association selling their headquarters for a huge loss in less than two years. The building which was acquired for $76 million was sold to CoStar for $41.25 million. How the MBA is in any way supposed to provide insight on sentiment and market perspectives after a slap in the face such as this is beyond us. At best, they should start a $2.95 newsletter titled “How to top tick the market and never look back while waiting for the Dow 36k.” The other implications of this transaction are self-explanatory. Yet courtesy of diligent readers, we have received some other very amusing information, which however focuses on the buyer in this transaction, specifically CoStar, which on its website brands itself as the “#1 Commercial Real Estate Information Company.” Apparently the validity of this branding is only as good as the (un)solicited hot tips CoStar receives every day. A letter sent out earlier by an editor of CoStar’s Watch List Group seeks to expand on the groupthink permeating the permabullish CRE investor landscape (we hope they approached Cohen and Steers with their query for an objective and unbiased perspective), with a set of questions that makes one question the validity of CoStar’s self-branded characterization.

We present the letter in its redacted entirety and request that helpful readers will provide their CRE perspectives to an otherwise confused CoStar:

From: XXXX
Sent: Monday, February 08, 2010 7:31 AM
To: XXX
Subject: Comments sought for upcoming Watch List story on CRE Loan Sales

Judging by FDIC numbers, 2009 was a huge year for sale/purchase of CRE debt. The FDIC alone sold about 3,500 CRE loans with a book value of more than $6.1 billion. That compares to CRE loans sales in 2008 of just $153 million.

I am preparing a story for an upcoming Watch List article sort capsulizing that activity. Any color or insight on any of the following points you could provide would be greatly appreciated.

How active is the market for CRE debt right now?

What is the outlook for 2010?

In a nutshell, what is the profile of the most active buyers in the market? And most active sellers?

Does there seem to be a preference for performing or nonperforming debt and does the quality dictate the type of buyers and sellers.

Does there seem to be a preference for loans by property type? And if so why?

Thanks in advance for taking the time to consider this request.

Sincerely

XXX
The Watch List Newsletter
CoStar Group

 

by Tyler Durden via zero hedge
http://www.zerohedge.com/article/costar-seeks-your-input-truth-behind-commercial-real-estate

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Janet Yellen, who in mid-November completed a “fact-finding” trip to Hong King and China, provides some insightful observations into the closely tied monetary fates of China, Hong Kong and the US, as well as China’s Catch 22 paradox of overcapacity. As Yellen points out, US monetary policy is a critical factor for both Hong Kong and the mainland “both Hong Kong and the mainland are currently pegging to the dollar, they are both to some extent stuck with the policy the Federal Reserve has chosen to promote recovery.” In essence, and in confirmation with Zero Hedge’s “vassal theory” of the Sino-US relationship, China has a “considerable interest” in the Fed’s exit strategy. Yellen demonstrates that while China is forced to look to growing its own internal economy now that the export-led, current account surplus model is over, the transition will require yet more stimulus, thereby further inflaming the asset bubble, spurred by the massive overcapacity already in place in the country, and further pushing the country into a monetary-fiscal zone of disequilibrium. This would be exacerbated by any move to strengthen the Yuan, which is what has to happen for the US to keep inflating its troubles, yet won’t happen so long as China continues being in denial about its bubble conditions, thanks to a phenomenal precedent set by none other than the Federal Reserve itself. Yellen won’t go so far as admitting it, but all the ingredients for a massive Chinese (and thus, U.S.) crash are now in place.

The problem for China as it struggles to readjust from an export-led economy, is that admitting a need to focus more internally, would suggest even more stimulus is needed to prop up precisely the sectors where immediate job creation is greatest. For China keeping its population employed and happy is critical which is why “given the difficult in winding down the engines of job creation will make a transition toward a less trade-oriented growth strategy” to take place slowly.

Yellen then highlights some of the critical flaws in the economic model and makes a full circle to what Hugh Hendry was discussing yesterday about substantial Chinese overcapacity (and why he took some not so friendly jabs at Jim O’Neill):

To hold down the renminbi’s value in the face of continuing trade surpluses and sizeable capital inflows, China’s central bank has had to buy dollars at a rapid pace. The result is that China’s foreign exchange reserves have now swelled to over $2.25 trillion dollars (see Figure 3). China’s money supply has also increased rapidly. Inflation in China has turned up, and most analysts with whom we met recognized that the renminbi will need to be revalued and monetary policy tightened to avoid inflation. Even though future exchange rate adjustments seem all but inevitable, they are unlikely to resume until at least the middle of 2010 because of lingering concerns about the pace of economic recovery among China’s major trading partners.

Alas, it is dangerous to confuse wishful thinking with reality. And China is more than likely going to need a persistently weak currency even as it struggle with increase price pressures which will demand that the Yuan rate be let loose again.

And, at the very bottom of it all, is the problem which Hendry highlighted so well - massive overcapacity.

Household consumption is already growing at a robust double-digit pace. The problem is that investment is growing at an even faster pace, so the household consumption share is likely to continue to decline. Moreover, the stimulus packages introduced to counter the global recession have had the unfortunate side effect of acting against reform, since the bulk of stimulus was in the form of increased investment, which primarily found its way into the export-oriented and state-owned sectors, or into infrastructure projects that supported these sectors. The consequence is that the stimulus has exacerbated overcapacity in Chinese manufacturing and increased pressure on Chinese firms to export.

Bottom line - China is screwed, and every false move performed by the Fed, whose actions by implication reflect in China’s broader monetary policy, will be amplified and make the bubble increasingly worse, as the right move here, which is for China to cut down on its stimulus and to focus on the growth of its own economy, will likely not occur before it is far too late. One should just look to the US to see how eager politicians are to step away from a tenuous and ultimately destructive status quo and proceed to do the right things needed to fix a broken system, which however would result in significant popular revolt and most likely a near-certain loss in any future political elections/referendum. This is precisely why the economic system, from a physical system perspective, is teetering on the balance and is about to break.

Full must read FRBSF Economic Letter.

 

by Tyler Durden via zero hedge
http://www.zerohedge.com/article/janet-yellen-discusses-china-paradox

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