The Fed has been actively beefing up the earnings and balance sheet of financial institutions in four major ways.

First, a 325bps reduction in the Fed Funds rate sharply reduced the cost of
borrowing for banks and allowed them to enjoy a nice intermediation margin (the
difference between longer terms interest rates at which they lend and the much
lower short term interest rates at which they borrow). This steepening of the
yield curve is a major subsidy to financial institutions.

Second, the Fed has created a range of new liquidity facilities - the TAF,
the TSLF, the PDCF - that allow banks and now non-bank primary dealers to swap
their illiquid toxic asset backed securities for liquid Treasuries and that
provide access for non-banks - and now also Fannie and Freddie - to the Fed's
discount window liquidity.

Third, the bailout of Bear Stearns creditors - JP Morgan and many other
counterparties of Bear - not only avoided a systemic meltdown and a certain run
on the other broker dealers but it has led the Fed to take on a significant
credit risk by taking off the balance sheet of Bear Stearns over $29 billion of
toxic securities. So the Fed has directly and indirectly systemically subsidized
and propped up the financial system and the earnings of bank and non-bank
financial institutions.

Fourth, a variety of forbearance regulatory actions - starting with the
waiver of Regulation W for some major banks - have been used to beef up the
profits and earnings of financial institutions and reduce their reported
writedowns.

The entire Federal Home Loan Bank system - another GSE system that is another effective arm of the government - has been used to prop hundreds of mortgage lenders. The insolvent Countrywide alone received more than $51 billion of funds from this semi-public system. This is a system that has increased its lending in the last 18 months by hundreds of billions of dollars: Citigroup, Bank of America and most other US mortgage lenders have also been beneficiaries of this public subsidy to the tune of dozens of billions of dollars each.

...

In spite of the headline figures that showed better than expected earnings at some major financial institutions - Citi, JPM, Wells Fargo - the details were utterly ugly. For one thing, Merrill announced massive writedowns and losses that were much worse than expected. Second, even JPMorgan's results details were worrisome: for example the recognition of a significant amount of rising losses on prime mortgages. In the case of Citi - a firm that has a presence in over 100 countries and whose revenues come, to a great extent, from foreign operations - there was a sharp increase in the losses on its consumer credit operations, including a large increase in delinquencies on credit cards both in the US and other markets (Brazil, Mexico). Thus, after having already shut down its money losing consumer credit operations in Japan, Citi is now experiencing a surge of delinquencies on unsecured consumer debt both at home and abroad. And the reserves set aside to take care of such expected loan losses are still woefully insufficient as they are based on very optimistic assumptions about the level at which such delinquencies will peak; this is another way to pad earnings and not recognize early on such losses. Systematic use of creative accounting is at work in all of these institutions and other banks and other financial institutions to hide the extent of the incoming losses on assets and loans.

With the excuse of wanting to crack down on "manipulators" the SEC has now imposed restrictions on short sales on the stocks of 19 major financial institutions including Fannie and Freddie. Let us be clear about this new rule: this is a clear and naked attempt by the SEC to manipulate upwards the price of equities of financial firms. The SEC should start investigation and legal action against itself for actively manipulating the stock market. And shame on the SEC for this most un-capitalist and manipulative action: when there is an upward bubble in stock prices and 95% of investors/speakers on CNBC are talking their books in that most public forum to manipulate upwards their portfolio the SEC does nothing and allows this charade to go on. But when short sellers are shorting the stocks of firms that are likely to be bust that is considered manipulation. That is a pretty pathetic action by the SEC that has artificially boosted the equity valuations of US financial firms - now up 20% plus in the last part of the past week after the introduction of this manipulative rule. And of course this manipulated increase in financials' equity prices reduces the mark to market losses that banks and other financial firms holding such equities would have incurred, another additional way to pad upwards earnings.

The few and rare banks and mortgage/MBS analysts that were willing to provide a realistic assessment of the mortgage market and the financial conditions of US banks and brokers have been effectively muzzled by upper management. With the partial exception of Meredith Whitney who benefits from being at an independent research firm, many other analysts have gone into the spin mode that the Fed, the regulators and the senior management of these financial institutions have dictated to them. Sell-side research that was never independent - even after the additional Chinese walls that the corporate scandals of the early part of the decade led to - is even less independent today. So you have financial institutions manipulating at will their earnings and analysts falling for this supreme baloney.

The FDIC will for sure run out of money as hundreds of banks will go bust and their depositors will have to be made whole given deposit insurance. With funds of only $53 billion, already up to 15% of such funds will be used to rescue the depositors of IndyMac alone. Thus, the FDIC is already requesting to Congress that the deposit insurance premia should be raised to compensate for this shortfall of funding. Too bad that this increase in insurance premia - that should be high enough in advance (not ex-post) to ensure that deposit insurance is incentive-compatible and not leading to gambling for redemption via risky lending in banks - is now too little and too late and is requested when the damage is already done as the biggest credit bubble in U.S. history is now going bust. Also the FDIC has done a mediocre job at identifying which banks are at risk. So far there are only about 90 banks on its watch list; and IndyMac was not put on that list until last month! So if the FDIC did not even identify IndyMac as in trouble until it was too late, how many other IndyMacs are out there that that the FDIC has not identified yet? Certainly a few hundred but such honest analysis of banks at risk is nowhere to be found.

As I have argued in previous work all independent broker dealers are in deep trouble and may not survive - in a few years' times - as independent firms. And some of them are already walking zombies. In a few years time there will be no major independent broker dealers as their business model (securitization, slice & dice and transfer of toxic credit risk and piling fees upon fees rather than earning income from holding credit risk) is bust and the risk of a bank-like run on their very short term liquid liabilities is a fundamental flaw in their structure. I.e. the four remaining U.S. big brokers dealers will either go bust or will have to be merged with traditional commercial banks. Indeed, firms that borrow liquid and short, highly leverage themselves and then lend in longer term and illiquid ways (i.e. most of the shadow banking system) cannot survive without formal deposit insurance and a formal permanent lender of last resort support from the central bank. (They did have quite a long run though - Jesse)

While a formal government bailout of most U.S. financial institutions has not occurred yet the U.S. government has avoided such bailout only by making sure that foreign government-owned institutions - the Sovereign Wealth Funds - did that job in lieu of the U.S. government. So instead of the U.S. government recapitalizing U.S. financial institutions we have seen foreign governments doing the job. Too bad that such SWFs have already lost 30% to 50% of their initial investments in such financial institutions. Thus, while U.S. financial firms will need hundreds of billions of additional capital injections to survive this crisis it is not obvious that foreign governments (SWFs) will not require conditions for such recapping (a percentage of equity that implies control, board membership, voting powers, common shares rather than preferred stock, etc.) that may not be politically acceptable in the U.S.

One could go on in more detail - as I have done in recent analyses - in discussing the severity of the current banking and financial crisis in the U.S. and how the official figures on earnings and balance sheets of financial institutions provide a misleading picture of the real financial state of such firms. As I argued before the $1 trillion of credit losses ($300-400 bn for mortgages and $600-700 bn for all the other non-mortgage credit) that I estimated last February are only a floor, not a ceiling, for such expected losses. Such losses are likely to end up being closer to my $2 trillion estimate. And such an estimate do not include the $200 to 300 billion that the rescue of Fannie and Freddie will entail. And such losses don't even include scenarios where up to 50% of households who will end up underwater will walk away from their homes: that factor alone could entail mortgage losses of $1 trillion (average mortgage of $200k times the 50% loss that a foreclosure/walk away implies on that mortgage times 50% of the 21 million households that are underwater) rather than the $300-400 bn that I originally estimated.

So when you add it all up this will be the worst financial crisis since the Great Depression: not as severe as that episode but second only to it. And the real effects of this financial crisis will be severe and more severe if remedial policy action is not rapidly undertaken. Ditto for the US recession: this will be the worst of such U.S. recessions in decades.

pour stiff drink and read the rest

~"When an inner situation is not made conscious, it appears outside as fate." Karl Jung~