Rolfe Winkler

Already, we’ve written about NY’s budget hell.  Adding to the pressure, estimated tax payments came in too heavy earlier in the year, necessitating $800 million worth of rebates through October.  According to the NYT:

New York City, grappling with the aftershocks of the global financial crisis, has been forced to refund more than $800 million to companies that overpaid their taxes this year based on expectations of a more robust business performance.

The refunds — three times the amount typically returned — have triggered deep unease among city budget officials, who are already struggling with weakening revenue and face pressure to slash services and raise taxes.

They come as the city, according to the Bloomberg administration, faces a budget shortfall that is expected to climb to $4 billion over the next two years. And having to give back such a large amount of money is certainly going to make the situation even bleaker.

And because cash is king in a credit crunch:

In a departure from previous years, when the companies would simply instruct the city to apply any overpayment to subsequent tax bills, they are demanding the cash now.

The amount the city must pay back is likely to surge again in the next two months, analysts who follow the city budget said, as companies stymied by tight credit markets scramble for additional money to pay for operating expenses and other needs.

The article notes that NY State is having a similar problem, having had to refund $1 billion so far this year, up from $581 million in the first 10 months of last year.

NY State/City will continue to be sources of cash for companies in desperate need of liquidity.

[Today on OA, a guest column by Dash Riprock.  Dash previously worked as a CDO underwriter at a U.S. brokerage house in New York.  He currently helps evaluate fixed income derivatives for banks and insurers.]

With all the talk of bank failures and government involvement here on OptionARMageddon and throughout the media, I thought it made sense to explain a basic concept that investors and regulators use to measure solvency: how assets are “risk-weighted” in order to measure banks’ so-called “Tier 1 capital ratios.”

Rolfe (rightly) has been estimating the amount of leverage (and, by extension, a rough relative default probability) by looking at companies’ tangible assets relative to tangible equity.  Again, Leverage = Assets/Equity.

Reiterating the basic definition of “tangible equity,” imagine that a company’s owner decided today that he was going out of business. He holds a going-out-of-business sale and sells everything—buildings, office equipment, any securities the company held, and so on. Once he has sold all his assets, he uses the proceeds to pay back all his lenders (bonds and loans), his senior equity holders (preferred shares) and, if he’s a financial, anyone who has given him money to hold or invest (depositors).  Tangible equity is what’s left after the business has been liquidated and all its debtors paid off.

Unfortunately, it is not easy for the casual investor to find tangible equity figures.  For starters, when it comes to banks, it’s nearly impossible to set the value of illiquid financial assets like CDOs.  But another reason investors may have trouble finding tangible equity stats is that they are rarely reported.

There are a couple of reasons for this.  The most cynical perhaps: If companies reported their true tangible equity, even more investors would run for the hills. The 280x tangible leverage that Rolfe calculated earlier for Citigroup is a pretty terrifying number. For an individual with $100,000 in assets to run that leverage ratio (let’s call her Cindy), she would need to borrow $27.9 million. Even the worst mortgage banker wasn’t handing that type of money out to borrowers, which is why you could imagine Citi investors weren’t totally comfortable with their position.

But the more accurate reason that banks don’t report leverage numbers like ‘tangible equity’ is because the balance sheet is only half the story. Let’s look at Cindy again: she has $100,000 of assets to start and is borrowing $27.9 million for a total of $28 million, and she is planning on investing that money in good faith, because she wants to pay her lenders back. So she is considering two business plans:

1. Investing all $28 million into BBB-debt (rated Baa2/BBB by Moody’s/S&P)
2. Investing $20 million into short term (less than 1-year) treasuries and $8 million in AAA-debt (rated Aaa/AAA by Moody’s/S&P)

Now in both cases Cindy has an assets-to-tangible-equity leverage ratio on her investments of 280x. But in case 1, the risk of loss on her investment is much, much higher than in the second. In fact, if Cindy can borrow at a rate around treasuries (maybe she locked in some great rates when the market was lending money to anyone and everyone) then case 2 might be an ok deal for everyone involved.

So how do you compare the relative risks of the two situations? You adjust the leverage for the relative risk of the portfolios. This is known as risk-weighting and became a key part of bank analysis after Basel I in 1992.

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Here’s a hilarious story (via SWF Radar).  Libya has a sovereign wealth fund, and Gadhafi’s son said he wants to invest here in the U.S.:

Libya wants to open a new chapter in relations with the United States by investing some of its $100 billion sovereign wealth fund in U.S. companies and sending thousands of students to study in America, the son of Libya’s leader said Friday…

He said Libya’s new sovereign wealth fund, a government-owned investment fund with almost $100 billion, “wants to invest here in America” despite the current financial crisis.

Because the fund is new, he explained, “we avoided that tsunami, the big wave. We escaped that risk, and now we are in good shape to invest right now.”

Why invest in the United States?

“This is a great country with the biggest economy in the world, with a great opportunity,” the younger Gadhafi said. If some companies are having financial troubles “it doesn’t mean the whole economy is collapsing and it’s useless to invest here. Of course not. I think just the opposite. It’s the right time to invest here.”

Thanks Moammar, for helping out a friend in need.  Can you talk Ahmadinejad into forking over $50 bil?  Detroit could really use it.

In all seriousness, congratulations to W. on the rapprochement with Libya, his greatest (only?) foreign policy achievement.

For all of you asking: “Why all these bailouts?” Below is why.

The Iceland economy is at a standstill after the implosion of its banking system.  What caused the implosion?  A ridiculously overleveraged banking system, not unlike our own.

The bailouts are our government’s attempt to avert the kind of banking collapse that would reduce accumulated wealth to near zero (via a sudden nationwide bank run). My fear is that the banks are going to blow up anyway, and that if the Fed goes down with the ship, government will be powerless to help us out of this mess.

(Dare I say it?)  I wonder if Andrew Mellon’s infamous advice to Herbert Hoover might actually have been correct: “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate . . . purge the rottenness out of the system.”

Folks, especially those of you who are so vociferously against these bailouts, understand that without them, our banks would have collapsed by now, making a Depression more or less inevitable. That’s what’s happening in Iceland and that’s what would happen here.

My concern, and the reason I oppose the bailouts despite possibly Icelandic consequences, is that the long-run alternative is worse. Inflating a PUBLIC credit bubble to replace the imploding PRIVATE credit bubble solves nothing. A crash will come, the business cycle can’t be banished. By committing itself to guarantee all of the liabilities of the private financial system, the government will have little ammunition left once the downturn gets going in earnest.

(Thanks to Michael Y.($20) for his donation)

A good op-ed in today’s WSJ argues that the Fed is “out of ammunition” and that the fallout of this crisis, and in particular the government’s choice to fight it with unlimited guarantees, may well be the break-down of our monetary system.  It concludes with this:

In this respect the present crisis in the West will ultimately end up discrediting mechanical monetarism — and with it the fiat paper-money system in general — as the U.S. paper-dollar standard, in place since Richard Nixon broke the link with gold in 1971, finally disintegrates.

The catalyst will be foreign creditors fleeing the dollar for gold. That will in turn lead to global recognition of the need for a vastly more disciplined global financial system and one where gold, the “barbarous relic” scorned by most modern central bankers, may well play a part.

The Fed/Treasury can’t guarantee infinite liabilities without standing ready to print infinite dollars.

The yellow metal gets shinier as the Fed’s balance sheet gets messier…

(Here are part 1 & part 2 in case you missed them)

Why am I excluding preferred capital?  A great question from reader Mark.  GE and GS are both on my leverage chart, and not only an I excluding the preferred capital they raised from Buffett, I’m excluding the TARP capital injections as well.  Those represented increases in “bank capital,” and yet I’m not including them in my calculation of equity in the chart.  Here’s why, from the Treasury’s press release announcing TARP:

Under the [TARP] program, Treasury will purchase up to $250 billion of senior preferred shares on standardized terms as described in the program’s term sheet…

The senior preferred shares will qualify as Tier 1 capital and will rank senior to common stock and pari passu…

“Pari Passu” means “of equal step” in Latin.  So the preferred shares purchased by Treasury with the TARP money, and other preferred issuances to Buffett for example, rank “senior” to all common equity and anything else equivalent to it in the company’s capital structure.

What does that mean in English?  That common shareholders are still in-line to absorb the first losses.  If assets fall in value, common equity is the first thing to be marked down.  And it will get marked to zero before the preferred starts to lose dollar 1.

That’s why banks stocks kept falling despite the TARP bailout, especially after Paulson said the government wouldn’t be buying troubled assets.  When he said that, it became clear common shareholders would be the first to lose.

But not anymore!  With the Citigroup bailout today, the government is actually agreeing to absorb hundreds of billions of losses BEFORE common shareholders lose anything.  That’s why financial stocks are up huge, because Paulson reversed himself, saying the government WILL absorb losses.

Citigroup’s stock price confirms what the rest of us know to be true: this latest bailout (and all similar ones to follow) is simply a transfer of capital directly from taxpayers to Citigroup shareholders, to the tune of hundreds of billions of dollars.

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As I noted in my last post, I was being charitable when I calculated leverage ratios for the big banks.  Citigroup, for instance, has $165 billion of “Other Assets” listed on their most recent balance sheet.  The company deliberately does NOT provide additional disclosure regarding what’s in that bucket, not in the quarterly OR annual filings.  But an enterprising Bloomberg reporter seems to have tracked down at least one other intangible item lurking there, the same one that Fannie/Freddie counted as “capital”:  Deferred Tax Assets (hat tip JL).

As of Sept. 30, Citigroup’s net DTAs were about $28.5 billion, after subtracting deferred-tax liabilities. That represented 29 percent of the bank’s common shareholder equity and a whopping 80 percent of tangible equity, which excludes goodwill and other intangible assets. On a gross basis, DTAs were even bigger; the bank hasn’t disclosed how much.

If you subtract that $28.5 billion from assets and from tangible common equity, Citi’s leverage ratio goes from 56x to, um, 280x.  That’s because the denominator, tangible common equity, falls to only $7 billion.  Over which we still have nearly $2 trillion of on-book assets.  And again, we’re STILL NOT INCLUDING off-balance sheet commitments of $1.2 trillion.  David Reilly in the WSJ recently estimated that they may have to bring at least 20% of that amount back onto the balance sheet.  So the numerator in our leverage calculation continues to explode.

Everyone’s pointing at Citi because they’re the ones in the news THIS week.  But mark my words, all of the other banks will come crawling to the Fed and Treasury, demanding that the government absorb hundreds of billions of losses lurking on their balance sheets.

This is short-termism at its worst.  Sure the stock market is happy today that Citigroup isn’t going to fail.  But what happens when other banks come calling and the $7 trillion bailout (Bloomberg’s number) balloons to $10 trillion?  What happens when it’s clear there’s no way the government can possibly borrow enough to actually fund its guarantees?

On that day, I don’t want to be holding dollars.

So what is the capital cushion underneath our largest financial institutions?  I spent today compiling this spreadsheet:

Those are some ugly numbers and I’ll explain why. Citigroup’s leverage ratio of 56 means that the bank has $56 of assets for every $1 of common equity. If the value of those assets falls 2%, then common stockholders are wiped out. Here’s why: Assets = Liabilities + Equity.  If you understand this formula, you will understand the credit crisis. So read on…

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The Financial Times’ blog FT Alphaville has me going toe-to-toe with Dick Bove.  For the uninitiated, Dick is a high-profile banking analyst, regularly interviewed on CNBC.

He said last March to buy financials.  Oops.  He also said Lehman would survive.  Double oops.

Bove’s is the first block quote in the article.  Mine is the second.  Who comes out ahead?  I invite readers to be the judge…

Here, again, is the link.

The stock just keeps falling.  It’s at $3.70 as I write this (see chart down and to the right, hit refresh if it doesn’t appear).

And the selling pressure is likely to continue.  A close friend that works in JPM’s prime brokerage unit forwarded this report from CNBC.  The selling pressure will continue…

Most institutional investors and pension funds are barred from owning stocks below $5. So if Citigroup’s stock remains below that level, it could trigger a wave of selling that would send the share price even lower.

“That’s the danger of crossing that $5 threshold,” says Owen Malcolm, senior vice president of Sanders Financial Management in Atlanta. “They’re (Citigroup) already in trouble. It could get worse.”

Money managers don’t necessarily have to sell Citi immediately. But they would have to get out before the end of the quarter if the stock doesn’t recover and may opt to do so now to mitigate potential losses.

They aren’t all forced to sell out immediately.  But this will keep up the selling pressure.

I’d love to be a fly on the wall in today’s board meeting.

Don’t look now, but the other four big banks are also cratering. JPM is down nearly $9 in the last two days, WFC is down $14 the last two weeks. Both are at risk of going below $20.

And B of A is about to cross below $10.

And it’s in Treasuries.  Hopefully, Brad Setser doesn’t mind me borrowing one of his charts:

Remember, bond yields vary inversely with bond prices (see chart below for what flight to quality looks like in terms of bond prices).  People are willing to pay virtually any price to own short-term Treasuries.  (For any of my bond-trading readers, is it possible for a bond yield to go negative?)

People are so afraid to hold ANY risky asset, they’re willing to lend to the U.S. government for free.  Inflation?  Capital appreciation?  These are distant concerns next to capital preservation.  And yet the fundamentals of the federal govt’s balance sheet suggest this is a losing long-term bet.

Hopefully, this bubble doesn’t pop.  Hopefully it just slowly deflates.  Then again, take a look at this chart for LT debt circa the Great Depression (chart from Karl Denninger via Aaron Krowne):

That chart is for the long-bond index, and here’s Karl’s take-away:

The point here is that in the 1930s the government ringfenced and DID NOT contaminate its own balance sheet.  The rest of the bond market cratered but the US Treasury market DID NOT.

This time around the government IS the bond index because it has taken all the crap on itself.  Therein lies the danger…. if TREASURIES do what the index did in the 30s…… BOOM!

I fear there is no escaping major wealth destruction even from these levels as investors everywhere rush to exit all their investments.  What do they do with the money?  Much of it may be taken from them involuntarily as banks implode and their deposits disappear.  In the meantime, they’ll try to get as much cash out as possible amidst a global bank run.

The run has been on for some time, of course, though primarily at higher levels of the financial food chain.  It was a bank run that destroyed Wall Street, as well as IndyMac, WaMu and Wachovia.

An attentive reader noted that his mother, a bank employee, explained to him that fractional reserve banking is effectively a pyramid scheme.  New credit must always be available to roll over the loans of prior borrowers.  With the disappearance of credit, the pyramid scheme implodes.  Well said.

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The Citigroup Death Watch continues, according to the Journal:

The sell-off in Citigroup shares has led executives to start laying out possible contingency plans. In addition to pondering a move to sell the entire company to another bank, executives have started exploring the possibility of selling off parts of the firm, including the Smith Barney retail brokerage, the global credit-card division and the transaction-services unit, which is one of Citigroup’s most lucrative and fast-growing businesses, the people said.

Mr. Pandit, an enthusiastic defender of Citigroup’s existing mix of businesses, is loath to pursue such an approach, the people said.

Bank executives argue the company is well-capitalized, but that’s simply false. And the market knows it.  As I wrote a few days ago, Citi’s true leverage ratio (after backing out goodwill and intangibles from capital and adding back off-balance sheet liabilities and commitments) is somewhere between 35:1 and 70:1.  Even at the lower end, that means Citi is terribly vulnerable to a decline in the value of the asset side of its balance sheet.  PR efforts highlighting the bank’s “strengths” are kind of hilarious:

Executives in recent days have been telling traders, brokers and other employees to reach out to clients and tick off a list of factors that showcase Citigroup’s strength. On Thursday, for instance, executives in the wealth-management unit arranged a Friday-afternoon conference call for clients. A brochure that brokers were asked to share with clients promises that the call “will help you to better understand the current financial crisis.”

The government won’t let Citi collapse.  They’ll force a sale to another bank, like Chase, B of A, Wells Fargo, or perhaps a stronger, foreign rival.  But the problem is that we’re just building a bigger time bomb.  All of the above banks have very high leverage ratios.  Fundamentally, they’re not in a significantly better position to withstand the crisis than Citi.  The government will, perhaps, try to roll up all private banking assets into one super bank, which will receive unconditional government support.  And yet, the potential failure of the super bank could blow up even the government’s balance sheet.

Interesting times…

According to a confidential IAEA report, the site in Syria bombed by Israel last year was likely a nuclear reactor:

…The [IAEA]…said that soil samples taken from the bombed site had a “significant number” of chemically processed natural uranium particles. A senior U.N official, who demanded anonymity because the information was restricted, said the findings were unusual for a facility that Syria alleges had no nuclear purpose…

The report took note of Syrian assertions that any uranium particles found at the site must have come from Israeli missiles that hit the building, near the town of Al Kibar. And it cited Damascus officials as saying the IAEA samples contained only a “very limited number” of such particles.

But the report spoke of a “significant number of … particles” found in the samples.

The senior U.N. official said “the onus of this investigation is on Syria” and noted that the traces were not of depleted uranium — the most commonly used variety of the metal in ammunition, meant to harden ordnance for increased penetration. [i.e. the nuclear material found at the site was not from an Israeli bomb.]

If Syria was innocent, why would they destroy evidence at the site and restrict IAEA access to similar sites?

Satellite imagery made public in the wake of the Israeli attack noted that the Syrians subsequently removed substantial amounts of topsoil and entombed the building in concrete. But the report also suggested similar activities at three other Syrian sites of IAEA interest.

“Analysis of satellite imagery taken of these locations indicates that landscaping activities and the removal of large containers took place shortly after the agency’s request for access,” it said.

Beyond one visit in June to the Al Kibar site, Syria has refused IAEA requests to return to that location and examine the three other sites, citing the need to protect its military secrets.

In addition, said the report, “Syria has not yet provided the requested documentation” to back up its assertions that the bombed building was a non-nuclear military facility.

A few days ago, IAEA chief Mohamed El Baradei said that tests were inconclusive.  Given the actual contents of the report, it seems likely he was trying not to ruffle any feathers.  Syrian apologists take note.

Oh and by the way, the same IAEA report says that Iran is “stonewalling” inspectors:

The report on Iran — which also went to the U.N. Security Council — cautioned that Tehran’s stonewalling meant the IAEA could not “provide credible assurances about the absence of undeclared nuclear material and activities.” And it noted that the Islamic Republic continued to expand uranium enrichment, an activity that can make both nuclear fuel or fissile warhead material.

While that conclusion was expected, it was a formal confirmation of Iran’s refusal to heed Security Council demands to freeze such activities, despite three sets of sanctions meant to force an enrichment stop.

—What if there’s no such thing as a risk-free asset?—

The foundation of so-called “modern” portfolio theory is the concept of diversification.  A well-constructed portfolio should have a mix of asset classes—e.g. stocks, bonds, CDs—and a mix of securities within each asset class—e.g. large cap and small cap stocks.  There’s no way to guarantee that a particular stock or bond will make you money, so better to keep your eggs in multiple baskets.  Or just buy a mutual fund.

But why hold stocks, bonds or CDs to begin with?  Because each has a distinct risk/return profile.  Stocks carry relatively higher risk, but they also offer the prospect of higher returns.  Again, in theory.

“CAPM” is an acronym for “capital asset pricing model,” a simple financial equation that determines the “required rate of return” for an asset.  Sounds complicated, but it isn’t.  In fact, anyone with savings to invest uses this theoretical framework all the time.  (I’m going somewhere with this, I promise.)  Here’s an example of the CAPM model using Goldman Sachs stock:

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Quality of life in NYC is likely to deteriorate over the next few years as state/city governments make draconian cuts and/or raise taxes to balance their budgets.  According to the Journal:

…New York finds itself in a particularly perilous spot because of its increasingly heavy reliance on the financial sector as its tax base. This summer, Gov. Paterson offered a stark example of the challenges: The top 16 banks paid $173 million of state taxes in June 2007, but that number fell to just $5 million this past June. And the financial sector generates one in five state tax dollars today, up from just 3% of state tax revenue in 1980.

The state’s budget division now projects a 35% drop in capital-gains revenue and a 43% decrease in bonuses. That alone would translate into a year-over-year decline of $20.7 billion in income, much of it taxed at the top rate.

Wall Street won’t have taxable income for years.  And banks that survive will have tax loss carryforwards to offset profits for a decade.  And big bonuses for bankers themselves are gone for the foreseeable future.

Already NYC subways and buses face significant cuts and fare hikes, including:

…[wiping out] the W line, zapping the Z line and axing more than 1,500 NYC Transit jobs…

…the $2 base bus and subway fare is on track to being raised to $2.50 or $3 without a state bailout.

To Governor Paterson’s credit he wants to balance the budget by making cuts, not by raising taxes:

Gov. Paterson has rejected calls for higher taxes on the wealthy — unlike New York City Mayor Michael Bloomberg, who has proposed tax increases.

“[T]he higher we tax even the wealthy, the more we lose population and the less job creation there is,” Gov. Paterson said in an interview Friday. “We’re pretty resigned to the fact that we’re going to have to do this with spending cuts.”

Paterson, the Democrat, would not raise taxes.  Bloomberg, the former Republican, would.  Already we pay CITY income taxes at rates between 2.5% – 3.7%, the highest in the nation I believe.  We also pay STATE income taxes at rates between 5 – 7%.  Many states have no income tax whatsoever.

There’s plenty of fat to cut, especially Medicaid, on which NY State spends far more than any other state in the union, or did as recently as 2005.

(Here is a fascinating NYT article on fraudulent billing in NY’s Medicaid program.  AIDS drugs redirected to bodybuilders, a dentist billing 900+ procedures in a single day, a school official sending multiple thousands of students to “speech therapy” without evaluating any of them, again, in a single day.  The article is 3 years old, but I suspect things haven’t improved too much.  When government programs get this big, there are bound to be inefficiencies and fraud.  I bet the story is similar in other states.)

[Thanks to Pawel Y. ($20) for his donation]