A Paper You MUST Read


A Paper You MUST Read

Posted by Karl Denninger

Buried in the smoke and furor yesterday was the second panel in the FCIC testimony – the one CNBC did not provide any meaningful coverage of.

And right up front is the one person’s testimony you need to read.

That would be Michael Mayo.

Mr. Mayo hits on the themes that I have been hammering for the last two and a half years, absent some of the pointed allegations of knowing deception (that’s otherwise called “fraud”.)

Mr. Mayo used to work at The Federal Reserve, and was there during the previous banking crisis.  He points out, as has Bill Black, that we learned nothing from the S&L crisis when it came to lessons on control fraud and overextension of risk, and in fact we’re doing it again.

He calls out ten failures, and then puts forward three prescriptions.  I will not reproduce them here, since I maintain that everyone who reads The Ticker owes it to themselves not to read my summary, but rather to read Mr. Mayo’s original work – every word of it.

I will capture a few points however:

  • It is pointed out that it is difficult to recreate the reality of a balance sheet through analysis if the numbers are not reported on a similar basis. Exactly.  I cannot, today, analyze a given bank’s balance sheet and tell you whether I believe they are in good health or bad, whether their cash flow is sufficient to service their debt, or the likelihood that their assets will perform.  This obfuscation is intentional and in no small part a direct consequence of lobbying by the banks themselves for the ability to provide other than market prices for alleged assets!
  • Mr. Mayo asserts that there is such a thing as “too big to fail.”  I argue that if JP Morgan is too big to fail then anti-trust law says they’re too big to legally exist, as they continue in business with a de-facto unlawful “put” from the federal government, acquired through what amounts to extortion, that smaller institutions do not enjoy.  This is the essence of anti-trust law – that some firms, when they control too much of a market, abuse that position to gain advantage and shut out competition through collusive action.  This is what the “government PUT” for “too big to fail” entities comprises and the solution is simple: If you have to be bailed out in any way by the government you are broken up and your entire management team is permanently barred from ever serving as an officer of a public company again.  No ifs, ands or buts.
  • Mr. Mayo also talks about capital and the need to be certain that there is never a question as to whether there is enough.  The simplest way to do this is to impose hard leverage limits and require that liquid and/or immediately-convertible capital be present at all times to cover any potential deficiency on carried assets.  At the same time all off-balance sheet exposures and naked derivative positions must be absolutely barred.  The simplest means to accomplish this is to restore Glass-Steagall, thereby removing the ability of commercial banks to play with levered instruments in the first place, limiting their leverage to their reserve ratio, and reinstate mark-to-market accounting performed nightly.  Bingo: We know you have enough capital in each and every case, and if you get close to the line you’re forced to divest assets or convert some of your prearranged debt to equity.

Folks, these solutions are not technically difficult.  They are politically difficult but the question we need ask ourselves in this country is this:

Are we willing to undergo another crash similar to 2008/2009?  WE WILL if we don’t stop the insanity, and it will likely come sooner rather than later.

The bad debt on the balance sheets of the banks and others has not been removed, either by payment or default.  It is being carried at values that suggest performance will occur even in instances where we know that is very unlikely, such as with second mortgage lines (HELOCs, etc) that are underwater.  When, not if, the foreclosures occur on the senior (first) mortgages these lines will be exposed as worthless, triggering another problem.

Nor is the issue confined to second lines.  Commercial Real Estate, OptionARMs and allegedly-“prime” loans that in fact were not all are deteriorating in record numbers.  These losses have already occurred and are being hidden, but that charade can continue only so long as the cash flow permits.

This is why there are no meaningful numbers of permanent modifications on mortgages nor will there be – the program cannot succeed as for it to do so the losses embedded in these institutions must be admitted to and recognized, and our government refuses to force that to happen.

The current attempt is to re-inflate house prices and thus pretend the crisis has past.  But we have destroyed our wage base over the last 18 months, which has simply compounded more losses into what were doomed loans, rather than forcing the defaults out into the open and selling them off at whatever price they would fetch.  By doing so we have literally added hundreds of billions of additional dollars in loss to what was already a horrible situation, and that loss has now been accrued and will not be able to be avoided either.

Within a few years time (before 2010) we will face a new problem – boomer retirements will go “over-center” and they will be net sellers of all asset classes to fund their retirements, while entitlement spending will ramp toward the moon.  That problem is extremely serious but on the path we are on now we will not get there before what we believe avoided smacks us.

Our choice is to take our medicine now and be able to recover before this tectonic shift occurs with boomer retirements and entitlement spending, or walk straight into that mess in the midst of a decade-long depression.